Reforming Corporate Governance in Southeast Asia: Economics, Politics, and Regulations 9789812306326

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Reforming Corporate Governance in Southeast Asia

The Institute of Southeast Asian Studies (ISEAS) was established as an autonomous organization in 1968. It is a regional research centre for scholars and other specialists concerned with modern Southeast Asia, particularly the many-faceted problems of stability and security, economic development, and political and social change. The Institute’s research programmes are the Regional Economic Studies (RES, including ASEAN and APEC), Regional Strategic and Political Studies (RSPS), and Regional Social and Cultural Studies (RSCS). ISEAS Publications, an established academic press, has issued more than 1,000 books and journals. It is the largest scholarly publisher of research about Southeast Asia from within the region. ISEAS Publications works with many other academic and trade publishers and distributors to disseminate important research and analyses from and about Southeast Asia to the rest of the world.

Reforming Corporate Governance in Southeast Asia

First published in Singapore in 2005 by ISEAS Publications Institute of Southeast Asian Studies 30 Heng Mui Keng Terrace Pasir Panjang Singapore 119614 E-mail: [email protected] Website: http:///bookshop.iseas.edu.sg All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the Institute of Southeast Asian Studies. © 2005 Institute of Southeast Asian Studies, Singapore The responsibility for facts and opinions in this publication rests exclusively with the editor and contributors and their interpretations do not necessarily reflect the views or the policy of the Institute or its supporters. ISEAS Library Cataloguing-in-Publication Data Reforming corporate governance in Southeast Asia : economics, politics, and regulations / edited by Ho Khai Leong. 1. Corporate governance—Asia, Southeastern—Congresses. I. Ho, Khai Leong, 1954HC441 A843 2004 2005 ISBN 981-230-291-3 (soft cover) ISBN 981-230-295-6 (hard cover) Cover design by Elaine Ho Typeset by International Typesetters Pte Ltd Printed in Singapore by Utopia Press Pte Ltd

CONTENTS

List of Tables List of Figures List of Contributors Acknowledgements Foreword by J. Y. Pillay

viii x xi xvii xix

Introduction HO Khai Leong

xxi

Part I

Overviews

1

1.

Corporate Governance: An Alternative Model Madhav MEHRA

3

2.

Political Institutions and Corporate Governance Reforms in Southeast Asia WU Xun

16

3.

Disclosure, Reporting, and Derivative Actions: Empowering Shareholders in Southeast Asia LOW Chee Keong

38

4.

Governance Reforms in the Banking Sector in Southeast Asia: Economics and Institutional Imperatives Dipinder S. RANDHAWA

51

vi

Contents

Part II Country Studies

83

Malaysia 5.

Corporate Governance Reforms in Malaysia: Issues and Challenges CHEAH Kooi Guan

85

6.

Corporate Governance in Malaysia: Reforms in Light of Post-1998 Crisis Philip KOH Tong Ngee

102

Indonesia 7.

Indonesia’s Tolerated Low-Speed Reform of Corporate Governance Djisman S. SIMANJUNTAK

157

8.

The Political Economy of Corporate Governance in Indonesia Andrew ROSSER

180

Thailand 9.

Building Good Corporate Governance after the Crisis: The Experience of Thailand Deunden NIKOMBORIRAK

10. National Corporate Governance Committee: Three Disciplines for Good Corporate Governance in Thailand Saravuth PITIYASAK

200

223

Singapore 11. State of Corporate Governance Reforms in Singapore: Economic Realities, Political Institutions, and Regulatory Frameworks Kala ANANDARAJAH

241

12. Corporate Governance Reforms and the Management of the GLCs in Singapore: Pressures, Problems, and Paradoxes HO Khai Leong

269

Contents

vii

Philippines 13. From the Inside Out: Reforming Corporate Governance in the Philippines by Engaging the Private Sector Felipe ALFONSO, Branka A. JIKICH and René G. BAÑEZ

299

14. Corporate Governance of Financial Institutions: The Philippine Case Mario B. LAMBERTE and Ma. Chelo V. MANLAGÑIT

314

Vietnam 15. Promoting Good Corporate Governance Practices in Vietnam: A New Element in the Economic Reform Agenda Nick J. FREEMAN

333

16. Corporate Governance in Vietnam’s Equitized Companies: Progressive Policies and Lax Realities NGUYEN Van Thang

352

Index

375

LIST OF TABLES

2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8

4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 4.10

Concentration of Ownership in Selected Asian Countries Separation of Ownership and Control in Selected Asian Countries Control of the Public listed Companies in Selected Asian Countries Concentration of Family Control in Selected Asian Countries CLSA Corporate Governance Ratings in Southeast Asia Corporate Governance Rating and Share Price Performance in Southeast Asia Veto Power and Coalition Quality of Regulatory Environment and Compliance of CG Regulations in Southeast Asia Composition of External Finance (in % shares of total) The Costs of Banking Crises Overview of the Banking System and NPLs, end-2002 (in %) Challenges in Governance of Financial Institutions State-Owned Banks Percentage of Bank Capital to Assets (in %) Bank Provisions to Non-Performing Loans (in %) Legal Environment for AMCs in Asset Resolution Corruption Perception Index 1998–2003 The EIU’s Transparency and Fairness of Legal System Rating Score

19 21 22 23 25 26 28 31

53 55 56 57 59 61 62 64 67 68

List of Tables

4.11 4.12 4.13 4.14 4.15 4.16

NPLs in the Commercial Banking System of Crisis-Affected Countries (in % of total loans) Moody’s Weighted Average Bank Financial Strength Index (in %) in Selected Asian Countries Indicators of Institutional Framework (Mid-1997, unless otherwise indicated) Sovereign Ratings, June 2004 Corporate and Financial Sector Comparison for Asian Crisis Countries, 1998 and 2003 Number of Banks and Bank Concentration in CrisisAffected Countries

ix

70 72 74 75 75 76

6.1

Malaysia: Profile of Audit Committee Members

131

8.1

Markets Ranked by Corporate Governance by Credit Lyonnais Securities Asia (CLSA)

181

9.1 Control of Publicly Traded Companies in East Asia 9.2 Separation of Ownership and Control in East Asia 9.3A Weighted Average Ownership Share of Top Five Largest Shareholders among 150 Largest Listed Thai Companies, 1999 and 2002 9.3B Weighted Average Equity Share of Top Five Shareholders by Sector, 1999 and 2002 9.4 Thailand: Corporate Governance Ranking (IMD 1999 and 2004) 9.5 Thailand: Recent Initiatives to Promote Good Corporate Governance by State and Private Organization

202 202 203

204

12.1 12.2 12.3 12.4 12.5

Characteristics of GLCs’ Evolution Temasek Holdings’ Stakes in Key Listed Companies (%) Singapore: Temasek Group of Companies Singapore: Divestment of the GLCs Temasek’s Board of Directors

272 274 275 283 291

13.1

Committees within the Boards of Major Philippine Corporates

307

14.1

Number of Closed PDIC Member Banks, Philippines, 1970–2003

316

208 210

x

List of Figures

14.2 14.3 14.4 14.5

Philippine Commercial Bank Mergers, 1998–2003 Profit Function: Definition of Variables and Data Structure Definitions of Correlates of Profit Efficiency Measure Correlates of Profit Proficiency

320 324 325 326

16.1 16.2

Two Perspectives in Corporate Governance Vietnam: Shares Structure at the time of Equitization (%)

356 361

LIST OF FIGURES

2.1 2.2

Predictability of Changes in Rule, Laws and Regulations in Southeast Asia Southeast Asia: Bribery Figures

28 33

12.1 12.2

Singapore: Temasek Organizational Chart Chains of Accountability — Corporate Governance of Temasek Holdings in Singapore

277 279

16.1

Vietnam: Number of SOEs Equitized, 1990–2002

358

LIST OF CONTRIBUTORS

ALFONSO, Felipe B. (MBA, New York, 1967) is the Vice-Chairman of the Asian Institute of Management (AIM) Board of Trustees and the Executive Director of the AIM-Ramon V. del Rosario Sr. Center for Corporate Responsibility, Philippines. He specializes in human behaviour in organizations, general management and organizational development. He served as the President and Chief Executive Officer of the Asian Institute of Management and concurrently the President of the AIM Scientific Research Foundation (1991–99); as Associate Dean for Research (1982–88); and Associate Dean of the Center for Development Management (1988–90). He has over thirty years of collective experience in conducting management development programmes for private and public entities in Southeast Asia. E-mail: [email protected] ANANDARAJAH, Kala (LL.B., Hons., National University of Singapore, 1989; MBA, Nanyang Technological University, 1997) is a Partner in Rajah & Tann, Singapore. She is Head of the Knowledge & Risk Management Group and Lead Partner of the Corporate Governance Group. Her practice includes corporate and banking advisory, competition & trade law, employment law and environmental law. She was appointed a member of the Review Committee by the Council of Corporate Disclosure and Governance in 2004 to review Singapore’s Code of Corporate Governance. She is author of over half a dozen books, including Corporate Governance Compliance (2003), Professional Liability — Auditors & Accountants (2003), The Laws of Bankruptcy in Singapore & Malaysia (1999), The Bills of Sale in Singapore and Malaysia (1995), and coauthor of several books. E-mail: [email protected]

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List of Contributors

BAÑEZ, René G. (LL.B., Ateneo de Manila, 1981) is Chief Governance Officer, Philippine Long Distance Telephone Company. He is also Professor of Law at Ateneo De Manila School of Law handling taxation and governance. He was previously a tax partner of PricewaterhouseCoopers and formerly the Philippines’ Commissioner of Internal Revenue. E-mail: [email protected] CHEAH Kooi Guan (Ph.D., Leeds, 1991) is Associate Professor in the economics programme of the School for Distance Education, Universiti Sains Malaysia, Penang, Malaysia. He is actively involved in teaching, consulting and research in the areas of banking, finance, corporate governance, and distance education. He was visiting professor at the University of Georgia at Athens in 1996–97. His latest publications include The Malaysian Financial System: Structure, Development and Change (2002) and Learning at a Distance: From Principles to Practice (2004). E-mail: [email protected] DJISMAN, S. Simanjuntak (Ph.D., Cologne, 1983) is Executive Director, Prasetiya Mulya Business School, Jakarta, Indonesia. His publications include: The Petrochemical Industry of Indonesia on the Threshold of a Progressive Growth (1997), EU-ASEAN Relationship Trends & Issues (1996), “Expanding The Focus of The G-7”, Japan Review of International Affairs (1994), Problems and Prospect for Transition and Democratization (1992), Recent Developments in and Prospects for Pacific Co-Operation and Possibilities therein for ASEANChina Economic Relations (1992). E-mail: [email protected] FREEMAN, Nick J. (Ph.D., Bradford, 1993) is an independent consultant specializing in foreign direct and portfolio investment, capital markets, and private and SME sector development. He is a Visiting Senior Fellow at the Institute of Southeast Asian Studies, Singapore. His publications include: Financing Southeast Asia’s Economic Development (editor, 2002) and The Future of Foreign Investment in Southeast Asia (co-editor, 2004). E-mail: njfreeman@ fastmessaging.com JIKICH, Branka A. (M.A. Johns Hopkins, 2002) is fellow and director of the Hills Programme on Governance at the Center for Strategic and International Studies in Washington, D.C. She is responsible for managing events and research in Washington, coordinating activities of Hills Governance Centers in the Philippines and Korea, planning for future Hills Governance Centers in East Asia and elsewhere, and contributing to the programme’s long-term development efforts. She joined CSIS from the Asian Institute of Management, where she was Senior Research Fellow and Project Manager on Corporate

List of Contributors

xiii

Governance with the AIM-Ramon V. del Rosario Sr. Center for Corporate Responsibility. Her latest publications include: Corporate Governance at a Crossroads: Recommendations for Regulators, (co-author, 2004) and Managing Corporate Governance in Asia: Options, Positions, Emerging Structures (coauthor, 2004). She has also researched European agricultural policy as a Fulbright Fellow in Economics and European Law. E-mail: [email protected] KOH Tong Ngee, Philip (FCIS, LL.B., Hons., Malaya, 1978; LL.M, London, 1980; Advocate & Solicitor of High Court Malaya, 1979) is Advocate & Solicitor High Court Malaya and Senior Partner of Messrs Mah-Kamriyah & Philip Koh. He joined the corporate world in 1995 as an Executive Director and Group Legal Director of Phileo Allied Bhd. a public listed company involved in inter-alia, banking and capital markets. He also served in the Exco of the Federation of Public Listed Companies and also Chairperson of the Technical and Regulatory Committee. He is currently Adjunct Professor Deakins University, Australia and a Fellow of the Institute of Chartered Secretaries and Administrators. He is a co-author of The Law of Contract in Malaysia and Singapore — Cases and Commentary (1979), Legal and Accounting Implications of S 67A of the Companies Act: Scope and Strategic Operation of Share Buy Back (MAICSA) and Chan & Koh’s Company Law, Sheridian & Groves The Constitution of Malaysia, Fifth Edition (2004). E-mail: philip.koh@ mkp.com.my LAMBERTE, Mario B. (Ph.D., Philippines, 1982) is currently the President of the Philippine Institute for Development Studies (PIDS). He also directly coordinates the Monetary and Banking Policies Research Programme of the Institute. His publications include: “Reforming the International Financial Architecture: The East Asian View” (2001); “No to YES (Yen, Euro, $)? Enhancing Economic Integration in East Asia through Closer Monetary Cooperation” (2001); “The Philippine Payment System: Efficiency and Implications for the Conduct of Monetary Policy” (2002); “Developing the Fledgling Debt Securities Markets in Southeast Asia” (2003); and “Central Banking in the Philippines: Then, Now and the Future” (2004). He was a Visiting Research Fellow at the International Food Policy Research Institute (IFPRI), Washington, D.C. in 1989 and at the Ohio State University in 1989 and 1993. E-mail: [email protected] LOW Chee Keong (LL.M., Hong Kong, 1995) is Associate Professor in Corporate Law at The Chinese University of Hong Kong with research interests in issues pertaining to corporate governance and the regulatory

xiv

List of Contributors

framework of capital markets. He has published in the Australian Journal of Corporate Law, Columbia Journal of Asian Law, Hong Kong Law Journal, Journal of Asian Business, North Carolina Journal of International Law & Commercial Regulation, Northwestern Journal of International Law & Business and Singapore Journal of Legal Studies, and his books include Securities Regulation in Malaysia, Financial Markets in Hong Kong and Corporate Governance: An Asia-Pacific Critique. E-mail: [email protected] MANLAGÑIT, Ma. Chelo V. (M.A., University of the Philippines, 2001) is currently pursuing her Ph.D. in Economics at the University of Hawaii, Manoa as an East-West Center Degree Fellow. She worked as a Research Associate (2002–04) and Research Analyst (1998–2000) at the Philippine Institute for Development Studies (PIDS) with research interests in Monetary and Development Economics and Microfinance. She also worked as a Teaching Fellow at the University of the Philippines School of Economics. E-mail: [email protected] MEHRA, Madhav is President of the World Council for Corporate Governance, UK. He is also the Chairman of the World Quality Council. He has the unique distinction of converging the issues of quality, environment and governance to deliver a holistic transformational model to corporations to improve both their compliance and competitiveness. He is also the Chairman of the Editorial Board of several publications including Corporate Governance — Turning Rhetoric into Reality, Business Success Models for 21st Century, Quality Times and Corporate Governance. He has authored numerous articles on management, leadership, employee involvement, team building, communication, TQM and quality of corporate governance. E-mail: [email protected] NIKOMBORIRAK, Deunden (Ph.D., McGill, 1995) is Research Director, Economic Governance, Thailand Development Research Institute (TDRI). She is also the advisor to the Office of Fair Trade Promotion, Department of Internal Trade, Ministry of Commerce, Thailand, and Executive Board of Directors, the International Chamber of Commerce (ICC), Thailand. She was also a member of Thailand’s delegation to the WTO Working Group on Interaction between Trade and Competitive Policy. Her latest publications include: “Liberalisation of Air Transport Services” (2003); “Regional Liberalisation in Services” (2002), and “The Thai Corporate Governance: An Overview” (2001). E-mail: [email protected] NGUYEN Van Thang (Ph.D., Oregon, 2002) is Senior Lecturer of Strategic Management, NEU Business School, National Economics University, Hanoi.

List of Contributors

xv

His current research interests are the development of inter-firm networks, trust in transition economies and strategies for managing change in stateowned enterprises in Vietnam. His latest publications include: “Learning to Trust: A Study of Interfirm Trust Dynamics in Vietnam”, Journal of World Business (2005), “A Study of the Formality of Human Resource Management Practices in Small and Medium-Size Enterprises in Vietnam”, International Journal of Small Business (co-author, 2004) and “Conducting Qualitative Research in Vietnam: Observations about Ethnography, Grounded Theory and Case Study Research Approaches” (co-author, 2004). E-mail: nvthang@ bsneu.edu.vn PITIYASAK, Saravuth (LL.M., Sydney, 1997) is a lecturer in the School of Law, Sukhothai Thammathirat Open University, Thailand. His latest publications include: “Electronic Contract Law of Thailand, England and UNICITRAL Compared”, Computers and Telecommunications Law Review (2003), “Does Thai Law Provide Adequate Protection for Copyright Infringement on the Internet?” European Intellectual Property Review (2003), “Thai Electronic Transaction Act 2001: Recent Development Surrounding IT Law in Thailand”, World Internet Law Report (2002). E-mail: lwaspsar@ hotmail.com RANDHAWA, Dipinder S. (Ph.D., Syracuse, 1998) is a Research Fellow at the Saw Centre for Financial Studies, NUS Business School, National University of Singapore. His work experience includes stints in the banking sector and with policy-formulation agencies within the government. His research interests are in the areas of finance and development, institutional economics, banking and financial crisis. His latest publications include: “Financial Liberalisation, the Origins of Financial Fragility and Financial Crisis: The Indonesian Experience”, European Journal of Management and Public Policy (2004), “Competition, Liberalization and Efficiency: Evidence from a Two-Stage Banking Model on Banks in Hong Kong and Singapore” Managerial Finance” (2004), a case study on the Transformation of DBS Bank (2004), and “Financial Services for the Poor: Assessing Microfinance Institutions” (2004). E-mail: [email protected] ROSSER, Andrew (Ph.D., Murdoch, 2000) is Fellow at the Institute of Development Studies, United Kingdom. He has a special interest in the politics of economic policymaking and the role of the state in economic development. His latest publications include “Coalitions, Convergence and Corporate Governance Reform in Indonesia”, Third World Quarterly (2003)

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and The Politics of Economic Liberalisation in Indonesia: State, Market, and Power (2002). E-mail: [email protected] WU Xun (Ph.D., North Carolina, 2001) is Assistant Professor, Public Policy Programme, National University of Singapore. He teaches environmental and natural resource management, policy research methods, policy evaluation and cost-benefits analysis. His research interests are in energy policy, water resource management, non-market valuation and public sector governance, and his current research projects include the political economy of power sector reforms in Southeast Asia, corporate governance and corruption in Asia, and conflict resolution of international water disputes. He has acted as a consultant for international organizations such as the World Bank and International Vaccine Institute. E-mail: [email protected]

Editor HO Khai Leong (Ph.D., Ohio State, 1988) is Fellow at the Institute of Southeast Asian Studies, Singapore. He has taught at the Public Policy Programme, National University of Singapore and Department of Political Science, West Virginia University, and was a visiting scholar at Sophia University and a visiting fellow at the Japan Institute of International Affairs, Tokyo, Japan. His current research projects include corporate governance in Singapore, Malaysian and Singapore politics and China-ASEAN relations. His latest publications are The Politics of Policy-Making in Singapore (2000) (the new edition is published as Shared Responsibilities, Unshared Power. The Politics of Policy-Making in Singapore, 2003); Performance and Crisis of Governance of Mahathir’s Administration (co-editor and contributor, 2001); and China and Southeast Asia: Global Changes and Regional Challenges (co-editor and contributor, 2005). E-mail: [email protected]

ACKNOWLEDGEMENTS

The collection of papers in this volume were first presented at the ASEAN Roundtable held at the Grand Copthorne Waterfront Hotel in Singapore on 25–26 August 2004.The purpose of the ASEAN Roundtable, which was initiated by ISEAS in 1986, is to review major developments in ASEAN and to explore new dimensions for ASEAN cooperation in the light of the rapidly changing global environment as well as in terms of the emerging domestic economic situation and needs. The theme chosen for the Roundtable 2004 was “Reforming Corporate Governance in Southeast Asia: Economic Realities, Political Institutions and Regulatory Frameworks”. Mr K. Kesavapany, Director of the Institute of Southeast Asian Studies, initiated the idea in 2003 and he has been instrumental in providing the motivation and the inspiration for the contents of the seminar. Konrad Adenauer Stiftung generously sponsored the Roundtable. In addition, I would also like to thank the following individuals: Dr Colin Duerkop, regional representative of Konrad Adenauer Stiftung, for his relentless support for the project throughout the whole year; Ms Kala Anandarajah for her input into the seminar programme; Dr Sakulrat Montreevat and Dr Denis Hew Wei-Yen for sharing their ideas; Mr Rajenthran Arumugam for his enthusiastic assistance in organizing the roundtable and writing of the executive summary; ISEAS staff, especially Ms Ch’ng Kim See and Ms Susan Low, in compiling an excellent bibliography on corporate governance in Southeast Asia for the roundtable participants; Ms Karthi and Mr Tee Teow Lee for their efficient management of seminar logistics; Mrs Y. L. Lee for her kind administrative support; Ms Elaine Ho for her cover design; Mrs Triena

xviii

Acknowledgements

Ong, Managing Editor at ISEAS Publications Unit, for her professional guidance in preparing the manuscript; and last but not least, J. Y. Pillay, Chairman, Council on Corporate Disclosure and Governance (CCDG) for his Foreword.

Ho Khai Leong January 2005

FOREWORD

Corporate governance is an idea whose time has, it seems, resoundingly come. That is the impression the observer gets from casting an eye on the plethora of conferences, books, scholarly papers, media reports, and so forth on that subject. The good word of corporate governance has now invaded other areas of life as well. In Singapore, there is, for example, a governance charter for charities. The remit of corporate governance covers a wide field: the relationship between the board and its shareholders; the composition of the board and its committees; the remuneration of executives; the salience of the audit committee; and not least, the concepts of openness, disclosure, and transparency. Nobody seriously quarrels with the rapidly evolving trend in corporate governance. How could anyone take issue with laws and regulations and rules and codes that are designed to encourage listed companies to conduct their affairs properly in their own interest? All those impositions have, no doubt, laid a heavy and expensive burden on companies and their boards. And there is no end to the process. The demands of shareholders will not abate. So, listed companies will just have to brace themselves for a succession of stringent dispensations. Their consolation is the consequent toning-up of management, leading to enhanced performance, which will be, in turn, reflected in the share price. Even now, the Council on Corporate Disclosure and Governance in Singapore is reviewing the corporate governance code (CGC), activated hardly three years ago, to make it more relevant to the times. The council is taking the pulse of the investing community and listed companies. It will

xx

Foreword

push the envelope, but in a measured manner in accordance with societal norms. Despite rapid progress in the discipline of governance, the string of corporate scandals around the world is not diminishing. Nor is the magnitude of their impact diminishing. Even well-regulated jurisdictions, like Singapore, have suffered periodic upheavals. When such corporate disasters erupt, a clamour arises for the authorities to reach for their armoury of regulatory enforcement and other weapons to address the newly-perceived threat. But that panoply of weapons, however augmented, will not eliminate disasters. Man is both fallible and sinful. So the authorities are increasingly turning to the question of how to improve the assessment of character and integrity of the leaders of companies seeking money from the public. The Institute of Southeast Asian Studies is to be commended for its initiative in advancing the interest of corporate governance in ASEAN countries. The papers submitted at an ISEAS workshop on “Reforming Corporate Governance in Southeast Asia” have now mutated into a book of no mean size. The editor, Dr Ho Khai Leong, and all the contributors deserve recognition for their arduous efforts. Even if they have given the principles and practice of corporate governance in ASEAN countries just a gentle push, their labours will not have been in vain.

J. Y. Pillay Chairman Council on Corporate Disclosure and Governance (CCDG) 4 February 2005

INTRODUCTION HO Khai Leong

Corporate Governance: A Cross-Disciplinary Study In contemporary policy discourse, corporate governance has become a byphrase. It has been used so often and so casually that one accepts it readily as a value which should permeate throughout the contemporary business world. Seemingly a commonsensical term in our vocabulary, on deeper reflection, however, it is actually a complex idea. The discussion of corporate governance can be found in public finance, corporate management, law, economics and political science literatures. Obviously, the apparent relationship between the economic health of corporations and society did not escape the observations of social scientists who are interested not just in one particular facet of evolutionary change but the casual relationships of corporate governance and social development. Given the multi-disciplinary nature of the subject, it is therefore unsurprising that one is unable to find a commonly-agreed definition of corporate governance. However, it is important to start somewhere. At the most general level, “[c]orporate governance is about promoting corporate fairness, transparency and accountability”. This is the President of the World Bank, James Wolfensohn’s definition, as quoted in an article published in Financial Times, 21 June 1999. That is as general a definition one can get about the concept, which, due to its generality, is perhaps more acceptable and continues to attract public attention and gain popularity as such. The Organization of Economic Cooperation and Development (OECD 1999), on the other hand, provides a more detailed, and hence, more meaningful, definition:

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Introduction

Corporate governance is the system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as, the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs. By doing this, it also provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance.

This is probably the most commonly quoted definition of corporate governance in policy as well as corporate discourse, for it provides the functional perimeters by which scholars and policymakers alike are able to embark on their tasks at hand. Many accept this definition as the most authoritative. In that regard, it is useful to reiterate the OECD Principles of Corporate Governance. They cover five areas: 1. The rights of shareholders The corporate governance framework should protect shareholders’ rights. 2. The equitable treatment of shareholders The corporate governance framework should ensure the equitable treatment of all shareholders, including minority and foreign shareholders. All shareholders should have the opportunity to obtain effective redress for violation of their rights. 3. The role of stakeholders The corporate governance framework should recognize the rights of stakeholders as established by law and encourage active cooperation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financial sound enterprises. 4. Disclosure and transparency The corporate governance framework should ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including the financial situation, performance, ownership, and governance of the company. 5. The responsibility of the board The corporate governance framework should ensure the strategic guidance of the company, the effective monitoring of management by the board, and the board’s accountability to the company and the shareholders. The OECD principles of corporate governance are by no means carved in stone. A general framework has emerged from these principles, enabling Southeast Asian states to mould them according to their unique developmental

Introduction

xxiii

experiences to build their own rules. However, scholars and practitioners in Southeast Asian nations have yet to thoroughly discuss these principles, comprehensively and comparatively, so as to emerge with a common platform to further build their own contextual reform agenda. Corporate Governance in Southeast Asia: Motivations and Consequences of Reforms Corporate governance, or the lack of it, has emerged as a major policy concern in Southeast Asia especially after the Asian financial crisis in 1997. The weaknesses in the corporate sector — poor investment structure, weak legal and accounting systems, faulty financial practices, questionable political interventions — in Indonesia, Malaysia, the Philippines and Thailand (and Korea), have been identified as having contributed significantly to the sharp economic decline during that particular period of crisis. These countries, learning from painful experience, have since implemented various policy measures to improve the status of corporate governance, which include policy transparency, institutional accountability and fiscal prudence. Corporate governance reform, however, were not limited to these crisis stricken countries. States which have been relatively unscathed by the crisis, such as Singapore, China and Taiwan, were also quick to acknowledge the importance of good corporate governance practices and embarked on various reform efforts of corporate restructuring, based on stronger ethical foundations. They believed that it was better to jump onto the bandwagon instead of to wait for another crisis to strike. In Southeast Asia today, almost all top policymakers within the state and in the business world have acknowledged that “good” corporate governance — however we define it — is indeed a key to economic recovery. For too long, this issue in development has been ignored, or inadequately considered. It took a sudden and prolonged financial catastrophe for the state and market to realize that negative consequences appeared without proper corporate management. Subsequently, they also began to realize that good corporate governance is also a key ingredient to sustained economic growth. At the same time, a spectre has spread through Southeast Asia; it is the spectre of intense regionalization and globalization. These are two forces, which at times may be going in different directions and consequently create more tensions within the states, that probably impacted on the Southeast Asian states to be more committed to corporate governance reform. Globalization, technology and deregulation are combining to challenge established corporations. Indeed, the capitalist multilateral system has

xxiv

Introduction

continued to put pressure on the governments and private sectors to reform the corporate sector and to adopt the best practices which can withstand the onslaught of global competition. The needs for corporate reform for Southeast Asian states therefore are both necessary and urgent. Consequently, the governments of these crisis-stricken countries introduced strident corporate governance reforms at all levels: formal and informal, institutional and regulatory, political, economic as well as organizational. They have resorted to various strategies which, by and large, attempted to make a difference to the short- and long-term success or failure of a corporation. While policymakers know very well that good corporate governance reform is dependent on the legal, regulatory, and institutional environments, they are also mindful of other factors such as business ethics, environmental and societal interests. Some have tried to resolve the governance problems result from the separation of ownership and control; others have tried to reconcile expectations of shareholders and other stakeholders. Observers are impressed by the sheer variety of activities — codes of conduct, legislative enactments, political rhetoric, bureaucratic initiatives, etc. — that have surfaced, propelled first and foremost perhaps by well-intentioned politicians who claimed to be reformers. The impacts of these policies on the economic restructuring, political institutionalization and legislation, however, were by no means clear. Indeed, it has been seven years since the financial crisis swept through the region; since then, efforts undertaken and corporate governance structures have substantially improved in the corporate governance of several ASEAN member countries. While genuine and substantive reforms have been made in this respect, the path to further reforms continues to be arduous. It is in this spirit that the Institute of Southeast Asian Studies (ISEAS) in Singapore initiated a research project in “Reforming Corporate Governance in Southeast Asia”. Renowned scholars from various disciplines of business administration, economics, law, political science and public policy and business practitioners from the Southeast Asian states were invited to review and critically examine the corporate governance reform experiences of each country, and to present their arguments and evidence in the ASEAN Roundtable 2004. The result was a vigorous discussion and an exchange of a wide range of arguments and ideas among the participants. After substantial revision of the drafts, we are now able to present these ideas in the present volume. Organization of the Book In Chapter 1, entitled “Corporate Governance — An Alternative Model”, Madhav Mehra provides a global view of corporate governance issues and

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argues for an alternative model that would eventually take off in a complex capitalist economy. Mehra opens the discussion by noting some major positive changes of the corporate world, especially at the board level. On the market front, however, the pictures of reform look grimmer. Scandals in Enron, Anderson, WorldCom, Parmalat, Scandia, Vivendi, Equitable Life, Computer Associates, Ahold and Shell should be instructive. Mehra also noted that in the recent years, ASEAN member countries have taken great pains and commitments to enhance corporate governance structures. His contention is that ASEAN countries ought to draw lessons from the many corporate scandals in the last decade in the developed countries so as to better reform their corporate sectors. Raising public awareness about the importance of corporate governance is certainly a task that demands the focus of these governments. In Chapter 2, entitled “Political Institutions and Corporate Governance Reforms in Southeast Asia”, Wu Xun, discusses the complementarities between political institutions and corporate governance to explain the rigidities in corporate governance. Although corporate governance reforms have been initiated at varying degrees in the ASEAN states, real progress has been slow. Therefore, it would be difficult to envisage a convergence of corporate governance practice in the region vis-à-vis other regions, partly because of differences in culture, legal tradition, and history and path dependence. Other issues raised by Wu include peculiarities found in the corporate sectors of most ASEAN member countries: high proportion of ownership concentration, which permeated pyramiding and cross-holding to enhance control; high concentration of insider ownership; the power of family conglomerates and government dominance; close links between control and management; exploitation of minority shareholders; and last but not least, rogue politics and corruptions. He warned that ASEAN governments ignore the relationships between political institutions and corporate governance at their own perils. In Chapter 3, “Disclosure, Reporting and Derivative Actions: Empowering Shareholders in Southeast Asia”, Low Chee Keong discusses the merits and demerits of quarterly reporting and statutory derivative actions. He argues that the existing problems are too pervasive and complex for these processes to address adequately. Indeed, good corporate governance has to encompass solutions including the observation of credible corporate transparency and accountability. The encouragement of shareholder activism and vigorous response is an idea that corporate stakeholders should entertain. As a legal specialist, Low identifies the inherent limitation of minority shareholders’ rights to derivative action at both common law and statutory against the

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majority shareholder. The introduction of class action to corporate law litigation is another solution to the problem. In Chapter 4, “Governance Reforms in the Banking Sector in Southeast Asia: Economics and Institutional Imperatives”, Dipinder S. Randhawa addresses the much neglected issue of banking reform in the corporate governance literature with specific reference to several ASEAN member countries on and after the financial crisis in 1997. He makes several critical observations on the inherent opacity in the Southeast Asian banking sector. While the recovery from the financial crisis has been impressive, there are still many hurdles ahead where building a sound and viable banking sector is concerned. Such hurdles would include under-developed financial markets, inadequate financial regulation and lack of policy coordination. Development of capital markets and contractual savings institutions is an overriding priority for Asian economies in the coming decades. The chapters on the individual countries in ASEAN are empirical case studies which detail the reform experiences, lessons learnt, important issues and challenges that continue to confront policymakers in these states. By focusing on the Malaysian corporate governance reform experience from different perspectives, Cheah Kooi Guan and Philip Koh Tong Ngee seem to advocate for more urgent steps to be taken in the direction of an institutional development of international organization. In Chapter 5, “Corporate Governance Reforms in Malaysia: Issues and Challenges”, Cheah argues that the Malaysian corporate sector has been characterized by a high concentration of ownership (family or government) with significant participation of owners in management. Malaysia has undertaken significant corporate governance reforms, particularly in the aftermath of the Asian financial crisis (1997). Indeed, the amendments to various corporate statues since 1997 have considerably strengthened the corporate governance regulatory framework, provided the authorities with the necessary powers to enforce the laws relating to corporate governance, and served to act as deterrents to potential abuses. In Chapter 6, “Corporate Governance in Malaysia: Some Aspects of Reforms and Institutional Constraints in Light of Post-1998 Crisis”, Koh takes the position that Malaysia’s current implementation and enforcement of corporate governance laws and regulations are not entirely satisfactory. The politicization of regulatory bodies and relatively weak judiciary seem to be major reasons for such an outcome. Most importantly, apart from regulatory concern, other social and cultural norms (such as the prevailing Bumiputera affirmative action policy) would also continue to significantly influence the form and substance of corporate governance structure.

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Like other Southeast Asian countries, Indonesia has also undertaken a sizeable amount of corporate governance reformatory works in the last seven years. Djisman S. Simanjuntak’s chapter (Chapter 7, “Indonesia’s Tolerated Low-Speed Reform of Corporate Governance”) describes these reforms efforts, which include amendments and modifications to the Company Law, Capital Market Law and Bankruptcy Law. Accordingly, it appears that accountability and transparency have been enhanced in the corporate sector through the introduction of independent directors and various independent board committees. However, he is not very optimistic as to the eventual outcome, as there is still a very wide gap between the spirit and letter of governance-related laws and regulation and implementation. The reliance on weak legal protection may not be adequate to bring about significant improvement in the corporate standards. In Chapter 8, “The Political Economy of Corporate Governance in Indonesia”, Andrew Rosser introduces a valuable perspective, that is, the challenges faced by Indonesia as a result of the politicization of the corporate governance in the country. Given the shrewd politicization of Indonesian economy, Rosser argues that any push for credible corporate governance reform should emanate from outside the state pedestal. In this regard, a bottom-up approach is ideal. The Thai chapters were written by an economist and a legal scholar. In Chapter 9, “Building Good Corporate Governance after the Crisis: The Experience of Thailand”, Deunden Nikomborirak provides detailed and up-to-date descriptions of the Thai policymakers’ concerted effort to enhance the existing corporate governance structure in the wake of the Asian financial crisis. She argues that high corporate concentration of ownership (family and to a lesser extent the government) has resulted in corporate abuses which, amongst others, include: expropriation and misuse of company’s funds by major shareholders; corporate wrongdoings that are legitimate due to certain legal loopholes; connected transactions; and state directed and relational lendings in the banking sector. In Chapter 10, “National Corporate Governance Committee: Three Disciplines for Good Corporate Governance in Thailand”, Saravuth Pitiyasak reviews a three-pronged strategy which Thailand has adopted for reform: regulatory discipline, market discipline and self discipline. Such an approach was combined with policy and institutional frameworks namely, the National Corporate Governance Committee was established in 2002 to inculcate good corporate governance structure in the short-, middle- and long-term bases. He concludes that the National CG Committee has been effective.

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Furthermore, it is moving towards the right direction and will eventually bring positive benefits to the Thai capital market as a whole. The Singapore experience in corporate governance reform may be unique in many ways. In Chapter 11, “State of Corporate Governance Reforms in Singapore — Economics Realities, Political Institutions and Regulatory Frameworks”, Kala Anandarajah notes that Singapore’s corporate regulatory framework has moved visibly from merit-based to disclosure-based regime. The promulgation of the recent Code of Governance 2001 brings fresh impetus to corporate governance practice. However, heavy corporate concentration of ownership largely centred on families or governments continue to pose as a sticking point. As government-linked companies (GLCs) have been severely criticized by both domestic and international market players and academics, Ho Khai Leong addresses this issue in Chapter 12, “Corporate Governance Reforms and the Management of the GLCs in Singapore: Pressures, Problems and Paradoxes”. Ho argues that criticisms directed at the GLCs are generally levelled at the outcomes of their success (for example, crowding of the local capitals) as opposed to their failures (corruptions, collusion and nepotism). Arguably, the underlying nuances between the government authorities and the GLCs have never been vigorously questioned, if not, challenged. There is a prevalent perception that the GLCs are not entirely transparent and this has resulted in some degree of economic advantages over other forms of corporate entities. In order to render the Singapore economy more competitive, the state will have to deal with what he calls “paradoxes” which are inherent in reforming the practice and policy of corporate governance. In Chapter 13, “From the Inside Out: Reforming Corporate Governance in the Philippines by Engaging the Private Sector”, Felipe Alfonso, Branka A. Jikich and Rene G. Banez argue that the Philippines has been suffering from the same malaise of corporate governance in other Southeast Asian countries — opaque financial reporting, conciliatory boards of directors, poor internal controls, haphazard disclosure, and substandard audits etc., as these problems are entrenched in the corporate structure. The years of reform efforts by the Securities and Exchange Commission have yielded limited results. The authors conclude by noting that an internal, sustainable culture of good governance is essential, and that the vigorous enforcement of requirements is much more urgent than rhetorical adaptation of requirements which were ignored. In Chapter 14, “Corporate Governance of Financial Institutions: The Philippine Case”, Mario Lamberte and Ma. Chelo V. Manlagnit examine the extent to which financial institutions in the Philippines are profit efficient and in so doing, examine the way in which profit efficiency is affected by

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three sets of correlates, namely market conditions, corporate governance, and agency costs. Their findings suggest that market conditions, corporate governance and agency costs are important factors in explaining variations in profit efficiencies across financial institutions. They argue that such findings will assist the shareholders, regulators and the general public in monitoring the performance of financial institutions and improving the corporate governance systems of financial institutions in the Philippines. Nick Freeman’s chapter (Chapter 15, “Promoting Good Corporate Governance Practices in Vietnam: A New Element in the Economic Reform Agenda”) focuses primarily on the burgeoning private sector in Vietnam and its corporate governance practices. Freeman notes that there is a lack of committed political will at policy level to promulgate comprehensive corporate governance provisions. The prevailing corporate laws, namely the Enterprise Law (currently under review), State Enterprise Law and Foreign Investment Law, are inconsistent and are ambiguous vis-à-vis corporate governance principles. This, in turn, reveals a large amount of legal loopholes in the State Enterprise Law and Foreign Investment Law. In Chapter 16, “Corporate Governance in Vietnam’s Equitized Companies: Progressive Policies and Lax Realities”, Nguyen Van Thang provides an analysis of current policy and the reality of corporate governance in Vietnamese equitized companies since the introduction of “Doi Moi ”, or “market economy under socialist orientation” in 1986. Although there are existing impediments to the progression of good corporate governance practice in Vietnam, barring any dramatic political setback, the corporate governance structure is poised to improve in the middle to long term. These introductory paragraphs only touch the surface of the analyses and arguments of these chapters which study the rich nuances of the issues and problems of corporate governance. Beyond an attempt to succinctly summarize these articles, the editor is unable to do justice to these authors’ views. It is hoped that this volume will be able to provide policymakers in Southeast Asia with the most current research, ideas and policy options on corporate governance reform, thereby allowing them to be more committed and effective in fostering governance change in the future. Despite a decade of reform effort by the Southeast Asian states, policymakers know there is little ground for gratification and complacency. Undoubtedly, there continues to be a need for the reform of the policy and practice of corporate governance. The ultimate goal, if there is one at all, is to build strong and effective institutions capable of sustaining economic and business performance while maintaining greater accountability and transparency, not only to the shareholders but also to the citizenry in general.

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References Asian Roundtable on Corporate Governance (2003) White Paper on Corporate Governance in Asia. OECD and OCDE. Bernard, Mitchell and John Ravenhill (1995) “Beyond Product Cycles and Flying Geese: Regionalization, Hierarchy, and the Industrialization of East Asia”, World Politics 47, no. 2 (January 1995): 171–209. Berglof, Eric and Ernt-Lugwig von Thadden (1999 The Changing Corporate Governance Paradigm: Implications for Transition and Developing Economies. Working Paper (Stockholm Institute of Transition Economics, Sweden). Blair, Margaret M., and Bruce K. MacLaury (1995) Ownership and Control: Rethinking Corporate Governance for the Twenty-First Century. Washington, D.C.: The Brookings Institution. Boyd, Gavin (1999) “Corporate-Government Relations in the Pacific”. In Deepening Integration in the Pacific Economies: Corporate Alliances, Contestable Markets and Free Trade, edited by Rugman, Alan, M. and Alan Boyd. Cheltenham and Northampton: Edward Elgar, pp. 149–92. Capulong, M., D. Edwards, D. Webb, and J. Zhuang (2000) Corporate Governance and Finance in East Asia: A Study of Indonesia, Republic of Korea, Malaysia, Philippines and Thailand: Volume One: A Consolidated Report. Manila: Asian Development Bank. Claessens, Stijn, Simeon Djankov, and Lixin Colin Xu (2000) “Corporate Performance in the East Asian Financial Crisis”. The World Bank Research Observer 15, no. 1 (February): 23–46. Iu, J. and J. Batten (2001) “The Implementation of OECD Corporate Governance Principles in Post-Crisis Asia”, The Journal of Corporate Citizenship. no. 4,: 47– 62. United Kingdom: Greenleaf Publishing. O’Sullivan, Mary (2000) “Corporate Governance and Globalization”. The Annals of the American Academy of Political and Social Science 570 ( July): 153–72. Organization for Economic Cooperation and Development (1999) OECD Principles of Corporate Governance. Paris: OECD Publications. OECD (2001) Corporate Governance in Asia. A Comparative Perspective. Roe, Mark (2002) The Political Determinants of Corporate Governance, New York: Oxford University Press. Wade, Robert (1998) “The Asian Debt-and-Development Crisis of 1997: Causes and Consequences”. World Development 26, no. 8 (August).

Corporate Governance: An Alternative Model

Part I OVERVIEWS

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1 CORPORATE GOVERNANCE An Alternative Model Madhav MEHRA

CORPORATE GOVERNANCE — THE REPORT CARD On the eve of the second birthday of the Sarbanes-Oxley Act, it is only appropriate that we look at the report card of corporate governance reforms worldwide and evaluate whether it has achieved the intended goal. There is no doubt that there is plenty of good news. Directors have started taking their jobs seriously. Boards are awash with independent directors. Audit committees, nomination committees, remuneration committees are all being taken seriously. Board meetings, once short briefings, now focus on in-depth corporate issues, stakeholder dialogues and corporate social responsibility. Certification of financial statements by CEOs with lapses leading to penalties and prison sentences has put a chill in the spine of chief executives and they are taking far deeper interest in the organizations’ financial reporting. SQUEEZING THE STAKEHOLDERS It is all hunky dory, especially for audit companies whose revenues are increasing sharply. Audit fees for Fortune 500 companies are expected to climb 88 per cent this year, according to a survey by the Public Accounting Report. Top accounting firms already look healthier. Ernst & Young booked

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a 17.4 per cent revenue increase in its 2003 fiscal year, to US$5.3 billion. Grant Thornton booked a 21 per cent increase, to US$485 million. Of course, with the bean counters cashing in, stakeholder expenses are going up. The largest U.S. companies will typically spend more than US$4.6 million each to comply with just one section of the law, according to Financial Executive International. In Europe, one major energy firm listed in the U.S. market puts the annual cost of complying with Sarbanes-Oxley at over US$100 million. And large companies complain that the get-tough accounting regimen is draining resources. Paul Schmidt, Controller for General Motors, says GM’s chairman and CFO are spending more time on accounting and certification issues, “instead of strategy”. And it could get harder, if more governments follow suit. “One of the problems two years down the road is the danger that we’re going to have a proliferation of several country codes”, warns Rod Armitage, head of company affairs at the Confederation of British Industry. “For a company with multiple listings, this is very costly.” NO REMISSION FROM CORPORATE SCANDALS On the market front, things are far from satisfactory. Frauds are continuing to take place with unremitting regularity. The fraud at Ahold, the Dutch supermarket giant, which revealed that its 2003 accounts were overstated by US$500 million, caused its shareholders losses of more than US$6 million. According to Sherrin Watkins, the Enron whistle-blower, the directors have still got their hands in the till. The year 2003 witnessed value destruction in a whole lot of iconic enterprises such as Skandia, Boeing, Hollinger and Parmalat. The world’s oldest stock exchange, NYSE, has also not been spared. After defending for months the obscene remunerations of US$140 million that it paid to its former chairman Richard Grasso, NYSE has decided to join SEC in ordering investigation into Grasso’s earnings. The pay package will be investigated by famed New York Attorney General Eliot Spitzer. Skandia provides a classic example of what can happen when strong management is left unsupervised by a weak board and flawed auditing process. As usual the management represented by former chief executive Lars Eric Peterson and his deputy helped themselves to huge bonuses and company perks while Skandia’s share price plunged by 90 per cent. Latest to face SEC charges is another American icon IBM. The widening of the Parmalat probe has shown the involvement of even Bank of America and Deutsche Bank, Germany’s biggest bank. Here is a lesson that investigations, unless carried out with full commitment and persistence, do not unravel the magnitude of skulduggery.

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American mutual funds, a US$7 trillion industry, known to be the saviours of small investors were also caught by SEC while trying to make a fast buck at the expense of small investors. Even UK’s Invesco was involved, raising the question once again as to why corporate misdoings by the same institutions escape scrutiny in the United Kingdom. SEC said it found fourteen brokerage firms taking cash from mutual fund advisors and ten funds accepting payments in the form of brokerage commission. DIFFERING STANDARDS Shell has been fined a total of US$151 million (£83 million) for wrongly booking 20 per cent of its reserves. The fine imposed by UK’s Financial Services Authority is only a fraction — £17 million against £66 million imposed on it by Securities and Exchange Commission. The penalties are a flea bite as far as Shell is concerned which has just reported £2 billion of net profit in the second quarter alone, thanks to the boost in oil prices. Contrast it with over US$1 billion in fines imposed by Eliot Spitzer on three financial services giants: Citibank, Merrill Lynch and Credit Suisse First Boston (CSFB) even before the Sarbanes-Oxley came into force. As with so many of these fines, the punishment does not seem to be particularly painful and therefore not a sufficient deterrent. By paying these fines, Shell has been able to get the investigations against it closed without having to admit wrongdoing. This does not mean that the company is now over the hill. It still faces a regulatory enquiry in the Netherlands, a potential criminal investigation by the U.S. Justice Department and a raft of class action suits. When asked about the weakness of FSA in imposing fine on Shell, it was found that FSA did not even require oil and gas companies to make disclosures about their reserves. NO CORRELATION BETWEEN OCCURRENCE AND REPORTING There is little correlation between occurrence of a fraud and its detection and reporting. The fact that most of the corporate scandals are reported in the United States does not necessarily mean that frauds occur in the United States alone and other countries are more honest. If at all it should be the other way around. Countries where no corporate frauds are reported should be the ones to be watched and avoided by investors. It is like the third truth. Truth, as we know, has several aspects. An Indian Scripture Bhagwat Geeta says, “Infinite truth has infinite aspects.” We deal with three aspects here. The first truth is that we tell ourselves, that is, the reality, as we know it. The second truth is

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what we tell others: not the reality as we see it but the way we would like others to see it. The third truth is when the reality is so distressing that we fear even acknowledging its existence. Countries which do not report corporate frauds fall into the last category. Here one must acknowledge and commend the power of U.S. institutions to take up the frauds head on. One wonders why frauds by the same companies are rarely reported this side of the Atlantic. Even when they are reported, the establishment closes up and soon all is forgotten. INSIDER TRADING A lot of hue and cry was made about allegations of insider trading in Marks & Spencer shares. FSA had ordered investigations. Finally nothing came out at the end. Here is the stark difference between how British and U.S. establishments deal with such issues. One could never think of a British icon being incarcerated the way Americans have done to Martha Stewart. These differing standards in corporate governance have come into sharp relief in imposing fines on Shell by the two watchdogs. Though Shell’s crime of suppression of vital information from shareholders is the same, the fine imposed by Britain’s Financial Service Authority is one fifth of what has been imposed by the Security and Exchange Commission of the United States. ONLY A SLIM MAJORITY ON TRACK The United States has had a head start in legislation on corporate governance, having passed the Sarbanes-Oxley legislation on 31 July 2002. There was more dithering on this side of the Atlantic. Even though Sir Derek Higgs had submitted his report not very long after Sarbanes, the combined code on corporate governance incorporating his recommendations came into force only on 1 November 2003. According to the research conducted by Manifest, commissioned by the Financial Times of UK, only a slim majority of leading companies are on track to meet corporate governance standards as outlined by Sir Derek. Smaller companies have actually scaled down the number of non-executives on the key boardroom committees taking advantage of the exemption given by Sir Derek. The data shows that while 86 per cent of small capitalization companies boosted at least three non-executives at the audit committee in July 2003, twelve months later the figure dropped to just 70 per cent. Sir Derek came down heavily against the combined role of chief executives and chairmen. There is good news here. While last year twenty of the biggest 350 companies had chairmen and chief executives rolled into one

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the figure has now gone down to thirteen. Also the number of FTSE 100 companies that had designated a senior independent director has increased from 73 per cent to 83 per cent. EXCESSIVE REMUNERATION TO NON-EXECUTIVES The biggest rub however is only on remunerations paid to the non-executive directors. These have risen sharply. HSBC pays its non-executives £35,000 a year with plans to increase that to £55,000. Audit committee members get an extra £15,000 while the chairman pockets £40,000 more. By contrast, the chairman of the bank’s remuneration committee received an extra £20,000. At Diageo, the drinks company, non-executives receive a base £50,000, an increase of £15,000 on 2002. Its audit committee chairman gets an extra £20,000, double the amount of the year before. At Reuters, non-executives get a base £50,000, an increase of £15,000 on the year before; the audit committee chairman is paid an extra amount equivalent to triple that of his counterpart on the nominations committee. Independent directors’ remunerations have increased vastly even in developing economies. According to a news report in Economic Times, independent directors in India are raking in US$24,000–$36,000 a year. This is in a country where the minimum wage is less than US$700 a year. This has dampened the efforts to rein in CEO salaries. INDEPENDENT DIRECTORS ARE THE CORNERSTONE OF GOOD GOVERNANCE Independent directors are the cornerstone of good corporate governance. Theirs is the duty to provide an unbiased, independent, varied and experienced perspective to the board. Corporate scandals of Enron and WorldCom have revealed how this independence has been compromised by a cosy relationship between the CEO even with the so-called independent directors. The chairman of the audit committee of Enron was no less a person than the Dean of Stanford Business School. Yet he could not spot the murky goings-on in the company? The same has been true of auditors. Why did auditors of the status of Arthur Andersen allowed the deception to continue? In both cases the independence was compromised by expectation of excessive rewards. Should we not draw lessons? When a director has developed a stake in a company to the tune of US$100,000 a year and commission and stock in addition, would he be able to risk it all by going against the current? This is a hard bat to knock.

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DEFEATING THE PURPOSE Payment of such remuneration to independent directors defeats the very object of the exercise. Their remunerations have soared so much that they rate alongside the executive directors, raising the same issue of conflict of interest. An analysis of 2004 compensation data shows the average remuneration for so-called “non-employee” directors of the top 200 U.S. companies rose 13.4 per cent to US$177,000 (£97,000). Fees paid for attending committee meetings jumped by more than a third. This is when other employee salaries have risen by barely 3 per cent. This mocks the principle of equity and fairplay. Yet there are weird explanations. Edward Archer, managing director of Pearl Meyer & Partners, the New York compensation consultant that carried out the analysis, said: “It is like hazardous duty pay. They are worried about the risk to their reputations as well as legal liability from the fact that they have to put their name on the dotted line.” Pearl Meyer says most companies now choose to issue shares to directors plus fixed annual retainers because of criticisms of past reliance on variable attendance fees, share options and other perks such as pensions. For some companies, share awards now make up the bulk of director compensation. At Goldman Sachs, for example, new arrangements mean directors are offered restricted stock worth US$280,000 a year plus a retainer of up to US$100,000. COURT RULING ON CEO REMUNERATIONS In all these there is good news coming from United States in its bid to champion corporate reforms. So far, no matter how outrageous a CEO’s compensation may be, it has been impossible for shareholders to sue over it because of the legal principle of “business judgement”. The onus is on shareholders to prove that directors did not exercise due care in making the business judgement. But the Delaware Court of Chancery — the United States’ most important business court — has set a new yardstick. In a suit against Disney over the pay of Michael Ovitz who served as Disney’s president for just over a year in the mid-1990s and left with some US$140 million in pay, the court refused to throw out the suit. This was because the plaintiffs alleged not that Disney’s directors exercised poor judgement but that they exercised no judgement at all. Specifically, the plaintiffs say the directors approved Ovitz’s pay agreement without having seen even a draft of it, with no analysis of how much the deal might cost. So if a court were to find that a board had handed a CEO a mammoth contract without even checking to see how expensive it could be, then those directors could be personally liable

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for major damages. As the Corporate Counsel newsletter concludes, “this could mean that each director would have to pay out of his or her own pocket. Several million dollars each!” Applying this standard to Sainsbury in the United Kingdom can cause real problems for the Sainsbury board, which includes a minister of the British realm. TRANSPARENCY IN REPORTING One of the issues that came into the forefront in Philip Green’s takeover battle with Marks & Spencer is the degree of opacity still maintained even by star companies in their financial statements. Philip Green merely wanted to carry out a programme of due diligence on Marks & Spencer before buying it. How his attempt was foiled is now history. The story is instructive to the extent it brings into fore the difficulties experienced by a typical private equity investor. The World Council for Corporate Governance has always believed that the focus of corporate governance should not be simply compliance to regulation but making corporations more competitive. Competitiveness can improve only if companies are open about sharing information. Philip Green had to sweat and bleed even to get information on Marks & Spencer pension funds. Investors who wish to hold significant stakes in businesses want those companies to be more competitive and naturally want a lot more information than is currently available as per statutory requirements. ENTERPRISE GOVERNANCE According to Charles Cary-Elwes who set up RREV, the corporate governance joint venture between the National Association of Pension Funds and the Institution of Shareholder Services: the debacle such as at Sainsbury — where Sir Peter Davis, the chairman, was awarded a substantial bonus despite poor performance would not have happened had private equity investors been serving on the board. The big difference is that when pension funds and other institutional shareholders talk of engaging with companies, they usually mean Corporate Governance; whereas, when private equity investors talk of engagement, they tend to mean something different, namely ‘Enterprise’ Governance.

We believe that corporate governance without “enterprise” governance is an almond without a kernel.

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INNOVATIVE BOARDS Today’s business faces multitude of challenges, increasing business pressure on all fronts, globalization, shorter product life cycles, Internet, over capacity, complex regulations, currency volatility, value migration, are just some of these pressures. Meeting these challenges will bring about economic discontinuities that are unprecedented in rate and scope, and would require highly innovative approaches. We have to leapfrog over existing technologies rather than incrementally improve them. Using Nicholas Negroponte’s expression for the times that we are living “incrementalism is our worst enemy”. But innovation will bring tremendous resistance from vested interest. One only has to refer to Jim Utterback’s (a MIT professor) case studies of pressures on electric companies brought by gas lighting companies in the 1880s, recorded in his book, Mastering the Dynamics of Innovation, to understand how hard it is to resist change. This is the board’s number one job in an economy driven by innovation. GLORIFICATION OF GREED The fact is that even two years after Sarbanes-Oxley and similar acts elsewhere, there is no let-up in the frequency and magnitude of corporate frauds. These frauds have only added to the burden of shareholders and costs to the customers. The glorification of greed continues with the rape of corporations for the personal enrichment of the senior executives and the creation of ventures whose business plans do not extend beyond the initial public offering. The real question is how do we handle greed before it destroys capitalism. Greed is the becoming the biggest blot of the market economy and may well become the death knell of capitalism. So, the biggest challenge before us is how to handle this greed. How can human behaviour be rewarded through non-financial measures? One therefore has to look for the fundamental purpose of the corporation. UNHOLY ALLIANCE The fines and restitution amount of US$1.4 billion imposed on the big U.S. banks were expected to end the multimillion dollar pay packets some analysts enjoyed in the bill market, which were justified by the amount of investment banking business they brought in. But such is the bizarre world of corporate finance that soon after CSFB had offered an equity analyst at JP Morgan Chase a package that could earn him up to US$4 million in the first year.

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Where will this money come from if not from an unholy alliance between the analysts and underwriters? A revealing statistic was presented to Congress during the hearings leading up to the Sarbanes-Oxley Act: the ratio of buy to sell recommendation by securities analysts employed by brokerage firms rose from 6 to 1 in 1991 to a high of 100 to 1 in 2000. During the 1990s, analysts appear to have moved from being neutral umpires to becoming cheerleaders for their firms’ underwriting clients. DANGERS OF QUARTERLY REPORTING In a recent article, Professor Jensen, with Joseph Fuller of The Monitor Group, argued: “As the historic bankruptcy case of Enron suggests, when companies encourage excessive expectations or scramble too hard to meet unrealistic forecasts by analysts, they often take risky value-destroying bets. In addition, smoothing financial results to satisfy analysts’ demands for quarterto-quarter predictability frequently requires sacrificing the long-term future of the company.” MAKING ETHICS WORK FOR BUSINESS The problems in corporate governance are the problems of execution. There is too much rhetoric and too little conviction. There are many among business still not convinced about the moral angle of business. There is still an argument as to whether more money is destroyed by frauds or strategy. Despite our witnessing the fall of the mighty with unremitting regularity, the corporations are yet to realize how ethics and morals can be made to work for business and improve bottom lines. MIGRATION OF CORPORATE VALUES The simplistic view that prevailed in 1990s that business leaders need to focus exclusively on shareholder value as determined by the share price and that financial analysts are the best judge of business strategy has now simply become entirely outmoded. Companies have to find innovative ways to contribute to broader needs of society and at the same time improve the revenue and cut operating costs. The corporations need to find new models of constructive engagement involving all stakeholders to bring about change in the society. The business must look for innovative formats that stimulate systemic thinking and dialogue rather than posturing. The question is no

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longer whether the business has a role in social change but how it should play this role. Corporate governance has to be catalytic for that change. Corporate governance has to be based on equity and fairness. The issue is not simply growth but that the growth is shared. A company’s goal should not be the prosperity of a few but many. Inequality will be the greatest threat for the security of corporations in the twenty-first century. People can live in poverty but not injustice. This is why corporations are increasingly realizing that the social good has become the greatest competitive differentiator. THE CHALLENGE OF DIVERSITY The good news is that the role of business today is far more encompassing than ever before. Its constituency has extended to become global. So, its mindset should not be stuck into parochial grooves. It must recognize that its success will come from involving everyone and that it is only by valuing diversity, dissent, difference and dialogue that it can encourage a healthy clash of ideas that will spark innovations that alone can sustain the corporations of the future. Corporations have to recognize that value today comes not from deference but difference; it is created not by conformity but dissent. BUSINESS CAN MAKE A DIFFERENCE Today it is the economy that drives politics. It is business that drives governments. The terror, turmoil and turbulence all around us are proof enough that the political system has failed to address the human problems of inequity, poverty and security. Business can offer a hope, if run on true principles of transparency, equity, accountability and integrity, and responsible business can make a difference. It is this knowledge that you can make a difference that can be a powerhouse and pride for executives and a true incentive for driving the corporations. INSIDE-OUT TRANSFORMATION For making corporate governance work, we have to go through a profound metamorphosis from inside out. We have to change our metaphors of success from “winner takes all” and “success at all costs” and develop an inner value system which prides on ethics, morality, equity, legitimacy, transparency, diversity and most of all courage to own genuine failures.

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CATCH THEM YOUNG The real problem lies in our education system, which does not prepare us to own the problems and handle failures. By focusing on short-term success, it makes us use our creative energy and ingenuity to find excuses and pass on the buck. As Einstein said, “it is not the mistake that we make that causes the damage. It is the mistake that we make of defending the first mistake that causes serious damage.” The corporate scandals are stark evidence of this. All too often these were simple business failures which catapulted themselves into major collapses because of the managements’ attempts to cover them up. Our action, therefore, has to begin from schools in instilling courage to own up to the problems and have pride in saying “I am sorry, I made a mistake.” We need to change our success models and time horizons. Our focus should be on long-term goals. Companies must change the culture of living from quarter to quarter where CEOs are more interested in managing the stock market and move towards long-term sustainability. ROLE OF TRAINING This requires a 180-degrees shift and cannot come without a deep commitment for training. Practice of Corporate Governance, therefore, cannot be ingrained in boardrooms without a sharp focus on the training of directors. It is only proper training that would make directors learn communication skills and develop independence of mind. Its power has been illustrated by Mahatma Gandhi. There cannot be a more powerful illustration of the transforming power inherent in training. Gandhi who moved Indian masses and led a movement of truth and non-violence to seek India’s independence from Britain and, is today regarded as the greatest communicator, was hopelessly shy of speaking. He described his first encounter in a small cause court where he was required to crossexamine a witness of the plaintiff. Mahatma wrote: I stood up but my heart sank into my boots. I could think of no question to ask. My head was reeling and I thought the whole court was doing likewise. The judge must have laughed and the lawyers no doubt enjoyed the spectacle. But I was past seeing anything. I told the agent ‘I could not conduct the case’.

The same Gandhi wrote further: “But I persevered and I persevered and I persevered. I can now give a certificate to myself that a thoughtless word has

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neither entered my tongue nor escaped my pen.” I have no doubt that it is only through perseverance that our boards will be able to instil a culture that can help transform corporate boards to become engines of economic and social transformation. LESSONS FROM THE WEST There are a lot of lessons for developing and emerging Asian economies in the way corporate governance has been practised in the West. While these markets are highly sophisticated their governance systems are far from satisfactory. They cannot serve as role models for Asian and African economies but their scandals such as Enron, Anderson, WorldCom, Parmalat, Skandia, Vivendi, Equitable Life, Computer Associates, Ahold, and Shell offer great lessons. They make us wonder that if companies such as Shell whose slogan was “Judge us not by what we say but what we do,” can lie through their teeth to their biggest shareholders, would they have any qualms in doing so to Nigerian or Indian villagers? PROTECTING CAPITALISM FROM THE CAPITALISTS These corporate failures are largely the handiwork of entrenched incumbents who are manipulating the system to serve their personal agenda. They illustrate the need to save capitalism from the capitalists. We have to recognize that open financial markets are the best human innovation. Open markets are the only instrument to make the third world truly competitive and spread prosperity. Our challenge lies in finding ways to present the greedy incumbents from feeding off these markets through manipulation, corruption and subterfuge. Instead of criticizing the markets we need to launch a movement of bringing transparency, equity, integrity, accountability and social responsibility in the market and free it from these elite and powerful incumbent groups who are scuttling its growth by stifling reforms. In this we need active participation of the governments and reputable agents to keep the parasites out of the system. Governments have to take a proactive role in taking measures to diffuse ownership, improve efficiency of the productive assets, protect minority rights, instil independence in the boards, enhance enforcement capacity of the legislative measures, provide a safety net for victims of market excesses, and at the same time prevent regulations from being oppressive.

Corporate Governance: An Alternative Model

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A NATIONWIDE MOVEMENT In the end we have to recognize that corporate governance practices cannot be imposed by legislation alone — least of all ticking boxes. A box-ticking approach only encourages double standards. All energy is put on sticking to the form and throwing away the substance. Issues of corporate governance are issues of the heart. Do you pride yourself in being transparent and honest and have the conviction to own your mistakes or do you continue to do business as usual using all the techniques, skills and technology to ensure you do not get caught? As long as markets are driven by crass greed, codes will have little power to remove the practice of double standards. Only investors can — by punishing those at the helm of companies that get caught. It is in fact the investors who should adopt differing standards — forgive companies who admit to having made genuine mistakes and undertake to improve, and incarcerate those who use corporate governance simply as a cover to conceal their “business as usual” approach. For this we have to raise public awareness and work at many levels — shareholders, investors, policymakers, civil society and other stakeholders — and launch a national movement to cleanse the markets of entrenched incumbents, because it is only through good corporate governance that nations can realize their vision of prosperity for all. References Globe White Page (2004) Global Corporate Governance Guide 2004: Best Practice in the Boardroom. London: Globe White Page. Hall, P. and D. Soskice, eds. (2001) Varieties of Capitalism: The Institutional Foundations of Comparative Advantage. New York: Oxford University. Johnson, S., P. Boone and A. Breach (2000) “Corporate Governance in the Asian Financial Crisis”. Journal of Financial Economics 58: 141–86. La Porta, R., F. Lopez-De-Silanes, and A. Shleifer (1999) “Corporate Ownership Around the World”. Journal of Finance 54: 471–518. World Bank (1993) The East Asian Miracle: Economic Growth and Public Policy. Oxford: Oxford University Press for the World Bank.

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2 POLITICAL INSTITUTIONS AND CORPORATE GOVERNANCE REFORMS IN SOUTHEAST ASIA WU Xun

INTRODUCTION The “Asian model” of economic development, once hailed as the engine for the unprecedented economic growth in East and Southeast Asian countries, has been under heavy scrutiny following the Asian financial crisis in 1997. In particular, the impacts of corporate governance structure on the crisis have received a great deal of attention in the literature. Evidence shows that, at the macro level the weaknesses in corporate governance added to the vulnerability to the exchange rate depreciation and stock market collapse (Johnson, Boone and Friedman 2000), and that at the firm level the ineffective corporate board, weak internal control and lack of adequate disclosure led to excessive exposure to debts (ADB 2001). The governments in the region have responded decisively to these criticisms. Malaysia’s new Code of Corporate Governance requires one third of board members in the public listed firms to be independent; the Security Exchange of Thailand (SET) requires that financial information from listed companies conform to the International Accounting Standards. Similar measures have been undertaken in other countries throughout the region.

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Despite these efforts, however, the progress in reforming corporate governance in Southeast Asia has been rather modest. Ownership concentration remains at a high level (WSJ 2003), new regulations have yet to translate into real change in corporate behaviours, and there is even a perception that the quality of corporate governance has actually declined (Claessens and Fan 2003). The resistance to the reforms indicate that there might be some rigidities in corporate governance in Southeast Asia. The existence of such rigidities may hamper firms’ abilities to alter their corporate governance practices in responding to either the changing economic conditions or governmental directives. Such rigidities can be looked upon in light of the current debate over corporate governance convergence. The proponents for convergence argue that globalization (Hansmann and Kraakman 2001) and stock market competition (Coffee 2002) will force the corporate governance systems in different countries to converge to an international norm. The opponents, however, claim that culture, legal tradition, and history have all played an important role in the evolution of corporate governance, and that corporate governance at the national level will continue to diverge in the future due to path dependence (Bebchuk and Roe 1999). For those scholars, the sources of the rigidities in corporate governance stem from factors such as culture, legal tradition, history, and path dependence. In this chapter, we focus on the complementarities between political institutions and corporate governance to explain the rigidities in corporate governance. Corporate governance is concerned with the allocation of power, privileges and economic benefits among some of the most influential groups — such as investors, shareholders, mangers and employees — in any political system, and the relative strengths of claims made by these groups are often dictated by institutional factors such as party politics or electoral system. In addition, politicians and governmental officials often have vested interests in the existing corporate governance structure, as they derive various resources from the corporate sector. Corporate governance reforms that would alter the existing resource allocation are likely to be resisted in the political system. Last, even if the alternative corporate governance structure may benefit the firms in the long run, the firms may not have incentives to change their current practices as these practices may represent the best response to the existing political environment. For example, firms may resist the demand for more transparency as doing so could potentially increase the chances of extortions by corrupt officials in an environment where corruption is pervasive. While the prevailing political institutions are among the key determinants in the evolution of corporate governance, the corporate sector is not merely

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a passive participant in the political system. In fact, business elites can be involved in politics in various capacities in order to secure and advance their interests. Political institutions and the corporate governance structure mutually reinforce each other and become mutually dependent on each other. Such a mutual dependence may not only explain why a dominant corporate government structure is persistent over time, but also in part accounts for the difficulties in reforming political institutions. Understanding the linkage between political institutions and corporate governance has several important implications in practice. First of all, a corporate governance reform agenda that neglects the impacts of political institutions fuel unrealistic (high) expectation of what the reform can achieve. Political institutions determine the formation and quality of the corporate governance, and thus changes in corporate governance are likely to come about slowly and the outcome muddled if the existing political institutions remain unchanged. Second, understanding the role of political institutions in determining the corporate governance actually broadens the strategies and measures at the disposal of the government because the changes in political systems can effectively improve the prospects of success of corporate governance reforms. Third, the complexity between the corporate governance and political institutions imply that governments need to have a corporate governance strategy in dealing with the priority, scheduling and options of various reform initiatives in areas such as privatization and deregulation. In this chapter, we focus on the corporate governance practices in five Southeast Asia countries, namely, Indonesia, Malaysia, Philippines, Singapore and Thailand, and their relationship to the key characteristics of political institutions in these countries. The unique political and economic landscape of Southeast Asia presents an ideal setting for such a comparative study. There are striking similarities in corporate governance if compared with countries in other regions as a group, but the differences across these countries are also substantial. The chapter will be organized as follows. In the next section, we compare the corporate governance practices in the five Southeast Asian countries, and then present some stylized facts about the similarities and differences across these countries. In the third section, we discuss theories that link corporate governance with political institutions and examine their relevance in the context of Southeast Asia. In the fourth section, we conclude our analysis by pointing out some key policy lessons for the reformers in the region in designing and implementing corporate governance reforms.

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COMPARING CORPORATE GOVERNANCE IN SOUTHEAST ASIAN COUNTRIES: STYLIZED FACTS Since Southeast Asian countries display striking similarities in corporate governance structure, they have often been treated as a whole group in the literature; however, considerable differences do exist across these countries. Both the similarities and the differences form the building blocks of our analysis. This section draws heavily from some recent research conducted at international organizations such as the World Bank and Asian Development Bank. Ownership Concentration Table 2.1 shows the ownership concentration for corporations in the five Southeast Asian countries. Three measures are presented to show the robustness of the results. The first one is the average percentage of shares owned by the insiders of corporations (the managers, directors and controlling shareholders). High concentration of insider ownership may raise the agency costs for outsider shareholders as it increases the risk of the expropriation of outsider shareholders by the insiders. The second and third measures show the percentage of shares owned by the largest single shareholder and largest five shareholders, respectively. All three measures consistently point to a trend that the ownership concentration is high in Southeast Asia. For example, in Indonesia the insiders own about 70 per TABLE 2.1 Concentration of Ownership in Selected Asian Countries

Indonesia Malaysia Philippines Singapore Thailand Japan Korea

% of shares owned by the insiders*

% of shares owned by the largest top shareholder**

% of the shares owned by the largest five shareholders**

68% 50% 55% 55% 45% 41% 29%

48% 30% 34% — 29% — 20%

68% 59% 60% — 57% — 39%

Source: * Himmelberg Charles P., R. Glenn Hubbard, and Inessa Love, Investor Protection, Ownership, and Investment, World Bank Policy Research Working Paper no. 2834 (2004). ** Asian Development Bank (2001).

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cent of the shares in the public listed companies and the largest shareholders own roughly half of the equity stakes in the companies. On the other hand, regional variations are not insignificant — the average percentage of shares owned by the largest shareholders in Thailand is 30 per cent as compared to about 50 per cent in Indonesia. While corporate ownership is indeed highly concentrated in Southeast Asia, it is nevertheless not a distinctive Southeast Asian phenomenon. In fact, La Porta et al. (1999) argue that dispersed corporate ownership as found in the United States and United Kingdom is an exception rather than the norm, even in the developed world. For example, both France and Germany have high concentration of ownership, and the percentage of shares owned by corporate insiders are 62.6 per cent and 68.1 per cent, respectively (Himmelberg, Hubbard, and Love 2004). The high concentration of ownership also should not be perceived as inferior to low concentration of ownership. Some empirical evidence from Asia and elsewhere even suggests the exact opposite. For example, Claessens, Djankov, Fan and Lang (2002) report that firm value is higher when the largest owner’s equity stake is larger, and Joh (2003) finds that firm’s accounting performance is positively related to ownership concentration. These findings are consistent with the principle-agent theory, which suggests that agency costs would be higher in the dispersed ownership than in the concentrated ownership. However, ownership concentration in Southeast Asia does open the door for some corporate governance practices that are potentially harmful. High ownership concentration has facilitated the separation between ownership and control and the family dominance in Southeast Asian economies. It is over these practices that some interesting and important patterns of variations have emerged across Southeast Asia. Separation between Ownership and Control Following the definitions used by La Porta et al. (1999), we define ownership as cash flow rights, and control as voting rights. Voting rights may deviate from cash flows in firms with high concentration of ownership because the controlling shareholders can use various mechanisms such as pyramiding and cross-holding to enhance control. The separation between ownership and control raises the agency costs for minority shareholders as their rights may be expropriated by the controlling shareholders (the entrenchment effect). Table 2.2 shows that expropriation of minority shareholders is widespread in Southeast Asia.

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TABLE 2.2 Separation of Ownership and Control in Selected Asian Countries

Indonesia Malaysia Philippines Singapore Thailand Japan Korea

Ratio of cash flow to voting rights

Pyramids with ultimate owners

Cross-holdings

Management

0.784 0.853 0.908 0.794 0.941 0.602 0.858

67% 39% 40% 55% 13% 36% 43%

1% 15% 7% 16% 1% 12% 9%

85% 85% 42% 70% 68% 37% 81%

Source: Claessens, Stijn, S. Djankov, and L.H.P. Lang.“The Separation of Ownership and Control in East Asian Corporations”, Journal of Financial Economics 58 (2000): 81–112.

The first column shows the ratio of cash flow rights to voting rights, indicating that the separation of ownership and control occur more frequently in Singapore, Indonesia and Malaysia. The second column compares the use of pyramid structures1 and crossing-holdings2 in Southeast Asia. The use of pyramid structures and crossings is prevalent in Malaysia (39 per cent and 15 per cent) and Singapore (55 per cent and 16 per cent); while the pyramid structures occur most frequently (67 per cent) among corporations in Indonesia, the use of cross-holdings is relatively rare in that country and the pattern is similar for the Philippines. The figures also suggest that the separation of ownership and control occurs the least frequently in Thailand. The last column in Table 2.2 indicates the percentage of the managers who are affiliated with the controlling shareholders (family ties or otherwise). For 85 per cent of the firms in Indonesia and Malaysia as well as about 70 per cent of firms in Singapore and Thailand, the control and management are not separated. The only exemption is the Philippines, but Tan (1993) attributes it to the fact that many Philippine corporations have interlocking directorates and management boards. The high percentage of the affiliated managers suggests that the use of professional managers has not been a standard practice in Southeast Asia. The adverse effects of the separation between ownership and control on the value and performance of the firms are reported by a number of recent studies. The separation of ownership and control lowers firms’ value (Lins 2003), and decreases their financial performance (Yeh, Lee, and Woidtke 2001).

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Family Dominance and State Control Another key feature of corporate governance in Southeast Asia is the dominant role of family businesses in the economy. Table 2.3 shows the distribution of control across Southeast Asia. Companies are divided into widely-held and with ultimate owners, and five ultimate owners are presented: family, state, widely-held financial corporation, and widely-held non-financial corporations. In comparison to firms in East Asia, widely-held firms are a rarity in Southeast Asia, with the exception of the Philippines. Families control the majority of the public listed firms in Indonesia (72 per cent), Malaysia (67 per cent), Thailand (62 per cent) and Singapore (55 per cent). In the Philippines, where relatively high percentage of firms are widely-held (19 per cent) compared to its Southeast Asian neighbours, the share of family-controlled firms is still the highest (45 per cent) of all types. Perhaps a more striking feature of corporate governance in Southeast Asia is the concentration of economic power in an extremely small number of families. Table 2.4 shows the percentages of the capitalization in the stock exchanges in these economies are owned by one, five and ten largest families. In Indonesia and the Philippines, the largest families control 17 per cent of the total market capitalization, and the largest ten families control over 50 per cent of the total market capitalization. Substantial regional variations do exist across the five countries. For example, in Singapore and Malaysia, the largest ten families control about a quarter of the total market capitalization, very close to the level in Korea. The dominance of families in the corporate sector in Southeast Asia presents some special challenges for corporate governance. First of all, it may amplify the problems caused by the separation of ownership and control in a TABLE 2.3 Control of the Public listed Companies in Selected Asian Countries Country Indonesia Malaysia Philippines Singapore Thailand Japan Korea

Widely held

Family

State

Widely held finanical

Widely held corporation

5% 10% 19% 5% 7% 80% 43%

72% 67% 45% 55% 62% 10% 48%

8% 13% 2% 24% 8% 1% 2%

2% 2% 8% 4% 9% 7% 1%

13% 7% 27% 12% 15% 3% 6%

Source: Claessens, S. et al. (2000).

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TABLE 2.4 Concentration of Family Control in Selected Asian Countries

Indonesia Malaysia Philippines Singapore Thailand Japan Korea

Average number of firms per family

Top 1 family

Top 5 families

Top 10 families

4.09 1.97 2.68 1.26 1.68 1.04 2.07

17% 7% 17% 6% 9% 1% 11%

41% 17% 43% 20% 32% 2% 30%

58% 25% 53% 27% 46% 2% 27%

% of total market capitalization that families

Source: Claessens, S. et al. (2000).

vicious cycle of pyramiding controls and family dominance: Pyramiding controls strengthen the family dominance which affords them an increased capacity to engage in more pyramiding controls. Second, the family control subjects the minority shareholders to a sets of risks — such as intra-family disputes and exploitation of some family members by others — which are absent in firms that are not controlled by families (Morck 2004). Third, the high concentration of economic power in the handful of families adds to the vulnerabilities to the overall macroeconomic environment, because decisions made by a handful of business elites — private in nature — may lead to disastrous consequences to the whole economy for which they cannot be held accountable. In addition to a high concentration of family control, another noticeable feature in corporate governance in Southeast Asia is the important role played by state-controlled corporations, although the degree of importance varies greatly from country to country, as shown in Table 2.4. Singapore has the highest share of the state-controlled corporations (24 per cent), followed by Malaysia (13 per cent), Indonesia (8 per cent) and Thailand (8 per cent). The only outlier in this group is the Philippines, where the share of state-controlled is merely 2 per cent, similar to Japan and Korea. Corporate Governance Performance While certain characteristics of the corporate governance, such as family dominance or corporate control through pyramiding and cross-holding, expose

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minority shareholders to greater risk of being exploited by the insiders, it is overly simplistic to assume that there exits a one-to-one relationship between the structural characteristics of a corporation and their actual performance. Therefore, we have added the corporate governance performance as a separate dimension in comparing the five Southeast Asian countries. The importance of measuring the corporate governance performance has been recognized by a number of countries in the region. For example, in Thailand a corporate governance rating agency has been established to provide corporate governance rating services to companies listed in SET; in Singapore, Business Times has started to issue its corporate governance rating for some leading companies in Singapore. Several international consulting firms, such as PricewaterhouseCooper, McKinsey & Company and Credit Lyonnais Securities Asia (CLSA), have also begun their coverage of corporate governance measure at either the country or firm level. The corporate governance rating by CLSA is selected as the benchmark of our analysis for several reasons. The first is that it covers all five Southeast Asian countries included in our analysis. The second reason, perhaps more important, is that it embraces a broader definition of corporate governance instead of narrowly focusing on the protection of shareholders. For example, “social awareness”, referring to the company’s emphasis on ethical and socially responsible behaviour, has been a component of their corporate government rating. The third is that it combines both the subjective responses as well as objective measurement in their rating. For example, the rating on independence of the board of directors for a particular company not only reflects the analysts’ opinion but is also based on an actual investigation of the relationship between the directors and the controlling shareholders. Table 2.5 shows the corporate governance ratings for the five Southeast Asian countries. There are substantial variations in the quality of corporate governance measured by the ratings across different countries. Singapore is consistently rated the best in the region in all of these categories except for accountability and social awareness, and companies in Indonesia perform the worst in corporate governance over almost all categories. The weighted overall scores are shown in Table 2.6. Table 2.6 also demonstrates the correlation between corporate governance ratings and share price performance. While the dramatic fall in share price reflects the devastating effects of the Asian financial crisis, which in part was due to poor corporate governance in some Southeast Asian countries, it indicates that the investors have clearly recognized the importance of corporate governance and adjusted their valuation accordingly.

36 49 41 56 36

57 63 44 67 65

Transparency 22 67 46 81 43

Independence 21 38 34 45 63

Accountability 34 52 36 70 47

Responsibility

Description of variables: Discipline — management’s commitment to emphasize shareholder value and financial discipline Transparency — the ability of outsiders to access the true position of a company Independence — the board of directors’ independence of controlling shareholders and senior management Accountability — the accountability of the management to the board of directors Responsibility — the effectiveness of the board to take necessary measures in case of mismanagement Fairness — the treatment of minority shareholders received from majority shareholders and management Social awareness — the company’s emphasis on ethical and socially responsible behaviour Source: Credit Lyonnais Securities Asia (CLSA) Saints & Sinners: Who’s Got Religion? (2001).

Indonesia Malaysia Philippines Singapore Thailand

Discipline

TABLE 2.5 CLSA Corporate Governance Ratings in Southeast Asia

53 70 41 76 70

Fairness

37 60 78 54 65

Social awareness

Political Institutions and Corporate Governance Reforms in Southeast Asia 25

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TABLE 2.6 Corporate Governance Rating and Share Price Performance in Southeast Asia

Indonesia Malaysia Philippines Singapore Thailand

Overall CG Score

5-year share price performance (%)

37 57 44 65 55

–61.4% –40.1% –61.4% 62.7% –41.9%

Source: Credit Lyonnais Securities Asia (CLSA) (2001).

A number of questions emerge from our comparison of corporate governance in Southeast Asia. Why are so few companies widely held in Southeast Asia? Why are family businesses so dominant? Why does the concentration of family businesses in the economy vary greatly from country to country? What are the implications of the extremely high concentration of family businesses in the economy? Why do countries perform so differently in corporate governance ratings even though a similar corporate governance structure is in place? If some features of the corporate governance structure, such as family dominance and low transparency, are proved to be harmful to the investors, why have they been persistent for so long? And why are the structural characteristics of the corporate governance so resilient despite the tremendous efforts devoted to the reforms? In the next section, we show that the analysis based on the linkage between political institutions and corporate governance may provide some plausible answers to these questions. LINKING POLITICAL INSTITUTIONS AND CORPORATE GOVERNANCE IN SOUTHEAST ASIA A clear definition of political institutions is in order as the term might mean different things for different people. We define political institutions broadly as to include constitutional structures, political party systems, regulatory arrangements, various forms of public-private linkages, and informal rules and constraints governing political interaction. Political institutions influence corporate governance through structuring the incentives of the demand and supply in the political marketplace for a particular type of corporate governance regime.

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Veto Power and Coalition Much of the politics is concerned with the allocation of power, and this is where we launch our inquiry of the linkage between political institutions and corporate governance. Hall and Soskice (2001) argue that the preference over different ownership concentration levels rest on the ability of a government to make credible commitment to maintain a regulatory regime to protect private investment. Highly concentrated ownership will be more likely if the government cannot credibly commit to its claims because concentrated ownership gives the investors more flexibility to deal with the ex post shifts when the government behaves opportunistically.3 What type of political system do a better job in preventing government from behaving opportunistically? The number of veto players matters. Beck et al. (2001) explain that a political system with multiple decision makers may offer greater protection from arbitrary government to individuals and minorities. Hall and Soskice (2001) report that, when the number of veto players rises, dispersed ownership becomes more likely. Another important dimension of investor protection is policy implementation, because governments’ ability to take actions decisively also matters. The Asian financial crisis is a good case in point when both policy credibility and decisiveness are both essential. In contrasting the policy failures in Thailand and Indonesia during the Asian financial crisis, Andrew MacIntyre (1998) writes: The institutional problems in Thailand and Indonesia were quite different, but ultimately produced the same outcome — massive loss of investor confidence. Where Thailand suffered policy paralysis as a result of weak multiparty parliamentary government, Indonesia suffered from almost the opposite set of institutional circumstances: massive centralization of power which left government vulnerable to deep problems of credibility due to unreliable policy commitments. Thailand’s system of government suffered from too many veto points and Indonesia suffered from too few.

The key is that institutions such as multiple veto players have to be coupled with coalition with breadth and depth to guarantee the implementation of policy. Hicken and Ritchie (2003) define the coalitional breadth as “the number of different interests represented in the coalition, such as labor, business, landholding elites, peasants, and at time civil service”, and coalition depth as the “level and extent of participation”. Table 2.7 shows how the five Southeast Asian Countries would fall into the typology developed by Hicken and Ritchie.

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TABLE 2.7 VetoPower and Coalition Broad-deep coalition

Shallow-narrow coalition

Concentrated veto power

Decisive Policy stability Implementation Singapore

Decisive Policy volatility Lack of implementation Philippines Indonesia Malaysia

Dispersed veto power

Decisiveness of difficulties Policy stability

Decisiveness difficulties Policy stability Lack of implementation Thailand

US Source: Hicken, Allen and Bryron K. Ritchie (2003).

Table 2.7 shows the challenges facing countries in Southeast Asia in promoting dispersed ownership in the economy. Concentrated veto power undermines policy credibility in the Philippines, Indonesia and Malaysia, while in Thailand, dispersed veto power coupled with shallow-narrow coalition leads to frequent gridlock of the decision process. This explains why the ownership concentration has been so high in Southeast Asia, and unless significant changes in the political system can be expected, business owners would not be keen to giving up their controlling shares. Figure 2.1 shows the FIGURE 2.1 Predictability of Changes in Rule, Laws and Regulations in Southeast Asia Singapore

87%

Malaysia

63%

Philippines Thailand Indonesia

13% 37%

53% 40% 34%

47% 60% 66%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Predictable Unpredicable

Source: World Business Environment Survey, World Bank (1999).

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results from World Business Environment Survey, and an original question asks the firms “do you regularly have to cope with unexpected changes in rules, laws or regulations which materially affect your business?” The results are generally consistent with the typology developed by Hicken and Ritchie (2003). Most business owners in Singapore believe that the government is capable of making credible commitment to their approaches while two-thirds of business ownership in Indonesia think that unexpected changes in rules, laws and regulations are likely. Vote Buying and Money Politics Several Southeast Asia countries such as Indonesia, the Philippines, and Thailand have made some significant progress towards democratization in recent years. Both the electoral politics and electoral process have undergone changes of paramount importance to corporate governance reforms. Callahan (2000) reports that election in many Asian countries often requires huge amount of resources because of the widespread practices of vote-buying. If this holds true, then increased electoral competition resulting from democratization may reinforces the family dominance in economy, as families are best poised to supply with the much needed resources to the system — money, network and politicians. In addition, the involvement of family businesses in politics helps to solve the free-rider problem normally associated with the political contribution. Party politics and the electoral system in Thailand offer an interesting example. Most Thai parties are loosely structured groups of factions, and do not have a national network, and as a result, there is no long tradition of mobilization and organization at the local level. Parties have to rely on votebuying to obtain support at the local level. In addition, because the cabinet position is awarded on the number of the Members of Parliament (MPs) a faction leader controls, MP-buying is also a widespread practice. During the 1996 general election, it is estimated that 20–30 billion baht (Wingfield 2002) were spent on the election (campaigning, vote-buying, MP-buying). On the other hand, however, Thai parties do not have a mass base and thus cannot depend on membership subscriptions for funding party campaigns (Wingfield 2002), and the chief means for political parties to secure this level of funding is to through political patronage through their connections with the corporate sector. The vote-buying and party financing open the door for growing business participation. In 1992, 68 per cent of the assemblymen were businesspeople. Callahan (2000) describes the nature of the growing business participation and its relation to politics: “political power allows them

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to firm up and expand their business activities, while income generated from business gives them access to business power.” The commercialization of Thailand’s electoral gives the edge to family conglomerates to use their economic strengths to advance their interests because their size gives them some comparative advantages in the competition for political power. On 9 February 2001, Thaksin Shinawatra, the richest man in Thailand, was appointed prime minister of Thailand. His party — Thai Rak Thai — a single party representing the interests of business, won 41 per cent of the votes. Commentators believe that with the direct access to power, the wealth will be even more concentrated in just a few families and “narrow rather than broadening opportunities in the Thai marketplace” (Far Eastern Economic Review, 4 January 2001). The rise of the Thai family conglomerates in the political arena may have been an extraordinary case. However, money politics in Indonesia, Malaysia, and the Philippines have been well documented (Callahan 2000; Eklof 2002; Gomez 2002) and vote-buying has also been reported for Indonesia and the Philippines. Campaign financing provides an important venue for the family conglomerates to further their economic power by securing rent-seeking arrangements from politicians who demand financial contributions. Ironically, policies designed to roll back the state involvement in the economy, such as privatization and deregulation, have bred the “new rich” who are not to be outdone by the old ones as a new group of family conglomerates have emerged from newly deregulated and privatized sectors in the region. Quality of Regulatory Environment and Corruption The corporate governance reform is a regulatory reform in nature, and just as any other type of regulatory reforms, the ability of the government to implement the rules and regulations will depend on the quality of the regulatory environment. Table 2.8 shows the linkage between the quality of the regulatory environment and the compliance of corporate governance rules across Southeast Asia. There are discrepancies between the rules and their implementations for all five countries with varying degrees. Malaysia has very tough corporate governance rules and regulations, but the enforcement is of very poor quality. The regulatory environment of the five countries measured by rule of law, the protection of property rights and competence of public officials are also of low quality, with the exception of Singapore, where all rankings are considerably higher than other Southeast Asian countries. It is clear that that regulatory environment is not up to the task to implement the corporate governance

4 8 5 9 7

Country

Indonesia Malaysia Philippines Singapore Thailand 2 2 2 7 2

Committed and effective enforcement of rules and regulations 4 7 3 10 3

Rule of Law (out of 10) 63 33 53 6 37

Property rights (rank out of 79 countries)

Sources: Credit Lyonnais Securities Asia (CLSA) (2001); Global Competitive Report, 2001–2002.

Clear, transparent and comprehensive rules and regulations 48 65 58 1 44

Competence of public officials (rank out of 79 countries)

TABLE 2.8 Quality of Regulatory Environment and Compliance of CG Regulations in Southeast Asia

58% 25% 53% 27% 46%

Top ten families

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standards — which are low to start with in several countries — and that poor regulatory environment leads to poor quality of enforcement. Theorists have postulated several explanations. La Porta et al. (1999) show that countries with poor legal and regulatory environment are likely to have concentrated ownership. This is because both the state and individual owners can enforce property rights, and enforcement by individual owners (in the form of concentrated ownership and family businesses) will gain more importance in the absence of effective enforcement by the state. Shleifer and Wolfenzon (2002) argue that the concentration of ownership becomes dominant as large shareholders cannot sell out in a low quality regulatory environment because becoming a diversified passive investor in other firms is simply not a viable alternative. Morck and Yeung (2004) claim that family ownership and groups will become the dominant choice of the institutional arrangements based on the theory of transaction costs: the transaction costs among family members and closely affiliated corporations will be lower, because they face a lower degree of information asymmetry problems. The last column in Table 2.8 shows that the high level of concentration by family businesses does seem to correspond to the quality of regulatory environment. Focusing on the incentives of the corrupt officials, Morck and Yeung (2004) argue that family pyramids are preferable trading partners for corrupt politicians. Family firms are more likely to return past favours because of a longer continuity of management. Being involved with a few families instead of a large number of firms could also reduce the chances of being exposed because politicians only need to deal with only a few patriarchs. In addition, families controlling pyramids are more able to come up with side payments because they are able to pay by expropriating minority shareholders (Morck and Yeung 2004). Given the importance of the global fight against corruption, our analysis shows that reducing the level of corruption can decrease a country’s reliance on a small number of families and such benefits should be taken into consideration by the policymakers in designing the anti-corruption strategies. The existence of widespread corruption would potentially undermine the efforts in toughening the rules on corporate information disclosure, because firms that comply with the regulations might find themselves in a weakened position when dealing with the corrupt officials. The accurate information reported by the firms can be used by the corrupt officials for increased level of extortions. Root (2001) points out that business transparency may be dangerous in a poor quality regulatory environment because firms that disclose profits can still be subject to arbitrary government audits and expropriations,

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and this forces the firms to internalize risks by maintaining a closed production system. In this case, firms might be discouraged to participate in equity financing through listing in stock markets because of unreasonably high level of rules and standards. Figure 2.2 shows the occurrence of bribery activities reported by firms in the five countries based the World Business Environment Survey. The levels of corruption faced by the firms in some Southeast Asian are astonishing: 68 per cent of firms in Indonesia and 79 per cent in Thailand pay bribes to public officials on a regular basis. The size of the bribe is often substantial. Findings from the 2001 Indonesia national survey show that 27 per cent of businesses reported paying over 10 per cent of their companies’ total revenue as bribes. Smith notes that in Indonesia most bureaucrats took pungli payments (“informal tax”) to supplement meagre salaries, and the government expected this since it reduces the needs for more formal tax (Smith 2001). The important dynamic effects of the relationship between the quality of regulatory environment and the various characteristics of the corporate governance structure should be paid sufficient attention. Claessens, Djankov and Lang (2000) discuss the possibility of the endogeneity of the legal systems, that is, the dominance of family business hampers the development of legal and regulatory environment as these firms have more resources to FIGURE 2.2 Southeast Asia: Bribery Figures

Singapore

Malaysia

Philippines

Thailand

Indonesia 0%

20%

Frequently

40% Sometimes

60%

80%

Seldom

100% Never

Source: World Business Environment Survey, World Bank (1999).

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shape the government and they have vested interests in the continuation of the existing regulatory environment. CONCLUSION: POLICY LESSONS FOR CORPORATE GOVERNANCE REFORMS IN SOUTHEAST ASIA Our analysis of the linkage between political institutions and corporate governance offers several important policy lessons for designing and implementing corporate governance reforms in Southeast Asia. First of all, the policymakers in the region should consider the differences in political institutions before they commit to a comprehensive set of reform measures that might be promoted as universally desirable. Different countries face different challenges in corporate governance based on how their corporate governance system matches up with the prevailing political institutions, and thus would demand different sets of solutions. Policies should be devised to reflect on the key features of the underlying political environment. Ignoring the relationship between political institutions and corporate governance significantly reduces the relevancy of the reform policies. Second, governments should not commit to a set of comprehensive reform measures prematurely because much of the real progress might depend on what happens to firms’ political environment. Firms’ corporate governance practices are largely shaped by forces outside the corporate boardrooms. For example, there is little chance that the adoption of international accounting standards would lead to high quality disclosure as long as both the firms and their political patrons have vested interests in defending the secrecy of the existing rent-seeking schemes critical for the survival of both. Tightening standards for listed firms prematurely can even backfire as firms contemplating equity financing may give up this option altogether if they are convinced that it is impossible to meet these standards in the prevailing political environment. Third, our analysis of the importance of political institutions does not mean that our choice set of reform measures are narrowed by any means. In fact, the scope of effective measures for corporate governance can be broadened because a new set of instruments focusing on the firms’ political environment may now be at the disposal of the reformers. For example, reducing corruption might decrease the incentives for the family conglomerates to further their territory. In addition, while the fundamental changes in the political changes take time and are often outside the scope the reformers, they can position themselves in anticipation of the arrival of favourable conditions. In many Southeast Asian countries, substantial changes in both political and economic institutions are taking place. Reformers should couple the strategies for good

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corporate governance principles with some changing characteristics in the political institutions. The recent surge of interests on political corruption, for example, offer an important window of opportunity for make improvement in corporate governance issues such as bribery and information disclosure. On the other hand, however, ignoring the linkage between political institutions and corporate governance might not only lead to the waste of otherwise golden opportunities, but also aggravate problems. The experiences in public sector reforms such as privatization and deregulation in Southeast Asian provide some important examples. For example, while the original intention of deregulation is to undermine the state’s regulatory discretion and to allow more competition in the marketplace, what has happened in reality is the transfer of the public monopoly to private hands which further strengthens the power of family conglomerates at the expense of a weakened economy and risen inequality. It is crucial to put in place appropriate corporate governance structure to spearhead the process of public sector reforms in privatization and deregulation. Notes 1. Defined as owning a majority of a stock of one corporation which in turn holds a majority of the stock of another, a process that can be repeated a number of times (Claessens, Djankov and Lang 2002). 2. Defined as a company further down the chain of control has some shares in another company in the same business group(Claessens, Djankov and Lang 2002). 3. Haber, North and Weingast (2003) argue it is almost intrinsic for governments to engage in such opportunistic behaviour as they are often confronted with many, and often conflicting, objectives, in dealing with the corporate sector.

References Asian Development Bank (ADB) (2001) Corporate Governance and Finance in East Asia. Bebchuk, L.A. and M. J. Roe (1999) “A Theory of Path Dependence in Corporate Ownership and Governance”. Stanford Law Review 52, no. 1: 127–70. Beck, T., G. Clarke, A. Groff and P. Walsh (2001) “New Tools and New Tests in Comparative Political Database of Political Institutions”. World Bank Economic Review 15, no. 1: 165–76. Callahan, W. (2000) “Political Corruption in Southeast Asia”. In Party Finance and Political Corruption, edited by R. Williams, pp. 163–98. London: Palgrave. Claessens, S., S. Djankov, J.P.H. Fan, and L.H.P. Lang (2002) “Disentangling the Incentive and Entrenchment Effects of Large Shareholdings”. Journal of Finance 57: 2741–71.

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Claessens, Djankov and Lang (2000) “The Separation of Ownership and Control in East Asia Corporations”. Journal of Financial Economics 58: 81–112. Claessens, S. and J.P.H. Fan (2003) Corporate Governance in Asia: A Survey. Unpublished manuscript. Coffee, J.C. (2002) “Racing Towards the Top: The Impact of Cross-Listings and Stock Market Competition on International Corporate Governance”. Columbia Law School Working Paper no. 205. Eklof, S. (2002) Politics, Business, and Democratization in Indonesia, in Political Business in East Asia, ed. E.T. Gomez, 216–49. Routledge. Gomez, E.T. (2002) Political Business in Malaysia: Party Factionalism, Corporate Development, and Economic Crisis, in Political Business in East Asia, ed. E.T. Gomez, 82–114. Routledge. Hall, P. and D. Soskice, eds. (2001) Varieties of Capitalism: The Institutional Foundations of Comparative Advantage. New York: Oxford University. Hansmann, H. and K. Reinier (2001) The End of History for Corporate Law. Georgetown Law Journal 89, 439–68. Hicken, A. and B.K. Ritchie (2003) The Origin of Credibility Enhancing Institutions in Southeast Asia. Unpublished manuscript. Hiaimelberg, Hubbard, and Love (2004) “Investment Protection, Ownership and Cost of Capital”. World Bank Working Paper no. 2834. Joh, S.W. (2003) “Corporate Governance and Firm Profitability: Evidence from Korea before the Economic Crisis”. Journal of Financial Economics 68, no. 2. Johnson, S., P. Boone and A. Breach (2000) “Corporate Governance in the Asian Financial Crisis”. Journal of Financial Economics 58: 141–86. Khouw, M. (2004) “The Private Sector Response to Public Sector Corruption”. In Business in Indonesia: New Challenges, Old Problems, edited by M.C. Basri. Singapore: Institute of Southeast Asian Studies. La Porta, R., F. Lopez-De-Silanes, and A. Shleifer (1999) Corporate Ownership around the World. Journal of Finance 54: 471–518. Lins, K.V. (2003) “Equity Ownership and Firm Value in Emerging Markets”. Journal of Financial and Quantitative Analysis 38: 159–84. MacIntyre, A. (1998) “Political Institutions and the Economic Crisis in Thailand and Indonesia”. ASEAN Economic Bulletin 15: 3. McBride, S. (2003) “Why Asia Can’t Be Too Cocky”. Wall Street Journal, 19 December. Morck, R., and B. Yeung (2004) “Family Control and the Rent-Seeking Society”. Entrepreneurship: Theory and Practice, 28: 4. Root, H. (2001) “Asia’s Bad Old Ways: Reforming Business by Reforming Its Environment”. Foreign Affairs, Mar/April. Shleifer, A., and D. Wolfenzon (2002) “Investor Protection and Equity Markets”. Journal of Financial Economics, 66: 3–27. Smith, A.L. (2001) “Indonesia”. In Government and Politics in Southeast Asia, edited by J. Funston. Singapore: Institute of Southeast Asian Studies.

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Tan, E. (1993) “Interlocking Directorates, Commercial Banks, Other Financial Institutions, and Non-Financial Institutions”. Philippines Review of Economics and Business 30: 1–50. Yeh, Y.H., T.S. Lee, and T. Woidtke (2001) Family control and corporate governance: Evidence from Taiwan, International Review of Finance 2: 21–48. Wingfield, T. (2002) “Democratization and Economic Crisis in Thailand: Political Business and the Changing Dynamic of Thai State”. In Political Business in East Asia, edited by E.T. Gomez, 250–300. Routledge.

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3 DISCLOSURE, REPORTING, AND DERIVATIVE ACTIONS Empowering Shareholders in Southeast Asia LOW Chee Keong

INTRODUCTION At its most elementary form, corporate governance is simply about the interaction and relationship among the various participants, or stakeholders, in determining both the performance and the direction of companies. The modern company is a relatively recent creation of the common law and its genesis may be traced back about a century ago to the landmark pronouncement of the English House of Lords in Salomon v A Salomon & Co Ltd, wherein Lord Halsbury LC opined that a company has “a legal existence with, as I have said, rights and liabilities of its own whatever may have been the ideas and schemes of those who brought it into existence”.1 Therein lies the foundation of modern company law, as the “veil of incorporation” effectively segregates the owners from the management of the company, thereby according its members with the protection of limited liability. The company may therefore be viewed as a conduit with two masters,

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namely, the board of directors deciding as a collective unit and the members deciding at a general meeting. While this may, at first glance, raise conceptual difficulties as regards the precise scope of the respective authority of the board of directors and of the general meeting, the issue is deflected by the articles of association conferring wide powers of management of the affairs of the company to its board of directors. It is established law that the general meeting may not override the directors and involve itself in the management of the company.2 In short, while shareholders have the theoretical right to elect persons of their choice to the board, they do not have the ability to instruct such persons on matters that pertain to the affairs of the company.3 The Asian financial crisis brought to the foreground the common occurrence of weak corporate governance that has allowed companies to engage in excessive over-leverage, some of which were aided by implicit state guarantees. The concepts of transparency, disclosure and accountability were largely ignored in the lead up to the crisis as investors assumed shortterm outlooks to derive increasing profits from the steadily rising regional financial markets. Companies across the region were equally guilty of neglecting the principles of good corporate governance, the difference being perhaps in the degree of neglect. This is evident from instances of corporate abuse through related party transactions, incidence of capricious decision-making, shifting of assets within the corporate group, undertaking of transactions without proper disclosure and poor financial management by directors. The abuse of corporate power and/or the lack of effective management oversight have been well documented over recent years with such notable examples as Enron and WorldCom in the United States of America, HIH Insurance in Australia, TPI in Thailand, Barings plc in Singapore and Perwaja Steel in Malaysia, to name but a few. However, the billions of dollars that were lost by investors brought about an important, albeit somewhat belated, benefit namely, an appreciation of the urgent need for improved standards of accountability and transparency. An area of concern is how the interests of shareholders may be better protected. This chapter examines two proposals that have been implemented and/or are being actively considered by a number of Southeast Asian countries, namely, quarterly reporting and statutory derivative actions. While not disagreeing with the merits of these measures, this chapter nonetheless identifies and analyses a number of principal deficiencies within the present system before concluding with some proposals which adoption may contribute to the resolution of some of the existing problems.

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QUARTERLY REPORTING — QUANTITY OR QUALITY? Quarterly reporting has now been adopted in a number of emerging markets throughout East Asia including the People’s Republic of China, the Republic of Korea, Taiwan, Thailand, Malaysia and Singapore, while the European Union is moving towards adoption of the same although not without strong opposition from some sectors. Hong Kong presently maintains a “dual system” as only companies that are listed on the Growth Enterprise Market are required to report on a quarterly basis, while proposals are afoot to extend this requirement to all companies that are listed on the Stock Exchange of Hong Kong.4 In the United States, where quarterly reporting has been mandated since 1946, companies are required to provide more a comprehensive summary of data which include the income statement, balance sheet and the cash flow statement. As providers of capital that facilitate the expansion of the company, shareholders enjoy certain rights including the right to vote, the right to a dividend if declared, the right to a return of capital and a right to be treated fairly. These rights are personal to each individual shareholder and cannot be interfered with by either the company or another shareholder.5 To ensure that the shareholder is kept apprised of the development of the company, he or she has the right to inspect registers that are kept by the company.6 They are also entitled to receive copies of the interim accounts, audited profit and loss account, the balance sheet as well as the reports by the auditors and the directors of the company. The principal argument in favour of quarterly reporting is enhanced transparency, which is a central pillar of good corporate governance. Proponents maintain that more regular disclosure leads to a better understanding of the operational and financial aspects of the company, and through it to a more accurate reflection of the share price. Armed with a higher level of confidence, investors will reward the companies that are perceived as better performers relative to their peers or contemporaries. Increasing the frequency of disclosure will also highlight any bad news more quickly, thereby allowing investors to rebalance their portfolios on a timely and informed basis. Is More Always Better? There are a number of market mechanisms that provide strong incentives for companies to adhere to high levels of voluntary disclosure. These include the use of equity as currency for acquisitions or expansions, the need to maintain strong share prices to maintain the value of share option schemes, and the

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market for corporate control as the value of companies that are less transparent may be discounted thus making them potential takeover targets. However, there is an important caveat for this hypothesis, namely, that it applies best in jurisdictions with mature capital markets that enjoy a diversified shareholding base without any significant controlling shareholder. It is well documented that the family and/or the state dominate corporate ownership in East Asia.7 It is equally undeniable that mandatory quarterly reporting contributes towards redressing the information asymmetry that exists between company insiders and outsiders. In the context of ASEAN, with the dominance of the family and state-owned or government-linked corporations, the term “insider” refers to the controlling shareholders who have preferential access to monthly management accounts while “outsiders” refer generally to independent minority shareholders who rely on public disclosures, which are often somewhat outdated when received. Opponents of quarterly reporting have long questioned whether increasing the frequency of reporting will lead to an actual improvement of transparency. The case of Enron has often been cited as an example of how quarterly reporting failed to allude investors to the financial house of cards that ultimately caused what was once the seventh largest company by market capitalization on the New York Stock Exchange to implode. Critics have also argued that quarterly reporting does not adequately capture the variations that are caused by seasonality, which may misrepresent the financial position of the company and mislead investors, and promotes short-termism in investing. Comparability, Consistency and Cost 8 In the opinion of the author, quarterly reporting as it is presently practised in Southeast Asia does not adequately pass the tests of comparability, consistency and cost. First, it must be recognized that quarterly reporting does not actually mean quarterly reporting in the true sense. Rather, the term simply means that the shareholder will get four sets of accounts, namely, the First Quarterly Report, the Interim Report, the Third Quarterly Report and the Annual Report, which are not as directly comparable as they may seem at first glance. Unlike the interim report, neither the first nor the third quarterly reports are subject to any external review by the auditor of the company. In fact, of the four, only the annual report is subject to the rigour and application of professional standards of an independent external audit. Consistency is another key issue that should be alluded to as the present system allows for a degree of duplication since quarterly reports are required

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to include “post-quarter” events. Furthermore, it is possible to report an event three times in a fiscal year. For example, assuming that a financial year corresponds to a calendar year and an event occurs on 28 February. Not only will this event be captured in the first quarterly report, which is unaudited, it will also be reflected in the interim report, which is subject to review by the external auditor, and again in the annual report that is subject to a full audit. If the same event were to happen just nine months later on 28 November, it would only be reflected once, namely, in the audited annual report of the company. Last but not least comes cost, which not only involves the actual monetary quantum for professional services and related printing costs, but perhaps more importantly the time and attention of the management. Contrary to common belief, quarterly reporting is not simply a process of transposing internal management reports into a set format for distribution to shareholders. Management reports are neither audited nor subject to auditor review, and are generally not prepared to the full extent as required by the Statements of Standard Accounting Practices for disclosure purposes. The process is further complicated should the need to consolidate accounts arise for the holding company would need the requisite financial information to be cascaded upwards. The tight time constraints will mean that there will be little time with which to properly conduct critical reviews of the data, which will in turn result in more quantity but with much less quality. What Options Remain? The regulators may consider the merits of two alternatives as the capital markets in Southeast Asia move towards a disclosure based system of regulation. The first would refine the present system by requiring that only two types of reports to be published each year, namely, the audited annual report and three quarterly reports. Unlike the present regime, the three quarterly reports would be prepared to the standard of the current interim reports with sections comprising analysis and discussion by management. These reports must be evaluated by the audit committee and thereafter reviewed by the independent external auditor as is presently the case for interim reports. Taking cognizance of the considerable strain that the foregoing would impose on corporate resources, the more pragmatic option would be to simply do away with quarterly reporting altogether and implement an effective enforcement regime built around timely and accurate disclosure. Under this proposal, a company would only need to prepare an interim and an annual

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report as the onus will shift onto its directors to ensure that the market is kept fully apprised of all material price sensitive information. To this end, directors of companies must be held accountable to a higher and more exacting standard of care that is based on an objective standard.9 In addition, company and securities laws should also be reviewed to facilitate lawsuits by shareholders against directors who have breached the standard of care expected of them.10 These are necessary to effect a “stick and carrot” approach to “facilitative regulation” where the regulators assume a passive role so as to allow the market forces to dictate and run its true course. STATUTORY DERIVATIVE ACTIONS — FORM OVER SUBSTANCE? There has recently been some active debate over the possible introduction of statutory derivative actions to the corporate scene in a number of jurisdictions as a means of enhancing shareholder protection.11 A derivative action refers to civil proceedings brought by minority shareholders to seek a remedy for the company in respect of a wrong done to it, with damages awarded by the court going to the company, instead of to the members initiating the derivative action. Despite the presence of obstacles, such actions have had their successes particularly in the Republic of Korea where leading companies including Korea First Bank, Samsung Electronics, Hyundai Heavy Industry, SK Telecom, LG Semiconductor and Daewoo Auto have been taken to task by the Participatory Economy Committee of the People’s Solidarity for Participatory Democracy.12 Nonetheless, despite these successes, the author advocates the introduction of class action for corporate law litigation so that an effective regime premised on a “carrot and stick” approach can be implemented. Obstacles to Effective Shareholder Action Shareholder suits are far and few between due to the English decision of Foss v Harbottle13 that enunciated two rules namely the proper plaintiff rule and internal management rule. The former states that only the company is allowed to sue for losses that it suffers while the latter refers to the reluctance of the court from interfering with internal irregularities that are capable of being ratified by shareholders at general meeting. These rules have had the unintended consequence of placing a major obstacle in the way of minority shareholders given that companies are unlikely to bring an action against their directors and/or majority shareholders for a breach of duty or acts of bad governance. However, the door is not completely closed on minority

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shareholders as they are, in limited circumstances, allowed to sue on behalf of the company by way of a derivative action.14 It must nonetheless be recognized that the path to litigation is fraught with practical difficulties for the minority shareholders. First, they must take cognizance of the fact that they are potentially liable for the costs of initiating the action in the name of the company. Secondly, they have no corresponding right to potential damages that may be awarded by the court since these will go to the company. Thirdly, the courts have often been persuaded to give due regard to whether the alleged breach may be ratified by the general meeting. Lastly, the inability to access information, which flow is controlled by the directors, by the minority shareholder is a substantial obstacle to the commencement of a proper action. It is for the foregoing reasons that calls have been made for the introduction of a statutory derivative action that will empower the court to consider factors such as the good faith of shareholders and the interests of the company, rather than whether the case falls within the established exceptions to the rule in Foss v Harbottle, in determining whether a shareholder should be allowed to sue in the name of the company. Derivative Actions — The Legislature and the Common Law The company is named as the “nominal defendant” where a derivative action is brought by the plaintiff shareholder at common law. Professor Gower has opined that this is a highly misleading arrangement since the action of enforcing the rights of the company takes the form of an action against the company, which is joined as a nominal defendant for the purpose of discovery of documents.15 Although a “defendant”, the company does not assume any active part in the proceedings since the principal targets are, in reality, usually the directors and/or controlling shareholders who are alleged to have committed the wrongdoing in respect of which the claim is brought. Under a statutory derivative action, the shareholder brings the action in the name of the company. Thus, unlike the common law, the company is the plaintiff rather than the nominal defendant. However, there is a striking similarity with the common law as regards procedure since the company does not take any part in the proceedings. This will remain almost exclusively in the hands of the shareholder who has sought leave of court to commence the action. Such an arrangement facilitates the discovery process since any attempt by the directors and/or controlling shareholders to thwart the process may be remedied by way of an application for direction or relief under the equivalent of Order 24 of the Rules of the High Court in Malaysia and Singapore. In the

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circumstances, unlike the common law, there will be no need to restrict the scope of the proceedings to a select type of actions that could be brought under a statutory derivative action. Different Structure with the Same Deficiencies Despite the provision for a more conducive procedure, the statutory derivative action shares a key “deficiency” with its common law counterpart namely, that the award of damages will be given to the company. Herein lies the anomaly as control of most companies rest in the hands of the persons whose alleged breaches necessitated the proceedings in the first place. In its most simplistic form, the entire exercise may well turn out to be a case of “out one hand and in to the other” since the persons who are liable for damages may well share a portion of this in their capacity as shareholders of the company. The reality is therefore such that, at the end of the day, the minority shareholder may not see any benefit from this award of damages given the myriad of possible uses of this quantum, which is perhaps only limited by the collective creativeness of the management and/or its professional advisors. Furthermore, while the minority shareholder takes the action on behalf of the company, it does not automatically mean that he or she will not be responsible for costs as this remains within the purview of the court depending on the circumstances of the case. In fact, to minimize the instances of frivolous or vexatious claims, there is usually a restriction on the award of costs to the shareholder who initiates the action namely, that he or she must have acted in good faith and had reasonable grounds for bringing the action against the alleged wrongdoers. A Complementary Way Forward It is obvious that reforms are urgently required to facilitate shareholder activism and to empower shareholders, if the capital markets in Southeast Asia are to avoid the perception of being associated as “risky” places in which to invest. The thrust of these reforms must be directed at the minimization and/or removal of legal impediments that prevent shareholders from the effective enforcement of their rights and would include enhancing the access to company information, removing obstacles for lawsuits and allowing shareholder groups to “piggy-back” on findings against companies and/or their directors.16 In short, shareholders should be allowed to sue on instances of bad governance and the companies should be required to assist on the proviso that

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the rendering of such assistance does not materially compromise the interests of the company. Any action, reprimand or censure that are issued by the regulators and/or the stock exchanges against the company or its directors should be deemed as sufficient bona fide grounds for an action to be initiated and the onus would then fall upon the company or its directors to establish their innocence. While this may be viewed as a reversal of the onus of proof, its benefits as an important “signalling” device should outweigh the costs. To provide the necessary stimulus to encourage shareholder activism particular attention may be directed at two principal areas, namely, the introduction of class actions and the elimination of the “loser pay” principle in civil litigation. Most markets in Southeast Asia do not suffer from a lack of rules and regulations, but rather from weak enforcement thereof. The White Paper on Corporate Governance in Asia, hereafter “the White Paper”, that was issued under the auspices of the Asian Roundtable on Corporate Governance17 recognizes this deficiency and recommended that “all jurisdictions should strive for effective implementation and enforcement of corporate governance laws and regulations” as a key area of reform.18 In particular, it observed that: The credibility — and utility — of a corporate governance framework rest on its enforceability. Securities commissions, stock exchanges and self-regulatory organizations with oversight responsibilities should therefore continue to devote their energies to implementation and enforcement of laws and regulations … In this regard, it is important to stress the interaction between effective market discipline and selfdiscipline. The role of policy-makers is not only to enforce current laws but to promote institutions that facilitate market discipline.19 (emphasis added)

Empowering shareholders to take legal action will compensate for the perceived lack of enforcement. The success of capital markets depends in part on the ability of shareholders to enforce their fundamental private rights as investors and/or to seek recompense should these not be given effect to. Class action suits have a number of advantages over derivative action suits, the latter of which appears to be the preferred option for regulatory reform. First, it allows shareholders to file suits against directors and/or controlling shareholders with the burden of proof shifted to the latter group. Secondly, awards of damages are paid to the plaintiff shareholders rather than the company. Thirdly, it avoids the expense associated with multiplicity as only one lawsuit is filed and the ruling applies to all shareholders that are subject to the same case unless he or she has opted out

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of the same. Fourthly, it provides an incentive for shareholders to sue as the burden of legal costs is shared amongst the entire group, rather than being borne by an individual. Lastly, it provides a credible and effective threat to directors to ensure that they keep on the “straight and narrow” as regards the affairs of the company. The establishment of the necessary legal infrastructure for class action lawsuits is not expected to be a major obstacle. For example, it may be modelled after the system that exists for securities law litigation in the United States, with such amendments as are necessary to reflect the specific requirements of the legal framework of the member countries of ASEAN.20 However, unlike the practice in the United States, the author does not advocate the introduction of contingency fees at this juncture given the possibility of abusive litigation and the creation of an entirely new industry of “professional plaintiffs”. In its place, it is proposed that the “loser pay” principle in civil litigation be dispensed with. This principle has been a major obstacle to the filing of shareholder suits on two grounds. First, there is an inherent worry by individual shareholders that they would be pursued to bankruptcy if they fail in their litigation against the directors and/or controlling shareholders as defeat in civil proceedings not only exposes the minority shareholder to bear his or her own legal costs, but also those of the party in whose favor the court has decided. This “double or nothing” approach is compounded by the fact that the case may be taken on appeal should the directors and/or controlling shareholders lose the verdict, especially since their legal costs are usually borne either by the company itself and/or by the insurance company that has assumed the risk. Secondly, directors and/or controlling shareholders have been successful in thwarting minority shareholder suits by demanding security for costs under the equivalent of the applicable Rules of the High Court in Malaysia and Singapore. This in essence requires the plaintiff shareholder to deposit into court such sums of money or security as is deemed appropriate in the circumstances to ensure that the “loser pay” principle may be effected. While this is perfectly within the rights of the company and/or directors, it acts as an effective impediment since the plaintiff shareholder may not be able to post the quantum as ordered by the court despite his or her having a reasonably good case at law against the defendants. The removal of this principle will contribute towards a level playing field between the plaintiff shareholders and the defendant directors and/or controlling shareholders within the arena of corporate law litigation.21

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CONCLUSION There are a number of ways in which the standard of governance may be improved, including a re-examination of the role that is assumed by the regulator.22 The protection of shareholder interests has been a common theme in regulatory reforms across the world. However, despite the rounds of reforms, there has been a rather disappointing failure to compel investors to shoulder the responsibilities for their investments, which has in turn created the problem of moral hazard in investing. There can be no argument that shareholders are the best placed persons to monitor their investments in the company, be it in terms of assessment of risks or the exercise of oversight of management. Their attendance and participation at the general meetings of the company is crucial as this remains the only realistic forum at which their opinions can be conveyed. That said, shareholders must also be empowered to take such actions as are necessary to protect their investments, which would include both the ability and the right to sue alleged wrongdoers. The introduction of a statutory derivative action would remedy some of the deficiencies that exist at common law but it would not be sufficient to go the full distance. For the reasons as expounded above, due consideration must be given to the establishment of a complementary regime which empowers minority shareholders through class actions and the removal of the “loser pays” principle. Statutory derivative actions have to be viewed as merely a means to an end, rather than the end itself, and an early appreciation of its inherent deficiencies will allow for the introduction of a more facilitative regime for enhanced shareholder protection. The same rationale may be applied towards quarterly reporting for rather than focusing strictly on quantity, the thrust should be upon quality, which may be measured by accuracy, comprehensiveness and timeliness. As capital markets only achieve their full potential when they are allowed to operate unhindered, it is imperative that investors not only be compelled to assume responsibility for their investment decisions but also be more vigilant in monitoring the performance of their companies and the actions of their directors. To facilitate this, there must be a framework that provides timely, full and accurate disclosure of all material information since there exists a positive co-relation between the movements in the prices of securities and availability of information. Unfortunately, in the opinion of the author, quarterly reporting in its present form does not adequately meet these requirements and the challenge is therefore to revisit and to revise the existing framework to ensure that it meets its stated objectives of contributing towards enhancing the protection of shareholders.

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Notes 1. [1897] AC 22 at 30. 2. See for example Automatic Self-Cleansing Filter Syndicate Co v Cunninghame [1906] 2 Ch 34 and John Shaw & Sons (Salford) Ltd v Shaw [1935] 2 KB 113. 3. In fact the law imposes a duty upon the directors to act bona fide in the best interest of the company and not be subservient to the interest of any particular shareholder(s) or group(s) thereof: see for example Re Smith and Fawcett Ltd [1942] 1 All ER 542; Greenhalgh v Ardene Cinemas Ltd [1951] Ch 286 and Walker v Wimborne (1976) 137 CLR 1. 4. See . 5. See for example Pender v Lushington (1877) 1 Ch D 13 and Edwards v Halliwell [1950] 2 All ER 1064. 6. These include the registers of members, directors, substantial shareholders, debenture holders, charges and holders of participatory interests. There is usually no charge for inspection during prescribed periods although a nominal charge is normally imposed for making copies. 7. See for example Faccio M., L. Lang and L. Young (2001) “Dividends and Expropriation”, American Economic Review 90, no. 1: 54; and Classens S., S. Djankov, J. Fan and L. Lang (1999) “Expropriation of Minority Shareholders: Evidence from East Asian Corporations”, Working Paper, World Bank (available from ). For convenience, “government-linked corporations” are deemed to fall within the definition of the “state”. 8. Parts of this section of the chapter is drawn from Greenwood P.W., “Quarterly Reporting —The Case Against”, Company Secretary, August 2004. 9. For an expansion of this theme, see generally Low C.K. (1997) “The AWA Case: Implications for the Hong Kong Director”, Journal of Asian Business 13, no. 2: 81. The benchmark that directors will be held against with respect to the standard of disclosure would be that as is reasonably necessary to ensure that all shareholders are kept equally informed: see for example Regulation FD or “Fair Disclosure” as practised in the United States of America. 10. See for example Low C.K. (2004) “A Road Map for Corporate Governance in East Asia”, Northwestern Journal of International Law and Business 25, no. 1: 165. An aspect of this is discussed in the ensuing section on statutory derivative actions that are being heralded as an important step towards enhancing the protection of shareholder rights. In the opinion of the author the review of the laws will not be extensive since the principal issue is not so much the lack of regulations but rather the lack of effective enforcement thereof. 11. Australia, New Zealand and Singapore presently have such provisions while these will soon be gazetted as law in Hong Kong. 12. See . 13. (1843) 2 Hare 461; 67 ER 189.

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14. The most important exception to the rule in Foss v Harbott is “fraud on the minority” where the wrongdoers are in control of the company. 15. Davies P.L., Gower’s Principles of Modern Company Law, at p 666 (1997). 16. See generally C.K. Low, “Comments on the Securities and Futures Bill”, Hong Kong Lawyer, April 2001, and C.K. Low, “Regulating the Regulators”, Company Secretary, December 2002 for some observations on the approach to regulatory reforms in Hong Kong. 17. The Asian Roundtable on Corporate Governance serves as a regional forum for structured dialogue between senior policy-makers, regulators and representatives from stock exchanges, private-sector bodies, multilateral organizations and nongovernmental institutions. The five meetings carried different themes and were held between 1999 and 2003. The first Asian Roundtable was held in the Republic of Korea with the theme “Corporate Governance in Asia: A Comparative Perspective” in 1999. This was followed by meetings in Hong Kong (“Role of Disclosure in Strengthening Corporate Governance” — 2000), Singapore (“Role of Boards and Stakeholders in Corporate Governance” — 2001), India (“Shareholder Rights and the Equitable Treatment of Shareholders’’ — 2002) and Malaysia (“Enforcement and Finalization of the White Paper’’ — 2003). 18. See White Paper, paragraphs 39 to 42. 19. Ibid., paragraph 41. 20. The framework in the United States of America derives its foundations from three principal legislation, namely, the Federal Rules of Civil Procedure 1938, the Private Securities Litigation Reform Act 1995 and the Securities Litigation Uniform Standards Act 1998. 21. To safeguard the company and/or directors against lawsuits that are frivolous, vexatious and abuse of process, it is proposed that the judge retains the discretion to impose costs on the plaintiff shareholder where the facts of the case reasonably justifies such an order. Hence, while the impediment against the lawsuit is removed at the outset, there nonetheless exist the threat of imposition of costs at the end of the trial under certain strict circumstances. 22. For an expansion of this theme, see generally Low C.K. (2001) “Revisiting the Regulatory Framework of Capital Markets in Malaysia”, Columbia Journal of Asian Law 14, no. 2: 277.

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4 GOVERNANCE REFORMS IN THE BANKING SECTOR IN SOUTHEAST ASIA Dipinder S. RANDHAWA

“Banks have proven themselves to be the most hazardous economic institutions known to man. Breakdowns in banking lie at the centre of most financial crises. And banks are unusually effective at spreading financial distress, once it starts, from one place to another.” Economist, Survey on Banking, 1 March 2003

INTRODUCTION For institutions that account for an overwhelming proportion of funds mobilized by the corporate sector and have been at the epicentre of repeated instances of financial crisis since the early eighties, governance of banks has received surprisingly little attention. While corporate governance has assumed centre stage in the debate on governance reforms, banks and related institutions have been relatively neglected. On the face of it, this neglect of the role instruments of governance of financial institutions is puzzling. However, as this chapter shows, we can proffer reasons for this oversight. Following the Asian financial crisis of 1997, a substantial body of research has investigated the causes and manifestations of the crisis, as well as the

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efficacy of initiatives taken to deal with its aftermath. Macroeconomic instability, failures in coordination, contagion effects, problems latent in the financial sector, widespread lapses in governance, moral hazard problems in the domestic banking sector and among multinational banks lending to Southeast Asian entities, are considered the main explanations for the crisis. The literature provides an informative analysis and useful insights into what went wrong, and the initiatives that have been undertaken since to enhance the resilience of the financial sector, and, thus of the economy. Lapses in governance assume a central position in the debate. Failures in governance in both the private and public sectors are widely acknowledged as one of the major causes of the Asian financial crisis. The breakdown is by no means confined to the corporate sector. The banking system, capital markets, and indeed the regulatory authorities entrusted with the task of supervising financial markets and institutions and surveillance of the financial system, were themselves remiss in their delegated tasks and responsibilities. Resource allocation by the invisible hand of free markets can be efficient only when governance of institutions is sound. Good corporate governance seeks to ensure that individuals who run companies serve the interests of those who own the companies. An analysis of governance should encompass the institutions, structures, and channels through which objectives are set and implemented and provide the means for monitoring performance (OECD 2003). This chapter examines the problems latent in the banking sector that led to the financial crisis in 1997, the reforms that have been carried out since, and the effectiveness of these reforms. It focuses on two issues. We make the case that governance of the banking sector is intrinsically different from governance of non-financial firms, and delineate the characteristics distinctive of the economies of Southeast Asia that compounded the effects of the financial crisis. We suggest reasons why governance of the banking sector has received less attention in the literature. This is followed by a preliminary assessment of the reforms that have been carried out over the past seven years. Many of these reforms are ongoing. In order to lend a sharper focus to the analysis, we concentrate on channels of governance external to banks, for example, the role of competition, regulation, efforts at reducing information asymmetries and improving governance. We do not consider the role of internal agents, such as the board of directors and the audit committee. These issues have been dealt with in detail in the country studies and overview chapters in this volume. The experience of Malaysia, Thailand and Indonesia, the economies that were the most affected by the crisis, are examined in

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detail. Where possible we present evidence for other Southeast and East Asian economies. At the outset we explain the neglect of financial institutions in the debate on corporate governance. This is followed by a discussion on the obstacles in the way of effective governance of financial institutions. Section 3 summarizes the impact of the Asian financial crisis on financial institutions in the region. This is followed by a review of the response of policymakers to the crisis. Section 5 surveys the reforms in governance of financial institutions that have been carried out over the past five years. Section 6 briefly discusses some policy issues that arise from the ongoing reforms. The chapter concludes with some observations on outstanding issues and the challenges that lie ahead. GOVERNANCE OF FINANCIAL INSTITUTIONS Why the Banking Sector has been Neglected in the Debate Studies on governance tend to concentrate on the corporate sector. This orientation draws upon the Anglo-American model with capital markets predominant in the financial sector. In Asian economies, and indeed in nearly all economies other than the United States and the United Kingdom, banks rather than capital markets account for a majority of funds lent to the corporate sector (See Table 4.1). Thus governance of banks and other financial institutions is vital. Several reasons can be put forth for the inadequate attention paid to financial institutions in the debate on corporate governance. Much of the academic and policy debate is grounded in market-dominated economies where the focus is on governance of non-financial firms. Given the intrinsic TABLE 4.1 Composition of External Finance (in % shares of total)

China Hong Kong Malaysia Singapore South Korea Thailand

Domestic credit provided by banking sector

Stock market capitalization

Outstanding debt issues

62.89 26.29 41.81 31.22 57.52 71.15

25.49 71.25 36.58 57.72 20.76 14.11

11.63 2.46 21.61 11.07 21.72 14.74

Sources: World Bank and BIS (From Barry Eichengreen, Financial Development in Asia: The Way Forward, 2004).

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risk associated with banking, governance of the banking sector has often been deemed synonymous with risk management. This is also reflected in efforts over the past decade to devise policies to stem potential contagion effects, efforts culminating in the Basel Accord on capital adequacy. Issues of governance in the banking sector, for reasons that we shall spell out, are more nuanced and complicated and are predicated on broader reforms in the financial system and the economy. The Case for Governance of Financial Intermediaries Governance of the financial system and the firms to which it dispenses resources is important. The market places a premium on firms that demonstrate sound corporate governance. Similarly banks that are deemed to be wellgoverned and meet global standards of disclosure and risk management find it easier to attract funds and clients and to raise funds at a lower cost. Effective governance nurtures efficient banks and capital markets. Domestic and foreign capital is drawn by confidence in the system. This can lead to a broadening of the shareholder base as a premium is placed on well-managed companies and banks. Monitoring of financial institutions and the corporate sector’s operations ensures efficient utilization of resources, minimizes the chances of misuse of resources, and eventually paves the way for sustained growth in the economy. There has been extensive research on corporate governance and reform in the financial sector following the Asian crisis (Mitton 2002, Johnson, et al. 2000). The focus has been on issues pertaining to monitoring of firm’s activities, board composition, disclosure norms and regulations and rights of minority shareholders. Curiously corporate governance in the banking sector has received little notice in this context. Curious because capital markets in Southeast Asia which have been at the centre of attention are still in the formative stages of development, albeit, with considerable heterogeneity across the regional economies. Banks on the other hand account, for a majority of funds mobilized by the corporate sector (Table 4.1). The damage inflicted on the economy by a banking crisis is severe, thus the banking system bears considerable responsibility for efficiently allocating and monitoring the use of funds. There are stronger reasons for ensuring banks fulfil their mandate of efficient allocation of resources. Aside from occupying a unique and distinctive space in the economy, banks account for an overwhelming proportion of funds transferred to the corporate sector. Unlike the corporate sector, where the costs of default are borne by shareholders, bondholders, and banks, the

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burden imposed by a bank failure is transmitted throughout the economy, for example, liquidity problems encountered by banks can readily metamorphose into solvency problems, leading to bank failure and possible contagion effects. Instances of systemic failure in the banking system are well documented through history. A bank failure can cause severe disruption to the payments system, wreak havoc with liquidity creation in the economy, and lead to widespread loss of confidence and resultant flight of capital from the banking system. Firms that are functioning normally may find access to liquidity drying up abruptly. A sudden rush on deposits can lead to systemic problems in the banking sector. High leverage ratios further increase banks’ vulnerability to liquidity constraints. The burden imposed by bank failures is borne not only by the exchequer but the entire population as the payments system is disrupted, liquidity dries up and firms’ access to funds is disrupted. The costs of a crisis, reflected in non-performing loans, the cost of bank bailouts and capital injections soar (Table 4.2). Costs resulting from rehabilitation of the banking system coupled with the need to maintain fiscal stability require governments to make across the board cuts in spending programmes. This may reduce growth potential in the economy for years to come. TABLE 4.2 The Costs of Banking Crises

Chile United States Norway Finland Sweden Mexico Argentina Brazil Thailand South Korea Indonesia Malaysia Philippines

1978–83 1984–91 1988–92 1991–93 1991–93 1995–97 1995 1995– 1997– 1997– 1997– 1997– 1998–

Peak non-performing loans as % of total loans

Cost of restructuring as % of GDP

19 4 9 9 11 13 — 15 47 25 55 25 12

41 5–7 4 8–10 4–5 14 2 5–10 24 17 58 10 7

Sources: IMF, World Economic Outlook, May 1998; JP Morgan, Asian Financial Markets, 28 April 2000; World Bank, Global Economic Prospect and Developing Countries, Table 3.6; Barth, Caprio and Levine (2000), Table 2; Central banks, extracted from BIS, “The Banking Industry in Emerging Market Economies: Competition, Consolidation and Systemic Stability”, 2001.

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The costs of the banking crisis in Thailand add up to nearly a quarter of its GDP, in Indonesia it exceeds 50 per cent of GDP. According to some estimates (Litan, et al. 2002) the costs of assuming the obligations of private sector banks exceeds 100 per cent of GDP in Indonesia. The costs rise as bank management and the monetary authorities deal with the mounting legacy of non-performing loans and fiscal costs arising from government bailouts. Table 4.3 provides estimates of the magnitude of non-performing loans (NPLs). Developments in the domestic and international financial systems over the past two decades have further underscored the importance of governance of financial institutions. Aside from the substantial costs and negative externalities resulting from a banking crisis, which have soared with increasing financial globalization and cross-border financial flows, the frequency of banking crises has also risen dramatically over the past two decades. Looking ahead, as economies open up to external investment and competition, and foreign investment into the financial sector accelerates (BIS 2004), the banking system has to adapt on multiple fronts. Domestic consolidation and the entry of foreign banks and narrowing margins from funds mobilization from capital markets have all added to competitive pressures on banks. The immediate impact may be felt via narrower margins. Well managed and effectively monitored banks alone would be in a position to grow in such an environment. TABLE 4.3 Overview of the Banking System and NPLs, End-2002 (in %) Indonesia

S. Korea

Malaysia

Philippines

Thailand

Banking system assets as % of GDP

74

154

158

84

136

Assets of state-owned banks as % of total assets

49

NA

NA

11.5

27.71

NPLS / GDP Peak End-2002

26.8 2.12

8.4 8.4

25.5 18.5

7.9 6.23

54.1 8.4

NPLs / Total loans Peak End-2002

48.6 8.12

9.7 9.7

30.1 8

18.1 153

51.6 10.11

Source: BIS FSI Occasional Paper no. 3.

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How Governance of Financial Institutions is Different The dominance of banks in the financial system coupled with the underdeveloped state of financial markets creates a strong case for paying special attention to banks in developing economies, including Southeast Asia. Governance of banks raises a unique set of challenges on account of the distinctive characteristics of banks (Levine 2004). Table 4.4 provides a synopsis of these challenges. Three characteristics define how governance of banks is different from governance of non-financial firms. Firstly banks are opaque. In economies where accounting systems and practices are not well-developed and estimation of borrower’s creditworthiness is difficult to assess, it is extremely difficult to estimate the value of bank portfolios. This allows managers to exploit the information gap to their advantage. In the years prior to a crisis, loans to favoured clients, risky investment decisions, rolling over of non-performing loans are some of the common excesses uncovered by enquiries into bank behaviour. The information gap between bank management and outside stakeholders also precludes outside agents from marshalling enough information to execute a takeover. TABLE 4.4 Challenges in Governance of Financial Institutions Assumptions underlying traditional model

Banks

Market structure

Competitive

Banking structures tend towards monopolistic competition

Information asymmetry

Forms crux of agency problem

Agency problem far more complex; banks are opaque

Capital structure

Low leverage ratios

Highly leveraged

Regulation

Common for all sectors

Intensive and extensive regulation in the financial sector, with intervention of third party regulatory agency

Ownership

Dispersed, or a few controlling owners

Family ownership and government ownership / control common in Southeast Asia

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The difficulties inherent in assessing the value of a bank’s loan portfolios is reflected in empirical studies documenting how bond analysts have greater disagreement over the value of banks than of other corporate entities (Morgan, 1999). The opacity in information availability makes it easier for bank managers to exploit the institution for personal gain. Some of the most egregious yet unheralded financial crimes take place in the banking sector. As is evident from the Barings Banks and Allied Irish Bank cases, it takes a single rogue trader to bring down or severely impair an entire business. Enron was brought down by its financial intermediation business, not the energy trading division (Sale 2005). For external agents, it is extremely difficult to make informed and accurate assessments of the value of banks’ portfolios and, thus, a priori, to assess the merits of banks’ decision-making. The problem is more serious in developing economies with inadequate and poor disclosure regulations that impair the ability of outside stakeholders and regulatory and supervisory authorities to monitor banks. In economies where family ownership plays an important role, the problem is compounded by the presence of cross-ownership and the “evergreening” of loans. This was true of banks in East and Southeast Asia in the years leading up to the financial crisis. Secondly, the financial sector is, and in the foreseeable future will continue to be, the most extensively regulated sector in the economy. The rationale for regulation is to ensure fair and efficient functioning of the financial system and to create conditions for financial stability. Within the financial sector, banks are the most heavily regulated entities. In developing economies the regulatory agenda often goes beyond the objectives of safety and stability to meet strategic national goals via directed lending, portfolio controls, or outright control of lending decisions. This is especially true if there is pressure on banks to meet financing needs of stateowned enterprises. These policies may be inimical to the interests of shareholders. The manifestations of regulation are manifold. The presence of deposit insurance reduces incentives for depositors to monitor banks, and makes banks less dependent on uninsured depositors for funds. This induces bank managers to reduce the bank’s capital base and frequently seek low cost loans from the central bank. Government ownership of banks, restrictions on ownership, regulatory restrictions on credit allocation, are aspects of regulation that tend to restrict competition and may result in different and possibly conflicting objectives for regulators and bank managers. As Table 4.5 shows, a number of banks were nationalized during the crisis. Policymakers are now confronted with the challenge of reprivatizing these banks and putting them back on the path to growth.

percentage of total bank assets

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TABLE 4.5 State-Owned Banks Assets held by State-owned banks as a percentage of total bank assets

Hong Kong Indonesia Korea Malaysia Philippines Singapore Thailand

Return on assets

Capital ratio: Risk-weighted

1980

1990

2000

1998

1998

0 … 25 … 37 0 na

0 55 21 … 7 0 13

0 57 30 0 12 0 31

— –19.9 –5.2 … 0.5 — –12.1

— –21.4 6.9 … 13.3 — 8.7

Source: BIS, “The Banking Industry in Emerging Market Economies: Competition, Consolidation and System Stability”, 2001.

The challenge of corporate governance in banking is further complicated as banks are highly leveraged and operate in industries characterized by concentrated, if not monopolistic, market structures. High leverage ratios increase the vulnerability of financial institutions and firms to a downturn in the economy. It is also indicative of a small shareholder base. Concentrated market structures dilute the effectiveness of an important channel for governance — competition. Coupled with this, in most Asian economies the concentrated ownership structure of banks, often under family ownership or association with industrial groups, etc. makes banks particularly vulnerable to exploitation. In Indonesia in 1997, an economy with few macroeconomic problems, it is difficult to explain the massive collapse in the banking system and the sharp downturn in the entire economy. However, a closer examination by Tabalujan (2001) documents some banks in which insiders’ borrowings accounted for 85 to 345 per cent of bank capital. These loans were often extended on terms much more favorable than those available to outsiders. Exposure at such levels often financed through funds mobilized in international markets made banks vulnerable to any downward trend in the economy, all the more so in situations where external borrowing was mediated by the domestic banking system. The effects on the rest of the economy are cumulative. The shallow base of the financial system in developing economies compounds governance problems in the banking sector (Barth, Caprio, and Levine 2001). The absence of deep capital markets precludes some obvious takeover mechanisms, furthermore securities that can be deployed to effect

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greater monitoring may not be viable (for example, subordinated bonds, etc.). Low liquidity levels in capital markets make it difficult for a potential takeover agent to mobilize adequate resources for takeovers. The dependence on banks for funds and the resultant high leverage ratios in the corporate sector increases the vulnerability of the entire economy to an economic downturn. Banks draw heavily upon borrowed funds. Other than the ones with large capitalization, most banks, especially those in developing economies, tend to have thinly traded issues. Furthermore a substantial maturity mismatch in bank balance sheets accentuates vulnerability of the bank to a change in the economic environment. Problems at a single bank can easily be transmitted to other banks and result in a systemic crisis. Notwithstanding these challenges, banks in developing economies banks are uniquely placed to enhance the general level of corporate governance in the economy. Given the unique role banks play in the economy and the distinctive problems they face, risk management and corporate governance are inextricably intertwined. This is manifest in the dual nature of governance challenges faced by policymakers, regulators and bank managers. As stated earlier, efficient financial intermediation requires effective governance of banks and by banks. Risk management calls for timely disclosure and accurate and timely valuation of bank’s risk exposure, sound governance requires bank managers to work in the best interests of the shareholders by extending loans to creditworthy clients. In practice the two notions are flip sides of the same coin, efficient screening and monitoring of borrowers would facilitate selection of borrowers with the highest probability of repayment. This is in the interests of bank shareholders, regulators and the bank management itself. However, the presence of information asymmetries and the safety net provided by deposit insurance, and the reassurance of bailout in the event of a financial crisis creates incentives for bank management to lend to high risk borrowers and maximize short-term profits. As a result, both shareholders and bond holders suffer. This distinctive characteristic of banks makes their governance a challenging and complicated task relative to governance of non-financial corporations. THE IMPACT OF THE ASIAN FINANCIAL CRISIS ON BANKS Southeast Asia achieved impressive growth rates in the two decades leading up to the 1997 crisis. The 1997 crisis notwithstanding, outward economic orientation, coupled with commensurate financial sector policies constitutes an important explanation for the widely divergent performance between Latin America and East and Southeast Asia since the seventies. This

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macroeconomic framework in tandem with policies conducive to domestic and foreign investment laid the foundations for rising volumes of investment in Southeast Asia. Generally prudent fiscal and monetary policies paved the way for sustained capital inflows and high levels of investment and growth. At the end of June 1997, the classic symptoms of impending crisis — an unsustainable fiscal deficit and rising inflation rates — were not present. The only indication of macroeconomic disequilibria was a rising current account deficit, but at levels it was believed that could be financed through sustained capital inflows. The only warning signs were pressures on exchange rates and some incipient problems in the banking sector, notably in Thailand, with the Farmer’s Bank receiving considerable attention in the press. A World Bank report the same year located this problem in a more systemic context (Claessens and Glaessner 1997). A speculative attack on the Thai baht in the summer of 1997 eventually forced the Bank of Thailand to initially defend, and then as speculative pressures mounted, take the baht off the peg. A sharp and abrupt devaluation and a flight of capital followed. Overnight, a large number of banks found themselves facing serious liquidity and, shortly thereafter, solvency problems. Tables 4.6 and 4.7 document the impact of the crisis on the capital

TABLE 4.6 Percentage of Bank Capital to Assets (in %) 1998

1999

Bank Regulatory Capital to Risk-Weighted Assets Hong Kong 18.5 18.7 Indonesia –13.0 –2.4 Korea 8.2 10.8 Malaysia 11.8 12.5 Philippines 17.7 17.5 Singapore 18.1 20.6 Thailand 10.9 12.4 Bank Capital to Assets Hong Kong Indonesia Korea Malaysia Philippines Singapore Thailand

7.7 –12.9 2.8 8.9 14.8 7.5 4.8

8.1 –4.1 3.9 8.9 16.0 7.8 5.5

2000

2001

2002

2003

17.8 –18.2 10.5 12.5 16.2 8.3 12.0

16.5 19.2 10.8 13.0 15.8 7.8 13.9

15.7 19.7 10.5 13.2 16.7 8.1 13.7

15.6 21.4 10.4 13.4 16.1 7.6 13.6

9.0 5.2 3.8 8.5 15.3 7.1 4.5

9.8 5.4 4.1 8.5 15.4 9.6 5.5

10.7 7.3 4.0 8.7 15.5 8.3 5.8

11.5 8.3 4.0 … 15.9 8.5 6.2

Sources: National authorities; EDSS; OECD; IMF staff estimates.

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TABLE 4.7 Bank Provisions to Non-Performing Loans (in %)

Hong Kong Indonesia Korea Malaysia Philippines Singapore Thailand

1998

1999

2000

2001

2002

2003

… 28.6 46.2 … 36.4 … 29.2

… 77.7 66.6 39.0 45.2 86.2 37.9

… 59.4 81.8 41.0 43.7 87.2 47.2

… 97.7 85.2 37.7 45.3 90.1 54.9

… 125.7 109.4 38.1 53.2 96.7 61.8

… 152.5 … 38.5 52.2 96.6 60.8

Source: National authorities and IMF staff estimates.

positions of banks across Asia. The massive losses in the banking system in Indonesia resulted in significantly negative bank positions. Elsewhere, aside from the Philippines and Malaysia, capital levels in the banking system fell below the 8 per cent level prescribed by the Basel Accord. With hindsight, a number of weaknesses were latent in the financial sector. Clearly high levels of exposure to the property sector, the shortening of the maturity structure of external borrowings by the banks, and the increasing level of dependence on borrowed funds rendered banks increasingly fragile. As is almost inevitable with periods of rapid growth, leverage ratios of non-financial firms grew and the brisk growth of credit resulted in bank portfolio leverage increasing to levels that threatened stability. RESPONSE OF POLICYMAKERS TO THE CRISIS Timing is of the essence when dealing with banking crises. A delayed response by bank management and monetary authorities to the onset of a crisis results in rising NPLs, panic withdrawals by depositors, an exodus of foreign deposits, and increased panicked borrowing to cover positions. In this scenario, liquidity problems can easily turn into solvency problems. A multitude of approaches were followed by countries confronted with the crisis. Thailand, Indonesia and South Korea turned to the IMF for loans, Malaysia responded by imposing capital controls which were controversial in the initial stages but subsequently acknowledged to have largely achieved their original intent. Singapore and Hong Kong with the most effectively regulated and managed banking systems, were able to withstand the crises through internal policy initiatives. The initial efforts of policymakers sought to contain panic within the banking system. This was done through explicit guarantees to depositors and

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provision of liquidity to banks. Once a modicum of stability was restored, efforts turned towards medium- and longer-term issues of dealing with nonperforming loans and recapitalization of banks. Recapitalization was carried out through injection of funds from the IMF, via issuance of bonds by the fiscal or the monetary authorities, and where possible, through bonds issued by the banks themselves. Bank restructuring assumed several forms. In Indonesia a large number of private banks were closed down. In Thailand a number of finance companies, a class of intermediaries that experienced large losses, were closed. Malaysia put into operation a comprehensive consolidation programme via mergers and acquisitions in the banking system centred around a core of ten anchor banks. In Indonesia bank consolidation is nearing completion, though as Table 4.11 shows, problems with non-performing loans persist. Thailand opened its banking sector to foreign acquisitions. Earlier this year, the authorities announced a strategy for consolidation within the banking sector. The huge volume of outstanding non-performing loans, especially in Indonesia, Thailand and Malaysia, point towards the unfinished task ahead for policymakers. The objective was to deal with the losses from the crisis and also to strengthen the banking system to face increasing competition from multinational banks once the WTO accord on financial services was implemented. Regulatory and legal reforms have been initiated at different speeds across the region. Singapore has been the most proactive. A substantially improved disclosure regime and adoption of Basel II standards allowed for a paradigm change from close and intrusive regulation to a risk-based supervisory regime. Local banks faced with serious competition on their home turf from foreign banks had to adapt quickly to new entrants. In Malaysia disclosure and regulatory reform is widely acknowledged to have been effective. The authorities in Thailand have pursued a gradualist approach to reforms, but the move towards consolidation is expected to gather pace soon. Indonesian banks saddled with some of the most serious problems in the region, seem to be turning the corner. Increasing competitive pressures via entry of foreign banks and further deregulation of the domestic banking sector has provided an impetus to regulatory authorities and bank management to accelerate the pace of change. Incorporated as independent entities, asset management companies (AMCs) take over non-performing loans and are delegated with the vital task of recovering these bank loans. AMCs were established in Malaysia, Indonesia and Thailand, the three economies most seriously affected by the financial crisis. To fulfil their mandate AMCs would be required to confront the

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TABLE 4.8 Legal Environment for AMCs in Asset Resolution Business laws (corporate, bankruptcy, foreclosure, etc)

Special legal powers1

Legal protection for AMC staff

Independence

Indonesia

Revised and updated in 1998

Yes

No

No

Japan

Ongoing revisions

No

No

Limited

Korea

Strengthened in 1998

Yes

No

Yes

Malaysia

Ongoing revisions

Yes

No

Limited

Thailand

Revised in 1998

Yes

No

Limited

1. For example, power to seize assets or foreclose on loans without going through the courts, to buy or sell loans without debtor approval, or exemptions from taxes. Sources: National authorities; BIS, Financial Stability Institute, Working Paper no. 4 (2004).

powerful and vested interests in the economy, the “crony capitalists”, large and influential industrial houses and groups that may have had access to easy credit. These entities are generally well connected and influential, often with direct links to the ruling establishment. Thus the independence and efficacy of AMCs is a strong indicator of the seriousness of authorities to address the root causes of the crisis and confront powerful business interests. Table 4.8 offers a detailed insight into the operational autonomy granted to AMC managers entrusted with the task of recovering NPLs. Korea has made concerted efforts to deal with NPLs, especially those held by chaebols. In Indonesia on the other hand, although IBRA, the national asset management and bank restructuring company has completed its mandate, a large volume of NPLs remain outstanding. Reported data suggests that the problem is more serious in Thailand (Table 4.11). GOVERNANCE REFORMS IN FINANCIAL INSTITUTIONS It is difficult to construct quantitative measures that offer direct insights into the impact of governance and broader financial reforms on the performance of banks and the economy. In the absence of direct data, proxies indicating effectiveness of reforms offer useful insights. For banks that have issued equity and public debt, mandated disclosure requirements partially help

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bridge the information gap. Rating agencies conduct a detailed analysis of banks that issue public debt. Following sharp criticism of their inability to detect problems in the financial sector, rating agencies specializing in evaluating banks, such as Moody’s and Fitch’s have undertaken to expend more resources and energy on their business. Implementation of Basel II Accord on Capital Adequacy The Basel Accord on capital adequacy seeks to establish uniform risk measurement guidelines for international banks. Adherence to the accord is voluntary, however given the rapid growth of cross-border banking business and the increasing level of systemic risk and the associated threat of contagion effects, monetary authorities in all major economies have mandated implementation of the accord. Southeast Asian nations are no exception. The final date for implementation of the accord for developed economies is 2008. Developing economies have been given time to adapt their banking systems to the significant data and disclosure requirements necessary for implementing provisions of the accord. The major ASEAN states have all committed themselves to adhering to the guidelines prescribed by the agreement, albeit with varying deadlines. The accord rests on three pillars — minimum capital requirements, supervisory oversight, and market discipline based on risk-based disclosure. As table 4.6 shows, Malaysia, Indonesia, Thailand, South Korea, Singapore and Hong Kong all meet the minimum capital adequacy requirement; however norms for establishment of appropriate risk measurement techniques are still being discussed and defined in most economies. Singapore and Hong Kong have progressed to risk-based supervision. The internal ratings based (IRB) approach is likely to be implemented in Hong Kong and Singapore by 2008, other countries in the region will need more time to establish the disclosure, risk measurement norms required for IRB. Malaysia has established a time-table for implementation of assessment using the IRB approach. Thailand and Indonesia have also released consultative reports with feedback from banks. The standardized approach is expected to adopted by the end of 2008. Systems for IRB are still in a formative stage. There are a number of challenges banks face here, ranging from inadequate expertise in risk measurement and management to the limited availability of historical loss data. The establishment of credit bureaus is deemed to be an important step. The most serious challenge Asian banks face is in implementation of Pillar Three of the accord. Market discipline, drawing upon risk-based

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disclosure, makes extensive data demands on the banks. The disclosure regime prevailing in the developing economies of Southeast Asia is grossly inadequate for this purpose. Improvements in disclosure are essential if central banks are to meaningfully persuade commercial banks to mobilize funds from the public. Aside from vanilla securities, the issuance of hybrid instruments is also encouraged. As an illustration, issuance of subordinated debt is seen as an instrument for enhancing monitoring effort by a class of stakeholders exposed to greater risk than plain bond holders. In the absence of deep capital markets, prospects for use of these instruments as monitoring devices are limited. However, with a broader spectrum of banks going public, this trend is laying the foundations for issuance of an expanded array of market instruments that could be used for monitoring financial institutions. Some regional banks have been successful in issuing subordinate securities; however, banking systems still have a long way to go before they are able to effectively implement the third pillar of the Basel Accord. Regulation and Disclosure Reforms Disclosure norms and requirements and their effectiveness differ significantly across countries, and across banks within a country. Following the financial crisis, the multilateral agencies took a number of initiatives to improve disclosure within financial institutions and enhance the stability of the financial system. Foremost among these are the Financial Sector Assessment Programme (FSAPs) conducted by the International Monetary Fund, and the move by the Bank for International Settlements to improve the timing and quality of disclosure. Many of these norms are prescribed in the disclosure requirements encapsulated in the Basel II Accord on capital adequacy. FSAPs conduct country level surveys on the structure, stability, regulatory imperatives, and vulnerability to instability in the financial sector. Periodic neutral appraisals of this sort facilitate identification of systemic weaknesses and sources of instability, and serves as a guidepost for market players and policymakers alike. At the bank level, measures indicating changes in the financial strength of banks and in the volume of NPLs over time offer insights into the stability, solvency and profitability of the banking system. At the macroeconomic level, broader indices measuring effectiveness of public institutions are important proxy measures of reforms in governance. Moody’s “Weighted Average Bank Financial Strength Index” is a useful metric for evaluating a bank’s financial strength, and over time, progress with respect

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to banking reform. For changes in the macroeconomic environment, the Economist Intelligence Unit’s Transparency and Fairness of Legal System Rating Score provides measures indicating the effectiveness of the broader reform agenda. Research shows a high correlation between indices of transparency in public governance and stability and resilience of the financial sector (Fons 1998). Market movements or changing macroeconomic circumstances aside, losses in the banking system are in large measure due to malfeasance in extending loans. “Crony capitalism”, connected lending, loans within industrial groups, over-exposure to single sectors or borrowers, etc., fall in this category. Economies with sound disclosure levels in the banking system, which in turn is related to transparency in public decision making, suffer lower levels of corruption. Data since 1998 (Table 4.9 and 4.10) shows little improvement in the scores for countries most seriously affected by the crisis, viz. Indonesia and Thailand. Malaysia’s scores demonstrate a marginal improvement. The EIU’s Transparency and Fairness of Legal System Rating Score mirrors similar trends. The EIU scores also provide indicators of the likely effectiveness of AMCs, as these institutions have to work through the legal system to recover assets. Again, timeliness, consistency and transparency in decision making are crucial. TABLE 4.9 Corruption Perception Index, 1998–2003 Country Hong Kong Indonesia Japan Malaysia Philippines Singapore South Korea Thailand United States Vietnam

1998 CPI Score

1999 CPI Score

7.8 2.0 5.8 5.3 3.3 9.1 4.2 3.0 7.5 2.5

7.7 1.7 6.0 5.1 3.6 9.1 3.8 3.2 7.5 2.6

2000 2001 CPI Score CPI Score … … … … … … … … … …

7.9 1.9 7.1 5.0 2.9 9.2 4.2 3.2 7.6 2.6

2002 2003 CPI Score CPI Score 8.2 1.9 7.1 4.9 2.6 9.3 4.5 3.2 7.7 2.4

8.0 1.9 7.0 5.2 2.5 9.4 4.3 3.3 7.5 2.4

Transparency International’s Corruption Perception Index (CPI) is a composite index drawing on different polls and surveys from independent institutions carried out among business people and country analysts. The CPI focuses on corruption in the public sector and defines corruption as the abuse of public office for private gain. The country with the lowest score is the one perceived to be the most corrupt of those included in the index. Source: Transparency International Annual Report.

1 4 3 2 4 3 2 2 3 2 2

1994

1 4 3 2 4 3 2 2 3 2 1

1995

1 4 3 2 4 3 2 2 3 2 1

1996 1 4 3 2 4 3 2 2 3 2 1

1997 1 3 3 2 4 3 3 2 4 2 1

1998 1 3 3 2 4 3 3 2 4 2 1

1999 1 3 3 2 4 3 3 2 4 2 1

2000 1 3 3 2 4 3 3 2 4 2 1

2001 1 3 3 2 4 3 3 2 4 1 1

2002 1 3 3 2 4 3 3 2 4 2 1

2003

1 3 3 2 4 3 3 2 4 2 1

2004

Source: EIU Market Indicator and Forecasts.

Legend: 2002, 2003 = Estimated score; 4 = Forecasted score

EIU’s Transparency and Fairness of Legal System Rating scores countries between 1 and 5 on the transparency and fairness of legal system, with 1 being very low/unfair and 5 being very high/fair .

China Hong Kong India Indonesia Japan Korea Malaysia Philippines Singapore Thailand Vietnam

Country

TABLE 4.10 The EIU’s Transparency and Fairness of Legal System Rating Score

68 Dipinder S. Randhawa

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On the Role of Institutions and Public Governance Corporate governance cannot be meaningfully analysed in isolation. The effectiveness or otherwise of corporate governance hinges crucially on the wider institutional context in which firms operate (Williamson 1985, 1996, 1998, 2000). Probity and efficiency of governance in the public domain has powerful implications for the effectiveness of corporate governance. One is hard-pressed to think of an instance in which a country with poor public governance scores high on corporate governance. Tables 4.9 and 4.10 highlight Transparency International and EIU Intelligence Unit findings on “Corruption Perception’’ and “Transparency and Fairness of Legal System”. The close links between scores on transparency and legal reform and the performance of the banking sector are self-evident. The low scores for Indonesia and Thailand correspond to the weak performance of the banking sector. The opacity of bank portfolios makes the challenge of reform in bank governance daunting. Large borrowers have close and often intricate and concealed relationships with banks. Lack of transparency in decision making regarding loans, and an inadequate infrastructure for assessing creditworthiness of borrowers enables powerful and connected borrowers to corner loans. Outside stakeholders lack the wherewithal to accurately assess the value of banks. In the absence of reliable and timely disclosure — a requirement not fulfilled in most emerging market economies — the central bank itself may find it challenging to make an informed assessment. In the case of NPLs, even the benefit of hindsight makes it a challenging task to differentiate loans made with poor judgement from those where mal-intent may have been at work. These ratings are particularly meaningful for the operation of asset management companies. AMCs are entrusted with the important mandate of recovering non-performing loans from defaulters. There is a direct correlation between transparency and corruption levels and bank’s financial strength. Transparency facilitates meaningful monitoring of banks. Greater transparency in investment and lending decisions also helps eliminate incentives and avenues for corruption. This would help lower the incidence of connected lending. Non-Performing Loans and the Role of Asset Management Companies Rapid economic recovery after the crisis, fuelled by devaluation of the regional currencies, continued growth in the U.S. economy, and sustained export performance has masked many of the underlying structural faults in regional economies. Family and state ownership of banks in Southeast Asia is widely prevalent. Though the region has made impressive strides in reducing the volume of NPLs, there is still a large overhang of bad loans. Table 4.11 traces

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TABLE 4.11 NPLs in the Commercial Banking System of The Crisis-Affected Countries (in % of total loans) 1997 Dec

1998 Dec

1999 Dec

2000 Dec

2001 Dec

2002 Dec

2003 Dec

2004 Jun

Indonesiaa Excl. IBRA

— 7.2

— 48.6

64.0 32.9

57.1 18.8

48.8 12.1

31.1 7.5

18.1 6.8

17.9 6.2

Koreab Excl. KAMCO & KDIC

8.0 6.0

17.2 7.3

23.2 13.6

14.0 8.8

7.4 3.3

4.1 2.4

4.4 2.7

2.6

Malaysia Excl. Danaharta

— —

21.1 16.7

23.4 16.7

22.5 13.4

24.4 16.3

22.4 14.7

21.2 13.1

20.1 12.3

Philippinesc

4.7

10.4

12.3

15.1

17.3

15.0

14.1

13.8

Thailandd Excl. AMCs

— —

45.0 45.0

41.5 39.9

29.7 19.5

29.6 11.5

34.2 18.1

30.6 13.9

29.6 13.0

Memo: Malaysiae Excl. Danaharta

— —

10.6

10.6

8.3

10.5

9.3

8.3

7.7

a. Only includes IBRA’s AMC. b. The NPL ratio increased in 1999 due to the introduction of stricter asset classification criteria (forward looking criteria). c. From September 2002 onwards, the NPLs ratios are based on the new definition of NPLs (as per BSP Circular 351) which allows banks to deduct bad loans with 100 per cent provisioning from the NPL computations. d. Includes transfers to AMCs but excludes write-offs. (Note that the jump in the headline NPLs in December 2002 was a one-off increase, reflecting a change in definition and did not affect the provisioning requirements). The June 2003 figure is preliminary and was estimated using transfers to AMCs and lending to AMCs as of March 2003. e. NPL series used by Bank Negara Malaysia, which is not of provisions and excludes interest in suspense. Source: BIS, FSI Occasional Paper no. 3, 2004.

the evolution of NPL ratios in the crisis affected countries. By factoring in the role of asset management companies, we can obtain a nuanced insight into the management of the NPL problem by banks and monetary authorities. It is evident from the data that a large volume of NPLs persist (Table 4.11). Government ownership of banks, in part brought on by the need to nationalize failing banks during the crisis, continues. While this need not necessarily translate into inefficiency, it may conceal the true health of the banking system.

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As discussed earlier, AMCs play a vital role in resolving the huge overhang on NPLs. Aside from the profound implications for the fiscal deficit, the effectiveness of AMCs determines how equitably and fairly the burden resulting from the crisis is distributed. To function effectively, AMCs need the power and authority to seize assets of defaulters, and where necessary carry out restructuring or liquidation of defaulting firms. The institutional requirements for AMCs to fulfil their mandate are demanding. At the very least they need to be autonomous of bureaucrats and politicians. An independent, fair, transparent judicial system which dispenses justice expeditiously, a clearly defined exit policy for firms, well defined property rights, an efficient bureaucracy, liquid capital markets and a stable macroeconomic climate, and at a broader level, efficiently functioning institutions — are all a sine qua non for successful AMCs. It warrants repetition that information is central to the functioning of banks. One needs to bear in mind that if information were freely available, banks would lose their raison d’etre, and, of course agency problems would cease to manifest themselves. Meaningful reforms in corporate governance and risk management are predicated on enhanced, timely and accurate disclosure. Thus, increased disclosure and transparency are crucial for effective risk management and corporate governance. In developing economies, poor enforcement of disclosure laws, and accounting standards render regulatory authorities unable to monitor banks. The challenge for bond and equity holders is more daunting. Rating Agencies In situations where outside stakeholders lack the wherewithal to produce information to monitor banks, rating agencies play an important role. However, if data sources are weak, rating agencies have to make their own inferences and also depend on qualitative information to make assessments. In the period leading up to the crisis of 1997 the performance of rating agencies came under severe criticism. Reasons put forth to explain their performance range from outright incompetence to being misled by questionable information provided by financial institutions. Reforms since the crisis have focused on the mandate before these agencies, and on measures that would enhance their effectiveness. Moody’s Bank Financial Strength Ratings (Table 4.12) provide investors with a metric measuring banks’ resilience in the face of financial stress. BFSRs thus supplement ratings awarded to banks with public debt issues. BFSRs are bank specific ratings, nevertheless, averaging them across a country offers

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TABLE 4.12 Moody’s Weighted Average Bank Financial Strength Index1 (in %)

Hong Kong Indonesia Korea Malaysia Philippines Singapore Thailand

Financial Strength Index

Percentage change

Dec. 2001

Dec. 2002

Dec. 2003

from Dec. 2002

66.6 1.7 14.2 30.4 17.5 75.0 15.8

62.3 3.0 16.7 31.7 20.4 74.7 15.8

62.3 3.0 18.3 33.3 20.4 74.7 15.8

0.0 0.0 10.0 5.3 0.0 0.0 0.0

1. Constructed according to a numerical scale assigned to Moody’s weighted average bank ratings by country. 0 indicates the lowest possible average rating and 100 indicates the highest possible average rating. Source: Moody’s.

insights into the strength of a banking system over time. Mirroring the trends or lack thereof in the EIU scores, BFSRs over the past three years show no clear trend in the region. An improvement in disclosure and prudential risk management helps lower the cost of capital for financial intermediaries and for non-financial corporations. Investors gain confidence and are willing to pay a premium for firms with higher disclosure and better governance. This enables corporate entities to draw funds from international markets and attract overseas investors, especially mutual funds which may be restricted by home country regulation to firms that meet global disclosure norms. In response to intensifying competition from capital markets, banks are increasingly issuing market based-instruments and syndicated loans. Interest margins are narrowing; as a result banks are becoming increasingly dependent on feebased services and off balance sheet activities. With deregulation and consolidation and the ability to offer a range of financial services, relationship banking is becoming the main source of income in traditional banking. For money-centred banks, improved transparency and governance is crucial for banks obtaining funds at competitive rates. Conversely, the lack of transparency may well place a premium on the cost of funds. To outside investors, poor disclosure suggests the possibility of corrupt practices, connected lending, and the ability to conceal weaknesses in the balance sheet.

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Timely detection of problems in the banking sector is vital for monetary authorities. Costs associated with problems in the banking sector increase exponentially over time. Delays in responses by policymakers in countries ranging from Japan to Indonesia led to a massive increase in the damage stemming from problems in the banking sector. “Evergreening” of loans leads to a rapid escalation in the volume of NPLs. The deeper an individual bank gets into trouble, the stronger are the incentives for witholding information from regulators. The risk of contagion effects, as weak banks start pulling down other banks in the economy or beyond, grows rapidly. The Basel capital adequacy accords are in response to concerns regarding systemic crises as financial systems and institutions become more integrated. Country Experiences Table 4.13 offers a snapshot of the institutional framework that prevailed just prior to the onset of the crisis. The overall picture has improved considerably since, though progress is uneven across the region. With their well-managed and regulated banking systems, Singapore and Hong Kong emerged relatively unscathed from the crisis. Improved disclosure, consolidation, hiving off non-performing loans from bank portfolios and recapitalization of the banking systems are the main objectives of the monetary authorities in these countries. Direct government ownership in the banking sector has been reduced considerably through equity sales to the private sector and privatization or sale of banks to overseas investors. Indonesia, followed by Thailand has been proactive in this context. In Indonesia state owned banks have been publicly listed, private sector banks, on the other hand, have been sold off to reputable foreign investors. Connected lending has fallen sharply since. In Malaysia, direct ownership of banks by the government is negligible. Central banks across the region have mandated stringent loan classification criteria. While there has been progress in all the regional banking systems, implementation is uneven across the region. Satisfactory classification depends on reliable disclosure norms. Some progress notwithstanding, accounting norms are yet to meet global best practice norms. Diversification away from the Banking Sector A recommendation made by researchers, think tanks and multilateral institutions alike is development of capital markets. Mature capital markets help reduce

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TABLE 4.13 Indicators of Institutional Framework (Mid-1997, unless otherwise indicated)

Transparency

GS Frailty Score (0 = best, 24 = worst)

GS Camelot Score (1 = best, 10 = worst)

Good, improving

Very good

8

3.5

Satisfactory, improving

Weak, improving

Satisfactory

15

4.6

Korea

Weak, improving

Fair

Fair, improving

18

Na

Malaysia

Satisfactory, improving

Weak, improving

Satisfactory

15

4.5

Philippines

Good

Fair

Satisfactory

13

3.7

Singapore

Very Good

Very Good

Poor

7

4.0

Thailand

Weak, improving

Weak

Poor, improving

22

5.2

Bank regulatory framework

Bank supervision quality

Hong Kong

Very good, improving

Indonesia

Country

Source: Gochoco-Bautista, Ma. Socorro, Soo-Nam Oh, and S. Ghon Rhee, “In the Eye of the Asian Financial Maelstrom: Banking Sector Reforms in the Asia-Pacific Region”, Asian Development Bank, 2000.

reliance on the banking sector. This shift away from dependence on the banking sector is healthy as it promotes diversification in funding sources and helps reduce leverage ratios in financial and non-financial firms. Capital markets need time to develop and acquire credibility. Korea and Malaysia have made impressive progress towards developing bond markets, helped also the rapid growth of securitization. The Asian Bond Market Fund under the Chiang Mai initiative for integration of regional financial markets is helping lay the foundations for a pan-Asian bond market. Equity markets however, have been lagging, as most firms, other than large growing enterprises continue to depend on banks for funds. The rapid growth of securitization has enabled banks to hive off nonperforming assets, and tap a new source of liquidity. Securitization of loan

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75

portfolios also helps to reduce capital requirements, thus lowering the cost of capital for the bank. Again, Korea’s achievements are notable here, bond markets in Malaysia are growing rapidly, Thailand and Indonesia have made useful progress as well. TABLE 4.14 Sovereign Ratings, June 2004 Long-Term Foreign Currency

Hong Kong Indonesia Korea Malaysia Singapore Thailand

Fitch

Fitch Rating Outlook

Moody’s

S&P

AA– B+ A BBB+ AAA BBB

Stable Stable Stable Positive Stable Positive

A1 B2 A3 Baa1 Aaa Baa1

A+ B A– A– AAA BBB

Stable Stable Stable Positive Stable Positive

Aa3 B2 A3 A3 Aaa Baa1

AAB+ A+ A+ AAA A

Long-Term Local Currency Hong Kong Indonesia Korea Malaysia Singapore Thailand

AA+ B+ AA– A AAA A–

Source: Fitch Ratings, Asia Quarterly, July 2004.

TABLE 4.15 Corporate and Financial Sector Comparison for Asian Crisis Countries, 1998 and 2003 Indonesia

Corporate Sector Ordinary income to sales Interest expense to sales

Malaysia

Thailand

1998

2003

1998

2003

1998

2003

–12.0 13.0

8.0 3.0

3.0 4.5

7.0 1.7

7.5 8.2

11.0 1.0

0.6 2.3

2.7 22.0

1.8 11.0

1.6 13.0

–0.2 11.0

1.5 11.2

Financial Sector Commercial bank return on assets Capital adequacy ratio

Source: Global Development Finance, World Bank, 2005.

30 25 41 15

52.8 44.7 39.0 47.5

Largest 3 banks 86.9 78.3 80.3 83.5

Largest 10 banks 1263.6 918.9 819.7 1031.7

HH Index (1994) 13 10 27 13

Number of banks 43.5 43.4 39.6 41.7

Largest 3 banks

77.7 82.2 73.3 79.4

Largest 10 banks

Share in total deposits (in %)

Share in total deposits (in %)

899.7 1005.1 789.9 854.4

HH Index (2000)

Source: R. Gaston Gelos and Jorge Roldós, “Consolidation and Market Structure in Emerging Markets Banking Systems”, International Monetary Fund, May 2002.

R O Korea Malaysia Philippines Thailand

Number of banks

2000

1994

TABLE 4.16 Number of Banks and Bank Concentration in Crisis Affected Countries

76 Dipinder S. Randhawa

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The speed of consolidation in the banking sector has gained momentum over the past five years (Table 4.16). Malaysia has completed the first phase of the announced consolidation programme, reducing the number of financial institutions from fifty-four in the year prior to the crises, to ten at present. Privatization, domestic mergers and sales to strategic overseas investors enabled Indonesia to make impressive strides towards reducing the number of banks. Thailand announced a consolidation programme as late as 2004. Mirroring the experience of many developing economies, consolidation has helped reduce concentration in the banking sector (Table 4.16). This augurs well for the strengthening of competitive forces in regional banking systems. CONCLUDING OBSERVATIONS Economic recovery in the region since the 1997 crisis has been impressive. The macroeconomic indicators of growth, foreign exchange reserves, export performance, the fiscal situation and inflation management all point towards promising medium-term prospects. The growing volume of foreign exchange reserves has raised a number of challenges for policymakers, including a debate on how the reserves could be deployed more profitably with reduced reliance on an uncertain U.S. dollar. In the near future external developments and structural change in the economy are likely to provide impetus for improving governance. With further liberalization under the WTO agreement on financial services, banks face increasing competition internally as well as from overseas entrants. In the domestic arena, as capital markets develop, savers and borrowers will have an expanded menu of choices necessitating increasing efforts on the part of banks to attract business. Foreign direct investment in the financial sector has grown rapidly over the past fifteen years. A substantial volume of this has been earmarked for overseas expansion and acquisitions by multinational banks. Deregulation in the U.S. and the global trend towards universal banking has opened up new opportunities and imposed competitive pressures on the banking system. As banks move into fee-based services and increase linkages with financial markets, activities where increasing returns are often obtained, consolidation is a natural corollary. For Asian economies, development of capital markets and contractual savings institutions is an overriding priority. This would also help to absorb a larger proportion of foreign exchange reserves and lend resilience to the financial sector. Underdeveloped financial markets, inadequate financial regulation and lack of policy coordination are hurdles facing many Asian economies when it comes to building a sound financial sector.

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Aside from national efforts, rating agencies and multilateral institutions have also been proactive in formulating policies and recommending reforms for enhancing the resilience and efficiency of financial institutions. Moody’s, S&P and Fitch’s have expanded the number of banks rated. Bank Strength Financial Ratings compiled by Moody’s offer useful insights into individual banks financial health (Table 4.12). The financial sector adjustment programme (FSAP) initiated by the IMF offers detailed insights into factors impacting the stability and resilience of the financial system. Since the Asian financial crisis, the BIS has taken several initiatives oriented towards increasing stability and early identification of problems in the banking sector. These range from more timely and detailed information on bank portfolios, to detailed guidelines for computing risk-adjusted capital. “Connected lending”, “crony capitalism”, “evergreening of loans”, etc. are thinly veiled euphemisms for what are essentially corrupt practices. Our discussion pointed towards the importance of efficiently functioning institutions and a transparent and fair judicial system as prerequisites for resolution of problems stemming from accumulated NPLs. Without efforts at getting to the roots of corruption and enhancing transparency and fairness in the legal systems, problems in the banking sector cannot be resolved. The data on this is disquieting. The evidence cited shows that despite the wide range of reforms undertaken since 1997, most regional economies have made only marginal progress towards tackling the most important, albeit challenging problems, namely corruption, the lack transparency and the large volume of outstanding NPLs. The importance of transparency followed by clearly enunciated policy measures to stem the outflow of funds and loss of confidence cannot be overemphasized. In this context, the range of experiences across the ASEAN states is instructive. The handling of SARS in 2003 in the region offers an interesting parallel. Countries that came out in the open with the incidence of the disease and its transmission were able to deal with the medical emergency much more effectively than nations that were hesitant to acknowledge the problem and then divulge the rates of infection and transmission. After the initial pain, with timely disclosure and transparency in decision making, damage control and regaining confidence of international markets (community, in the case of SARS) is much easier. A detailed micro-level analysis and scrutiny is required to obtain a nuanced picture of the state of reforms of governance of the financial sector. This would encompass the effectiveness of the disclosure regime, and in what could be construed as a sign of confidence in the banking system — the prospects for an eventual shift from a regulatory governance regime to a riskbased supervisory regime.

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A brief report card on reforms in the banking sector shows impressive gains in recapitalization of banks and in consolidation within the banking sector. There remains considerable work to be done in establishing the institutional infrastructure for enabling the third leg of the Basel II Accord, market discipline, to be effective. With the advent of foreign banks, consolidation in the domestic banking sector and the impending opening of the financial sector in accordance with the WTO accord, competitive pressures have increased. This should benefit governance. Bond and equity markets have been growing, albeit slowly, and liquidity in financial markets remains a concern. Sustainable growth in the region depends on raising standards of governance, strengthening the legal and regulatory environment, and exploiting long term sources of funding through the development of capital markets and contractual savings institutions. Multilateral developments have increased pressures for enhancing the quality of governance. Regional financial cooperation envisaged under the Chiang Mai Accord is intended to facilitate greater financial integration in the region. Minimum internationally acceptable disclosure and governance norms are a prerequisite for meaningful progress on this front. The implementation of the Basel II Accord and further liberalization of the banking sector necessitated by the WTO Accord on financial services will add to the drive towards improving the quality of governance in the financial system. Promising medium-term growth prospects and the build-up of foreign exchange reserves provides economies with an opportunity to address the underlying weaknesses and further consolidate the gains made over the past six years. Growth by itself should partially help address the most serious weakness in the banking sector, non-performing loans. As liberalization proceeds, domestic banks will face more stringent competition on their home turf. This is already the case in Singapore and Hong Kong. Unless, transparency and corporate governance are improved and the infrastructure to effect a shift to risk-based supervision put into place, the likelihood of a recurrence of the problems of the summer of 1997, especially in the event of an economic downturn, will remain. Growth in the economy has helped alleviate the problem of nonperforming loans. During times of prosperity banks tend to hold off on difficult reforms as any underlying structural problems are masked by growth in income. High bank capital ratios in a number of countries can be partially attributed to the large holdings of government bonds, which in turn is an outcome of excess liquidity within the banking system and the absence of avenues for productive deployment of these funds. The fault lines become

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visible during an economic downturn. The large overhang of non-performing loans, reports of increasing portfolio concentration, and disclosure standards that are yet to meet international standards exemplify the unfinished agenda of reforms in governance of financial institutions. Though macroeconomic ratings have improved substantially since the crisis (Tables 4.14, 4.15), bank specific indicators (Table 4.12) point towards the remaining weaknesses in the banking sector — weaknesses that would engender fragility in the financial sector in the event of an economic downturn. Experience over the past decades does not offer insights into fundamental questions such as: Are market-dominated systems or bank-dominated systems better? Why are there differences in performance between banking system in Japan and Germany — both bank-dominated economies? What mix of policies facilitates effective public governance and private governance? The data shows there is a close relationship between corporate governance and public governance. Understanding the precise nature of the links requires further research. There is no blueprint policymakers can follow to design efficient financial systems. However, we do know that efficient and transparent public governance does lay the foundations for efficient corporate governance. Transparency in rules and regulations and in the actions of public decision makers is clearly conducive to good governance. The gist of this brief overview is that Southeast Asian economies have made impressive gains in dealing with the legacy of the financial crisis of 1997 in their banking systems. However, there are wide differences in the extent to which the necessary reforms have been carried out. The agenda on reforms in public governance which has a direct bearing on corporate and bank governance reforms, though well underway, remains incomplete. There is some concern that with satisfactory macroeconomic performance in recent years, policymakers run the risk of becoming sanguine about the remaining underlying weaknesses in the financial sector. References Acemoglu, D., S. Johnson, and J. A. Robinson (2001) “The Colonial Origins of Comparative Development: An Empirical Investigation”. American Economic Review 91: 1369–1401. ——— (2004) “Institutions, Volatility, and Crises”. In 13th NBER-East Asian Seminar in Economics, Chicago: University of Chicago Press. (Forthcoming). Bank for International Settlements (BIS) (2001) “The Banking Industry in Emerging Market Economies: Competition, Consolidation and Systemic Stability”.

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——— (2004) “Foreign Direct Investment in the Financial Sector of Emerging Market Economies”. BIS Source: National authorities; BIS, Financial Stability Institute, Working Paper no. 4, 2004. Barth, James R., Gerard Caprio, Jr., and Ross Levine (2002) “Bank Regulation and Supervision: What Works Best?” National Bureau of Economic Research, Inc. NBER Working Papers: 9323. Beck, T. and Ross Levine (2003) “Legal Institutions and Financial Development”. Prepared for the Handbook of New Institutional Economics. (Forthcoming). Berger, A.N and Humphrey, D.B. (1997) “Efficiency of Financil Institutions: International Survey and Directions for Future Research”. European Journal of Operational Research 98: 175–212. Chong, Alberto and C. Calderon (2000) “Institutional Quality and Poverty Measures in a Cross-Section of Countries”. Economics of Governance 1: 123–35. Claessens, S. and T. Glaessner (1997) “Are Financial Sector Weaknesses Undermining the East Asian Miracle?” World Bank. Claessens Stijn, Simeon Djankov, and Larry H.P. Lang (2000) “The Separation of Ownership and Control in East Asian Corporations”. Journal of Financial Economics 58, (2000): 81–112. Economist Intelligence Unit: EIU Market Indicators and Forecasts. Eichengreen, Barry (2004) Financial Development in Asia: The Way Forward. Singapore: ISEAS. Fons, Jerome S. (1998) “Improving Transparency in Asian Banking Systems”. Moody’s Investors Service. Gelos, R. Gaston and Jorge Roldós (2002) “Consolidation and Market Structure in Emerging Markets Banking Systems”. International Monetary Fund. Gochoco-Bautista, Ma. Socorro, Soo-Nam Oh, and S. Ghon Rhee (2000) “In the Eye of the Asian Financial Maelstrom: Banking Sector Reforms in the AsiaPacific Region”. Asian Development Bank. Johnson, S., P. Boone, A. Breach, and E. Friedman (2000). “Corporate Governance in the Asian Financial Crisis”. Journal of Financial Economics 58: 141–86. Levine, R., (1997) “Financial Development and Economic Growth: Views and Agenda”. Journal of Economic Literature 35: 688–726. ——— (2004) “Finance and Growth: Theory, Evidence, and Mechanisms”. In Handbook of Economic Growth, edited by P. Aghion and S. Durlauf. Amsterdam: North-Holland Elsevier Publishers. ——— (2004) The Corporate Governance of Banks: A Concise Discussion of Concepts and Evidence”. World Bank Working Paper. Litan, Robert E., Michael Pomerleano, and Vasudevan Sundararajan, eds., (2002) “The Future of Domestic Capital Markets in Developing Countries”. World Bank/ IMF/Brookings Emerging Markets Series. Washington, D.C.: Brookings Institution. Mitton Todd (2002) “A Cross-Firm Analysis of the Impact of Corporate Governance on the East Asian Financial Crisis”. Journal of Financial Economics.

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Morgan, Donald P. (1999) “Judging the Risk of Banks: Why Can’t Bond Raters Agree?” Federal Reserve Bank of New York Working Paper. OECD (2003) Corporate Governance in Asia. Paris. Sale, Hillary (2005) “Banks, the Forgotten Partners in Fraud”. University of Iowa, College of Law Working Paper 05-09. Survey on Banking, 1 March 2003. Tabalujan, Benny Simon (2001) “Why Indonesian Corporate Governance Failed in the 1990s — Conjectures Concerning Legal Culture”. Nanyang Technological University, Division of Business Law. Transparency International. Annual Report, various issues. Williamson, O. (1985) The Economic Institutions of Capitalism. New York: Free Press. ——— (1996) “Prologue: The Mechanisms of Governance”. In Williamson, O. The Mechanisms of Governance. Oxford: Oxford University Press. ——— (1998) “The Institutions of Governance”. American Economic Review 88, no. 2: 75–79. ——— (2000) “The New Institutional Economics: Taking Stock, Looking Ahead, Journal of Economic Literature 38, no. 3: 595–613. World Bank. (2005) Global Development Finance. Washington, DC: World Bank.

Corporate Governance Reforms in Malaysia: Issues and Challenges

Part II COUNTRY STUDIES

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5 CORPORATE GOVERNANCE REFORMS IN MALAYSIA Issues and Challenges CHEAH Kooi Guan

INTRODUCTION The attention accorded to corporate governance issues in Asian countries during and after the East Asian financial crisis sometimes gives the impression that corporate governance problems are peculiar to this part of the world. Debate and actions on corporate governance, however, have been taking place in the developed economies well before 1997. In the United Kingdom, for example, concerns about standards of financial reporting and accountability, heightened by BCCI and Maxwell have kept corporate governance issues in the public eye since the 1980s, culminating in the setting up of the Cadbury Committee in 1991. Subsequent measures included the establishment of the Greenbury Committee in 1995, to address controversies over excessive directors’ remunerations among newly privatized utilities (Ow-yong and Cheah 2000). The East Asian financial crisis, which occurred hardly five years after the World Bank commended the same countries for the miracle of economic success (World Bank 1993), led to desperate attempts to identify the culprits. A number of studies attribute corporate governance to be a major factor

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contributing to the crisis (Kim 1998, Lee and Park 2002, Suto 2003). As in the United Kingdom, several high profile corporate abuses and the devastating impact of the crisis prompted Malaysia to begin a series of concerted efforts to address issues of corporate governance (Ow-yong and Cheah 2000; Thomas 2002). Nonetheless, it should also be noted that a number of no less significant governance measures had actually been introduced some years preceding 1997. In 1993, the watchdog for Malaysia’s stock market, the Kuala Lumpur Stock Exchange, now known as Bursa Malaysia, introduced listing requirements that mandated all public listed companies to set up audit committees within the board of directors. In April 1996 (a year before the crisis), the Registrar of Companies, since then merged with the Registrar of Business to become the Companies Commission of Malaysia, introduced guidelines to regulate the behaviour of company directors and secretaries (Guidelines on Voluntary Codes of Company Directors and Company Secretaries, 1996). Just months prior to the outbreak of the 1997 crisis, the Financial Reporting Act was legislated in parliament to introduce a new financial reporting framework, with the establishment of the Financial Reporting Foundation, and the Malaysian Accounting Standards Board. Interestingly, appointments of the key members of the respective agencies were announced on 30 June 1997, just a matter of weeks before the full impact of the crisis began to hit Malaysia. We shall begin this chapter by providing an overview of the regulatory framework and types of reforms that have been introduced in Malaysia. THE CORPORATE GOVERNANCE REGULATORY FRAMEWORK IN MALAYSIA Several major government agencies are involved with corporate governance regulations in Malaysia. The Companies Commission of Malaysia (CCM), which is the principal regulator for companies in Malaysia, is responsible for the administration of the Companies Act 1965. The Securities Commission (SC) was established under the Securities Commission Act 1993. It is the central regulatory authority for the capital market. It administers the Securities Industry Act (SIA) 1983, which is an act to make provisions with respect to stock exchanges and persons dealing in securities, and for certain offences relating to trading in securities. The SC regulates capital market activities and is also in charge of the regulation of securities and futures intermediaries and issuers in Malaysia. Its jurisdiction spans across the primary market (fund raising, takeovers and mergers) and the

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secondary market (regulation of market offences and compliance with accounting and other standards). The KLSE is a self-regulatory agency responsible for both the front-line regulation of its members and of PLCs, and for the surveillance of the marketplace. The most important and comprehensive non-legislative regulation that applies to all PLCs is the Listing Requirements (LRs), administered by the KLSE. MAJOR TYPES OF CORPORATE GOVERNANCE REFORMS Over the recent past, corporate governance regulatory framework in Malaysia has undergone far-reaching changes. Most of the reforms have been in the form of regulatory changes. As elsewhere, the Malaysian corporate governance regulatory framework can be divided into statutory and non-statutory controls. Statutory controls consist of legal provisions. Non-statutory regulations which are by prescription, include both written codes and rules, as well as unwritten rules and procedures. Besides regulatory reforms, recent Malaysian corporate governance initiatives involved the establishment of a number of institutions, and the charting of new policies and plans. In addition, a broader base for corporate governance reforms actually involves efforts to upgrade corporate governance education and training, and includes attempts at enhancing public and investor awareness of corporate governance in general, and upgrading the knowledge and competency of company directors in particular. We shall bear in mind, however, that any classification of the reforms is necessarily arbitrary and subjective, and some overlapping as well as omission may be inevitable. Statutory Reforms Corporations, particularly PLCs in Malaysia are subject to several major legislations. These include the Companies Act 1965, Securities Industry Act 1983, and the Securities Commission Act 1993. Each of these enactments has been amended on different occasions, and many of the changes relate to improving corporate governance practices. As a direct result of the economic crisis, the Securities Industry Act (SIA) 1983 was amended in April 1998, to enhance the SC’s powers (including over directors and CEOs), and to institute civil remedies against offenders for insider trading. Through subsequent amendments to the SIA, the powers of the SC and KLSE have been considerably reinforced, to enable the authorities to require enhanced transparency and disclosure of companies, and to allow them to hold directors personally liable if the latter

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breach any Listing Requirements. A number of the amendments also directly necessitated changes in the Securities Commission Act 1993. Besides, the Securities Commission (Amendment) Act 2000, which was passed in April 2000, also provided further powers for the SC to “pursue civil action on behalf of investors where it is in the public interest to do so”.1 In 1999 and 2000, a number of amendments were also made to the Companies Act (CA) 1965. Many of amendments were meant to incorporate proposals made in the Finance Committee Report (1999). There were also other provisions on matters relating to duties and responsibilities of directors and officers of a company with emphasis on transparency and accountability. An example is the introduction of Section 132G to prevent a company from entering into transactions to acquire the shares or assets of another company in which a shareholder or director of the acquiring company has a substantial shareholding. This is a direct result of attempts to curb the abuses of “asset shuffling”.2 Amendments and new provisions were made to the CA 1965 in Sections 132A, 132B, 132C, 132D, 132E and Division 3A of Part IV as well, to ensure disclosure of interests in contracts with the company by directors, disclosure of interests in shares by directors and substantial shareholders, substantial property transactions by companies with their directors and insider trading. As mentioned earlier, the Financial Reporting Act (FRA) 1997 was promulgated just before the onset of the financial crisis in 1997. Under the FRA, The Financial Reporting Foundation (FRF) and the Malaysian Accounting Standards Board (MASB) were set up. The FRF, as a trustee body, has responsibility for the oversight of the MASB’s performance, financial and funding arrangements, and as an initial source of views for the MASB on proposed standards and pronouncements. It has no direct responsibility with regard to standards setting. This responsibility rests solely with the MASB, which is an independent authority to develop and issue accounting and financial reporting standards in Malaysia. Together, the MASB and the FRF make up the new regulatory framework for financial reporting in Malaysia. The measure is significant, because the MASB has become the authority in charge of issuing new accounting standards as approved accounting standards, and issuing statements of principles for financial reporting in Malaysia. In conclusion, the amendments made to various statutory acts since 1997 have strengthened considerably the corporate governance regulatory framework, provided the authorities with the necessary powers to enforce the laws relating to corporate governance, and served to act as deterrents to potential abuses.

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Development of Codes of Conduct and Industry Best Practices Besides statutory legislations, the SC has issued non-legislative rules. A notable example is the Policies and Guidelines on Issue/Offer of Securities, and the Code on Takeover and Mergers 1987. However, the most important and comprehensive non-legislative regulation that applies to all PLCs is the KLSE Listing Requirements (LRs). The LRs are administered by the KLSE which is the major watchdog overseeing the PLCs. Between 1997 and 2000, a number of piecemeal changes were made, some of which were nevertheless highly significant. For example, Part 4 of the KLSE Main Board LR which concerned related-party and interested party transactions, were amended effective January 1999, to protect minority shareholders. In the accompanying press announcement, it was admitted that “In the recent past, however, certain related-party and interested-party transactions have been undertaken without having due regard to the interests of minority shareholders.”3 To enhance the timeliness and frequency of disclosure, the LR was further amended in 1999 to require quarterly reporting of financial information, prepared in accordance with approved accounting standards of the MASB. However, the LRs underwent a major and comprehensive revamp, and the new version, known as the KLSE Revamped Listing Requirements, were released in January 2001. Besides integrating the earlier amendments, it incorporated a significant component of the recommendations contained in the Finance Committee Report, particularly the Malaysian Code of Corporate Governance (MCCG). The introduction of the MCCG in March 2000 is considered a landmark in Malaysian corporate governance reform. It represents a milestone in government-industry collaboration because the code itself is a product of an industry-led working group set up under the auspices of the government’s High Level Finance Committee. The MCCG sets out thirteen principles of conduct and thirty-three best governance practices. The revamped LR of 2001 mandated all PLCs to disclose their compliance with the MCCG in their annual reports. Through the introduction of new provisions and the strengthening of existing provisions in key aspects of regulation, including corporate disclosure and reporting, internal controls, directors’ rights and obligations and the general protection of minority shareholders’ interests, the revamped listing requirements have therefore considerably enhanced standards of corporate governance and investor protection amongst PLCs. Another significant progress of corporate governance reforms in Malaysia is the widespread support and cooperation given by professional bodies to

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streamline their respective codes of conduct and to promote both awareness and standards of corporate governance. In November 2000, the Malaysian Association of the Institute of Chartered Secretaries and Administrators (MAICSA) published a best practice guide entitled “A Guide to Annual General Meetings” and “The Company Secretary: A Reference Kit”. The former seeks to enhance the effectiveness of AGMs while the latter lays down clearly the duties and responsibilities of company secretaries, including issues of corporate governance. In line with the mandatory disclosure requirement on the state of internal controls (KLSE LR 2001), the Taskforce on Internal Controls developed a guideline entitled “Statement on Internal Control: Guidance for Directors of PLCs” in February 2001. Moreover, the Institute of Internal Auditors released, in August 2002, “Guidelines on the Internal Audit Function” to assist board of directors relating to internal audit functions (SC 2004). Institutional Reforms By far the most significant single event in institutionalizing Malaysian corporate governance reforms is the setting up of the High Level Finance Committee on Corporate Governance, and the release of the Finance Committee Report (1999). The High Level Finance Committee on Corporate Governance was established in 1998 to review the framework for corporate governance in Malaysia. The Committee, with the SC as the Secretariat, adopted a rigorous consultative process involving a broad spectrum of the financial community including regulatory agencies, corporates, banks, industry associations, standard setting bodies, and members of academia. Its report, known as The Finance Committee Report on Corporate Governance was released on 26 March 1999. The report covered three broad areas: • • •

Development of the Malaysian Code on Corporate Governance which sets out a set of principles and best practices for good governance; Reform of laws, regulations and rules to strengthen the regulatory framework for corporate governance; and Training and education to ensure that the framework for corporate governance is supported by the necessary human and institutional capital.

The revamp of the KLSE LRs was undertaken partly to implement the major recommendations of the Finance Committee Report. About twenty-two out of the twenty-five recommendations proposed in the report were incorporated in the revamped LRs by the KLSE. Significantly therefore, the amendments

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to the KLSE Listing Requirements also brought into effect the Malaysian Code on Corporate Governance. In terms of institution building, the establishment of two institutions: the Malaysian Institute of Corporate Governance (MICG), and the Minority Shareholder Watchdog Group (MSWG) should be highlighted. The MICG was incorporated in March 1998 with a grant of RM250,000 from the SC. It aims to be a “premier research and training institute for corporate governance, through public awareness compaigns, education and training, research and publications and setting good corporate governance standards”.4 The MSWG was established in August 2000 following the recommendation of the Finance Committee Report. The raison d’etre for the MSWG was to encourage independent and proactive shareholder participation by harnessing the ability of large albeit minority institutional investors to monitor and effect change in PLCs (SC 2004). Besides the setting up of these two institutions, a number of existing market institutions have been restructured and their powers enhanced. The most notable is the formation of a new agency known as the Companies Commission of Malaysia (CCM) on 16 April 2002. The CCM merged the functions of the Registrar of Company and the Registrar of Business. Education and Training A crucial aspect of efforts to improve corporate governance standards involves investing in human resource capital. Promoting training and education at all levels is therefore necessary to ensure that corporate governance reforms take root in the country. Through PN5/2001, the KLSE introduced mandatory training for company directors. It is divided into Mandatory Accreditation Programme (MAP) and Continuing Education Programme (CEP). Again this is a recommendation made by the Finance Committee Report. The revamped LR requires all directors of PLCs to undergo a MAP and, on an annual basis, participate in the CEP. The programmes seek to enhance the effectiveness of directors in discharging their duties, and ensure that they are continuously updated on developments in the securities industry, particularly in areas of corporate governance and other regulatory developments (SC 2004). The Securities Industry Development Centre of the SC, set up in 1994 strives to complement the promotion of corporate governance by organizing training, education and research. It conducts seminars, workshops and other training and education for a wide-ranging audience that includes directors, market intermediaries, and retail investors. It publishes educational material

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and provides general information on corporate governance. In the Investor Digest which it publishes monthly, there are interactive web pages that educate investors on shareholders’ rights, recourse for investors, and alert investors of potential pitfalls and scams. THE ROLE OF THE MARKET IN SUPPORTING THE REFORMS We observe from the brief overview above that there have been a large number of regulatory changes in the Malaysian corporate sector over the recent past. However, no amount of government reforms will be sufficient to bring about greater corporate governance if market forces are not conducive or supportive of the initiatives. Indeed, if market forces are strong and effective enough, the need for government intervention is correspondingly less necessary. Obviously the effectiveness of market forces depends on many factors. We shall here discuss only two of them, namely the availability of market mechanisms that can serve to enhance corporate governance, and the socio-economic environment in which market forces operate. In more developed financial systems, the threat of takeovers serves as an effective mechanism to minimise inefficient management and ineffective governance of a corporation. Takeovers are less common in Malaysia, with most occurring through friendly negotiations between the controlling shareholders of the corporations involved. One reason is the large ownership stake of the controlling shareholders, which prevents the accumulation of enough shares to threaten corporate control. Therefore the concentration of shareholding in Malaysia represents an important impediment to the development of a market for corporate control. The constraint on the disciplinary role of hostile takeovers necessarily affects the level of corporate governance, because controlling shareholders and other insiders who do not work towards the maximization of shareholder value can more easily get away from being penalized. Although the equity market has experienced tremendous growth especially in the early 1990s, most Malaysian corporations traditionally turn to bank borrowings for financing, including long-term funding. While banks play a dominant role in lending, they do not play a significant role in governance in Malaysia (with respect to the appointment of managers or director or the choice of investments). This is because they do not control significant block of shares or sit on boards of directors. While the banks themselves are not in a position to exert discipline on governance issues in the corporations concerned, the traditional reliance on bank borrowings in turn inhibits the growth and development of the capital markets. This

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again does not augur well for the practice of good corporate governance since open market forces in the capital markets are further constrained from effective operations. SOCIAL, CULTURAL AND ECONOMIC DIMENSIONS OF CORPORATE GOVERNANCE REFORMS In the evaluation of government-led initiatives of corporate governance reforms, the broader external environment in which the regulation as well as market forces operate need to be taken into consideration as well. There are actually social, cultural and economic dimensions in the corporate governance framework, which are related to the social, political, cultural and economic systems of the country. Of these, the economic dimension is probably the most straightforward, and will thus be addressed first. The economic environment exerts a far-reaching impact on the governance of corporations. In an economic boom, for example, profits can be easily made, and stock prices tend to be rising over time. High corporate profits and surging stock prices could camouflage weak corporate governance in some companies. Minority shareholders may not be too concerned with “minor” corporate abuses committed by substantial shareholders so long as surging share prices offer capital gains and “reasonable” dividends are declared. Other stakeholders may be equally less concerned too. Banks find ample opportunities to extend loans for which repayment would normally not be a problem. Creditors too are satisfied so long as the companies are riding high on the good economy. On the other hand, the economic dimension becomes a cause of concern when the economy enters its downturn phase. Under difficult circumstances, directors may resort to bending rules and cutting corners to make ends meet. The Finance Committee Report (1999, p. 42) listed the following corporate abuses under difficult circumstances: • • • • •

Related party transactions; Incidences of capricious decision making; Asset shifting; Blatant and abusive conflict of interest transactions; and Poor financial management by directors.

In this context, statutory laws are necessary. Besides punishing the wrongdoers, they serve as deterrents to others. However, it is all too often assumed that by passing a law, matters will change. While the legal framework has to be in place and sufficiently comprehensive, enforcement itself is a highly challenging

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task. This is more so in Eastern societies where social and cultural values may be not be supportive of harsh and strict enforcement of laws. In most cases, litigation is regarded as the last resort. If possible, open conflict is to be avoided, and conflict resolution is sorted out through other formal and informal channels. Moreover, an inherent difficulty with statutory enforcement, as admitted in the Finance Committee Report (1999), is that enforcement is more often than not “after the fact”. While key governance mechanism such as the reforms introduced recently can better serve as “before the fact” enforcers, the social and cultural dimensions of the overall framework must be explicitly taken in consideration. Many of the scandals and white-collar crimes which occur in the corporate world, are due mainly to the “get rich quick” mentality of businessmen and company directors. Unethical and unfair business practices include misuse of funds, abuse of position and power, misappropriation of funds, breach of trust, fraud and forgery, and discriminatory practices. In a survey, nearly 53 per cent of Malaysian managers believed that ethical standards were lower today than they were fifteen years ago. This peception was attributed to a more laid-back attitude among the younger generation on the issue of ethical behaviour (Zabid and Ho 2003). Values and norms indeed underpin the behaviour of members of a society. Hence in performing their duties and responsibilities, the ethical conduct of directors is largely based on currently acceptable values and morals of the society. As Sir Derek Higgs remarked: “The key to non-executive director effectiveness lies as much in behaviours and relationships as in structures and processes” (Higgs 2003, p. 27). The objectives of regulations, particularly the non-statutory codes, should therefore in part be to establish standards of ethical conduct that will occur in the behaviour and emerge in the corporate and social interactions and relationships of company directors. REGULATION AND ENFORCEMENT Rules are only as effective as their enforcement. Thus, while social and cultural dimensions are significant, the importance of improving the enforcement of existing laws and regulations cannot be overemphasized. For the authorities to do so, however, the necessary enforcement infrastructure has to be put into place. Take as an example the KLSE. While the powers of the KLSE have been enhanced considerably through the various regulatory reforms, it is essentially a self-regulatory agency and does not have the enforcement infrastructure available to a statutory regulator. It does not have, for example, the statutory right to require information, rights of search and

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seizure that would make its enforcement exercise more effective. Besides securities related regulatory agencies, the structure, vigilance, and capacity of the judicial framework constitute an equally integral part of the corporate governance environment. Improved enforcement, however, extends beyond empowering securities regulators. It also requires broad reforms to improve the performance of the judiciary and increase the effectiveness of self-regulatory bodies. DOMINANCE OF GOVERNMENT-LED INITIATIVES From the overview of the broad types of corporate governance reforms outlined at the beginning of this chapter, one salient characteristic of the reforms is that most corporate governance initiatives have been public sectorled. In fact, the recent wave of corporate governance reforms began with the formation of the High Level Finance Committee. The establishment of the committee was part of a series of measures announced by the Minister of Finance on 24 March 1998 to boost and stabilize the Malaysian economy (Finance Committee Report 1999). The committee was chaired by the Secretary General of Treasury, with the SC serving as the secretariat. Several of the measures carried out later are themselves recommendations made in the committee’s report. The Malaysian Code on Corporate Governance (Chapter 5 of the report), the bulk of which was subsequently rendered mandatory through the KLSE revamped LRs effective 2001, constitutes the most important contribution of the committee. The setting up of the Minority Shareholder Watchdog Group, for example, resulted directly from the initiatives of the High Level Finance Committee. It is a recommendation made by the committee (Finance Committee Report 1999, pp. 197–98). Indeed, the deputy chairman/director of the Securities Commission admitted that “in respect of Malaysia’s corporate governance reform agenda, [is that] the government is a strong catalyst, sometimes driver, and always advocate and strong supporter of efforts in corporate governance” (Nik Ramlah Mahmood 2002).5 There is actually nothing wrong in being “officially induced”. As a matter of fact, numerous corporate governance reforms have been initiated by the authorities in most other countries as well. However, the relative lack of market-generated corporate governance initiatives stands out starkly in the light of the overwhelming range and number of government-generated measures. This in part has to do with the prominent role played by the public sector and the extensive scope of government intervention in most spheres of economic activities in most East Asian countries. Moreover, continued

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dependence in the long run on the government or the authorities could affect the effectiveness of the reforms in general, and the functional capacity of the measures concerned. The quandary currently experienced by the Minority Shareholders’ Watchdog Group (MSWG) is a case in point. As pointed out earlier, the MSWG represents another recommendation of the High Level Finance Committee and was set up in 2001 with annual funding (of RM300,000 each) from five government linked investment agencies, namely the Employees Provident Fund, the Perbadanan Nasional Bhd., the Pilgrims’ Funds (Lembaga Tabung Haji), the Social Security Organization, and the Armed Forces Funds (Lembaga Tabung Angkatan Tentera), who are all major institutional investors in the capital market. The funding, however, was for the initial three years only. As the deadline drew near in 2004 and uncertainty prevailed, members of the top management in MSWG began to leave, including the CEO.6 As long as the newly created entities cannot break away from the mindset of continued dependence for funding and directions from the authorities, the effectiveness and sustainability of the government-led initiatives may be called into question. Besides long run viability, the focus and priorities of government-initiated measures concerned may also be compromised in other ways. For example, during the three years of its existence, the MSWG has not been seen as a champion of the ordinary investor. This perhaps has to do with its being sponsored and fully funded by major government-linked institutional investors. According to the SC (2004), the raison d’etre for the MSWG was to encourage independent and proactive shareholder participation by harnessing the ability of large albeit minority institutional investors to monitor and effect change in PLCs. It is therefore obvious that the MSWG, which has been until the present day fully funded by five major government-linked institutional investors, has been set up to assist these “large albeit minority institutional investors”. While the pressing need for a minority shareholder watchdog group is undisputed, the issue to be contended is the focus and the targetted clientele of the newly conceived organization. Institutional investors, who are not majority shareholders, are relatively sophisticated investors due to their financial resources and expertise. They are aided by full time analysts and fund managers who research on the background, industry situation and financial health of the companies in which they have investment interests. Institutional investors have privileged access and visits to the companies. Besides on-site inspection, they are often given the latest corporate updates and progress reports. They can hold regular dialogues with companies before their AGMs and EGMs to sort out contentious issues and propositions deemed unfavourable to themselves or to other minority

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shareholders. In short, therefore, institutional investors are in a position to raise corporate governance issues, and are more effective in monitoring PLCs. If the authorities’ intention was to harness the ability of these large albeit minority institutional investors to monitor and effect change in PLCs, then the main focus of the MSWG becomes that of coordinating and promoting a far more proactive role in shareholder activism among its financial sponsors. Unfortunately, there has been no disclosure to the public on the focus and role of the MSWG, nor on the relationship between the MSWG and the institutional investors it represented. While institutional investors such as the EPF and PNB are major and influential minority shareholders in many PLCs, the world of minority shareholders is actually made up primarily of numerous small retail investors, who constitute the largest and most active participants in the stock market. While they are active investors, they are generally passive in shareholder activism. Very few indeed of the current corporate governance reform initiatives are aimed at these small investors, who actually have equal rights as the institutional investors and other majority shareholders. Unlike institutional investors who have privileged access to the companies, the main and possibly only channel of communication for the small investors is the annual general meeting (AGM). The lack of shareholder activism of the small investors can be gleaned from the newspaper report reproduced in the footnote.7 In the light of this situation, would it not be more meaningful and effective for the MSWG to concentrate its resources on promoting shareholder activism among these small minority shareholders? CONCLUDING REMARKS Our discussion of the corporate governance reform initiatives shows that Malaysia has not lagged behind its neighbouring countries in its attempts to improve the governance of the corporate sector. Although some significant measures have been introduced before the occurrence of the financial crisis in 1997, it is nevertheless the crisis that jolted the authorities from their complacency, and hastened the pace of the reforms. Since corporate governance problems are widespread, extensive and multi-faceted, the consequent reform measures are indeed wide-ranging and comprehensive. As discussed earlier, the bulk of the reform measures have been initiated by the authorities. This government-led approach is associated with certain ramifications. Moreover, the reform measures are largely compliance-based. They take the form of rules and regualtions, be they statutory or otherwise, that have to be complied with. Besides wielding the penalty stick to coerce

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compliance to corporate governance, however, the authorities now appear to be adopting the incentives approach as well. In April 2003, the SC introduced merit-demerit incentives in its Policies and Guidelines on Issue/Offer of Securities. The new framework broadly facilitates speedier approval by the SC of corporate proposals by companies which have a good track record in terms of corporate conduct.8 Further development and promotion of such incentive structures would be conducive in persuading PLCs to take cognizance of the need to address corporate governance issues. In some ways, the current Malaysian corporate governance reforms can be considered to be moving in the right direction. Although the bulk of the reform measures have been initiated by the authorities, a large number of codes of best practice and codes of conduct are beginning to be initiated by professional bodies and other related non-government institutions. Various professional bodies are seen to be setting guidelines and codes of behaviour and actively promoting them. The MAICSA came out with a set of best practice guidance for company secretaries in November 2000, and the Institute of Internal Auditors issued its guidelines on internal audit function in August 2002. Such codes of conduct would delineate “appropriate” behaviour expected of the members of the profession. In addition, some professional bodies conduct regular activities to bring about greater awareness and instil values and behaviour that conform to corporate governance standards. The MAICSA, for instance, organizes various briefings and updates, as well as conferences and events on corporate governance. Its efforts also include the publication of a practical guide specifically for directors of small cap companies. Other organizations too have been helping to propagate and promote awareness of corporate governance. For example, the Institute for Development Studies Sabah conducted a seminar on corporate governance in July 2003 in Kota Kinabalu.9 Such private sector initiatives would provide tremendous boost to promote an effective corporate governance culture in the society. While protecting minority shareholders constitutes an integral core of corporate governance, our review of the reforms shows that another equally important aspect does not seem to receive adequate attention in Malaysia’s preoccupation with corporate governance. A principal source of conflict in modern corporations lies in the agency problem which arises out of the separation of ownership and management. Issues of information asymmetry, cash flow, leverage, risk-taking and performance are intricately related to agency conflicts. The problem is compounded in Malaysia due to the lack of active takeover markets which could punish poor management. While some of the high profile corporate scandals in Malaysia are related to the firms’

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management, most management teams of the large PLCs appear to have been absolved of blame despite their respective firms’ poor performance. Perhaps all corporate governance issues are underpinned by a country’s social and cultural value systems. Be they majority shareholders, substantial shareholders or management, it is within the same cultural milieu that they conduct themselves. If this is so, then substantial changes cannot be achieved overnight. Long-term commitment and efforts are required. Besides regulations and codes of conduct, corporate governance reforms therefore have to aim at progressively strengthening the existing institutional framework. Koh (2001, p. 19) remarked that: “… the fundamental nature of our institutions mirrors our own value systems. A corporation cannot have good governance if the institutional milieu in which it exists does not embrace good governance principles.” Notes 1. Ali Abdul Kadir (2001) Corporate Governance: From Conformance to Performance. (Speech at the International Conference on Corporate Governance), Kuala Lumpur, 23 April 2001, paragraph 14. 2. Ramly Ali, The Rules of Good Corporate Governance: Methods of Efficient Implementation. Paper presented at the 12th Commonwealth Law Conference, Kuala Lumpur, September 1999, paragraph 6. 3. Source: . 4. Megat Najmuddin Khas (2000). 5. In a press release, the NEAC Secretariat made a similar statement: “Malaysia’s commitment to move ahead in raising standards of corporate governance is evidenced by its reform initiatives. These reforms have largely been Governmentled.’’ Business Times, 30 October 2000. 6. “Yusof to Leave Watchdog Group by Month-End” by C.S. Tan. The Star, 8 June 2004. According to the news report, “One of the problems that has dogged the MSWG was the lack of long-term funding or an independent source of income.” 7. “Lafarge Malayan Cement Bhd. saw a drastic drop in attendance of its AGM in 2004, believed to be the result of its decision not to serve food or give away food vouchers to its shareholders. Its AGM on 12 May 2004 in Petaling Jaya saw the registration of slightly over 100 shareholders and proxies compared with more than 400 last year. Last year, more that three quarters left after collecting their food vouchers without even stepping into the meeting room.” The Sun, 13 May 2004 “Lafarge Mcement Sees Drastic Drop in Attendance”. 8. SC: Policies and Guidelines on Issue/Offer of Securities (Revised Edition: 1 May 2003). 9. (accessed on 24 June 04).

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References Ali Abdul Kadir (2001) Corporate Governance: From Conformance to Performance. (Speech at the International Conference on Corporate Governance), Kuala Lumpur, 23 April 2001, paragraph 14. Finance Committee Report (1999) Report on Corporate Governance. Kuala Lumpur: Finance Committee on Corporate Governance, Securities Commission. Glassman, C. (2004) “Board Independence and the Evolving Role of Directors”. Speech delivered at the 26th Annual Conference on Securities Regulation and Business Law Problems. 20 February 2004, Dallas, Texas, U.S.A. . Higgs, D. (2003) Review of the Role and Effectiveness of Non-Executive Directors. London: Department of Trade & Industry. Khatri, Y., L. Leruth and J. Piesse (2003) Corporate Performance and Governance: A Stochastic Frontier Approach to Measuring and Explaining Inefficiency in the Malaysian Corporate Sector, International Monetary Fund Working Paper, pp. 1–26. Kim, E.H. (1998) “Globalisation of Capital Markets and the Asian Financial Crisis”. Journal of Applied Corporate Finance 11: 30–39. Koh, P. (2001) “Responsibilities of Corporate Powers and Control of Corporate Powers”. In 3 R’s of Corporate Governance: Responsibilities, Risks and Reform. Kuala Lumpur: MICG. Lee, Phil-Sang and K.S. Park (2002) Corporate Governance in South Korea: Institutional Structures and Operations. In Corporate Governance in Asia: Lessons from the Financial Crisis. Kuala Lumpur: United Nations Development Programme. pp. 87–125. Low Chee Keong (2002) “The Mythical Rights of Minority shareholders in Hongkong”. Paper presented at International Conference on Corporate Governance — Trends and Challenges in the Millennium. Istana Hotel, Kuala Lumpur 29–30 October. Megat Najmuddin Khas (2000) “The Malaysian Institute of Corporate Governance”. Paper presented in the Corporate Governance Conference, Kuala Lumpur. Morck, R., A. Shleifer and R.W. Vishny (1988) “Management Ownership and Market Valuation: An Empirical Analysis”. Journal of Financial Economics 20: 293–315. Nik Ramlah Mahmood (2002) “Trends in Corporate Governance and its Impact on Capital Markets”. Paper presented at International Conference on Corporate Governance — Trends and Challenges in the Millennium, Istana Hotel, Kuala Lumpur, 29 October. Ow-yong, Kean and K.G. Cheah (2000) Corporate Governance Codes: A Comparison between Malaysia and the UK”. Corporate Governance: An International Review 8, no. 2: 125–32.

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SC (2004). (accessed 20 June 2004). Suto, M. (2003) “Capital Structure and Investment Behavior of Malaysian Firms in the 1990s: A Study of Corporate Governance before the Crisis”. Corporate Governance 11, no. 1: 25–39. Thillainathan, R. (1999) “A Review of Corporate Governance in Malaysia (with Special Reference to the Rights of Shareholders and Creditors)”. Bankers’ Journal Malaysia 109, (March): 23–55. Thomas, T. (2002) “Corporate Finance and Debt in the Malaysian Financial Crisis of 1997”. In Corporate Governance in Asia: Lessons from the Financial Crisis. Kuala Lumpur: United Nations Development Programme. pp. 127–92. Weir, C. and D. Laing (2001) “Governance Structures, Director Independence and Corporate Performance in the UK, European Business Review 13, no. 2: 86–94. World Bank (1993) The East Asian Miracle: Economic Growth and Public Policy. Oxford: Oxford University Press for the World Bank. Zabid, A.R. and J.A. Ho (2003) Perceptions of Business Ethics in a Multicultural Community: The Case of Malaysia. Journal of Business Ethics 43, no 1: 75–87.

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6 CORPORATE GOVERNANCE IN MALAYSIA Reforms in Light of Post-1998 Crisis Philip KOH Tong Ngee

This country study on corporate governance in Malaysia1 will seek to answer three key questions: 1. What were the dominant corporate governance structures and practices in Malaysia, and what are the key features of the country’s corporate structure, financial system and the legal, regulatory and accounting frameworks conditioning corporate governance running up to 1998? 2. What are their strengths and weaknesses, in terms of the main elements of effective corporate governance such as (a) safeguarding the rights and responsibilities of shareholders and stakeholders; (b) mechanisms for oversight and checks and balances; and (c) system of disclosure and reporting to ensure transparency? and 3. What are the reforms and prospective measures needed to strengthen corporate governance, their sequencing and their likely benefits? What reforms are being instituted or underway, and who will address the weaknesses identified?

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INTRODUCTION Section A sets out an overview of the laws, regulations, rules, standards, etc. that form “core corporate law” and its impact on governance arrangements in companies. This chapter evaluates what we term as “core corporate law” (that is, company law, securities laws, exchange listing requirements, accounting standards and insolvency laws and regulations) and its impact on governance arrangements in companies. Corporate law in Malaysia is primarily set out in the Companies Act 1965 (No. 125) which is based on the UK Companies Act 1948 and the Australian Uniform Companies Act 1961. Major subsidiary legislation includes the Companies Regulation 1966, Companies (Winding Up) Rules 1972. In respect of public listed companies the following legislation and also regulatory directives apply — the Securities Industries Act 1983, the Securities Commission Act 1993, the Malaysian Code on Takeovers and Mergers, 1987, the Guidelines on the Regulation of Acquisition of Assets, Mergers and Takeovers, and the Bursa Malaysia Listing requirements and Practice Notes. The Companies Act 1965, administered by the Registrar of Companies sets out the fundamental rules governing procedures for incorporation, the basic constitutional structure and the cessation of existence of companies. The act imposes minimum requirements on the way in which corporations are incorporated consistent with the Malaysian contractualist system of company law where the control structure is left to be determined by the promoters and the company through the Memorandum and Articles of Association of a company. There is now the Companies Commission of Malaysia Act 2001 (the Act), which came into operation on 16 April 2002. The Act establishes the Companies Commission of Malaysia (CCM), provides for its function and powers and for matters connected therewith. The CCM is a merger of the Registry of Companies and Registry of Business. In contrast to the memorandum, the articles of association may, subject to the Companies Act 1965, be freely altered or added to. This power of alteration by special resolution can affect the pattern of rights and duties to the prejudice of a member’s rights. In practice, there have been a variety of devices which have been employed to entrench member’s rights and duties. Shareholder agreements, and voting arrangements can be entered into providing various procedural and substantive arrangements that delineate the lines of power and entitlements.

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In certain companies there has been the use of special voting rights that entrenches certain rights under its constitution. For example the Projek LebuhRaya Utara-Selatan Berhad (PLUS), the corporate vehicle that is part of UEM which implemented the North-South highway concessionaire has a Special Share that may be held only by or transferred only to United Engineers (Malaysia) Berhad (UEM) or any wholly owned subsidiary of UEM. Basically the Special Share entitles the holder of the share to exercise a negative veto over any resolution tabled. In certain GLCs, the government also holds a Special Share. For example, the national electric corporation, Tenaga Nasional Berhad (TNB) has a Special Shareholder, that is, the Minister of Finance Inc. (“the MOF Inc.”). The MOF Inc. as Special Shareholder has the right to appoint “any person to be director…so that there shall not be more than six (6) Government Appointed Directors at any time”. The Special Shareholder has clear veto rights over a number of matters. This type of Special Shareholder rights is a device used for privatized government corporations, for example, the national airlines (MAS) and the national telecommunications company (Telekom). This golden share holding may be utilized as a discipline measure for recalcitrant controllers, which the government is displeased with. It also alters and impacts the governance process. There are nevertheless some restrictions to the power to alter articles. First, when voting to alter the articles, a member must act “bona fides for the benefit of the company as a whole”. Where the capital of the company is divided into different classes of shares and there is a provision in the memorandum or articles authorising the alteration only upon the consent of some specified proportion of shareholders of that class, an alteration of articles to affect class rights may be restrained under section 65 Companies Act 1965. As in paragraph 7.15 of the Bursa Malaysia LRs, the repayment or preference capital other than redeemable preference capital or any other alteration of preference shareholders’ rights, may only be, made pursuant to special resolution of the preference shareholders concerned. Some amendments to securities laws have introduced duplication in regulation. For example the new section 99B Securities Industry Act 1983, introduced early 1998, imposes duties on chief executives and directors of public listed companies to disclose their interests in the company or any associated company to the Securities Commission (SC). Companies are now additionally required to submit certain information to the commission which include: •

A copy of the company’s audited annual accounts and interim and periodic financial reports;

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Any change in the registered business address of the listed entity; Any change in the chief executive or directors of the company.

The SC now has the power to apply to court for disqualification of chief executives and directors of listed companies where he has been convicted of offences under securities laws or has had an action taken against him for breach of listing rules or civil action for breach of the insider trading or market manipulation provisions.2 But while these amendments have introduced some overlap in company regulation, the amendments may be justified on grounds that they facilitate the SC’s enforcement of securities laws. In the past the requirements for disclosures in prospectuses are found in the Companies Act 1965 despite the fact that every company issuing securities would have to seek approval of the SC under section 32 Securities Commission Act 1993. This fragmentation in regulation has now been rationalized. The amendments has deleted from the Companies Act the provisions relating to raising of funds and vested in Securities Commission the exclusive jurisdiction over prospectuses under Division 3 of the Securities Commission Act 1993. DISCLOSURE AND TRANSPARENCY Until 1995, Malaysia had used a merit-based regulatory regime in deciding on the suitability of a company for listing and the pricing of new issues was usually based on the need to protect the interest of minority shareholders.3 From 1995, a disclosure-based regulatory regime is being implemented on a phased basis. Good corporate governance based on transparency and the exit route is critically dependent on a country’s accounting, auditing, financial reporting and disclosure standards and practices. These standards and practices will be examined at some length in this section. 1. What Aspects of Financial and Operational Performance must be Disclosed to All Shareholders, on what Schedule and in What Details? To increase transparency, the Malaysian regulatory framework mandates disclosure and dissemination to potential and existing investors timely, accurate and material information on corporate performance, affairs and events. Such disclosures are mandated at the initial public offering (IPO) of the securities and thereafter on a periodic or continuous basis depending on the information disseminated.

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With respect to the periodic disclosure and reporting requirements, a listed company is required to publish: • •

•

•

A quarterly reports not later than two months after the end of each quarter of a financial year; Income statements for the current quarter and cumulatively for the current financial year-to-date of the immediately preceding financial year; Issue to the shareholders the printed annual report together with the annual audited financial statements as well as the auditors’ and directors’ reports within a period not exceeding four months of the close of the financial year of the listed company; and Explanations for any differences between the audited accounts and any forecasts, projections previously made.

The interim financial statements are consolidated but not audited and are to present fairly the financial performance of the company (with comparative figures for the previous year) but not its financial position or cash flows. The required disclosures on financial performance are almost similar to those that are set out in the income statement which is one of the components of the annual financial statements. The financial statements are to be prepared and presented in accordance with the approved accounting standards of the Malaysian Accounting Standards Board and the 9th Schedule of the Companies Act, 1965. Under the Bursa Malaysia’s continuous disclosure requirements, a listed company is required to make immediate public disclosure of all material information concerning its affairs, except in exceptional circumstances. The company is required to release the information to the public in a manner designed to ensure fullest possible public dissemination. Chapter 9 Part J of Bursa Malaysia’s Listing Requirements sets out the requirements expected in relation to announcements. It imposes an obligation on listed companies to immediately divulge any information as is necessary to avoid a false market in the trading in securities. Listed companies are to make disclosures, in particular to the the Exchange and the market where: • • • •

It intends, or does not intend, to recommend a dividend; Call for meetings to pass ordinary and special resolutions; Receives notices of substantial shareholders or changes in substantial shareholders; Effects changes in directors, company secretary, chief executive officer or auditors;

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• •

• •

•

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Proposes to amend its mergers and acquisitions; Acquires shares in an unquoted company which results in the latter becoming a subsidiary or disposes shares in an unquoted company which results the latter ceasing to b a subsidiary. Acquires more than five per cent of the paid up capital of another listed company; Sells any shares in another company which would result in the latter ceasing to be a subsidiary, or where its shareholding falls below five per cent if the other company is a listed entity; Any application filed with court to wind up the company or any of its subsidiaries or major associated companies; Undertakes a revaluation of its assets and/or those of its subsidiaries (unless it is in the ordinary course of business and in accordance with the Guidelines of the SC); Proposes an acquisition or disposal whether involving the issue of new securities or otherwise where the percentage ratios are equal to or exceed twenty-five per cent; Purchases or sales of securities within the preceding twelve months, being equal to or exceeding five per cent of the consolidated net tangible assets; Proposes either a rights or a bonus issue; Proposes to allot shares to its directors or to implement an employee share option scheme; Any deviation of ten per cent or more between the profit after tax and minority interest stated in a profit estimate or the announced audited or unaudited accounts.

2. What Requirements Exist to Ensure that an Independent External Auditor Certifies a Company’s Financial Statement on a Regular Basis? The Companies Act requires, as per S169 (4), the profit and loss account and the balance sheet of a company to be duly audited before they are laid before the company at its annual general meeting. The auditor’s report is to clearly state the auditor’s opinion as to whether the accounts give a true and fair view (or are presented fairly, in all material aspects), in accordance with applicable approved accounting standards and whether the accounts comply with statutory requirements. Where the accounts have not been drawn up in accordance with a particular applicable approved accounting standard, the auditor is required to quantify

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the financial effects on the accounts of the failure to so draw up. If in his opinion, the accounts would not, if so drawn up, give a true and fair view, he is to state the reasons for holding that opinion, state if the directors have quantified its financial effects on the accounts and further give his opinion on the quantification. In the case of consolidated accounts, an auditor is required to state: (a) The names of the subsidiaries (if any) of which he has not acted as auditor; (b) Whether he has considered the accounts and auditor’s report of all subsidiaries of which he has not acted as auditor; (c) Whether he is satisfied that the accounts of the subsidiaries that are consolidated with other accounts are in form and content appropriate and proper for the purposes of the preparation of the consolidated accounts, and whether he has received satisfactory information and explanations as required by him for those purpose; and (d) Whether the auditor’s report on the accounts of any subsidiary was made subject to any material qualification, and, if so, particulars of the qualification. The auditor is also required to report on any defect or irregularity in the accounts or consolidated accounts without regard to which a true and fair view of the matters dealt with by the accounts or consolidated accounts would not be obtained, and if he is not satisfied as to any matter, his reasons for not being so satisfied. Under Paragraph 15.27(a) of the Bursa Malaysia’s Listing Requirements, the directors have to make a statement explaining the board of directors’ responsibility for preparing the annual audited accounts in its annual report. If an auditor, in the course of the performance of his duties as auditor of a company, is satisfied that: (a) There has been a breach or non-observance of any of the provisions of the Companies Act; and (b) The circumstances are such that in his opinion the matter has not been or will not be adequately dealt with by the directors of the company, he is required forthwith to report the matter in writing to the registrar. The penalty for a breach of this provision is imprisonment for two years or RM30,000 or both. The obligation to report is triggered when the auditor is satisfied that a breach of the Act has occurred and where he has no confidence that the directors will deal adequately with the matter. This introduces a subjective

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element to the duty to report. There is now a move to amend the section to enable an auditor to report matters that in “his professional opinion” constitute a breach of the Companies Act thus providing the auditor an objective standard on which to base his decision to or not to report. The responsibilities of the auditor in Malaysia under the reporting framework of approved auditing standards and the Companies Act requires an auditor to state whether the identified financial statements are properly drawn up to give a true and fair view. Reports other than a qualified report are unqualified reports. Qualified reports are required to be given if the auditor is unable to report affirmatively on those matters required of him under the reporting framework.4 3. What Accounting and Auditing Standards are Required of Companies when Preparing their Financial Statements? Malaysia has been adopting, starting from the late 1970s, accounting standards that are generally consistent with those issued by the International Accounting Standards (IASs) Committee. The approved accounting standards, which constitute the Malaysian Generally Accepted Accounting Principles (GAAP), comprise IASs adopted in Malaysia and Malaysian Accounting Standards (MASs) issued in Malaysia. MASs cover topics not dealt with in IASs or topics where particular features of the Malaysian environment warrant a domestic standard written specifically to address those features. By the beginning of 1998 Malaysia had adopted twenty-five of the thirtyone extant IAS standards. Only six of the remaining IASs had not been adopted in Malaysia but these can be accounted for. Of these six IAS standards, two deal with the accounting treatment of inflation, which are therefore not material, a third is on accounting for business combinations for which MAS standards exist. The fourth is on computing Earnings Per Share for which a MAS standard has been available from 1984. For the fifth on accounting for financial institutions BNM has drawn up its own standard format of financial reports. The sixth is on disclosure and presentation of financial instruments for which the standard is to come into force from 1 January 1999. Schedule II enumerates the IASs which have been adopted for application in Malaysia. Schedule III sets out the various Malaysian Accounting Standards. The Malaysian GAAP is inferior to the best practices recommended by IASC to the extent that Malaysia has been a little slow in adopting the revised IASs. Comfort can be drawn from a review of Schedule II. It shows that for

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financial year commencing from 1 January 98 only two of the revised IAS standards would not have been adopted for financial reporting in Malaysia, namely with respect to the standards for income taxes and segment reporting. Interestingly, even the IAS standard with respect to the disclosure and presentation of financial instruments will have been adhered to from financial year 1 January 1999. In line with what is happening in certain jurisdictions, the Malaysian Accounting Standards Board (MASB) was established under the Financial Reporting Act 1997 (the Act) as the sole authority to set accounting standards for Malaysia. MASB became operational during the second half of 1997. The MASB recognized, at its inception, that a body of accounting standards was in existence which had been issued by the Malaysian Institute of Accountants (MIA) and the Malaysian Association of Certified Public Accountants (MACPA) and which had been generally applied in the preparation of financial statements. As a transitional arrangement towards the establishment of a new financial reporting regime under the Act, MASB therefore announced on 5 January 1998 the adoption of twenty-four of the extant accounting standards as approved accounting standards for the purposes of the Act. These standards, which continue to be known as International Accounting Standards and Malaysian Accounting Standards as the case may be, have been accorded the status of approved accounting standards for the purposes of the Act until each of the standards is reviewed and revised, or replaced by new accounting standards issued by MASB, to be known as MASB standards. The remaining eight accounting standards issued by MIA and MACPA were not adopted by the MASB. But MASB announced that these eight standards will continue to be promulgated by MIA and MACPA as applicable standards in the preparation of financial statements until each of those accounting standards is reviewed and adopted as approved accounting standards, or relevant new accounting standards are issued. MASB stated that the eight accounting standards which had not been adopted by the MASB require further research and wider consultation and that accordingly they have been ranked as priority projects in MASB’s work programme. The MASB acknowledged that the extant accounting standards issued by MIA and MACPA represented a valuable starting point in the establishment of the new financial reporting regime in Malaysia. However, to carry out its own due process so as to satisfy itself that the standards are appropriate and reflect the input of its constituency, MASB embarked on a programme to review all extant accounting standards for consistency with the latest developments in International Accounting Standards, statutory and regulatory

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reporting requirements, and to evaluate the practical aspects relating to the application of the accounting standards. Since its commencement, the MASB has established forty-three working groups to execute its programme of action, including the review of all extant accounting standards issued by the MIA and MACPA as well as the development of new accounting standards and guidelines to address emerging issues. A special working group has been entrusted with the responsibility to develop a framework to set out the accounting concepts based on Syariah principles. As shown in Schedules II and III, by 31 January 1999 MASB had issued twelve exposure drafts which are expected to become Standards on 1 July 1999 as well as one foreword, one discussion paper, on statement of principles and three draft statements of principles and two technical releases. MASB has been a little cautious in adopting some of the revised IAS standards. This may be explained by its desire to go through a thorough due process in order not to run ahead of its constituency. The major differences between the IAS standards and approved accounting standards in Malaysia are set out in the Notes to Schedules II and III. The Council of the Malaysian Institute of Accountants (MIA) has determined that Approved Standards on Auditing for members comprise: (a) International Standards on Auditing (ISA) designated as AI and approved by the MIA and (b) Malaysian Standards on Auditing (MSA) designated as AM issued by the MIA. In addition to these promulgated standards, all statements issued by the Council relating to recommended practices, including guidelines on auditing are to be regarded as opinions on best current practice and thus form part of Generally Accepted Auditing Practices (GAAP).

International Standards on Auditing The MIA has adopted the International Standards on Auditing (ISAs) issued by the International Auditing Practices Committee of the International Federation of Accountants (IFAC) as the basis for approved standards on auditing and related services in Malaysia. MIA prepares an explanatory foreword on the status on each approved ISA that is adopted. In the event that an ISA contains guidance which is significantly different from Malaysian law or practice, the explanatory foreword to an approved ISA provides guidance on such differences. The ISAs which have been adopted in Malaysia are set out in Schedule IV. The International Auditing Guidelines (IAGs)

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which were replaced by the IASs in mid 1998 are set out in the same schedule.

Compliance with Approved Standards on Auditing The council expects members who assume responsibilities as independent auditors to observe approved Standards on Auditing in the conduct of their audits under all reporting frameworks as determined by legislation, regulation and promulgations of the Malaysian Institute of Accountants and where appropriate mutually agreed upon terms of reporting. The onus is on members to use their best endeavours to ensure that such standards are also observed by those persons who assist them in their work. 4. What Requirements Exist for Disclosure Regarding the Composition of a Firm’s Equity Ownership? The Annual Returns of Companies, which a company has to make to the Registrar of Companies under Section 165 — Part II of the Eighth Schedule of the Companies Act 1965 (CA) requires a disclosure of a company’s equity ownership. The CA and the Securities Industry (Reporting of Substantial Shareholding) Regulations 1998 (SC Regulations 1998), defines any person having two per cent (versus five per cent previously) or more of the nominal value of the voting shares of the company as a substantial shareholder. A substantial shareholder has to notify the exchange, the listed corporation and the SC of: • • • • • •

His substantial shareholding and of any changes thereto; The date of the change of interest; The circumstances giving rise to the change; The number of securities acquired or disposed of, both in absolute terms and expressed as a percentage of the issued capital; The amount of consideration received or paid for the securities, and The number of securities held before and after the change, both in absolute terms and expressed as a percentage of the issued capital.

Notices are required to be given within fourteen days from the date on which a person becomes a substantial shareholder, or there is a change in circumstances, or he ceases to be a shareholder, as the case may be. A change in circumstances, with respect to a substantial shareholder, also takes into account his deemed interest in shares. Under section 6A(4) of the Companies

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Act 1965, a person is deemed to have an interest in shares where a body corporate has an interest in shares and: • The body corporate is, or its directors are accustomed, or is under an obligation, whether formal or informal, to act in accordance with the directions, instructions or wishes of that person in relation to that share; • That person has a controlling interest in the body corporate; • That person, or associates of that person or that person and associates of that person are entitled to exercise or control the exercise of not less than 15 per cent of the votes attached to the voting shares in that body corporate. Failure to report as required subjects the defaulter to a penalty of RM1 million with a default penalty of RM5,000. However, the courts have powers with respect to defaulting substantial shareholders.5 The penalty for a contravention of the court order, is RM3,000 with a default penalty of RM500. The Securities Industry (Reporting of Substantial Shareholding) Regulations which came into effect on the 1 of May 1998 now require that any person who is a substantial shareholder of a public company (whether listed or not) is to provide notice of such interest to the Securities Commission. It should be noted that while these disclosure requirements mirror those which are provided under the Companies Act, breach of these regulations commits an offence. The Bursa Malaysia’s LRs requires a statement from a listed company to be made up to a date not earlier than six weeks from the date of issue of its annual audited accounts and indicating the date of such statement and setting out: • • • • •

Names of substantial shareholders and their equity interest; Number of holders of each class of equity securities and voting rights attached to each class; Number and percentage distribution of shareholders by size of shareholding of each class; A statement of the percentage of the total holding of the 20 largest holders of each class of equity securities and; The names of the twenty largest holders of each class of equity securities and the number of equity securities of each class held.

The listing manual also requires the shareholding spread to be set out in a particular format at a date no earlier than six weeks from the date of the issue of the audited annual accounts.

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5. What Requirements Exist for Disclosure of the Identity, Compensation, Equity Ownership and Background of Directors and Senior Managers, and of any Relationships between a Director, the Company and Managers? The LRs requires the following disclosures about all directors and executive officers in the prospectus for any new issue of shares: • • • • • • • • •

The person’s name, address, age and position or occupation; His business experience in the past five financial years or the principal business of the corporation he is employed in; Any other directorships held; The nature of the family relationship between the directors and executive officers; and Whether he has been convicted or is facing any criminal action within the past ten years; Aggregate remuneration paid or distributed to directors for all services rendered to the company or its subsidiaries during the last financial year; Details of all options (to subscribe for securities) that were received or exercised during the last financial year; as well as Particulars of all sanctions or penalties imposed on the directors; Particulars of material contracts involving the interests of directors or executive officers.

However, the Companies Act requires a periodic disclosure in the annual report of the shareholding interest of each director in the company or in a related corporation, the total number of securities bought and sold by him during that financial year, as well as particulars of material contracts involving directors’ interests, either still subsisting or entered into during the financial year. The aggregate remuneration paid or distributed to directors for all services rendered during a financial year are also disclosed in the annual report for that year. Section 99B of the Securities Industry Act 1983 now provides that a chief executive and a director of a listed company must disclose to the SC of his interest in securities of the listed corporation of which he is a director or chief executive or of his interest in an associated corporation of the listed company. The consequence of a breach of this provision is criminal sanction of up to RM1 million or imprisonment of up to ten years or both. The principle that a director or a chief executive must disclose all interests which may be in conflict with the interests of the company is recognized in the Securities Industry Act 1983 (SIA) and/or the CA.6 Conflicts of interest

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may arise through either a personal interest or a duty to some third party. These situations include: • • •

Holding of any other office in another company including being a nominee director of that company;7 Possession of any property; and An interest in a contract with that company.8 Under such circumstances, directors are required to notify the company.

6. What are the Requirements for Disclosure of Related Party Transactions? A related party means a director, substantial shareholder and/or person connected with a director or substantial shareholder. Under the Companies Act, only Section 132G recognizes the concept of a substantial shareholder in related party transactions but such transactions are prohibited. Section 132E only embrace transactions with directors or persons connected with directors. These transactions require disclosure and approval of shareholders. As a result of the review of the rules after the UEM-Renong debacle, the rules now cover transactions involving the interests, direct or indirect, of persons connected with directors or substantial shareholders. In 1995, the SC set out its special requirements for related-party transactions but these are in the nature of guidelines and not regulations. Under the Securities Commission guidelines and the LRs, a listed company is required to make a public announcement, send a circular and seek the approval of shareholders on all material9 related party transactions with the following disclosures: (a) The date of the transaction, the parties thereto and a description of their relationship, and the nature and extent of the interest of the related party in the transactions; (b) Particulars and purpose of the transactions; (c) The total consideration, together with the basis of arriving at the consideration, and how it is to be satisfied; (d) The effects of the transaction on the company including any benefits which are expected to accrue to the said company as a result of the transaction; (e) An opinion by an independent corporate adviser, as to whether the transaction is fair and reasonable so far as the shareholders are concerned,

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which opinion must set out the key assumptions made and the factors taken into account in forming that opinion; (f ) A statement by the directors (other than any director who is a related party in respect of the transaction) that the transaction is fair and reasonable so far as the shareholders are concerned, and that, if applicable, the directors have been so advised by an advisor, and (g) A statement that the related party will abstain from voting on the relevant resolution; (h) The rationale and risk in relation to the transaction. More pertinently related parties transactions are now subjected to a host of control mechanisms under Paragraph 10.08 of the LRs. This may be compared with International Accounting Standard S24 on related party disclosures which has been adopted as an approved accounting standard in Malaysia require financial statements to give disclosures about certain categories of related parties. In broad terms, the standard requires the following disclosures: (a) Related party relationships where control exists10 is required to be disclosed irrespective of whether there have been transactions between the related parties; (b) If there have been transactions between related parties, the reporting enterprise is required to disclose the nature of the related party relationships as well as the types of transactions and the elements of the transactions necessary for an understanding of the financial statements. (c) Items of similar nature may be disclosed in aggregate except when separate disclosure is necessary for an understanding of the effects of related party transactions on the financial statements of the reporting enterprise. Specifically, under the standard, attention is focused on transactions with the directors of an enterprise, especially their remuneration and borrowings, because of the fiduciary nature of their relationship with the enterprise. In addition, International Accounting Standard 5, Information to be Disclosed in Financial Statements, calls for disclosure of significant intercompany transactions and investments in and balances with group and associated companies and with directors. International Accounting Standard 3, Consolidated Financial Statements, requires in such statements a list of significant subsidiaries and associated companies, and, for unconsolidated subsidiaries, intra-group balances and the nature of transactions with the remainder of the group. International Accounting Standard 8, Unusual and

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Prior Period Items and Changes in Accounting Policies, requires disclosure of unusual items. The following are examples of situations where related party transactions may lead to disclosures by a reporting enterprise in the period which they affect: • • • • • • • • • •

Purchase or sales of goods (finished or unfinished) Purchase or sales of property and other assets Rendering or receiving of services Agency arrangements Leasing arrangements Transfer of research and development License agreements Finance (including loans and equity contributions in cash or in kind) Guarantees and collaterals Management contracts.

Under the standard, disclosure of transactions between members of a group is unnecessary in consolidated financial statements because consolidated financial statements present information about the parent and subsidiaries as a single reporting enterprise. Transactions with associated enterprise accounted for under the equity method are not eliminated and therefore, require separate disclosure as related party transactions. Although under the standard, disclosure of transactions between the parent and its subsidiaries is unnecessary in consolidated financial statements, this is inconsistent with the 9th Schedule requirement for the disclosure of significant transactions with related corporations. Therefore, an amendment of the 9th Schedule is in order to remove this anomaly. SHAREHOLDER RIGHTS This section sets out a discussion of the extent to which Malaysian law guarantees these basic rights associated with share ownership to shareholders. Shareholder’s Right to Secure Methods of Ownership Registration Malaysian law, provides these basic rights to shareholders, consistent with common law jurisdcitions. The law sets out a comprehensive body of provisions on how shares are to be registered, the identity of member(s), the amount, date of entry and cessation, date of allotment, location of register, register of index of members, openness for inspection, and entitlement for copy upon

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request.11 Section 358 Companies Act 1965 provides that if there is default in compliance with the keeping, closing or allowing inspection of the register, the company and every officer in default is guilty of an offence. Any agent who causes the company to commit specified breaches will be liable to the same penalties as if he were an officer of the company.12 The Malaysian Central Depository operates a system that enables securities transactions to be effected electronically without the need for physical delivery of shares scripts. This is done through a system that effects the transfer of ownership of securities through computerized book entries rather than by physical delivery and execution of instruments of transfer. With effect from 1 November 1999 it became mandatory for securities of companies listed on the Bursa Malaysia to be deposited with the Central Depository.13 Under section 107B of the Companies Act 1965, any name that appears on the record of depositors maintained by the Central Depository under Section 34 of the Securities Industry Central Depositories Act 1991 shall be deemed to be a member of the company. A depositor will not be regarded as a member of a company entitled to attend, speak or vote at the general meeting unless his name appears on the record of depositors not less than three market days before the general meeting.14 Crucially, any rectification of the register of depositors must be made to the court and the court’s discretion to rectify is limited to the circumstances set out in Sub-section 107D (2) Companies Act 1965. Shareholder’s Right to Freely Transfer Shares The nature of shares as personal property is recognized in Malaysia. Shares may be freely transferable as provided by the Articles of Association and are also capable of being inherited or transmitted by operation of law. Section 98 Companies Act 1965 provides that shares are subject to the general law relating to ownership and dealing in property.15 The principle of free transferability of shares is fundamental to listed shares. The LRs of the Exchange are clear that the articles contain no restriction on the transfer of fully paid securities, which are quoted on it.16 Shareholder’s Right to Information The act makes provision for members to have access to various records and registers that the company must maintain in order to enable the shareholders of a company to be kept fully informed of what is happening in the company. These include:

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The register of members; The register of directors, secretaries, managers and auditors; The register of directors’ shareholdings; The register of substantial shareholdings; The register of debenture holders; The register of charges; The register of holders of participatory interests; A copy of the last audited profit and loss accounts, the auditor’s report and the directors’ report on the accounts.

Shareholder’s Right to Vote The right to vote is one of a member’s fundamental rights. It is recognized in Malaysia as a proprietary right and every member has an unfettered right to exercise his votes as attached to the shares.17 The principal right of shareholders in respect of their right to vote is their right to vote on the election of directors, on amendments to the constitutional documents of the company, and on key corporate transactions which include transactions where an insider has an interest in the transaction, sale of all or a substantial part of a company’s assets, mergers and liquidations. This limits the discretion of the insiders on these key matters. In this respect, the one-share-one vote rule with dividend rights linked directly to voting rights is taken as a basic right in corporate governance. The one-share-one-vote rule is entrenched and observed strictly in Malaysia. Section 55 Companies Act 1965 provides in the case of public companies and their subsidiaries that each equity share (and this includes preference shares with voting rights) may carry only one vote thereby prohibiting the existence of both multiple voting and non-voting of ordinary shares and does not allow firms to set a maximum number of votes per shareholder in relation to the number of shares he owns. The idea behind this basic right is that, when votes are tied to dividends, insiders cannot appropriate cash flows to themselves by owning a small share of the company’s share capital but by maintaining a high share of voting control. The ease with which a shareholder is able to exercise his right to vote is also of crucial significance. Voting in Malaysia may be by show of hands or on poll, that is, a written ballot. Each member is entitled to one vote on a show of hands unless the articles of a company provide otherwise. But on a poll, a member will have as many rights as his shareholding entitles him. The right to demand a poll is therefore an integral right as a member has then the opportunity to realise his full voting power. The chairman is also not permitted to refuse a demand for a poll nor can he

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exercise his power in a manner that protects the control of management power by the incumbent directors. There being no statutorily prescribed mode of polling, it is normal for the use of a ballot. The manner and procedure as to the poll taken is set out in the articles, in absence of which it will be prescribed by the chair. It is the practice for public listed companies to appoint an independent firm of chartered secretaries or accountants to conduct polls thus ensuring their independence. A member may appoint a proxy to vote on his behalf. Section 149 Companies Act 1965 provides for a statutory right for the appointment of proxies. The statutory provisions as contained in the Companies Act 1965 are aimed at curbing undue restrictions that may be inserted in articles of associations against voting by proxy.18 A proxy has a right to speak at a meeting, in the absence of a contrary provision in the articles. Otherwise a proxy may only vote on a poll. And the proxy may demand a poll. The articles of associations of companies generally require proxy forms to be deposited with the company some time before the meeting to facilitate checking and validation of the forms. But any provision requiring forms to be deposited more than forty-eight hours before the meeting is void.19 And while this does facilitate shareholders exercising their voting rights, it nevertheless still requires the proxy to attend shareholders’ meetings to be able to vote. The law as it stands does not recognize voting by mail whether by a member or his proxy. Voting by mail certainly makes it easier for shareholders to cast their votes. It overcomes several practical difficulties associated with having to attend general meetings. The objective of broadening shareholder participation suggests the law should consider favourably the enlarged use of technology in voting, including electronic voting. Another crucial area in increasing the effectiveness of the shareholder’s right to vote is in terms of improving the quality and timeliness of information that gets out to shareholders before shareholders’ meetings. Companies start the visible process of preparing for AGMs by sending shareholders the notice of AGM. Section 145(2) Companies Act 1965 requires at least fourteen days notice of meetings other than for a meeting to pass a special resolution (twenty-one days) or for one requiring special notice (twenty-eight days). This means that there must be fourteen clear days between the issue of the notice and the date of the meeting. This applies to both AGMs as well as EGMs. Notice of meetings must be given to every member. The company’s auditor is also entitled to notice of meetings. Foreign shareholders have at times been disadvantaged by this notice period. It is customary for the registered address of service to be that of the custodian. There have been problems expressed with the fact that the notice

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of meetings do not get to these shareholders on time because of the additional layer of persons that it has to go through. This fact suggests that a longer circulation period may be necessary. The notice generally sets out the date, time and venue of the AGM and gives details of the business to be transacted. In practice the notice essentially sets out a series of resolutions for approval by members. The Companies Act 1965 does not regulate the contents of notice of meetings. The KLSE Listing Rules20 set out basic requirements that apply to its listed companies — the notice is to state the place, day, time and venue of the meeting at least fourteen days before the meeting or twenty-one days where any special resolution is to be proposed.21 However under common law, the notice calling a meeting must contain sufficient information to enable a prudent member to decide whether or not he will attend a meeting. Otherwise a member may be able to invalidate any resolutions passed. In the context of election or re-election of directors, in practice too few boards currently make any real effort to persuade shareholders of the merits of directors nominated for election or re-election. There is certainly scope for improvement in the information that accompanies notice of meetings. Shareholder’s Right to Requisition a Meeting The Companies Act 1965 provides that a meeting may be requisitioned by members not holding less than ten per cent of such paid up capital of the company as carries voting rights. If the directors do not convene a meeting within twenty-one days after the receipt of the requisition, the requisitionists may convene the meeting themselves;22 in this case the meeting must be held within three months of the date of deposit of the requisition. Crucially any reasonable expenses incurred by the requisitionists in calling the meeting are to be paid by the company, which may reimburse itself out of any sums due to the defaulting directors by way of fees or other remuneration. Members also have an independent power to convene an extraordinary general meeting under section 145(1) Companies Act 1945 which essentially provides that two or more members holding not less than one-tenth of the company’s issued share capital may call a meeting of the company. Shareholder Communications A number of developed economies have focused efforts on increasing the quality of shareholder communications, namely through the AGM, for it gives all shareholders, whatever the size of their shareholding direct and

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public access to boards. Attendance at AGMs in Malaysia is poor and dominated by retail investors. The idea should be to increase its effectiveness so institutional shareholders see value in attending the meetings. Some effort has been taken to improve the quality of AGMs by way of best practices, not unlike those developed by the Institute of Chartered Secretaries in the United Kingdom which basically establishes and defines best practices for the conduct of AGMs and the rights of shareholders in relation to them.23 However there may be scope for statutory intervention in several critical areas: • •

Member’s resolution The right to ask questions at AGMs

The Malaysian Code on Best Practices proposed that companies should use the AGM to communicate with private investors and encourage their participation. Private investors are able to make little contribution to corporate governance. The main way of achieving greater participation is through improved use of the AGM, for example, the chairman should provide reasonable time for discussion at the meeting and encouraging shareholders to ask questions.

Member’s Resolutions Section 151 Companies Act 1965 sets out the right of shareholders wishing to submit proposals to the general meeting. Under this section, shareholders holding in aggregate of not less than one-twentieth of the total voting rights, or one hundred shareholders holding shares in a company on which there has been paid an average sum per member of not less than RM500, may requisition the company to give to the members entitled to receive notice of the next annual general meeting, notice of any resolution which may properly be moved and circulate a statement of not more than 1,000 words on any matter referred to in the resolution on any business to be transacted.

Shareholder’s Right to Ask Questions at the AGM For shareholders, especially retail shareholders, lacking direct access to the board enjoyed by institutions, the ability to ask questions is an important source of information on the performance of the company. There may be a case for inclusion of a statutory provision in the Companies Act 1965 requiring companies to make provision for it at the annual general meeting. The alternative of course is to include a statutory provision that gives every

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shareholder the specific right to table a question to be asked at the AGM in addition to the current ability of the shareholder to ask questions under the “any other business” item of the AGM. This would enable a shareholder to raise a serious point of concern for discussion at the AGM after seeing the reports and accounts but without the need to contemplate a resolution. Shareholder Asset Protection Provisions/Related Party/Interested Party Transactions Given ownership concentration in Malaysian and elsewhere in Asia, these basic rights and improvements suggested above will not sufficiently address minority shareholder protection concerns and their fair treatment. Investor confidence that the capital they provide will be protected from misuse or misappropriation by controlling shareholders, managers and directors is an important factor in capital markets. Malaysia has a number of provisions designed to curb abusive behaviour by interested, related or connected parties, which range from provisions requiring shareholder approval upon disclosure to absolute prohibitions in some cases. • • • • • •

•

Loans to directors or director-related parties are prohibited (Sections 133 and 133A read with 122A) unless they are subsidiaries; The approval for disposal by directors of a company’s undertaking or property (Section 132C); The approval for issue of shares by directors (Section 132D); Substantial property transaction involving directors and persons connected to directors (Section 132E read with Section 132F and Section 122A); Prohibition of certain transactions involving shareholders and directors (Section 132G); Disclosure of shareholding and changes in substantial shareholding to both the company and the Exchange (Sections 69E and 69I, and the substantial shareholding regulations 1998). Appendix 1 sets out Sections 132C, 132E, 132G, 133 and 133A Companies Act 1965. For example, Section 132E of the Companies Act 1965 which allows substantial property transactions between directors and persons connected to directors to be ratified by the company at a general meeting. In substantial transactions such as that set out in Section 132E, ratification is sometimes the only option for the shareholders due to costs associated with turning back or unwinding a substantial transaction. And certainly in the case of substantial transactions, the need to make speedy decisions must give way to protection of shareholders interests generally.

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The provisions on interested or related party transactions in the Companies Act 1965, save for Section 132G do not embrace transactions between a company and a substantial shareholder or persons connected with a substantial shareholder. Section 132E for example only embrace transactions between a company and directors and persons connected to the director. This is potentially a very serious omission for not all substantial shareholders sit on boards and more importantly the law does not prevent a controlling shareholder from effecting a related party transaction to the detriment of the company. The laws should be clear as to the circumstances that require shareholder approval. For example, Section 132C has given rise to uncertainty as to the scope of meaning of “undertaking” “property” and “substantial value” leading to doubts as to whether in any one transaction approval of general meeting is needful. Furthermore, it is arguable that only acquisition/disposal which materially and adversely affects the performance or financial position of the company would require the approval of the general meeting. There is ambiguity in construing in any one case whether the transaction is adverse to the company performance or financial position. Section 132E is also ambiguous as to whether it precludes the board from executing a conditional agreement given the wide language of the provision. The penalties for breach of the legal provisions in relation to substantial and connected party transactions should be increased. The increase may for example be by reference to a multiple of gains made by the offenders (as is now the case for insider trading) or allowing investors to seek full compensation for loss from offenders.

Minority Shareholders’ Rights Majority and minority shareholders should be treated equally. Although most minority shareholders might be minnows, they play an important role in governance. However, it is not easy for outnumbered minor shareholders to swing sufficient votes to oppose the will of the majority. Besides, minority shareholders rarely care to call for EGMs or even attend AGMs. Only one or two people will be vocal in the sense that they will ask questions. Malaysian law provides avenues for shareholders’ voice to be heard. When shareholders detect any non-compliance of the law by the management, immediate action is needed. They have the right to call for EGM, without having to wait for the next AGM. Section 144 of the Companies Act provides such right.

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Enforcement of Shareholder Rights

Private Enforcement Rights The Companies Act 1965 provides statutory remedies for shareholders unhappy with acts of the company. Shareholders may currently choose the route of Section 181 or Section 218 of the Companies Act 1965. Section 181 Companies Act 1965 provides for a statutory remedy against oppression. It embodies the member’s personal right to be treated fairly. It entitles a member to make an application to court for appropriate orders where the member is oppressed, prejudiced or unfairly discriminated against or his interests disregarded. The underlying element is one of unfairness to the shareholder concerned. Shareholders generally favour the Section 181 route as it accords them a wider range of remedies. The locus classicus in Malaysian law was a decision by the Privy Council in Re Kong Thai Sawmill (Miri Sdn Bhd) (1978) 2 MLJ 227 where it was judicially recognized that the Section 181 provision is wider than its equivalent in the United Kingdom. Conduct caught under Section 181 encompasses autocratic conduct by the board, the appropriation of business, property or corporate opportunity at the expense of the company or its minority shareholders, unjustifiable failure to pay dividends, or the director’s neglect of the duty of care skill and diligence. The case also recognizes that the court has unfettered discretion to give relief and to safeguard the rights of minority that may have been trampled upon. Section 218 Companies Act 1965 gives the holder of fully paid up shares in a company the right to petition the court for a winding up order. The court would grant the order in a specified range of circumstances including: • •

•

Where the company is insolvent; The directors have acted in their own interests instead of the interests of the members; or acted unfairly or unjustly to other members in the company; and If the court is of the opinion that it is just and equitable for the company to be dissolved.

Remedies at Common Law There are three forms of actions that are capable of being brought by a shareholder: •

Personal action

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Representative action Derivative action

In a personal action, a shareholder takes action in circumstances where his personal rights as a shareholder has been infringed and he seeks relief on his own behalf. It could also take the form of an action to enforce compliance of the company’s memorandum and Articles of Association, general law, the provisions of the Companies Act 1965 (for example, to enforce the right to inspect the register of members without charge — Section 160 Companies Act 1965) and personal contracts. The defendant in a personal action is the company. In a representative action, a shareholder takes action on behalf of him and other persons to seek remedy against infringement of their collective personal rights. A court decision will bind all persons represented. The rationale behind representative actions is to avoid duplication of court actions in cases where one action would serve to determine the rights of a number of persons in question. Detailed rules are set out in the Rules of High Court.24 The biggest drawback to representative actions is that the relief sought cannot be a recovery of damages. In cases where relief sought is damages, the plaintiffs only have recourse via Order 15 Rule 4, which allows for joinder of parties or alternatively the court may grant declaratory relief. Practically this means that once the plaintiff in his representative capacity has established his claim to the declaratory relief sought, it will be necessary for each member of the class to bring his own action to establish damage suffered by him within the limitation period.25 In a derivative action, an action is taken where a minority shareholder is desirous of enforcement of the company’s rights against the majority. A court’s judgement or ruling would be given in favour of the company. The company is made a party to the proceedings. It should be noted in this respect that the director’s fiduciary and statutory duties as well as their common law duties of care, skill and diligence are owed to the company and not the individual shareholders. Also, the power to institute action in the company’s name generally rests with the board. It is practically very difficult to cause the company to commence action against the defaulting director especially where he controls the board. So it is not uncommon to find that a company commences action after there has been a change in management or where the defaulting director has left the company. The avenue for minority shareholders to institute action in the company’s name is through a derivative action. But to do so the minority shareholder would have to fall within one of the exceptions to the rule in Foss v Harbottle. Malaysia recognizes the exceptions in that if there are:

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Ultra vires acts or illegality Fraud on the minority Denial of individual rights of membership26

There has been some debate whether a statutory derivative action should be provided. The Singapore Companies Act27 has introduced provisions to that effect in 1993 but has excluded the operation of such a statutory remedy from listed public companies. It is evident that shareholder litigation is costly and involves a fair amount of monies. If the action is derivative in nature the benefit reside with the company. The incentive to engage in such litigation is minimal whilst the disincentives are prohibitive.28 The Corporate Law Economic Reform Programme in Australia (CLERP) argues for the introduction of a statutory derivative action.29 Section 155 of the Securities Commission Act now provides that the commission may recover loss or damage by reason of the conduct of another person who has contravened any provisions or regulations made under this act, whether or not that other person has been charged with an offence in respect of the contravention or whether or not a contravention has been proved in a prosecution. This new provision enables SC to take on derivative action against misfeasant officers and third parties who have caused loss and damages for the company.30 Public Enforcement The discussion here will focus on the following bodies: The Registrar of Companies is the enforcer of Companies Act 1965 and regulations made thereunder — the penalties set out in the act are essentially criminal. The registrar does not have the power to institute civil action on behalf of an investor suffering loss or damage. In this respect most of the penalties set out in the statute are due for updating. For example the maximum penalty for breach of Section 132E, a related party provision involving directors is RM30,000. In contrast Section 11 of the Securities Industry Act 1983 empowers the Kuala Lumpur Stock Exchange empowers the commission to impose a fine of up to RM1 million. The Securities Commission is the enforcer of securities laws and the regulator of the exchange. The Securities Commission’s jurisdiction over public companies stems from the Securities Commission Act 1993 where all public companies seeking to issue or offer securities are to submit

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their proposal to the Securities Commission for approval. The penalties for failure to submit the proposals for approval or for submitting false and misleading information in connection with the application is severe — fine of RM3 million or a term of imprisonment of ten years. The Securities Commission also administers the insider trading provisions under the Securities Industry Act 1983 and amendments to the provisions in early 1997 now allow the commission to institute civil action against the insider to recover the profit or loss avoided by the insider and to impose a civil penalty of up to RM 1 million. The powers of enforcement and investigation of the commission have been enhanced by the introduction in early 1997, of new Sections 99A, 99B, 99C and 99D Securities Industry Act 1987. The Bursa Malaysia Stock Exchange is the front-line enforcer of its listing requirements. Section 11 of the Securities Industry Act 1983 alters the contract between the exchange and listed entity by empowering the exchange to enforce its rules, not merely against the listed entity, but includes the directors of the listed entity and any person to whom the listing rules are directed at31. The section also sets out a very impressive range of actions and penalties the exchange may impose for breach. They include one or more of the following actions: • • •

Directing the person in default to comply with or give effect to the rules; Impose a penalty which shall be commensurate with the gravity of the offence but the penalty shall not exceed RM1 million; Reprimand the person in default.

The section also empowers the SC to enforce the listing requirements of the exchange directly. Each director of a listed company is now required to execute an undertaking in favour of the KLSE . This obviates the difficulties encountered in Australia as to the enforceability of the LR as against directors who use defence of non-privity of contract. MANAGEMENT OVERSIGHT This section sets our discussion of the various mechanisms or structures that are in place to ensure that management act prudently to use investor’s assets in the best interests of the company, and that significant shareholders do not abuse their control powers against the interests of minority shareholders of a company.

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Shareholder-level protections are generally more effective than board-level protections but more costly. But the more effective the board is in serving shareholder interests, the fewer the decisions that should require shareholder action. Towards this extent there are provisions in Malaysia that attempt to strengthen the effectiveness of the board’s oversight function through basic prescriptions on board structure and composition including prescriptions mandating the presence of independent elements on the board, provisions relating to the appointment and removal of directors and the imposition of strict and onerous duties of directors. Board Structure and Composition By way of background, Malaysian boards are essentially unitary in nature. The Code of Corporate Governance stresses this point when it sets out as the first principle of corporate governance: “Every listed company should be headed by an effective board which should lead and control the company.” This stresses the dual nature of the board. Boards are generally made up of a combination of executive and non-executive directors — the latter are meant to exercise independent judgement on the board. The KLSE/Price Waterhouse corporate governance survey indicates a reasonably proportionate mix of independent non-executive directors, non-executive directors and executive directors. Almost all (90 per cent) of companies have at least in name, two independent directors of which half (49 per cent) have two independent directors and nearly a quarter (23 per cent) have three independent nonexecutive directors. There is very little regulation of the structure and composition of boards. The Companies Act 1965 requires every company to have at least two directors. The term independence in the listing rules refers to two crucial aspects. First independence from management and second, independence from a significant shareholder. The exchange has introduced an expanded definition of independence to exclude substantial shareholders.32 An independent director does not get involved in the day-to-day running of the company. There is no contract of service between such a director and the company. To be truly independent, a non-executive director should be someone free from any business or other relationship which could interfere with the exercise of independent judgement or the ability to act in the best interests of the listed issuer. The function of the board of directors is two-fold: to lead the company into the future by determining strategy, while monitoring and controlling its performance in the present. Non-executive directors should contribute in both these areas.

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There is a risk however, that this proposal may disenfranchise the very group of people who have the most incentive (because of their large shareholding) to ensure that their rights are not abused. Beyond this there is very little regulation of board composition, not unlike the position in most other jurisdictions. In fact, countries with codes of best practices deal with this issue as a matter of best practice. The corollary is that directors should be prepared to disclose in the annual report as well as the notice of meetings embodying the resolution for their re-election, which of the directors are considered to be independent and be prepared to justify their view if challenged. The Malaysian Code on Corporate Governance adopts that approach. It introduces a form of proportional representation by requiring that one-third of the board should comprise independent directors, and in fulfilling this requirement, the board should include a number of directors, which fairly reflects the investment in the company by the shareholder other than the significant shareholder. This is supplemented with a requirement for the board to disclose on an annual basis whether one-third of the board is in fact independent and whether board composition fairly reflects the investment of minority shareholders of a company. This essentially leaves it to the market to judge the composition and effectiveness of the board. It relies on investors to take a positive interest in the composition of boards of directors, whether there are appropriate checks and balances, and to the appointment of a core of non-executives of the necessary calibre, experience and independence. Board Committees Again boards are essentially free to set up whatever committees they see fit to facilitate the management and supervision of the committee. The only committee that is mandated is the audit committee. The listing rules of the KLSE require all listed companies to have audit committees comprising three members of whom a majority shall be independent. The rules also set out the minimum functions of the audit committee. The Malaysian Code on Corporate Governance fleshes out the board to form an audit committee of at least three directors, a majority of whom are independent and chaired by an independent non-executive director within the KLSE Listing Requirements. The Kuala Lumpur Stock Exchange/Price Waterhouse Survey provides some insight into the profile of audit committee members set out in the following table:

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TABLE 6.1 Malaysia: Profile of Audit Committee Members Representation

Majority

About Half

Minority

None

No Answer

20%

17%

37%

21%

5%

Legal professionals

6%

8%

23%

52%

11%

Retired industry leaders

7%

6%

17%

61%

9%

Retired senior government officials

9%

6%

32%

45%

8%

Financial professionals

The Malaysian Code on Corporate Governance sets out an additional function of the audit committee, that is, to consider and where it deems necessary to investigate any matter referred to it or that it has come across in respect of a transaction, procedure or course of conduct that raises questions of management integrity, possible conflict of interest or abuse by a significant or controlling shareholder. The report further recommends that where upon reporting its findings to the board, the board fails to take any action, the directors of the committee should be required under the listing rules of the exchange to report the matter directly to the exchange. Some listed companies in Malaysia have an internal audit function though law does not mandate this. The Price Waterhouse/ KLSE survey suggests that about 68 per cent of companies that responded to the survey have internal audit functions and 33 per cent out of those have outsourced this function. In addition to the audit committee, typical issues to be delegated to committees of larger public companies include nominating directors (this is alluded to below) and the compensation and remuneration of directors and senior management. While the concept of a remuneration committee is said to be relatively new in Malaysia, the results of the KLSE/Price Waterhouse survey on corporate governance indicates that one in five companies already have remuneration committees in Malaysia. No data is provided on the membership of these committees. The Malaysian Code on Corporate governance, stresses the need for companies to establish a formal and transparent procedure for developing policy on executive remuneration and suggests in this respect the setting up of remuneration committees, comprising wholly or mainly of non-executive directors to recommend to the board the remuneration of executive directors in all its forms drawing from outside

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advice if necessary. The membership of the remuneration committee should be disclosed in the director’s report. The proposed code also requires companies to disclose in the annual report, the details of remuneration of each director. Appointment and Removal of Directors

Appointment of Directors The process for appointment of directors in Malaysia is essentially controlled by controlling shareholders. The articles of association of a company govern the process of appointment and removal of directors. Directors may be appointed by shareholders at a general meeting or by the board of directors. In practice, most directors are appointed by directors themselves for filling a casual vacancy or as an additional director by virtue of the powers granted to them under Article 68, Table A of the Companies Act 1965. Any directors so appointed shall hold office only until the next following AGM and shall then be eligible for re-election. Further the then Rule 305 of the listing rules requires that any director appointed by the board to fill a casual vacancy shall hold office until the next AGM and shall be eligible for reelection. In every appointment there are forms that are required to be lodged with the Registrar of Companies. In the case of listed companies, of the LRs require Bursa Malaysia to be notified of the appointment as soon as practicable. Section 99D(2)(c) Securities Industries Act 1983 now requires notification of appointments of new directors and chief executives of a company to the SC. It is evident therefore that while the law sets out notification requirements for the appointment of directors to the relevant authority, it does not prescribe the selection process. The Code on Corporate Governance attempts to strengthen the selection process somewhat by recommending that non-executive directors should be selected through a formal and transparent process. The suggested formal process — a nomination committee, with the responsibility for proposing to boards any new appointments, whether of executive or non-executive directors. The proposed nomination committee should have a majority of independent non-executive directors and should be chaired by such a director. The executive summary of the KLSE/Price Waterhouse corporate governance survey indicates that only about 20 per cent of companies that responded to the survey had a structured process for selecting independent non-executive directors, and amongst them, the majority (81 per cent) involved the board as a whole.

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Removals of Directors Section 128 Companies Act 1965 preserves the right of shareholders to remove directors. It allows members to remove directors any time during his term of office regardless of provisions to the contrary in the memorandum or articles of association of a company. Special notice is required of any resolution to remove a director or to appoint someone else in his place. While this provision is crucial, the law does not safeguard against capricious removals by significant shareholders. There are further provisions in companies and securities legislation that allow for the Registrar of Companies and the Securities Commission to apply to court to disqualify a director. Section 130A of the Companies Act 1965 provides for disqualification of directors of insolvent companies. An application for disqualification may in this respect be made by the Registrar of Companies or the Official Receiver. Section 99C of the Securities Industry Act 1983 allows the Securities Commission to commence disqualification proceedings against a director where the director has been convicted of an offence under securities laws or has had civil action taken for breach of certain provisions of the Securities Industries Act or any action as set out in the act for breach of the provisions of the listing rules. This provision came into effect first quarter of 1998 and has not been utilized as yet.

The Criteria for Independence The exclusion of substantial shareholders from independent participation on boards, (especially if a substantial shareholder is defined as one with a shareholding of 5 per cent or more), can have the effect of disenfranchising a significant group of persons with a strong incentive (as a result of their large shareholding) to ensure that their rights are not aggrieved by the conduct of the controlling shareholder. Collective action problems preclude effective monitoring by small shareholders. But large shareholders, in defending their own self interests will often defend the interests of small shareholders as well. Therefore to exclude these persons or their nominees from the definition of independence and thereby from the various board committees that mandate the presence of an independent majority seriously erodes the ability of large outside shareholders to make it harder for the insiders of a company to ignore or deceive a minority shareholder.

The Extent of Empowerment of Independent Directors There is now embedded in the LRs entitlements for directors. Under Paragraph 15.04 of the LRs, the directors have the right to resources, whenever necessary

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and reasonable, for the performance of his duties, including but not limited to the obtaining of full and unrestricted access to any information pertaining to the listed issuer or to the advice and services of the company secretary and also independent professional or other advice. Section 132 (1) Companies Act 1965 imposes upon directors, the general duty “to act honestly and use reasonable diligence in the discharge of the duties of his office”. Directors are also subject to a myriad of general law duties. Sub-section (5) of Section 132 preserves all of the common law and equitable duties relating to directors. These form the bulk of the directors’ duties to the company. These can be categorized into two broad categories — fiduciary duties and the common law duties of care skill and diligence. Other sources of duties include duties arising out of the articles of association of companies and contract. Strengthening of Duty of Care, Skill and Diligence There has been a heightening of duty of care and skill as courts are more aware of the growing complexities of modern commerce and also the importance of interest of a well managed corporation. In Commonwealth of Australia v. Friediech (1991) 5 ACSR 115; 9ACLC 946 the court suggested that it would be incumbent for directors to be capable and able to understand the company’s affairs to the extent of actually reaching a reasonably informed opinion of its financial health. Other Statutory Duties of Directors Directors are also subject to various other disclosure obligations under law. Section 135 Companies Act 1965 sets out the general duty of directors to make disclosures. These include disclosures with respect to the directors interests in the company or a related company, any changes in those interests, to name a few. The consequences for breach of this provision is criminal and the penalty, imprisonment for a term of 3 years or a fine of fifteen thousand ringgit. Independent legislation may also obligate a director to comply with various requirements e.g social security legislation; revenue Material Restrictions on the Ability of an Investor to Launch a Hostile Takeover Bid Under the Takeover Code there is no inhibition as to effecting a hostile takeover bid. In reality hostile takeover bids are not normal. In certain

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strategic industries, for example, banking and insurance, the inhibitions are more specifically provided for by legislation, for example, BAFIA. Any acquisitions that may lead to a hostile takeover bid in the instance of a financial institution will be void unless it received the consent of the requisite regulatory authority. The role of the Foreign Investment Committee is also legally ambiguous. Discipline via market control is an important goal that has not been realized in practice as competition and struggle for control of companies in key industries by the hidden but intervening hand of government can be discerned. Abuse of Minority by Reverse Takeovers and Back-Door Listings At the height of the boom years in the 1990s a number of corporate players utilized the mode of reverse takeovers as a means of gaining a back-door listing. In so doing a huge premium was paid for the mere listing status whilst the existing business was hived back to the previous controllers. Under existing Malaysian law which follows the English position, the controllers owed no direct fiduciary duty to the minority. Insofar as they act as vendors of their controlling block and are not also involved intentionally in abetting any offence under the takeover legal regime, the minority shareholders are left in the cold in the event the new controllers are not able to inject fresh assets or businesses into the company that can justify the premium paid. In such a circumstance the price of the share will suffer a severe fall to the detriment of the remaining shareholders. There is no rule or principle that prohibits the controllers as common law does not impose a fiduciary duty on the controlling shareholder qua shareholder. The Securities Commission in response to the abuse of back-door listings has introduced in Chapter 18 of Policies and Guidelines on Issue/ Offer of Securities the requirement for prior permission to be sought before a back-door listing can be effected. This is to minimize abuse of the minority. There is also a case for recognizing the fiduciary duty of the controllers to the minority in situations where there is a change of control. Independence of the Securities Market Regulator The SC is the mother regulator in the securities and capital market. Its work has been well-supported by a team of professional staff and its leadership in

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shaping various corporate governance initiatives leading to enhanced disclosures, and enhanced penalties for defaults against securities legislation has been recognized both regionally and internationally. There has been perception about the lack of autonomy of the SC. The widespread belief that the SC lacks autonomy stems from the lack of prosecution of offences and its apparent failure to enforce the requirement for general offers (GO) as per its takeover code. The criticism is not totally fair as some confusion has been caused by the overlap in jurisdiction between different regulators. An example is the UEM-Renong debacle. In the eyes of the public, the decision to waive the requirement for a GO ought not to have been granted. The grant of waiver to extend a mandatory general offer was made by the Foreign Investment Committee (FIC) and not the SC, and yet the SC, took the brunt of the criticisms. In the wake of this, the Minister of Finance brought into fore Section 11 of the Securities Commission (Amendment) Act 1995 which introduces new Sub-sections 33A, 33B, 33C, 33D, 33E. These provisions make the SC the sole authority to grant exemptions from provisions of the new code. In the Press Release dated 2 January 1999, the SC emphasizes that it will observe the principles and objectives that are specified in Sub-section 33A(5) of the Securities Commission Act 1993 in exercising this grant of exemption. OTHER INTERNAL MECHANISMS This section evaluates the role of company secretaries, share registrars and external auditors in corporate governance and the framework under which they operate. Company Secretaries Every company in Malaysia must have one or more company secretaries who must be resident in Malaysia.33 Section 139(3) provides that the company secretary shall be appointed by the directors. The Companies Act also requires all company secretaries to be a member of a professional body prescribed by the Minister for Domestic Trade and Consumer Affairs and licensed by the Registrar of Companies.34 Section 4 Companies Act 1965 deems a company secretary to be an officer of the company.35 The company secretary is therefore subject to liabilities as an officer, which include, among other things, liability under Section 132(2) Companies Act 1965 for misuse of corporate information and Section 132A of the same for insider trading. The company secretary is

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however not part of management and has no power therefore to make commercial decisions on the company’s behalf. There is also the developing role of the company secretary in terms of advising the board and chairman of their compliance obligations. The Cadbury Committee for example looked to company secretaries to advise the chairman and the board on issues pertaining to implementation of the Code of Best Practice. The Malaysian Code of Best Practices certainly takes this line by requiring that all directors should have access to the advice and services of a company secretary. Independent Share Registrars The law does not mandate the existence of an independent share registrar in the sense that they are required to be independent of the company or that they cannot be simply removed. However while the risk of abuse exists, to date the performance of share registrars in companies has generally been satisfactory. External Auditors External auditors are meant to provide an external and objective check on the way in which financial statements have been prepared and presented. However, the framework under which auditors operate is not well designed. For instance, accounting standards and practice allow boards too much scope for presenting facts and figures in a variety of ways. Whilst shareholders formally appoint auditors and the audit is carried out in their interests, shareholders have no effective say in audit negotiations and no direct link with auditors. Auditors instead work closely with management. Breaking out of the closeness of the relationship is difficult, as auditors have no easy line of communication with the shareholders to which they report. Audit firms also compete for audit work. There is, therefore, a significant amount of pressure for an auditor to reduce the scope of the audit to the minimum necessary. The situation is made worse by the apparent use by some auditors of “lowballing” or “predatory pricing” practices using audit as a loss leader for other more lucrative nonaudit services. Steps have been taken to improve the audit system. The Financial Reporting Foundation and its Associated body, the Malaysian Accounting Standards Board have been set up to improve and tighten accounting standards, to give these standards the force of law and to facilitate enforcement of these standards through companies. This is a very important step for accounting

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standards provide important reference points against which auditors exercise their professional judgement. There should be full disclosure of fees paid to audit firms for non-audit work. The problem with non-audit work is that where auditors undertake non-audit services, it will increase the value of the firm to the auditorship and thus make the auditors more reluctant to do anything which will render it likely that the board of directors will seek to get rid of them as auditors. Full disclosure of fees will enable the relative significance of the company’s audit and non-audit fees to be assessed. As such sub-paragraph 1(q) of the 9th Schedule Companies Act requirements in respect of disclosures in profit and loss accounts, should be extended to include disclosure of fees paid in respect of non- audit work. Auditors as Watchdogs The primary responsibility for prevention and detection of fraud or other illegal acts on the part of the company rests with the board as part of its fiduciary responsibility for protecting the assets of the company. The auditor’s responsibility is essentially to properly plan, perform and evaluate his audit work so as to have reasonable expectation of detecting material misstatements in financial statements. Sub-section 174(8) CA places a statutory duty on an auditor to report in writing to the Registrar of Companies, where in the course of performance of his duties an auditor of a company is satisfied that: • •

There has been a breach or non-observance of any of the provisions of the Act; The circumstances are such that in his opinion the matter has not been or will not be adequately dealt with by comment in his report on the accounts or consolidated accounts or by bringing the matter to the directors of the company or if the company is a subsidiary, of the directors of the holding company.

Failure to do so carries the penalty of imprisonment for two years, or RM30,000 or both. The obligation to report is triggered when the auditor is satisfied that a breach of the Act has occurred and where he has no confidence that the directors will deal adequately with the matter. There are several problems associated with this duty. The term “he is satisfied” introduces a subjective element to the duty to report. Also on a practical level, breaches of the law and especially in cases of fraud, if it involves forgery, collusion or management override of control systems is hard to detect. Also where they suspect that top management or the board itself is

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implicated in a illegal act but they do not have the necessary evidence to back up their suspicions, they are not in a strong enough position to confront the management or executive directors, nor have they a case to report to the authorities, as they only have a suspicion of wrongdoing and not that a breach has taken place. Paragraph 15.17 of the Listing Requirements provides that where an audit committee is of the view that a matter reported by it to the board of directors of a listed issuer has not been satisfactorily resolved resulting in a breach of these requirements, the audit committee must promptly report such matter to the exchange. The advantage to this phrasing is essentially that auditors are held to a more objective standard by which a decision to or not to report is assessed against. GOVERNANCE BY LARGE CREDITORS AND CREDITOR RIGHTS The banks in the country do play a major governance role in times of corporate insolvencies. They appoint receivers or liquidators. But for companies which are not insolvent but illiquid and which require to be restructured or rehabilitated, the procedures for turning control over to the banks (including the rules for them to change managers and directors) are not well established. Nonetheless, the legal environment, until recently, was more favourable to the creditors. And in the absence of well-established rules for the rehabilitation of companies, this may have caused firms suffering from illiquidity to be driven into insolvency. Banks do not play a role in governance save in bankruptcies. But there are some who are in favour of promoting in Malaysia governance based on banks or even state enterprises as large shareholders as an alternative to our current arrangements. We have some doubts about this recommendation. Banks in Malaysia as well as in Asia are hardly able to take care of themselves. Therefore, it will not be advisable to entrust them with a key role in the governance of listed companies. The loss of focus is likely to make matters even worse. Furthermore, the incentive of a bank in governance is likely to be severely distorted, as its primary interest is in lending. Where it is a significant minority shareholder and exercises control over a company by voting these shares and the shares of others for which it acts as a proxy, its main interest is in enhancing its own income from its lending and other related activities and not in enhancing shareholder value. Malaysia has five options for dealing with financial distress in the corporate sector from outright liquidation to debt restructuring and reorganisation of the company as an ongoing concern. Two of the options

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have always existed in the Companies Act but the other three options have emerged only this year.

Winding Up Under Companies Act 1965 (Act 125) Part X (Sections 212 through 318) of the act deals with winding up of companies. This part deals essentially with a terminal procedure where the intention is to liquidate and close the company. Under these provisions creditors can petition the high courts to wind up a company because of failure to pay its debts. The act provides for appointment of a liquidator/ receiver, defines the powers of the liquidator, establishes the priority and ranking of debt between and within different classes of creditors. The provisions under this part are extensive and provide a clear basis for winding-up.

Schemes of Arrangement and Reconstruction Under Companies Act 1965 (Act 125) Part VII (Sections 176 through 181) of the act deals with rehabilitation and restructuring of companies as ongoing concerns. Under this part of the act, the high court can permit a compromise or arrangement between a company and its creditors subject to a majority in number representing three-fourths in value of the creditors or class of creditors must agree to a reorganisation/ compromise plan. The court can also issue summary orders temporarily restraining creditors from proceeding against the company. The option embodied in Section 176 to Section 181 is to permit the preservation of the company as an ongoing concern while enabling creditors to recover monies under compromise and reorganization arrangements that have legal sanction from the courts. However, according to experts, there are no well-defined judicial management procedures for managing schemes of compromise and reconstruction. Unlike other jurisdictions on which Malaysian company law is based, such as United Kingdom, Australia and Singapore, in Malaysia there are no specific provisions or guidelines, the process is cumbersome and the courts have limited experience in supervising reorganization plans. Some experts have made a case for Malaysia to adopt the regulations in place in similar jurisdictions and to strengthen the capacity within the court system to manage corporate restructuring on an ongoing basis. During the course of 1998 some companies have misused the provisions of Section 176 to seek from the courts temporary relief from creditors for periods of up to nine months on a unilateral basis without the company being

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required to initiate a process of dialogue with its creditors and without the creditors being given a chance to present their case to the court before the relief is granted. As there is a high risk that the company could use Section 176 to pre-empt creditors and strip the company of assets, the government has now amended the section requiring that a company need the consent of creditors representing at least fifty per cent of its debts before it can apply for court protection and requiring that it submit a list of its assets and liabilities with the application. The courts have been granting temporary relief from creditors not only to the debtor companies but also to their guarantors. This has been so even where the guarantees have been issued by banks, and even where the bank guarantees require payment on demand. This has disadvantaged the bond holders as many had invested in certain bond issues on the strength of the bank guarantees.36 This can seriously undermine the credibility of bond markets and undermine its development.

Corporate Debt Restructuring Committee (CDRC) Process Post 1998 recession, a CDRC has been established under the aegis and with the secretarial support of Bank Negara Malaysia (BNM), to provide a framework to enable creditors and debtors to arrive at schemes of compromise and reorganization on a voluntary basis without resorting to legal processes. The aim of this scheme, based on the “London Approach”, is to tackle the complex cases of indebtness with outstanding debt of at least RM50 million and with more than three creditors. The key features of the CDRC framework have been worked out and are now in use. But guidelines which are viewed as credible, transparent and consistent have to be developed or must emerge to encourage the use of the voluntary process. To assist in this process, and in the absence of a long tradition of cooperation between participants, the CDRC has to first concentrate on those cases which will help it to develop and set these guidelines and which can then be used even for the more complex or controversial cases. All efforts must be taken to ensure that there is full disclosure and sharing of information with all creditors. There are also several specific issues that warrant further deliberations by BNM and the CDRC. To motivate creditors and debtors to use this voluntary process, its legal basis has to be established. For instance, the CDRC process provides for a “standstill” period of sixty days during which a moratorium is imposed on recall of loans and enforcement of security interests. The question is, can the CDRC impose this in a legally binding manner? Another key issue

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is, what majority rule would be used to reach an agreement over the restructuring plan and who would be eligible to vote? On the whole the CDRC discharged its duties satisfactorily .

Asset Management Company or Danaharta Danaharta has been established in 1998 to acquire non-performing loans from banks and assets from distressed companies to minimise the problem of a credit crunch as well as to facilitate an orderly payment/write-down of debts. It will have the same claims as the original creditors and will rely on a number of asset disposal methods (including private placements, public auctions and public tender offers) to recover its claims. The legal process to be followed by Danaharta aims to compensate for the absence of a well-defined scheme of judicial management of corporate restructuring under the Companies Act.37 The goal is to expedite and shorten the legal procedures and to bring to bear professional expertise in design and implementation of reorganization plans. The operations of Danaharta are covered under a special act that confers on it broad ranging powers to acquire and manage assets.

Restructuring of Small Borrowers For corporate borrowers with total outstanding debt of less than RM50 million, the Loan Monitoring Unit at BNM would provide assistance in enabling these borrowers to continue to receive financial support while restructuring their operations. In addition, these borrowers could also use the Danaharta route. In Asia the more serious problem arises not from large shareholdings but from the more widespread practice of pyramiding and cross-holdings. This causes a major divergence between the control and cashflow rights of insiders. Therefore, the incentive is for insiders to maximize their private benefits of control and not necessarily that of shareholder value. There is thus a higher probability that minority shareholders run the risk of being expropriated or squandered. The managers or controlling shareholders in a company are in a position to expropriate minority shareholders: • •

By selling to a connected party the output or an asset of the company at below market price; By buying from a connected party an input or an asset at above market price; and

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By acquiring an interest in a company connected with a related party at above market price.

A sample of the more reputable or larger of the listed companies (comprising 13 per cent of the total in number and over 50 per cent in market capitalization) showed that the incidence of concentrated shareholding (even as measured by the shareholding of the largest shareholder) is very pronounced in the Malaysian market. The incidence of dispersed shareholding is uncommon. The incidence of interlocking ownership and cross-guarantees between firms in the same conglomerate is low compared to the situation in Japan or Korea. However, concentrated shareholding through a pyramid structure is more widespread. The number of layers between the controlling shareholder and the most distant subsidiary is three, nonetheless it still makes for a significant divergence between control and cashflow rights of the controlling shareholder. A large investor may be rich enough that he prefers to maximize his private benefits of control (including investments in unrelated activities, whether for diversification or for the purpose of empire building), rather than maximize his wealth. Unless he owns the entire firm, the large investor will not internalize the cost of these control benefits to the other investors. This will then be reflected in the failures of large investors to force their managers or companies to maximize profits and pay out the profits in the form of dividends. An examination of the foreign-controlled companies, especially those which have a clear majority shareholder, shows that these companies have been paying out a high proportion of their profits in the form of dividends (and not re-investing the profits in diversified or empire-building activities). Such high dividend payout ratios may have been facilitated by the more healthy relationship between the control rights of the majority shareholder with its cashflow rights. In the case of locally-controlled companies, the control rights were usually well in excess of the cashflow rights of the controlling shareholder, usually because of the pyramid structure of companies in the same group. This could explain their much lower dividend payout ratios and their greater propensity to re-invest their profits even in unrelated activities, at least in part to maximize the insider’s private benefits of control. To prevent the abuse of minority shareholders by the controlling shareholders and other insiders, there are legal and regulatory provisions requiring the approval of shareholders on substantial and connected party transactions. However, there are still weaknesses which must be addressed as

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expeditiously as possible to reduce ownership concentration and increase the reliance of companies on external finance. Therefore the first critical area for reform would be to strengthen the related party provisions in the Companies Act 1965. Reform of Companies Act 1965 Provisions on Related Party Transactions It should be stated at the outset that the LRs on related party transactions are much tighter and better defined, especially the new rule which came into force in July 1998. Reliance on just the LRs, however, is not satisfactory for the following reasons: •

•

•

The range of penalties open to the LRs to take while impressive, cannot compare with that of the statutory regulator. Section 11 of the Securities Industries Act 1983 provides that in addition to any other action a stock exchange may take under its rules, the exchange can take the following actions — directing the person in default to comply with the rules, impose a penalty, the quantum of which shall commensurate with the gravity of the breach, provided that it does not exceed RM1 million and finally, reprimand the person in default. The exchange may under its listing rules also suspend or de-list a company and where the companies are punished through suspension or delisting, one may end up compounding the losses of the injured parties, namely the minority shareholders. There have also been doubts expressed as to the extent to which the listing rules of the exchange may restrict a shareholder from voting his shares in respect of a transaction that he is directly interested in. The exchange rules, it is felt, cannot deny a shareholder that fundamental property right. The exchange does not have the enforcement infrastructure available to a statutory regulator, which would include for example the statutory right to require information, rights of search and seizure that would make its enforcement exercise more effective.

The provisions on related party transactions in the Companies Act only requires the transactions to be disclosed and approved by shareholders but the interested parties are not required to abstain from voting. The LRs do not suffer from the same deficiency. Therefore, the Companies Act should be amended to require the interested parties to abstain from voting on a connected party transaction.

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With the recent amendments to the Securities Industry Act, penalties for insider trading have been increased to three times the insider’s gain. The new civil penalties also allow investors to seek full compensation for loss from the offenders. As substantial and connected party transactions have the potential to inflict more harm on minority shareholders then even insider trading, as amply demonstrated by recent events, the penalties for the breach of legal provisions with respect to such transactions should be reviewed and substantially increased. There is also a pressing need for improving the quality of legal enforcement against the breaches of such provisions. Facilitating the Shareholder’s Ability to Exercise his Right to Vote A second area for reform, it is suggested, is to strengthen the ease with which a shareholder is allowed to vote by providing for voting by mail whether by member or by proxy. Voting by mail overcomes several practical difficulties associated with having to attend general meetings,38 not to mention that it is a cheaper and more efficient manner of enabling shareholders to exercise their right to vote. This should be supplemented with provisions mandating longer notice periods and sufficient disclosure of information to give shareholders the opportunity of deciding how they should vote. Strengthening the Effectiveness of Independent Director Representation on Boards There has been a discernible trend in Malaysia to increase the range of matters where decision making authority is reserved to the general meeting of shareholders. But while shareholder level protections may be more effective, they are also more costly than board level protections. But the more effective the board is in serving shareholder interests, the fewer the decisions that should require shareholder decision. In Malaysia there appears to be increasing reliance on independent directors to strengthen the necessary checks and balances when broad powers of management are conferred on directors. There are broadly three areas of improvement that one may suggest to the position of independent directors: •

That any attempt to exclude large shareholders (albeit minority shareholders) from participating as independent board members can have the effect of disenfranchising a significant group of persons with a strong incentive (as a result of their large shareholding) to ensure that their rights are not aggrieved by the conduct of the controlling shareholder.

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One way of harnessing the ability of these large minority shareholders to put their representatives on the board is for the law to provide for cumulative voting for directors. Bearing in mind the heavy reliance on independent directors to take the lead in management oversight and control self dealing by controlling shareholders, a strong case may be made for strengthening the process by which independent directors are given a presence on boards. Once on boards, the law should ensure that the independent directors are empowered sufficiently to ensure that they are able to participate effectively. There is scope therefore for Section 131 Companies Act 1965 to be strengthened to require an interested director to abstain from voting in respect of transactions that the director has an interest in.

Strengthening the Enforcement Capability of Statutory Regulators Another critical area for improvement in lies in strengthening the effectiveness of enforcement action by the regulators. There has been considerable criticism of the speed and effectiveness of enforcement efforts by the various regulators. Critical areas for improvement include: •

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Strengthening the autonomy of powers granted to regulators to enforce laws — consistency in enforcement of laws and regulations ensures a level playing field for all participants; Rationalization of the regulatory framework — Fragmentation obstructs enforcement in two critical ways. First it confuses jurisdiction over laws that often lead to regulators struggling to react to situations and often in uncoordinated enforcement activity. A fragmented framework relies heavily on arrangements between regulators. Second, it causes confusion with the public, which then leads to unwarranted but inevitable blame being laid on a regulator, not responsible for regulating that activity, thus further entrenching the perception that regulators are not enforcing the law. Modernizing the range on enforcement powers of regulators which would include the introduction of a general power that allows the regulator to institute civil action on behalf of an investor to recover damages suffered by the investor as a result of transgressions. This right should be extended to investors to enhance their private enforcement capabilities.39 Developing the right experience and skills in enforcement — Priorities should be altered from market development to supervision and enforcement.

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Enhancing the accountability and transparency of regulators — Disclosure of details of enforcement activity and action taken allows the public to evaluate the extent to which the regulators are enforcing laws and the effectiveness of action taken which creates the right incentives for regulators to be proactive in its enforcement efforts.

Strengthening the Private Enforcement Capacity of Investors There is a major deficiency in the ability of investors to institute action against directors for breach of their fiduciary duties. The existing common law provisions on derivative actions have several practical and substantive difficulties that have proven to be almost insurmountable to minority shareholders. There is also considerable uncertainty whether ratification by some shareholders of a director’s breach of duty would result in denying other shareholders, the right to bring a derivative action to protect a company. The introduction of a statutory derivative action provides for a more effective means by which a director’s duties to a company may be enforced. This would increase private enforcement in the long run and reduce the need for public or regulatory interference. The Australian Corporate Law Economic Reform programme views the statutory derivative action as a valuable tool to enhance corporate governance and enhance investor confidence. The five areas set out above, are critical areas for reform in the immediate term. In the medium to long term, the following paragraphs set out key actions to be taken. The development and implementation of a code of best practices. The Finance Committee Report on corporate governance sets out the Malaysian Code on Corporate Governance, which sets out principles and best practices for good corporate governance. The report also sets out the intention of the committee to have the code backed by listing rules of the exchange. Essentially, the listing rules are to require companies to disclose their extent of compliance with the code. This then leaves it to the market to judge the effectiveness of the company’s governance practices. It is not intended to suggest by this that self-regulation is sufficient. The case has been made above that the strong arm of the law in necessary to prevent controlling shareholders from maximizing their private benefits of control. However the significance of a code for Malaysia is that it will require companies to make the relevant governance disclosures which then introduces more information about how boards function in Malaysia. Another fairly significant feature about codes is the aspirational and evolutionary way in which these codes influence the expectations of society that are eventually

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reflected in the law. The attention generated by the various codes of best practices have already had an impact on evolving judicial interpretations of director’s duties.40 Certainly the code also acts as a valuable guide to boards by clarifying their responsibilities and providing prescriptions strengthening the control exercised by boards over their companies. However, a necessary prerequisite to successful and effective implementation of the code is for shareholders to take an active interest and apply pressure to hasten the widespread adoption of the code. To put it in another way, the introduction of a code on corporate governance must be in tandem with efforts to build shareholder activism in Malaysia. A Minority Shareholder Watchdog Group has now been set up to monitor and combat abuses by insiders against minority shareholders and to evaluate governance disclosures by companies including issues such as board composition. The Employee Provident Fund of Malaysia, as major institutional investor can take the initiative to set up and organize such a watchdog group with technical assistance from the ADB or the World Bank. However, of late with the lack of funding, the MSWG group has ceased from active operations. Crucially the new Code on Takeovers and Mergers also makes the Securities Commission the sole authority to grant exemptions from provisions of the new code. This amendment is seen to be in response the tremendous public dissatisfaction that followed the fact that UEM and its concert parties had been granted a waiver from the requirement to make a mandatory general offer for the remaining shares in Renong by the Foreign Investment Committee (FIC) under Rule 34.2 of the old Code on Takeovers and Mergers.41 This gave the impression that the perceived bailout was supported by the authorities. The amendment to the code now subject the discretionary exemptive powers (previously conferred on the FIC) to a clear and transparent criteria as stipulated in statute so that the authority that exercises such discretionary power can be checked by investors who would have recourse to court if the power has been arbitrarily exercised. The SC emphasises that it must and will observe the principles and objectives that are specified in Sub-section 33A(5) Securities Commission Act 1993 in exercising its powers under the act, including when granting an exemption.42 The sub-section requires the SC to ensure that takeovers and mergers take place in an efficient, competitive and informed market. In this respect the SC will have to ensure that: •

The shareholders and the directors of an offeree and the market for the shares that are the subject of the takeover offer are aware of the identity

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of the acquirer and offeror, have reasonable time in which to consider a takeover offer, and are supplied with sufficient information necessary to enable them to assess the merits of any takeover offer; All shareholders of an offeree have equal opportunity to participate in benefits accruing from the takeover offer, including in the premium payable for control; Shareholders, in particular, minority shareholders, are treated fairly and equally; and Directors of the offeree and acquirer act in good faith to meet the objectives that are specified in Sub-section 33A(5) of the Securities Commission Act 1993 and that minority shareholders are not oppressed or disadvantaged by the treatment and conduct of the directors of the offeree or the acquirer.

Regionally Malaysia’s has active participation in the APEC Collaborative Initiative on Corporate Governance. Malaysia is currently leading the APEC Finance Ministers initiative on corporate governance in collaboration with the Asian Development Bank and the World Bank. Its involvement in this initiative is said to be based on the belief that: Discussions in the international arena on corporate governance issues will aid the process of peer assessment and review and given the scale of the challenge involved in overcoming the current problems and putting in place effective long-term solutions, the APEC process provides a forum for exchange of ideas, knowledge and expertise.43

The Malaysian Corporate Governance Code seeks to enhance the checks and balances and self regulatory mechanisms towards good governance. This recommendation sees the introduction of a Malaysian Code on Corporate Governance which sets put principles and best practices for good governance and is directed chiefly at directors of public listed companies. The code therefore contains prescriptions on matters such as board composition, procedures for recruiting new directors, remuneration of directors, the use of board committees, their mandates and their activities. The Malaysian Code on Corporate Governance was promulgated and applying the axiom that best practice prescriptions are necessary. Merely requiring disclosure of existing corporate governance practices of Malaysian companies is not sufficient. In this respect, it is important that these prescriptions are accompanied by a rule requiring disclosure of the extent to which listed companies have complied with the prescriptions and where they have not, the reasons why.

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Companies will be required by the Listing Requirements to include in their annual report a narrative statement of how they apply the relevant principles to their particular circumstance. This is to secure sufficient disclosure so that investors and others can assess companies’ performance and governance practice, and respond in an informed way. It defines a set of guidelines or best practices intended to assist companies in designing their approach to corporate governance. These guidelines is not mandatory, however, companies will be required as a provision of the listing rules of the KLSE to explain any circumstances justifying departure from best practice. Exhortations to other participants such as the auditors and investors in order to enhance their role in corporate governance. Explanatory notes and “mere best practices” are purely intended as a guide to boards and companies and do not require companies to explain circumstances justifying departure from best practices. Statement of Compliance It is proposed that all listed companies reporting in respect of years ending after the implementation date of the report should state in the reports and accounts how they have applied the principles set out in Part 1 of the code and a statement of compliance in respect of the best practices set out in Part 2 and identify or give reasons for any areas of non-compliance. In this respect, boards are not expected to comment separately on each item of the code with which they are complying, but areas of non-compliance will have to be dealt with individually. Sanctions for Non-Disclosure Where a company fails to comply with the mandatory disclosure requirements under the listing rules, it is open to the Exchange to take any action against the listed entity or its directors as mandated by the listing rules and Section 1 of the SIA. Keeping the Code Up-to-Date The code addressed those issues which have appeared to require the most immediate attention. The situation, however, is developing. The revamped Listing Requirements took effect from June 2001 and it aimed at raising the standard of conduct of directors and company officers of

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public listed companies, as well as developing effective internal governance and enforcement. The amendments to the LRs brought into effect the Malaysian Code on Corporate Governance. Besides, the exchange has issued twelve Practice Notes with the objective of promoting better understanding and to facilitate consistent application of the new Listing Requirements by industry participants. Acceptance by Industry Malaysia recognized industry buy-in to the efforts by the regulators in promoting corporate governance. Listed companies in particular must embrace corporate governance in total. However, rules and regulations by themselves may not be effective if not accompanied by acceptance and desire to comply by the industry. This is where surveillance, monitoring and enforcement continue to be part of Bursa Malaysia’s duty to the industry and without fear or favour. In tandem with the rising expectations of directors’ performance and accountability to the company and its shareholders, Bursa Malaysia is empowered under the new Listing Requirements, to take action against the directors personally, where they commit a breach of the Listing Requirements. This will serve as a wake-up call that they have been put in positions of trust and that they must honour this trust and act in the best interests of the company. To assist the directors in discharging their duties, Bursa Malaysia has also mandated them to attend training programmes on a continual basis. This mandatory attendance at CPD has attracted both commendations and criticisms. During the crisis of 1998, long-term development of the capital market has been an important aspect. The Capital Market Masterplan is designed with clarity of vision to the stakeholders in the capital market, the issuers, investors, and intermediaries. • •

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The recommendations contained in the Report on Corporate Governance will be affected in a timely and comprehensive manner. The SC will further facilitate efforts towards enhancing shareholder rights, especially those of minority shareholders, and broadening avenues for private enforcement of these rights. Minority shareholders’ rights in respect of related party transactions will be further strengthened. Public listed companies will be required to provide appropriate shareholder value disclosures for securities issuance, restructuring, take-overs and merger exercises.

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A set of principles, best practices and standards will be developed to encourage institutional investors’ activism in corporate governance and the promotion of shareholder value recognition. The SC will strongly support the efforts of Bandan Pengawas Pemegang Saham Minority Berhad in promoting shareholder activism in Malaysia. The SC will work with relevant industry bodies in enhancing the quality and independence of auditors of public listed companies. The SC will encourage the improvement of channels of communication between companies and their shareholders. The SC and the KLSE will initiate further measures to promote timely, comprehensive and regular dissemination of material and relevant company information to shareholders. Efforts to further enhance disclosures in annual reports by public listed companies will be examined.

SC has also introduced whistle-blowing protection legislation. This is a laudable measure to engender and foster a milieu which will permit disclosure of corporate wrongdoings without concomitant penalties of victimization and dismissal visited upon the witness. There has been some work done in areas of statutory derivative action and improvement of proxy voting mechanisms in SC. This has yet to completed or promulgated. Financial Institutions and Insurance The Financial Institutions and Licensed Insurance Institutions has various Bank Negara Directives which governs governance structures and practices that must be complied with by such institutions. These directives if adhered to will definitely foster a governance cultures that will lead to lessening of risks of insolvencies for these vital bodies. Notes 1. Updated and adapted from Thillinathan, Philip Koh and S. Kandiah, World Bank Country Report 1999. 2. Contrast approach of Section 130 Companies Act 1965 which prohibits a person who is convicted of offences from acting as director, promoter or participate in the management of a company within a period of five years from his conviction or after release from prison without leave of the Court. The registrar has the power to oppose application for leave. Note also that Section 130A gives

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the Registrar of Companies and the Official Receiver the power to apply to court to disqualify directors of insolvent companies. The need to promote certain special interests also led to the use of this regime. The fixing of new issue prices often at levels well below market prices, led to massive over-subscription, harmed issuers and in fact restricted the size of new issue activity. The need to promote certain special interests also led to the use of this regime. The fixing of new issue prices often at levels well below market prices, led to massive over-subscription, harmed issuers and in fact restricted the size of new issue activity. The approved auditing standards in Malaysia which are based on the International Standards on Auditing (IASs) have suggested wording to express a qualified opinion depending on whether the matters under consideration affect or do not affect the Auditor’s opinion and whether there is any limitation on the scope of the audit or any disagreement with management. See AI 700 on Auditor’s Report on Financial Statements. Section 69N of the Companies Act 1965. Section 99B of the Securities Industry Act 1983 provides that a chief executive and a director of a listed company must disclose to the commission of his interest in securities of the listed corporation. The consequence of a breach of this provision is criminal sanction of up to RM1 million or imprisonment of up to ten years or both. Sub-section 131(5) of the Companies Act 1965 provides that every director has direct or indirect duties or interest which might be created in conflict with his duties and interests as directors, shall declare at a meeting of the board of directors, the fact, nature and extent of the conflict. There are criminal sanctions for breach of this provision, also under Sub-section 131(8) of the Companies Act 1965. Section 131(1) of the Companies Act 1965 provides that every director of a company who is in any way interested in a contract or proposed contract with the company shall disclose the nature of his interest at a directors meeting. The consequences of a breach of this provision are criminal sanctions under Section 131(8) of the Companies Act 1965 — (seven years or RM150,000 or both). A transaction is deemed as material if its value exceeds five per cent of any one of a select set of variables such as profits, equity, market capitalization and assets. Section 24 defines a related party as follows: “Parties are considered to be related if one party has the ability to control the other party or exercise significant influence over the other party, to the extent that it prevents the other party from fully pursuing its own separate interest, in making financial and operating decisions.”

Malaysia requires a prior approval of related party transaction by shareholders who are not interested in the transaction, the risk of significant related parties and the transactions remaining undetected by the auditor can be high. The

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International Standard on Auditing, AI 550 states that the auditor should obtain sufficient appropriate audit evidence as to whether these related party transactions have been properly recorded and disclosed. If the auditor is unable to obtain sufficient appropriate audit evidence concerning related parties, the auditor is required to modify the audit report appropriately. Sections 158–161 of Companies Act 1965. Sections 358, 161 of Companies Act 1965. Securities Industry (Central Depositories) (Amendment) (No.2) Act 1998. Section 107B(3) Companies Act 1965. Note however that Section 103 (1) provides that notwithstanding anything in the articles a company may not register a transfer of shares, debentures or interest unless a proper instrument of transfer has been delivered to the company. There is therefore no automatic transfer e.g. by way of death of shareholder. The law permits free transferability of shares with some exceptions. If the sale and transfer of shares involved that of a corporation that requires the approval of a minister then there could well be inhibitions as to free transferability or even sale by private treaty. In private companies the problem arises as to the directors being vested with a right to refuse to register a share. Also it would appear that if directors refused to register a transfer on grounds that such refusal is done primarily to endorse the government’s policy of encouragement of active. Section 148(1) Companies Act 1965 provides that every member shall have the right to vote on any resolution notwithstanding anything to the contrary in the company’s memorandum and articles of association. The member’s right may be suspended when the member has not paid any calls or other sums payable by him in respect of his shares or if the shares in question are preference shares. A peculiar feature of Section 149 is that the proxy must be a member of the company or an advocate, approved company auditors or persons approved by the Registrar of Companies. Section 146 (1) (c) Companies Act 1965. If the article does not have such a prescription then a proxy may be lodged at the meeting itself. Paragraph 7.17 of the KLSE Listing Requirements. However where the notice calling for the meeting is to consider resolutions regarding material transactions, the KLSE rules do require circulars to be issued to shareholders in addition to the notice that is given. All circulars are vetted by the KLSE. Section 144(3) Companies Act 1965. See “A Guide to Best Practices for Annual General Meetings”, ICSA 1996. Essentially, a representative action in Malaysia may only take either the form permitted under Order 15 Rule 12 or Rule 13, Rules of the High Court Malaysia. The former is appropriate where every member of the class can be ascertained, where else the latter deals with representative actions involving parties which cannot be ascertained or cannot be readily ascertained.

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25. Civil procedure in the United States is much more facilitative of class actions as set out in Federal Rule on Civil Procedure 23. Notably there is no procedural bar against recovery of damages. The general rule is that differences in the amount of damages claimed by the class member would not defeat class certification so long as damages are readily calculable on a class wide basis. Each member of the class is entitled to a pro-rata share of the damages recovered in the action. 26. There has been suggestion of another exception, that is, in the interests of justice. It is unclear that such an exception is an independent one and whether Malaysian courts recognize it. 27. Sections 216A and 16B. 28. There is a judicial attempt to forge a solution to the costs issue in respect of a derivative action. It is clear that a grant of indemnity is seldom available. For example, if the suit is representative in nature or to seek remedies against an abuse of fiduciary powers then it would not be proper to apply such an indemnity. 29. It views its introduction, not as imposing a new form of liability on directors, but rather removes uncertainty and therefore provides for a more effective means by which director’s duties to a company may be enforced. This it suggests would increase in the long run, private enforcement and reduce the need for public or regulatory interference. In this respect, CLERP does look at the statutory derivative action as a valuable tool to enhance corporate governance and maintain investor confidence. 30. See Australian equivalent: ASC v Deloitte Touche Tohmatsu (1996) 138 ALR 655; 21 ACSR 332. 31. Section 11(2)(e) Securities Industry Act 1983. 32. Substantial shareholding is a defined term in Malaysia and recent revisions to the Companies Act 1965 (Companies (Amendment No.2) Act 1998 now define a “substantial shareholder” as a person who has interests in two per cent of the voting shares in a company. 33. Section 139(1) Companies Act 1965. 34. Section 139B Companies Act 1965. 35. Directors are also officers under Section 4. 36. As at end August 1998, the Rating Agency of Malaysia (RAM) published ratings to the tune of RM46.24 billion. Of this amount, close to 40 per cent or RM17.07 billion were bank guaranteed and of the papers guaranteed, about half (that is, RM8.15 billion) were issued by less credit worthy companies or what RAM considers as having below investment grade ratings on a stand alone basis. Also by end August 1998, RAM had thirteen outstanding issues totalling RM1.48 billion by twelve different issuers under Section 176 protection. Of these, ten were bank guaranteed, two were corporate guaranteed and one is a non-guaranteed mortgage bond. These companies include those that have applied for and obtained a direct restraining order and those that have its subsidiaries included in its court orders. See RAM, “Section 176: An Impact Analysis”, RAM Focus, Issue no. 9, September 1998.

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37. Danaharta can appoint Special Administrators (SA) that would have a legal mandate to manage and oversee all operations of the distressed enterprise. On the appointment of the SA a moratorium for a period of twelve months (which can be extended if necessary) will take effect over winding-up petitions, enforcement of judgements, proceedings against guarantors, repossession of assets, and applications under Section 176 of the Companies Act. 38. Shareholders may be dispersed all over the country not to mention foreign institutional investors, who may not be based in the country, so that attendance at general meetings would be difficult and costly. 39. Sections 90 and 90A Securities Industry Act 1983 now provide for the recovery of losses caused by insider trading, by way of civil actions instituted either by the Securities Commission or the investor. Contrast the general power given to the Australian Securities Commission under the Australian Securities Commission Act 1989, which allows the Commission to take action in a person’s name for recovery of property of the person. 40. See for example the Australian case of Daniels v Anderson (1995) 37 NWSLR 438 which is a clear instance of directors being increasingly held to a higher standard of care. 41. In November 1996, UEM Berhad announced purchase of a 32.6 per cent stake in Renong Berhad. The acquisition was perceived as a bailout of a cash-starved company and its major shareholders by a healthy, financially strong company, with scant regard for UEM shareholder interest. 42. See press release dated 4 January 1999 on the new Malaysian Code on Takeovers and Mergers, 1998. 43. Keynote address by Dato’ Dr Abdul Aziz Mohd. Yaacob, Deputy Secretary General, Ministry of Finance, delivered at the “Symposium on Corporate Governance in APEC, Rebuilding Asian Growth”, Sydney, Australia, 2 November 1998.

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7 INDONESIA’S TOLERATED LOW-SPEED REFORM OF CORPORATE GOVERNANCE Djisman S. SIMANJUNTAK

It took Indonesia six years to get back to the level of economic activities of 1997 after suffering from the severe crisis of the late 1990s. Enormous opportunities were lost. The challenge of returning to a socially shared and ecologically sustainable high growth is tough. While macroeconomic stability has been restored, some down-side risks continue to loom large, leaving Indonesia’s policymakers a narrow corridor of manoeuvre as will be discussed in section one. The return to high growth requires progressive increase in physical capital or investment and the use of labour on the one hand, and a similarly progressive export expansion on the other hand. Such a three-fold challenge may look formidable, but is not impossible to face successfully as some countries such as China have proved able to do. The three-fold challenge is discussed in section two. Obviously, sustainable high growth is possible only under efficient allocation, given the scarcity of resources. Allocation efficiency in turn is crucially dependent on the practices of corporate governance. The discovery of good corporate governance may perhaps be included in the lessons that Indonesia drew from the very severe crisis. Good corporate governance has become a standard entry in Indonesia’s policymaking vocabulary as it has been in other parts of East Asia. Between the talk and the walk there lie difficult barriers, however. East Asia, including Indonesia, is somehow afflicted with a disease of seeking to cure allocation inefficiency

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by relying on measures such as those of good corporate governance that assume a strong tradition in law enforcement, which in reality is absent. The governance enigma is discussed in section three. Notwithstanding the enigmatic nature of the current development in governance reform, agreement does exist on the indispensability of progress in good corporate governance, if Indonesia is to return to a socially shared and ecologically sustainable high economic growth. In the last section of the chapter alternative policy measures are explored, however small the probability may be of them being taken and enforced in the near future. THE POST-CRISIS INITIAL CONDITION: ROOTS OF BAD PRACTICES OF GOVERNANCE Indonesia has seen signs of successful macroeconomic stabilization in the last three years. Annual economic growth has strengthened to over 4 per cent. Level of output in 2003 has more than returned to the level of 1997. Total national income in 2003 was 2.8 per cent larger than in 1997. In some sectors the recovery has proceeded at a higher pace. Output in 2003 had risen cumulatively by 94 per cent over 1997 in communication, the fastest growing sector of the economy, by 91 per cent in non-oil mining, 47 per cent in electricity, gas and water, 28.6 per cent in fishery, and 28 per cent in personal and household services. On the expenditure side, consumption in 2003 was 12.5 per cent higher than in 1997, but export has been sluggish, and investment is yet to show signs of sustaining recovery. Monetary stabilization has also shown an encouraging trend. Annualized inflation rate fell to 6.2 per cent in September 2003. Interest rate on Bank Indonesia’s promissory notes, the main monetary policy instrument deployed, declined consistently to less than 8 per cent in the second half of 2004. Rates on bank deposits fell even more steeply, and they oscillate within a band, the ceiling of which is below the rate on Bank Indonesia’s promissory notes. Banks are, in other words, trapped in reverse intermediation, mobilizing financial resources from the public and investing them in Bank Indonesia’s debt papers. The fact that lending rate is far higher than average deposit rate cannot persuade banks on the merits of shifting gear to a much more active lending policy. The debris of the bank crisis has not been cleaned up completely. Banks are scared of a new wave of non-performing loans and the need for higher capital associated with loan expansion. The rupiah has gained substantially against the US dollar, thanks to a strong current account and the revival of capital inflows in such a way that deficit in the capital account shrunk substantially, though it suffered a heavy loss against the Euro and the

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Australian dollar. Aided by a strengthened rupiah and international disinflation, the rate of inflation was successfully brought down to a historically low level of the order of 6 per cent a year. The positive signs also include a government budget, which is virtually balanced in the sense that the deficit has been kept within the range of 2 per cent or less in spite of an enormously large interest payment on foreign and domestic debts. There is a price for the austerity policy, however. Quality of public services seems to have deteriorated and the stock of public physical capital to have shrunken. The government must also accept the fact of rising unemployment. Foreign exchange reserve is exhibiting an increasing trend thanks to a current account surplus that surpasses deficit in capital account by a substantial margin. The capital market has rebounded as reflected in rising price index, rising value of transactions, successful initial public offering by new entrants to the stock market, and strong activity of the bond market fuelled by the wide differential between lending rates and deposit rates at commercial banks (Kenward 2004). A relatively large size of foreign portfolio capital has returned to Indonesia. It now accounts for a large share in the traded shares of “blue-chip” companies. In addition to the success of macroeconomic stabilization, some other strengths lead one to believe that a socially shared and ecologically sustainable high growth is within Indonesia’s reach. The transitional nature of democratization and decentralization may look burdensome at its current early stage. Given the natural and cultural diversities of Indonesia, a democratic and decentralized structure appears to be the only sustainable power structure for Indonesia. Authoritarian governments of the past had proved able to bring about short episodes of boom, but failed the litmus test of sustainable development. Each of them ended up in devastating busts. Under natural and cultural diversity, authoritarianism is capable of delivering not much more than a Sisyphean growth, a growth that is equipped with the seed of its own demise. From this perspective the current democratization is a plus point for Indonesia. Democracy and decentralization may combine to unchain the strengths of diversity. They may not be as quick in yielding progress as the authoritarian model of the past, but even authoritarianism is not an instant development recipe. Needless to say, Indonesia can still count on a comparatively favourable resource endowment while seeking to return to high growth. The buoyancy has undoubtedly diminished to a very great extent. Daily oil production in recent months has dwindled to less than one million barrels. It can no longer cover domestic consumption. Forests have turned barren in most cases. Tin has seemingly neared exhaustion. Nevertheless, the resource-based sectors still offer attractive potentials in terms of absolute magnitude, though not in terms of contribution to growth anymore. Assuming

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a good management it still can provide Indonesia with an enviable differential advantage relative to other developing countries in the same stage of economic development in spite of the apparent curse of a practically irresistible temptation of corruption that goes along with richness in natural endowment and a denied diversity. Having recently gone through a devastating crisis, Indonesia is faced with a wide range of weaknesses that resulted from the crisis, on top of weaknesses that originated in pre-crisis periods. First of all, Indonesia is yet to earn the reputation of a stability-conscious country in spite of the disinflation and stringent budget in the last few years. Indonesians have been too often terrified by coercive monetary measures to believe that a few years of stability reflect a fundamental change in the cultural foundations of macroeconomic policymaking. Besides part of the disinflation and the gain in exchange rate against the US dollar is a global phenomenon rather than the result of an unshakeable commitment to stability. In fact the rupiah did lose heavily against some currencies, notably the Euro and the Australian dollar. Secondly, the contained budget deficit is a small consolation against the background of the huge stock of foreign and domestic debts, which skyrocketed in the wake of the crisis. The government was forced to borrow heavily from its official creditors or to schedule repayments of existing debts when capital fled during the crisis. Public external debt rose from US$57.86 billion in 1997 to US$74.92 billion in 2000, an increase of US$17.06 billion. Likewise, domestic debt, which was avoided throughout the period of 1967–98 to signal a strong commitment to fiscal policy discipline, was recreated in connection with bank restructuring. The restructuring bonds peaked at 435,307 billion rupiah in 2001, excluding the amount owed to the Central Bank. In return the government acquired enormous non-performing loans, the resale value of which is less than 30 per cent. Thirdly, the restructuring of Indonesian commercial banks is yet to be completed. Government bonds and Bank Indonesia’s promissory notes account for 35 per cent of total bank assets at the end of June 2004, compared for instance with the share of credits of 45 per cent. Part of the loan assets originated in the block sales by the Indonesian Banking Restructuring Agency. On the other hand, liabilities are protected by a blanket guarantee, making investment in deposit simply unbeatable in terms of risk-return relationship. Bankers seem to have turned highly risk-aversive. Fourth, the return to the level of total output of 1997 cannot obscure the fact that on a per capita basis, an average Indonesian has still to muddle through with a shrunken per capita income after six years of frustrating toiling. Some industries are still grappling with a level of output, which is far below the level of 1997. The negative differences in 2002 were

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16 per cent in iron and steel, 23 per cent in transportation equipments, 28 per cent in construction, 40 per cent in banking and 16 per cent in building rental. Even the increase in the level of consumption ceases to impress once population growth is taken into account. Unemployment is widely pictured a threatening economic and social weakness confronting post-crisis Indonesia. Politicians of all persuasions consistently attach a high priority to job creation in their respective economic platform. The true magnitude of unemployment is unknown. Most Indonesians are too poor to be openly unemployed. They undertake whatever is needed for survival, including illegal activities such as illegal logging, illegal mining, illegal fishing and various sorts of black economy. However, black economy is never a solution to unemployment given its zero-sum nature. People involved in illegal economies take something away from fellow citizens and impose on them unnecessary costs. In a knowledge-driven world economy black economy is, indeed, a liability. Future industries of high growth of Indonesia will have to be searched among industries that serve as drivers of the world economy. Considering the very narrow corridor for macroeconomic stimulation, the revival of high growth will have to rely on supply-side policy measures. Public works cannot be a solution to the current problems of unemployment in Indonesia. The tight budgetary constraints do not allow public works to be undertaken in a scale that is meaningful in terms of the number of people who are looking for job. What is needed is output expansion on a competitive basis. It can occur through a better utilization of existing capacity. There are limits to such growth, however. Even in industries that operate deeply below capacity, it is questionable whther they can compete globally given the damages to physical capital arising from non-use and obsolescence due to insufficient investments in the period following the crisis of 1997–98.The return to high growth is conditional upon a sustaining surge in investment. As a fraction of GDP, investment in Indonesia went down from the range of 30–35 per cent to 20 per cent in 1998 and 2002. It persisted at the same level in 2003. In absolute terms gross fixed capital formation in 2002 was 28 per cent smaller than in 1997. Other indicators tend to confirm the depressing state of investment. As hinted earlier, banks are reluctant to extend investment loans. Activities that banks find attractive in recent months are largely confined to the retailing of durable goods such as car and motor vehicles. Bond financing requires a proven track record and is, therefore, accessible only to a small number of debtors. Value-wise, import of mechanical machineries and equipments in 2002 was as small as 47 per cent of 1997

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import. The low level persisted in 2003. Even taking into account the surge of import of used machineries and an optimistic view on substitution of locally made machineries for imported ones the impact is not likely to compensate for the deep fall in import. The weak approvals of new investments persisted in 2003. While there was an increase of approvals in domestic and foreign investments in 2003 over 2002 the number must be interpreted with caution considering the high frequency of change in status in favour of foreign ownership following the sales of assets by the Indonesian Banking Restructuring Agency (IBRA) and privatization. Reasons behind the weak investments vary across industries. In some industries under-utilization of capacity explains the sluggish increase to a great extent. In some cases such as resource-based manufactures, legal uncertainty works as severe deterrence. Whether one talks about land rights, fishery rights, rights of passage, or mining rights newly gained autonomy has inspired local governments to seek a greater share in the proceeds from such rights. They add to the legal uncertainties of which Indonesia is known as a notoriously bad example. A stable equilibrium is yet to be found. An excessively pro-labour legislation constitutes another disadvantage of Indonesia as an investment location. While the present value of hiring a worker has not been estimated quantitatively, it is probably lower in Indonesia than in China, India, the new members of the European Union, and even in Vietnam. PENDING ISSUES OF A LONG PAST So far issues arising from the crisis of 1998 have been discussed. Underneath the new weaknesses there persist old weaknesses of which some are of direct relevance to the practices of corporate governance. They include, first of all, the weak tradition of law enforcement. Post-crisis Indonesia has been very quick to pass new laws, amend existing ones and to set up new institutions, including regulatory institutions and the constitutional court. Progress in enforcement seems to have been lacking, however or has lagged far behind the speed that is needed to make Indonesia feasible in the eyes of traders and investors who have been honeymooning with China and the transition economies of Europe, and Vietnam. The distinction between a reformed Indonesia and New Order Indonesia should perhaps primarily lie in law enforcement. Unfortunately, progress has notoriously been very slow. The root causes are yet to be decoded. They are seldom approached from an economic perspective except for the speculation that underpayment of judges, attorneys, policemen, and other officials and bureaucrats, plays a decisive role in the making of a corrupt officialdom. Studies on law enforcement in

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developing countries are limited in number, and Indonesia has been grossly under-studied. Cross sectional studies of which some include Indonesia are usually focused on phenotypes rather than the fundamental reasons behind inadequate enforcement. Some studies find that roots of weak enforcement are more complex than underpayment (Polinsky and Shavell 1998; Xu and Pistor 2003). In the years after the crisis some creditors and partners in joint ventures were amazed to find out that Indonesia’s law enforcement suffers from a very high degree of uncertainty. Creation of regulatory institutions is expected to ameliorate the problems, but such institutions too cannot be mature overnight. Of equal importance to governance is corruption. On this score Indonesia has also earned a very bad reputation. Various reports agree that the incidence of corruption is among the highest in the world. The change in political regime does not seem to have alleviated the problems. Indeed there is widespread worry about corruption having spread even to the remotest places in the archipelago, afflicting also local governments, which replicate at a high speed in the wake of decentralization that leaves local governments greater financial resources. Numerous local parliamentarians and local government officials have been openly implicated in corruption, but suffered severe fines and imprisonment only in a very few cases. Yet, the under-deterrence of the law persists. Corruption has been a very fertile soil for empirical research in recent years. (Dreher, Kotsogianis and McCorriston 2004). Incidence of corruption is correlated with a wide range of variables, including natural resource endowment as hinted earlier and denied diversity that serves as the arena for inter-ethnic rivalry for limited sources of rents. Indonesia subscribes to a constitution that endows the state with ownership control on enormous mining, land and forestry, and marine resources. The natural wealth serves as attractive collateral for international borrowing from official and private sources. The potential is tapped generously under Sukarno and Suharto. Proceeds from natural resources and external borrowing allow the government to enlarge its direct role in the economy through numerous state-owned enterprises in manufacturing, banking, insurance, underwriting, appraisal services, shipping, air transportation, property, and, needless to say, infrastructure. Reliable data on issue as trivial as the mere number of SOEs is not available. The number oscillates around 160, excluding enterprises owned by local governments. Perhaps corruption in the case of Indonesia is simply the confirmation of the nature of human as homo avaritia or modern human who is instinctively exposed to an insatiable appetite for material wealth. A state

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awash with treasures is doomed to face the ungrateful task of guarding its treasures against misappropriation by politicians and bureaucrats. Business people find in such treasures a lucrative source of rents. Collusion between politicians and business people in such state is even older than the modern nation state. Reference to it has been found in writings that even predated the current era. What indeed appears miraculous is the survival of the Republic of Indonesia after waves of looting under colonial governments and those of independent Indonesia. Most economic studies on corruption have been unable to provide a strong push to anti-corruption political programmes. Microeconomic studies typically argue that corruption is not much more than a transfer from one pocket to another within the same economy, putting aside dead-weight losses, which are typically small. Such studies assume at least implicitly a closed economy where corruption money is recycled back to the circular flow. The situation must be different in an open economy. In fact the study quoted earlier came to enormously high costs of corruption in terms of output foregone. It was found highest at 66 per cent of GDP for Nigeria and as high as 56 per cent in Indonesia. (Axel Dreher et al. 2004). Another study comes to a conclusion that corruption explains 70 per cent of the variance in the logarithm of income in open economies (Neeman, Paserman and Simhon 2003). Indonesia has been an extraordinarily open economy where citizens and aliens are free to bring money in and out at any amount. Such openness was introduced at the end of a hopelessly corrupt foreign exchange control agency in the early 1970s. Some Indonesians who are privileged enough to be able to participate in the bandwagoning politics are believed to have moved enormous wealth to tax haven economies. Detrimental impacts of corruption also depend on the stability of collusion between politicians and their cronies. The costs rise in terms of transaction costs as the collusion gets less stable as it is believed to have been the case of the Philippines and Indonesia (Kang 2002). In other words the impacts of corruption are far more detrimental in open economies as it is in closed economies, though hard evidence is lacking. The importance of governance reform can never be over-emphasized in a heavily corrupt environment. The pecuniary costs of corruption are undoubtedly hard to estimate. Yet, even if estimates indicate that corruption leads to enormous economic losses, anti-corruption campaigns may continue to be cosmetic rather than substantive in nature, as Indonesians have learnt to know to their astonishment. To create a sense of urgency, different approaches appear to be needed. One possibility is to borrow from information theory, particularly the parts dealing with the costs associated with rising entrophy (Pierce 1980). The greater is the

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uncertainty of law enforcement the greater the entropy of policy making. Such uncertainty may increase due to different interpretation of the same law across sectors, regions, times and individual actors. The encoding of such uncertain policies is deprived of efficiency-enhancing possibilities such as compression and block encoding. Without such efficiency-enhancing strategies the encoding of English texts for example would have been much more frustrating than it actually has been. To transmit high-entropy policies channel capacity will have to be increased. Such channel can be understood as the entirety of agents that are involved in the implementation of a policy. In a corrupt environment the transmission channel is loaded with noises, which in turn reduce the amount of information that can be transmitted through it at an acceptable level of uncertainty. What is more, high-entropy policies transmitted through noise-laden channels are difficult to encode. Larger capital and efforts are needed on the side of the recipients in decoding such policies. Indeed, they are most likely to be frustrating to recipients of the policies. Rather than enduring such frustrating games capturing policymakers, regulators and law enforcement institutions promises less uncertainty or entropy. A privileged few will come out of the rivalry successfully. Corruption ruins the efficiency of information in an economy. Such economy is likely to be banished in a knowledge-intensive world economy in the sense of being avoided by the world’s top traders and investors. In the governance environment, the degree of competition plays a critical role. Good corporate governance seems to correlate positively with the intensity of competition. Oligopolists who seem to have gained the upper hand during the unprecedented cross-border mergers and acquisitions of the 1990s are constantly faced with a virtually irresistible temptation of abusing their market powers. Lawmakers and regulators are often forced to take a permissive attitude to anti-competitive practices in cases of oligopolies. On this issue of competition ambiguity persists among Indonesian politicians. As mentioned earlier, the constitution sides with socialism of the soft type. Trust in competition is thin. People associate competition with flagrant imbalance. The dominant role of Chinese Indonesians in business is found displeasing, to put it mildly, adding to the distrust of competition. While a friendlier attitude toward competition has developed during the last forty years or so, the residual mistrust is strong enough to result in anti-competitive policies. Under such an environment progress in good corporate governance is bound to remain slow. Spatial fragmentation is another dimension of the initial post-crisis condition that originated in the pre-crisis period. Before colonialism, the archipelago that makes up the current Indonesia was divided into fragments

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of which none was dominant enough to serve as a lasting hegemon. The Dutch colonial ruler united the territory, but deepened the fragmentation through the strategy of divide and rule in order to exploit it at lower costs. In the period of independence an extreme centralization was adopted using coercive measures. Dissatisfaction was widespread followed by repeated rebellions. The lack of strong cohesiveness is reflected in the survival of subnational languages, which may be a blessing in disguise for anthropological reasons, but clearly reflects persistent fragmentation. The way in which the formation of districts is pushed deeper and deeper to smaller units of physical and anthropological classifications can also be seen as a sign of a resurfaced provincialism. Excesses of such fragmentation can range from “political incest” to a rise in the level of transaction costs to the detriment of international competitiveness of anything that bears the brand of Indonesia. A more fatalistic but less established stream of research attributes Sisyphean development to physical geography. It is known as physio-economics. It is built on the assertion that the energy need of a living creature, including humans, decrease as it moves downward to the equator in order to remain in homeostasis (Parker 2000). The closer one gets to the equator, the greater the diversity of life forms. A price of decreasing buoyancy of individual species is paid for the beauty of diversity. If homeostasis is measured in terms of comfort the assertion of declining energy is easily refuted. Nevertheless, there seems to be an agreement on the vulnerability of life in the tropics. To take off economically requires more effort and stewardship in the tropics than it does in the temperate zones. Success in diversity-based development is more difficult to sustain under tropical conditions, however absurd it may sound at first glance. It is with the much less favourable initial condition that Indonesia has to seek to re-enter the global competition. Convergence as it is understood in growth economics may still contain grains of truth. Backward economies do not have to re-invent the wheel. They can bypass costly experiments. Watchful followers often cultivate enormous second-mover advantage both at firm level and economy-wide. Openness has given birth to a global production system in which economies from different stages of development can participate in mutually beneficial ways. However, a few footnotes are in order. Firstly, the current globalization can perhaps be coined as “Globalization Stage Two” or “centripetal globalization” where players are directed to the few centres of the global markets for factors, goods and services. Such globalization is inherently richer in the seeds of conflicts than “Globalization Stage One” or “centrifugal globalization” where fragments of life or culture spread to different directions and founded in the course of time habitats that are remote from one another.

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Globalization Stage One is inherently peaceful. It is akin to avoidance strategy in a war. However, it came to an end with the arrival of humans in almost all corners of the globe some 2000 years ago. In the late fifteenth century the age of “European discoveries” dawned, heralding the rise of “Globalization Stage Two”. Second, catching up in a knowledge-based world economy appears to be more difficult than it is in a factor-driven world economy. Even the most abundant natural resource endowment is likely to be depleted in a matter of centuries. Knowledge capital is not only built to last, it gets bigger and bigger as it is used more intensively. Third, under the Cold War, alignment with one of the poles is associated with some economic benefits. Non-communist Southeast Asia benefited to some extent from the widely-held worry of Asia falling domino-wise to the womb of communism. With the end of the Cold War, benefaction seems to have lost its appeal. Competition between locations has heightened to the extreme. Indonesia, China, India, transition economies of Europe, and Latin America are now competing head-on to attract entrepreneurial, financial and intellectual resources. At least temporarily the balance seems to have tipped to Indonesia’s disadvantage. The threat of Indonesia disappearing into obscurity is imminent, unless innovative approaches are found to reverse the trend. THE TRIAD OF INVESTMENT, EMPLOYMENT AND EXPORT EXPANSION: IMPORTANCE OF GOVERNANCE Indonesian politicians are aware of the limitations to a consumption-driven growth. Those limitations may not be as tight as widely perceived. An assetbased development is a possibility. One can sustain consumption-driven growth for an extended period of time by selling assets to foreigners. Opportunities to do so have not been exhausted in the case of Indonesia. However, such a model is considered sinful from a nationalist point of view, which continues to play an important role in policymaking in spite of globalization. Seven years after the eruption of the financial crisis of 1997, there is a consensus among Indonesian politicians on the need for a strong investment rebound if the economy is not to lose steam. From the point of view of employment generation, investment rebound is critical. Output expansion on the basis of existing capacity is limited and so is its impact on job creation. Such limitations have to do with the margin of under-utilized capacity, but also with competitiveness. To stay competitive against foreign products in the domestic market and the rest of the world, investments in new machineries and equipments are indispensable. Physical capital requires continuous renewal in order to match changes in product and

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factor markets. On the indispensability of investment rebound to employment creation, there is also a widely shared agreement, notwithstanding the demand for public works as temporary measures. The views on the third leg of the triad are more colourful. Some consider Indonesia an anomaly among populous economies judged from its openness as reflected in the share of external trade in GDP, share of foreign investment in total investment, external debts as a fraction of GDP and recently, share of foreign employment in total employment. They argue that Indonesia’s return to high growth can rely on a progressive increase in domestic demand rather than export expansion. Few politicians would agree on the necessity of export expansion as a driver of growth. However, there are some reasons to argue otherwise. Given the very tight macroeconomic constraints, the room for macroeconomic stimulation is very limited as argued earlier. Removing obstacles to growth have proved to be a sticky task. Even if one can expects it to accelerate under the new government, there is a relatively long gestation period between policy initiatives and harvests. On the other hand re-entering global competition is a real feasibility for Indonesia in spite of the erosion of competitiveness in the last ten years or so. In some industries Indonesia has managed to maintain competitiveness. Where competitiveness has weakened, re-crafting it is possible through the use of the global production system. However imposing China and India may be in the rivalry for access to global product and factor markets spreading stakes to different locations remain relevant to global players. Obviously, failure to impress global players in the last ten years or so suggests that unconventional measures are needed to revive interest in staking limited resources in Indonesia. To borrow the vocabulary of physics, “strange attractors” need to be created around which matter would granulate and a force of gravity will form and grow over time. After reaching a critical mass, such “strange attractors” would become too strong to be ignored by leading global players across industries and spaces. The potential to create such “strange attractors” is definitely extant. One can declare Indonesia as a permit-free “investment area” for a limited period other than compliance with internationally accepted standards. One can re-price assets such as immense land that lays fallow following deforestation in different parts of the archipelago. Rather than introducing new charges as local governments have been very fond of doing under regional autonomy, they are well advised to make available dormant lands temporarily at zero price to investors who can contribute to employment, export and taxes. One may also experiment a “corruption-free” zone where officials are paid at market rates and fines against corruption prohibitive. A strongly inviting “attractor” would also be

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created when the court decides in accordance with the letter and spirit of the law in major and extraordinary cases. Lacking such unconventional measures, it is surely going to be very hard for Indonesia to attract investors and traders who are being drawn almost uncritically to China and, to a lesser extent, India. Indonesia has experienced an episode of investment boom that ended up in a fiasco. Therefore, investment should not be seen as an end in itself. To be sustainable it needs an efficient allocation across different industries and spaces. Indonesia’s recent experience tells that the visible hand is inferior to the market in ensuring the highest efficiency. State-owned enterprises do not seem to have been more resilient to the financial crisis than local private firms. In fact, endemic problems in some very big state enterprises surfaced after the crisis. Good corporate governance has a better chance to progress in a competitive environment. The fact that scandals can still occur even in the most competitive environment like the U.S. economy should not lead one to the belief that the degree of competition is immaterial to the practices of corporate governance. PROGRESS IN POST-CRISIS GOVERNANCE REFORM Good corporate governance is not new when understood as the exercise of power, or to be more specific, discretionary power, in compliance with the principles and rules of transparency, accountability and fairness and in observance of informal norms of good conduct that societies accumulate to allow non-zero interactions to flourish. Indeed, Europeans tend to look at good corporate governance as a “rebottled” wine. Nor is the prominence in which corporate issues enter policymaking agenda something new. Issues of governance within transnational corporations were attached great importance in the agenda of UNCTAD in the context of North-South relations that sank unfortunately into oblivion in the 1980s. Be it as it may, corporate board scandals around the globe suggest that grappling with issues of corporate governance is of great relevance to policymaking. Judging how the world has fared in respect of governance reform in recent years is difficult. Nevertheless, some trends are of interest to note. First of all, corporate governance seems to have infused into policymaking much more deeply and more universally. The combination of emerging equity markets, financial crisis and policy activism on the part of international financial institutions has made corporate governance an important item in policymaking in the developing world. In the developed economies the growing importance of managed funds to corporate finance and the “sudden

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death” that may follow flagrant violations of good corporate governance produce the same effects. Secondly, corporate governance issues have proved to be highly sticky. No government can claim to have resolved corporate governance issues once and for all. Indeed, governance is problematic in nature. A director who has gone through layers of selection instruments may still prove unable to resist the temptation of coming to big wealth through bad practices of governance. The biological foundation of human behaviour is too strong to be ignored in investigations on governance. In the stream of evolutionary genetics the genetic part of behaviour is given great attention (Plomin et al. 2000). Unfortunately, integrating animal instincts into studies on governance appears to be too far-fetched given the current state of science. Third, that a government reacts to violation of laws by legislating new laws or amending existing ones is increasingly typical across different legal traditions. As a result the world is witnessing an increasingly similar legislation on governance. The OECD’s Codes on Good Corporate Governance has diffused to many economies. Company Law, Capital Market Law and Bankruptcy Law have gotten more and more similar around the globe. Practices continue to differ greatly however (Palepu, Khanna and Kogan 2002). Some interesting changes such as decrease in board size, greater acceptance of older directors, stronger representation of law and finance firms in boards, preference for longer experience, the decline in interlocking directory and separation of the CEO from Chairman of the Board take place in the United States (Chaocharia and Grinstein 2004). Changes for the better are also reported from Korea. The legal infrastructure of governance has improved. Rights of minorities can be exercised much more adequately than they could be before the crisis. Before the crisis the board was considered a mere rubber stamp for the dominant shareholder. It has undergone a maturing process after the crisis, however. Yet, the gap between the laws and practices remains large (Nam 2004). Developments do not seem to have differed greatly in Indonesia. Governance-related laws have been or are in the process of being amended. The Indonesian laws and regulations are being aligned more and more with those of the United States. However, the real change in governance practices is hard to judge. A recent survey by the World Bank suggests that the wide gap between changes in laws and regulations on the one hand and changes in practices of governance on the other applies to Indonesia as well (Republic of Indonesia 2004). Such finding is no surprise. Indonesia is notorious for its weak law enforcement. Progress has been slow in spite of the crisis. Recognizing the deeply entrenched violations of laws and regulations, a very daunting question indeed arises on whether or not the quality of governance will ever improve at a speed that would allow traders and investors to rediscover

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Indonesia, if the approach chosen is largely legal in nature. The importance of law enforcement to a functioning open market economy can never be overemphasized. However, one cannot assume law enforcement in competition. People, including businesspeople, develop different responses to different degrees of law enforcement. In the absence of a consistent enforcement of laws, pushing market competition through deregulation becomes the more important. The gap between the spirit and letter of the laws and practices is by no means the only difficult obstacle to corporate governance reform in Indonesia. Recognition gap appears to be equally important. In an environment where bad practices of governance flourish unpunished, preaching good corporate governance stumbles most of the time on indifference on the part of corporate directors. It is hard to persuade Indonesian directors who in most cases are related to the majority owner, on the probability of good governance practices to gather momentum unless something dramatic occurs in law enforcement. According to the Evolutionary Stable Strategy (ESS), a small number of practitioners of good governance can over time grow in number and outnumber practitioners of bad governance assuming a proper organization, is simply too slow in pace to be attractive to largely myopic owners. Arguing that good governance reduces the amplitude of company performance or enhances stability of performance does not appeal much when badly governed companies can prosper. Trying to win constituents of good governance by referring to the positive effects of good governance on share prices is not very likely to succeed in markets where shares with underlying bad practices can also enjoy inflated prices. Dependence of success on good corporate governance in knowledge-intensive competition is perhaps obvious to businesspeople, but delaying compliance may still be considered a better game given dubious law enforcement. Few among Indonesian directors believe in the advantages of being first mover in the adoption of good corporate governance. Some advances do occur in corporate governance reform notwithstanding Indonesia’s preoccupation with the familiar structural problems. Being an emerging market implies, among others, more serious problems of information asymmetry on the one hand, and more limited ability to deal with them on the other. The audited report is published after a long delay in many cases of listed companies. Doubt is often cast on the opinions of external auditors and other reputation agencies such as appraisal firms. While standards are updated continuously to keep up with widely accepted international best practices, professionals and their clients can find ways to avoid compliance (Kurniawan and Indriantoro 2000). Efforts are made to ameliorate information asymmetry. The National Committee on Good Corporate Governance for

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instance, organizes reporting contests for listed companies on a regular basis. Stock analysis has also appeared on a regular basis in the popular press. However, the efforts look trivial against the background of a deeply rooted culture against transparency. Board composition is another area where steps have been taken to comply with laws and regulations. Independent commissioners have been widely accepted among listed companies. A growing number of firms have installed independent commissioner(s). The audit committee is increasingly seen as a useful practice, though compliance has not been as widely distributed as it is in the case of independent commissioners. The same can be said about the nomination committee. The effectiveness of the various committees is yet to be investigated empirically. Nevertheless, a few notes are in order. First, inclusion of the three committees in either one of the boards is an encouraging development, though doubt is cast on the ability of the new organs to maintain independence vis-à-vis the majority owner. Independent committees may take a relatively long period of transition to cultivate independence. Second, the two-board system as it is adhered to among Indonesian limitedliability companies is needy of a rethinking. In its current structure it contains some ambiguity. The idea of replacing the dual board with a single board has been occasionally floated. Third, a theory on board composition is lacking (Hermalin and Weisbach 2000). The number of board members is not the same across all industries, locations and times. The tinkering with board composition points to a deeply-seated suspicion against directors. Findings on the relationship between board composition and performance in value creation are indeterminate. One should also realize that directors are interested in durable reputation. It is probable that a market solution to board composition is better in value creation than a legally prescribed solution. Remuneration constitutes another important element of corporate governance. The basic idea is simple. A system needs to be found, which is able to attract good talents on the one hand, but also contributes to preventing directors from exposing the firm to excessive risks on the other. To do so numerous companies have granted share options, yet the policy has backfired in many cases. In spite of the flaws, share option is considered one of the most effective ways of minimizing agency problems (Jensen and Murphy 2004). The appropriateness of shares as compensation differs from one company to another. It depends on specific settings such as the risk profile of directors. Risk friendly directors react differently from risk aversive directors to the same package of share option (Core, Guay and Larcker 2002). In the case of Indonesia, directors’ compensation has not been discussed openly. Companies are reluctant to disclose directors’ compensation. Directors often engage in

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their own businesses while serving as CEO or member of one of the two boards, damaging transparency even further. However, such a multiple directory is tolerated partly because of the difficulties involved in recruiting directors, but also because of the acute shortage of entrepreneurs. Criticism against excessive compensation is expressed occasionally, but such criticism is targetted mainly at enterprises, which are related to government in one way or another. Another weakness in Indonesia’s stock market lies in its small size and the slow pace at which it is growing in the post-crisis period. In the universe of tens of thousands medium and large business establishments, the current group of listed companies of 338 is not very likely to serve as a revolutionary force. Most of the listed companies are part of privately owned groups. Therefore, the room is further narrowed for them to serve as champion of governance reform. Even the government is hesitant to privatize in spite of a perennial disappointment in financial performance. State-owned enterprises do not seem to have scored better than their private competitors from the perspective of governance. In spite of their status as state-owned enterprise, which theoretically means public ownership, state-owned enterprises are even more enigmatic than privately-owned listed companies. Raising the number of listed companies is among the priority issues facing Indonesia. Before the crisis imperfections of listing were tolerated. “Perfection” is expected to occur in the course of time as listed companies are exposed continuously to market disciplines. Interest in public listing has strengthened in 2003, but the number of new public offerings is still very small even if one takes bonds borrowing into account. Large companies continue to depend a great deal on bank borrowing in investment financing in spite of the reluctance of banks to lend. The risk of rising bank borrowing because of resistance to governance reform is real. (Bunkanwanicha, Gupta, and Rokhim 2003). The trade-off between the speed of market enlargement and the quality of governance persists. Indonesians are no great enthusiasts of capital market. The majority of shares are practically dormant in the market. Trading relies heavily on foreign investment. Foreign sales of shares to local investors is said to have been the only factor that contributes significantly to market volatility in Indonesia (Wang 2000). Therefore, making the stock market attractive to local investors is as important as making it attractive to owners of private companies and state-owned enterprises. Unfortunately, there are structural obstacles that are difficult to overcome. First of all, the memory of the fiasco of the late 1990s lingers. The hardship associated with the severe losses arising from the fiasco deters investors from returning to the stock market. Second, risk aversion is deeply rooted among many Indonesians, partly because of the very high

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frequency in which the government has scared people with coercive financial measures such devaluation, which makes shares worthless in a fraction of a second. Thirdly, under the current blanket guarantee in favour of bank deposits, investors are unlikely to divert investment in a substantive magnitude away from bank deposits. SHORT-TERM PROGRAMME OF ACTIONS The corporate governance environment is highly complex. Myriad forces interact in an intricate and highly dynamic way in the environment. They include firm strategies, intra-industry and inter-industry competitions, crossborder competition, laws and regulations on competition, laws and regulations on the very diverse aspects of corporate governance, informal norms of good conduct, competence or incompetence of a plethora of institutions, and ethical values that people populating the governance community adhere to. While facing temptations or dilemmas, humans in powerful positions often resort to the primal instincts and abuses of power with a view to maximizing net private benefit even at the cost of others. Considering such complexity, searching for a quick fix for governance problems is misplaced. Simplification is not going to help much either. Some of the issues are discussed in this closing section with the purpose of reminding researchers and policymakers of the difficulties involved in corporate governance reform. One of the basic questions that need to be raised continuously relates to the relative failure to push progress in spite of the elevation of corporate governance in the hierarchy of policy priorities. Obviously, people in responsible positions do not feel a strong urgency to push the implementation of governance reform programme in spite of the rhetoric suggesting otherwise. Obstacles may have turned out to be more formidable than assumed. Conventional measures such as legislation of new laws and amendment of existing laws are doomed to fail under the deeply entrenched bad practices of corporate governance. Politicians and regulators may also have under-estimated the economic importance of good corporate governance. The positive impacts of good governance on corporate performance may sound either unconvincing to politicians or of little relevance to economy-wide policymaking. The impacts on the efficiency of resource allocation may not be apparent. There is also a general scepticism about the possibility of progress in an environment where the majority of participants refuse to abide by the rules. The idea of Evolutionary Stable Strategy (ESS) is largely discarded as being unrealistic. A small minority of “doves” may be able to insulate themselves against a big majority of “hawks”, but are thought to be unlikely to prevail without the

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support of a functioning legal system. Change in a deeply entrenched governance environment seems to require a champion or a leader who largely failed to appear in the long series of election debates throughout 2004. Some modest steps can help draw stronger attention to governance issues. A number of NGOs have been established whose agenda are centred on corporate governance. They include Transparency International’s Indonesian Institute of Corporate Governance, the Indonesian Institute for Corporate Directorship as a collaborative institution among schools of business, law and economics and governance-related professionals such as accountants and lawyers. Independent directors and commissioners have also an established association of their own. Through advocacy various activities such as conferences, training and rating these institutions have helped disseminate ideas and practices of good corporate governance. Whether or not directors who participate in the governance activities care to change remains everybody’s guess. The activities will look like drops in the ocean unless lawmakers, the judiciary and regulators act to punish severely people who are involved in bad practices of governance. In the end, nothing substantial will ever occur in governance reform unless proper use is made of the fines and imprisonment stipulated in governance-related laws. Recognizing the gigantic obstacles to law enforcement, the question is what policy measures can one conceive other than the ones which are already stipulated in governance-related laws. Generally speaking, one can expect a better quality of corporate governance under an increasingly competitive environment. On this score, windows of opportunities are indeed open to Indonesia. Through progressive privatization, competition will heighten in businesses where state-owned enterprises enjoy the support of government as residual claimant. Imperfections of competition can also be reduced by way of free entry to and exit out of businesses where restrictions are maintained to protect existing players. In the 1980s and early 1990s, the government had done a great deal to reduce such restrictions. In fact, to allow a strong recovery of investment, Indonesia needs to come up with unconventional measures. Revival of investment would reduce entrenchment. Unfortunately, there are some discouraging signs that protectionists have returned to Indonesia’s policymaking. A more consistent implementation of the Anti-Monopoly Law would also reduce abuses of market power and bad practices of governance that are associated with such abuses. Measures need to be taken to pressure firms to choose a focused portfolio business. Such focus is widely considered superior to a wide dispersion of business portfolio, reducing the need to resort to bad practices of governance. However, the complaint about the weak enforcement of laws applies to competition law as well.

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Attempt has been made to put good corporate governance in a much broader context than one of agency problems in the narrow sense, where attention is focused almost exclusively on the relationship between noncontrolling suppliers who sink resources in the firm on the one hand, and management on the other. Record of governance has implications that go far beyond the borders of the firm. A country, which scores badly in corporate governance, is unlikely to attract well-governed foreign companies. The fact that Indonesia is largely avoided by such firms, putting aside a few Asian multinationals, is an alarming sign for the failure to provide an internationally hospitable governance environment. Failure to improve corporate governance can also result in a highly fluctuating market value of the firm, which in turn can propagate into stock market crisis and banking crisis. In short, corporate governance is not the exclusive business of firms. One area of governance which deserves a closer look, is the relationship between firms and banks. Policy objective consists, among others, of reducing the dependence of firms on bank financing. Banks should be dissuaded from lending to projects, which in terms of risk-return profile are suitable only for venture capital. On the other hand, explicit restrictions should be imposed on bank borrowing by firms. Such a reduced relationship between lenders and borrowers constitutes an important objective of prudential banking regulation. Yet, reinforcement is needed, if the mutual dependence of bank lenders and corporate borrowers is to diminish. Needless to say, such a reduced relation is only possible if alternative financing sources are available, namely a more buoyant capital market. Debt-to-equity ratio needs to be explicitly capped at a certain multiple, for instance at two. Limit should also be imposed on bank debt as a fraction of total debt or as a multiple of equity. What needs to be closely monitored is not the relationship between a firm and all banks rather than individual banks. The share of a single borrower in total bank lending can also be subjected to a ceiling. Exceeding such a ceiling should be made conditional on public listing. Only borrowers who comply with the principles and rules of good corporate governance should be allowed to engage in largescale bank borrowing. Banks on their part should free themselves from the control of a majority owner. All commercial banks should be publicly-listed in the stock market. Banks, which are too small to do so should be amalgamated to larger banks. A ceiling should be imposed on the fraction of shares that a single owner is allowed to hold, for instance fifteen per cent. These measures look certainly anti-competitive in nature. However, Indonesia has clearly learnt that market friendliness alone is insufficient to nurture sustainable banking. As regards governance mechanisms, a great deal has been made part of the Company Law, Capital Market Law and Banking Law. However, two

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mechanisms need to be scrutinized carefully. The two-board system is clearly in need of reform. At issue is the working relationship between the board of commissioners and the board of directors. This relationship will have to be defined as precisely as possible as regards nomination of commissioners and directors and remuneration. Indonesia can consider strengthening the board of commissioners along the German system or moving to a single board system where the CEO is the only representative of management in the board and the CEO is not allowed also to serve as chairman of the board. Independence of the board is critical to its attitude toward good corporate governance. Of similar importance is remuneration. A tradition is being carved among Indonesia’s listed company to listen to expert voices before remuneration decision is made. Some have established a compensation committee, which may also ask expert opinion before putting recommendations to the board of commissioners. However, there is a more fundamental issue in director compensation. It has something to do with the risk that directors in general and the CEO in particular are exposing the firm to. Generally speaking, the higher is the risk exposure, the higher the profit. A risk-sensitive remuneration system needs to be found. Share option is one mechanism, which is used extensively in the United States. However, the mechanism is also vulnerable to abuses. Self interest may lead a CEO to a policy, which is primarily aimed at high share prices. Another alternative is a remuneration system that combines fixed income and performance-based bonus without share ownership. Restrictions should also be imposed on the involvement of directors in other firms, including firms that are owned by directors. In good times, such multiple directorship may not pose a serious problem. In bad times, directors may be tempted to engage in transfer pricing at the cost of small shareholders. It is impossible to touch upon the whole issue of corporate governance in a single chapter. Many of the issues have been discussed in earlier works. The fact is undeniable that more and more Indonesian politicians, bureaucrats, business owners and professionals, investors in the capital market, financial analysts, lawyers, accountants, and academicians have dealt with the issues of corporate governance. Corporate governance has become a standard entry in any policy discussion. People even tend to attribute too much to governance when analysing a firm’s success or failure. However, a very long distance stretches between the embracement of an idea and its consistent implementation. The primary concern about corporate governance reform in Indonesia has to do precisely with the gap between the spirit and letter of governance-related laws and regulations and implementation thereof. There may be a wide range of benefits that come along with good corporate

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governance. Such benefits have so far failed to impress the people that count in business. What is more, reliance on legal protection as a mechanism of good governance at a time when the record of law enforcement is very poor is unlikely to yield great results. Unfortunately, there is practically no way in which one can dispense well-enforced laws while seeking to push improvements in good corporate governance. References Bunkanwanicha, Pramuan, Jyoti Gupta, and Rofikoh Rokhim (2003) “Debt and Entrenchment: Evidence from Thailand and Indonesia”. Working Paper, ROSESCNRS, University Paris, ESCP-EAP European School of Management and TEAM-CNRS, University Paris, 15 September. Chaocharia, Vidhi, and Yaniv Grinstein (2004) “The Transformation of US Corporate Boards: 1997–2003”. Cornell University, March. Core, John E. Wayne Guay, and David F. Larcker (2002) “Executive Equity Compensation and Incentives: A Survey”. Working Paper, The Wharton School, University of Pennsylvania, 8 January. Dreher, Axel, Christos Kotsogiannis and Steve McCorriston (2004) “Corruption around the World: Evidence from a Structural Model”. Department of Economics, School of Business and Economics Working Paper. University of Exeter, 8 June. Hermalin, Benjamin E. and Michael S. Weisbach (2000) “Board of Directors as an Endogeneously Determined Institution: A Survey of the Economic Literature”. Working Paper. University of California at Berkeley and University of Illinois, June. Jensen, Michael C. and Kevin J. Murphy (2004) “Remuneration: Where We’ve Been, How We Got Here, What are the Problems, and How to Fix Them”. Finance Working Paper no. 44. Harvard Business School, Monitor Group and USC Marshall Business School. Kang, David C. (2002) “Transaction Costs and Crony Capitalism in East Asia”. Working Paper no. 02–11. Tuck School of Business at Dartmouth. Kenward, Lloyd R. (2004) “Survey of Recent Developments”. In Bulletin of Indonesian Economic Studies 40, no. 1: 9–35. Kurniawan, Dudi M., and Nur Indriantoro (2000) “The Role of Disclosure in Strengthening Corporate Governance and Accountability”. Paper presented to the Second Asian Roundtable on Corporate Governance, Hong Kong, China: OECD. Nam, Il Chong (2004) “Corporate Governance in the Republic of Korea and Its Implications for Firm Performance”. ADB Institute Discussion Paper no. 10, Tokyo: ADB Institute. Neeman, Zvika, Daniele Paserman and Avi Simhon (2003) “Corruption and Openness”. Working Paper, Department of Economics, Boston University,

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Department of Economics, Hebrew University of Jerusalem and Department of Agricultural Economics, Hebrew University of Jerusalem, August. Palepu, Krishna, Tarun Khanna and Joseph Kogan (2002) “Negotiation, Organization and Markets”. Harvard University Working Paper, Strategy Unit, Harvard University, August. Parker, Philip (2000) Physioeconomics: The Basis for Long-Run Economic Growth, Massachusetts: The MIT Press. Pierce, John R. (1980) An Introduction to Information Theory. Symbols, Signals and Noise. Second revised edition, New York: Dover Publications, Inc. Plomin, Robert, John C. Defries, Gerald E. McClearn and Peter McGuffin (2000) Behavioral Genetics. Worth Publishers Inc. Polinsky, Mitchell, A. and Steven Shavell (1998) “The Economic Theory of Public Enforcement of Law”. John Olin Programme in Law and Economics Working Paper no. 159, Stanford Law School. Republic of Indonesia (2004) Report on the Observance of Standards and Codes (ROSC). Corporate Governance Country Assessment. A joint World-Bank-IMF programme on Reports on the Observance of Standards and Codes (ROSC). Wang, Jian (2000) “Foreign Trading and Market Volatility in Indonesia”. Working Paper, School of Banking and Finance, University of New South Wales, December. Xu, Chenggang and Katharina Pistor (2003) “Law Enforcement Under Incomplete Law: Theory and Evidence from Financial Market Regulation”. The Centre for Law and Economic Studies Working Paper no. 222, New York: Columbia Law School.

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8 THE POLITICAL ECONOMY OF CORPORATE GOVERNANCE IN INDONESIA Andrew ROSSER

INTRODUCTION Over the past two decades, the Indonesian Government has introduced a wide range of changes to its corporate governance policies and institutions including adopting accounting and auditing standards based on international standards; enacting a new bankruptcy law; establishing a new commercial court; and publishing a national Code for Good Corporate Governance (CGCG) (Rosser 2003, pp. 331–32; Tas-Anvaripour and Reid 2003). Despite these changes, however, the country’s corporate governance system is widely regarded as one of the weakest in East Asia in terms of the protection that it affords to external investors. CLSA Emerging Markets, a securities firm that conducts annual assessments of the quality of corporate governance systems in ten East Asian countries, for instance, ranked Indonesia in last place in its 2002 and 2003 assessments (see Table 8.1). Similarly, McKinsey and Company (2002) found in a survey of investor opinion that investors were willing to pay a premium of 25 per cent on average for well-governed Indonesian companies — much more than for companies in most other countries — suggesting that, in investors’ eyes, well-governed Indonesian companies are rather rare. The World Bank (2003a, p. 22) has also been highly critical of the

8 8 8 7 6 9 7.5 4.5 6 4

Singapore Hong Kong India Taiwan Korea Malaysia Thailand China Philippines Indonesia

Source: World Bank (2003).

2002

Markets

8.5 8 8 7 7 9 7.5 5 6.5 4.5

2003

Rules and Regulations

7 6 5 5 3 2.5 2 3 2 1

2002 7.5 6.5 6 5 3.5 3.5 3 4 2 1.5

2003

Enforcement

5.5 7 6 5 4 3 3 5 2 5

2002 6 6.5 6 5 5 4 4 5 2 4

2003

Political and regulatory environment

9 9 6 7 7 6 5 7 6 4

2002 9 9 7.5 7 7 7 6 5 6 5

2003

Adoption of IGAAP

8 7 6 6 5 6 4 3 4 2

2002

8 7 6.5 6 6.5 6.5 4.5 3 4 2.5

2003

Institutional mechanisms and corporate governance culture

TABLE 8.1 Markets Ranked by Corporate Governance by Credit Lyonnais Securities Asia (CLSA)

7.4 7.2 5.9 5.8 4.7 4.7 3.8 4.4 3.6 2.9

2002

7.7 7.3 6.6 5.8 5.5 5.5 4.6 4.3 3.7 3.2

2003

Country score

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quality of corporate governance in Indonesia, arguing that while a number of other East Asian countries including Malaysia and South Korea have made significant improvements in corporate governance since the onset of the Asian crisis in 1997, Indonesia has lagged behind. More specifically, it says that there continue to be serious weaknesses with Indonesia’s system of corporate governance in areas such as the enforcement of laws and regulations, corporate transparency and disclosure, and the independence of independent directors. The purpose of this chapter is to try to explain why Indonesia has failed to develop a system of corporate governance over the past two decades that has gained the confidence of external investors and foreign donors. It suggests that this failure is best understood in terms of the nature of the main coalitions of interest in the country and the balance of power between them at particular points in time. More specifically, it suggests that this failure reflects the political and social dominance of a coalition of interest, consisting of the politico-bureaucratic elements that occupy the state apparatus and the owners of the major domestic conglomerates, that is opposed to greater corporate transparency and accountability to external investors. The dominance of this coalition over the past two decades, it is argued, has translated into serious weaknesses, not so much in the country’s corporate governance regulations, as in the enforcement or implementation of these regulations. In presenting this argument, the chapter begins with a discussion of the various perspectives that scholars and other commentators have put forward to explain the poor quality of corporate governance in Indonesia and an outline of an alternative perspective that emphasizes the structure of power and interest in that country. It then employs this perspective to explain weaknesses in two areas of Indonesia’s corporate governance system: financial accounting and bankruptcy. The final section of the chapter presents the conclusion. EXPLAINING POOR CORPORATE GOVERNANCE IN INDONESIA For some commentators, the poor quality of corporate governance in Indonesia has stemmed from the nature of Indonesian culture. Iu and Batten (2001, p. 59), for instance, have argued that many Asian countries (including Indonesia) have failed to develop corporate governance systems that reflect international norms (as articulated, for instance, in the OECD’s Principles of Corporate Governance) because they have lacked “an inherent culture of

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integrity”. A sounder system of corporate governance is only likely to emerge in Indonesia, they suggest, after there has been a fundamental shift in the mindset of the people in this country in relation to the value of corporate transparency and accountability. While such culturalist explanations for Asian economic phenomena are very popular in the international business and international law literatures, they are problematic in at least two ways. First, it is difficult to sustain the idea that Asian business people lack any more integrity than Western businesspeople in the wake of recent corporate scandals in the United States, Europe and Australia. Cases such as Enron, WorldCom and Parmalat make it clear that Western businesspeople are just as capable of corrupt and dishonest behaviour on a massive scale as Asian businesspeople. This point is reinforced by the fact that Asian businesspeople — particularly the ones that own or manage major business groups — are amongst the most Westernized people within their respective countries. Corruption and dishonesty may be less a part of Asian business culture than of business culture more generally. Second, culturalist explanations obscure the way in which political factors shape the development of corporate governance systems. Corporate governance systems are not neutral phenomena in political terms. As particular configurations of rules, regulations and enforcement mechanisms that govern “who makes investment decisions in corporations, what types of investments they make, and how returns from investments are distributed” (O’Sullivan 1999, p. 2), they embody particular political and social interests (Rosser 2003). This in turn means that corporate governance reform — and in particular the introduction and implementation of corporate governance regulations based on the Anglo-American model of corporate governance,1 the model that Western governments (particularly through the OECD) and the major international financial organizations have tried to promote in developing countries (O’Sullivan 1999; Singh et al. 2002; Soederberg 2003; Rosser 2003) — is a highly political process. It requires, not a shift in mindset, but a shift in the balance of power away from coalitions of interest that are opposed to corporate governance reform and towards coalitions that support corporate governance reform. Seen from this angle, a proper understanding of Indonesia’s problems with corporate governance requires an understanding of the nature of the main coalitions of interest within that country and the balance of power between them at particular points in time. Other commentators have argued that the poor quality of corporate governance in Indonesia has stemmed from a lack of institutional capacity

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in key financial sector regulatory agencies and the judicial system. Indonesia, they have argued, has introduced many of the regulations required to support a sound corporate governance system — while there may be some “gaps and loopholes” in these regulations and some regulations may need to be “modernized” (Capulong et al. 2000, p. 3), it is argued, the country’s corporate governance regulations are basically adequate (Capulong et al. 2000, p. 3; Economic Analytical Unit 2002, p. 93; Tas-Anvaripour and Reid 2003, p. 7). The problem is that the judicial system and key financial sector regulatory agencies such as Bapepam (the Capital Market Supervisory Agency) have been ineffective in enforcing these regulations. The Economic Analytical Unit of the Australian Department of Foreign Affairs and Trade (2002, p. 106), for instance, has argued that: “Throughout Indonesia, weak regulatory institution capacity and the courts impede the potential of new laws to strengthen corporate governance standards.” Similarly, Capulong et al. (2000, p. 3) have argued that poor implementation of corporate governance regulations in Indonesia (and a number of other countries in Asia) has stemmed largely from “ineffective” judiciaries, “widespread corruption” and a relative lack of “trained and qualified personnel for legal enforcement” in those countries. In focusing on issues of institutional capacity, this perspective gives greater attention to the role of politics in shaping corporate governance outcomes in Indonesia. But, like the culturalist perspective, it stills obscures the role of coalitions of interest in this process. For Capulong et al. and the Economic Analytical Unit, the lack of capacity within key financial sector regulatory agencies and the judicial system in Indonesia stems from a lack of adequately trained personnel, unclear and complicated administrative procedures, and widespread corruption within the bureaucracy and judiciary rather than the interests of the dominant coalition. Yet the dominant political and social interests in Indonesia have been crucial in determining the way in which institutions in that country have operated. Under the New Order, for instance, the judicial system was particularly effective in punishing the opponents of the politico-bureaucratic and corporate elite, but relatively ineffective in prosecuting senior government and military officials and business leaders for corruption. Similarly, key financial sector regulatory agencies were much more effective in calling to account small financial firms with weak political connections than those with strong political connections. Put simply, whether these institutions were strong or weak, effective or ineffective depended to a significant degree on what they tried to do, to whom they tried to do it, and how this affected the interests of the politico-bureaucratic and corporate elite.

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A final group of commentators has suggested that the poor quality of corporate governance in Indonesia reflects the country’s legal heritage and, in particular, the fact that, as a former Dutch colony, the country’s legal system has been strongly influenced by the civil law tradition rather than the common law tradition. La Porta et al. (1998), for instance, have presented evidence to suggest that common law countries generally provide stronger protection of outside investors’ interests than civil law countries and, in particular, French civil law countries (a category which by their definition includes the Netherlands and Indonesia). They argue that common law countries are generally better at protecting these interests than French civil law countries, both in terms of the content of their respective laws and regulations and their enforcement or implementation of these laws and regulations. They do not provide a precise explanation for why this is the case but speculate that it may be related to the extent to which historically states have intervened in their respective economies. States in civil law countries, they argue, have historically been more interventionist than states in common law countries and have consequently tended to provide lower levels of protection to private property. The relatively weak protection of the rights of outside investors in civil law countries, they suggest, “may be one manifestation of this general phenomenon” (La Porta et al. 2000, pp. 9–12). Like the other approaches discussed above, this approach obscures the role that coalitions of interest have played in shaping the development of Indonesia’s system of corporate governance. La Porta et al. (2000, p. 12) acknowledge that political factors have shaped the nature of countries’ legal systems and hence their corporate governance systems. Yet they appear to have a very limited understanding of what politics involves. In their view, politics appears to be about degrees of state intervention in the economy rather than about conflicts between competing sets of interests. As such, they tell us little about how such interests have shaped the development of Indonesia’s corporate governance system or, for that matter, any other country’s corporate governance system. Argument In contrast to these perspectives, it is argued here is that the poor quality of corporate governance in Indonesia is best understood as the outcome of a struggle between two main coalitions of interest. The first of these has consisted of the international financial institutions (IFI)s, Western governments and controllers of mobile capital and has been represented within the Indonesian Government by the technocrats in the Ministry of

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Finance, the central bank, and various other government economic departments and agencies. This coalition has been broadly supportive of the adoption of regulations associated with the Anglo-American model of corporate governance and their implementation. To their advantage, these forces have been able to exercise considerable structural leverage over the Indonesian Government. The World Bank and Asian Development Bank (ADB), for instance, have incorporated corporate governance-related measures into their lending programmes for the country and made it clear that future lending is contingent on improved governance. The World Bank was a particularly important donor in the area of corporate governance prior to the onset of the Asian crisis in 1997 but it has been the ADB that has taken the lead in this area since the crisis. The IMF made the introduction of various corporate governance reforms a feature of its rescue programme for the country following the onset of the crisis in 1997 and demonstrated a willingness to withhold funds from the government if its policy demands were not met (Rosser 2003). Mobile capital controllers have effectively used their structural leverage in concert with that of donors. This can be seen, for instance, in the role of Standard and Poor’s (S&P), the credit rating agency, and CLSA Emerging Markets, a leading securities firm, in issuing corporate governance “scores” for major companies in key Asian markets (Standard and Poor’s 2004; Gill 2001). In assessing the quality of these companies’ corporate governance and attributing scores, S&P and CLSA Emerging Markets have drawn upon the OECD’s conception of good corporate governance as outlined in its Principles of Corporate Governance, the template that the World Bank and ADB have sought to promote.2 Insofar as investors have utilized these scores in making their investment decisions, donors’ conception of good corporate governance has served as “a veritable disciplinary mechanism” for countries within the region (Soederberg 2003: 15). Fluctuations in flows of mobile capital into the country — particularly portfolio capital — have effectively acted as a signal of mobile capital controllers’ approval of/displeasure with Indonesia’s corporate governance policies and practices. Stock market downturns in the wake of corporate scandals involving companies on the Jakarta Stock Exchange (JSX), as have occurred on several occasions since stock market deregulation in the late 1980s, have increased structural pressure on the state to improve corporate governance standards. The second coalition of interest has consisted of the politico-bureaucrats who occupy the state apparatus and the owners of the country’s major domestic conglomerates. While the members of this coalition have been willing to accept the introduction of certain Anglo-American style corporate

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governance regulations, particularly at times of economic crisis such as the mid-1980s and the late 1990s, they have resisted attempts to implement these regulations. The wealth of Indonesia’s corporate elite has derived in large part from their ability to secure privileged access to state facilities through corruption, collusion and nepotism. As the controllers of government policy and its implementation, the politico-bureaucrats have played a key role in facilitating their access to these facilities, usually in exchange for some sort of material or other reward. Both groups have stood to lose much from corporate governance reforms that lead to greater corporate transparency and accountability to outsider investors. Greater transparency would mean greater risk that the corruption, collusion and nepotism in which they have been engaged will be exposed and that they will either be prosecuted or at least lose the benefits of this activity. And increased accountability to outside investors would mean reduced control over the corporate empires that they have built together and access to the rents that these empires generate. Under Suharto’s New Order, the conflict between these two coalitions of interest over the nature of the country’s corporate governance system, and in particular the implementation of corporate governance reforms, was generally settled in favour of the politico-bureaucrats and the owners of the major domestic conglomerates. The collapse of international oil prices in the mid1980s shifted the balance of power in relation to economic policymaking away from the politico-bureaucrats and the owners of the major domestic conglomerates towards mobile capital controllers, Western governments and the IFIs by dramatically increasing the country’s need to attract financial capital and foreign aid to fuel the development of non-oil export industries and improve the government’s fiscal position (Rosser 2002, p. 46). Within this context, the technocrats were able to push through the deregulation of the country’s capital market and, subsequent to that, a range of changes to the country’s corporate governance regulations that were broadly consistent with the Anglo-American model of corporate governance. But the politicobureaucrats and conglomerate owners were able to maintain their control over the state apparatus — and in particular the judiciary and key financial sector regulatory agencies — through the late 1980s and most of the 1990s. The government’s electoral vehicle, Golkar — which embodied their interests — continued to win elections and, despite evidence of growing opposition to Suharto’s rule within sections of the military, his position as president remained secure. With control over the state apparatus, the politico-bureaucrats and the conglomerates were able to ensure that the process of corporate governance reform did not go so far as to seriously threaten their interests (Rosser 2003, p. 327). In particular, they were able to ensure that many of the regulatory

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changes that were introduced during this period of time effectively failed in implementation. Since the onset of the Asian crisis, the structural leverage of mobile capital controllers, the IFIs and Western governments over the Indonesian Government has increased significantly. With the government desperate to attract investment and foreign aid into the country, they have been able to exert enormous pressure on the government to improve the country’s business climate by improving corporate governance. The IMF and the Asian Development Bank have been particularly vocal in this respect, arguing that poor corporate governance was a principal cause of the crisis and that corporate governance reform is needed to support economic recovery (Capulong et al. 2000). But while this pressure has led to the introduction of numerous further changes to Indonesia’s corporate governance regulations, the politicobureaucrats and the owners of the major conglomerates have remained sufficiently powerful to frustrate many reform initiatives (Robison and Hadiz 2004; Hadiz 2003). The politico-bureaucrats, for instance, have retained much of their control over the policymaking process, notwithstanding the general shift in power away from the bureaucracy to the parliament as a result of democratization. Although the parliament now exercises an effective veto over government policy, it lacks the administrative, research and technical capacity to take full advantage of its authority to draft and initiate legislation. The bureaucracy, which is much stronger in terms of its administrative, research and technical capacity, continues to play the key role in this respect (Sherlock 2003). It also continues to formulate the various regulations, decrees, and other official policy decisions that allow enacted laws to be implemented. Although parliament is formally able to override these, its limited capacity means that it can only do so infrequently. In addition, politico-bureaucrats are reportedly able to influence parliamentary decisions through bribery and corruption. This is particularly the case in relation to the various commissions within parliament in which much parliamentary debate over policy issues occurs and recommendations for parliamentary action are initially brokered. It is widely believed that decisions in these commissions are regularly bought, especially those with a close relationship to “wet” ministries and agencies including the Ministry of Finance, the Ministry of Forestry and the Ministry for Mines and Energy (Indonesia Corruption Watch 2002, p. 24; Sherlock 2003). Similarly, many leading business people have retained effective control over their corporate empires, notwithstanding the fact that many of their companies became technically insolvent as a result of the economic crisis. While many of these people have been forced to surrender majority equity

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stakes in their companies to the Indonesian Bank Reconstruction Agency (IBRA) to settle debts incurred by their banks as a result of using Bank Indonesia liquidity credits in the early stages of the crisis, this has not necessarily meant losing management control over these companies. Although IBRA has assumed ownership of these companies, it has not had the capacity to manage them, forcing it in many cases to rely on the previous owners and managers to maintain them as going concerns. This in turn has left the previous owners and managers well placed to frustrate IBRA’s attempts to sell its shares in these companies to new foreign or domestic investors. The result has been that in a number of cases IBRA has been unable to sell its stakes in these companies. In other cases, it widely believed that IBRA has sold its equity stakes back to the original owners at a discount (Robison and Hadiz 2004, pp. 187–222). At the same time, both the politico-bureaucrats and the conglomerate owners have been able to reinvent themselves politically through new alliances and vehicles (Hadiz 2003, p. 593). Their continued influence in the political arena can be clearly seen, for instance, in the Indonesian Democratic Party of Struggle (PDI-P), the party headed by Megawati Sukarnoputri that “won”3 the 1999 national elections. While several leading figures in this party, such as Kwik Kian Gie, Laksamana Sukardi and Megawati herself, were members of the opposition under the New Order, many others were drawn from the senior ranks of the military, leading business groups, or even the New Order’s electoral vehicle, Golkar — in other words, from the dominant political and social forces under the New Order. With Golkar continuing to be an important party at both the national and local levels in the post-Suharto era, the political and social elements that dominated the New Order have retained significant influence. The recent victory of Susilo Bambang Yudhoyono, a former senior military official, in the 2004 presidential elections has merely reinforced this trend, notwithstanding his claims during the election campaign to be proreformasi. Within this context, there have continued to be serious problems with the implementation of Indonesia’s corporate governance regulations, as we will see in the cases below. THE POLITICAL ECONOMY OF CORPORATE GOVERNANCE REFORM IN INDONESIA SINCE THE MID-1980S: TWO CASES Case Study I: Financial Accounting Reform Prior to the mid-1980s, Indonesia’s accounting regulations were quite weak by international standards. In the early 1970s, Bank Indonesia, the central

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bank, and the Indonesian Accounting Association (IAI), the professional accounting body, produced Indonesia’s first set of accounting standards, known as Indonesian Accounting Principles (PAI). As Prawit (1988) has pointed out, the PAI was a compilation of basic accounting principles, practices, methods and techniques that were intended to address general accounting issues rather than provide detailed prescriptions for accounting practice. At the same time, the PAI did not have legislative backing — Indonesia’s company law at that time simply required that “adequate accounts” be kept (World Bank 1993). For this reason, and because the PAI permitted companies to refer to other countries’ accounting regulations where the PAI did not deal with a particular accounting issue, companies had enormous latitude in the way in which they accounted for their financial affairs (Rosser 2003). Following the collapse of oil prices in the late 1980s, however, the balance of power between the politico-bureaucrats and the conglomerates, on the one hand, and mobile capital controllers, the IFIs, and Western governments, on the other, shifted in favour of the latter, creating political conditions more favourable to accounting reform. Within this context, the technocrats were able to push through a range of important accounting regulatory changes as part of their attempts revive the capital market. Despite the boom in the capital market that occurred following deregulation, it soon became clear to the technocrats that mobile capital controllers would only keep investing in the capital market in the medium to long term if its regulatory infrastructure was brought up to international standard. This structural pressure translated into the introduction of several significant accounting regulatory changes during this time including the adoption of a new set of financial accounting standards based on IASs (known as PSAKs) to replace the PAI, the provision of legal backing for these standards in the government’s new Companies Code, and the introduction of a specific prohibition on publicly-listed companies providing untrue or misleading information to the public (Rosser 2003, pp. 325, 328). Yet implementation of these new regulations was poor, reflecting the continued political dominance of the politico-bureaucrats and the major conglomerates. During the capital market boom, there were a number of accounting and auditing scandals involving well-connected listed business groups that raised questions about the effectiveness of Indonesian auditors and regulatory agencies such as Bapepam in ensuring adequate transparency and disclosure on the part of Indonesia’s conglomerates. Even auditing work performed by the domestic affiliates of the large international auditing firms was called into question, particularly, that by the local arms of Arthur

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Andersen, Deloitte and Touche, and KPMG, the preferred auditors for most large conglomerates and state-owned enterprises.4 The Ministry of Finance had the authority to impose administrative sanctions on auditing firms but not to launch legal proceedings against them and so was limited in what it could do about poor auditing. In any case, there were significant political obstacles to taking action against the domestic affiliates of the international auditing firms. Neither the conglomerates nor their politico-bureaucratic patrons had any interest in seeing doubts raised publicly about the quality of the former’s financial reports. At the same time, the major auditing firms — particularly Arthur Andersen — cultivated strong links within the Ministry of Finance, affording them a degree of political protection (Backman 2002). Finally, the fact that the politico-bureaucrats exercised considerable influence over the judiciary, the prosecutors’ office, and the police force, and these actors were susceptible to bribery by private businesspeople meant that there was little scope for successful prosecution of auditors. Consequently, few Indonesian auditors were prosecuted or suspended for negligence, incompetence or corruption during this period. The onset of the Asian economic crisis in 1997 created political space for the introduction of further accounting reforms. The massive capital flight that occurred in Indonesia during 1997–98 signalled mobile capital controllers’ concern about corporate governance standards in Indonesia (amongst other things). At the same time, the government’s decision to call in the International Monetary Fund (IMF) to help it manage the crisis in late 1997 significantly increased that organization’s leverage over the government. Within this context, the technocrats were to able to push forward the process of accounting reform in Indonesia. Although accounting reform was not particularly high on either of the IMF’s or the technocrats’ respective agendas — they were more concerned, at least during the first year or so of the crisis, about stemming haemorrhaging in the banking system, reducing inflation, and bringing an end to the system of cronyism, corruption and nepotism constructed by Suharto — they nevertheless included it in the programme of reforms agreed between the government and the IMF. The July 1998 IMF Letter of Intent, for instance, committed the government to review the country’s accounting and auditing standards with a view to making them consistent with international standards. At the same time, the World Bank and the Asian Development Bank were also to emphasize the need for further reform of the country’s accounting regulations and to make funds available to assist the government in revising the country’s accounting and auditing standards to ensure greater conformity with international standards. Combined together, the efforts of these actors were

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to lead to a dramatic increase in the number of PSAKs. Moreover, according to a recent review of Indonesia’s accounting system, these standards are not just consistent with international norms, but compare favourably with those of most other countries in the region (Tas-Anvaripour and Reid 2003, pp. 101, 106). Despite these reforms, however, the continued power and influence of the politico-bureaucrats and the conglomerate owners has meant that there has continued to be serious problems vis-à-vis implementation of accounting regulations. In contrast to the U.S. government’s response to recent accounting scandals involving Enron, WorldCom, and Xerox, the Indonesian Government has not launched any major court cases against Indonesian auditors for their part in accounting scandals. During 2000, the Agency for Financial and Development Supervision (BPKP) launched an investigation into auditors who had given clean bills of health to Indonesian banks that had subsequently had their operations frozen following the onset of the crisis. But whilst this investigation found that several auditors had failed to adhere to Indonesian accounting standards in conducting their audits, the government took little action against them. The auditors concerned were sent “warning letters” rather than fined or prosecuted and the auditing firms for which they worked were not penalized in any way (Gatra, 19 April 2001; Koran Tempo, 28 April 2001). Part of the difficulty here appears to have been that key regulatory agencies, particularly the central bank, lacked the legal authority to sanction these auditors and it thus fell to the IAI to take action against them. As one commentator has pointed out, the IAI is hardly independent in these matters — the judicial board that considers violations of accounting rules consists of representatives from accounting firms — so it was always unlikely that these auditors would be severely punished (Jakarta Post, as quoted in Tas-Anvaripour and Reid 2003, p. 84). At the same time, however, the continuation during the post-Suharto period of close relationships between private business and government officials and influence-peddling and corruption within the judiciary means that the political obstacles that prevented sound implementation of accounting regulations — and, in particular, the prosecution of corrupt or negligent auditors — during the Suharto years remain. Over the past couple of years, the government has introduced two measures that suggest that it may be tougher on corrupt or negligent auditors in the future. In 2002, following the introduction of the Public Accounting Reform and Investor Protection (Sarbanes-Oxley) Act in the United States (the U.S. Government’s legislative response to the Enron and other accounting scandals), Indonesia’s Minister of Finance issued a decree

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on Public Accountant Services that tightened public accountant licensing requirements and procedures, mandated periodic audit partner rotation and audit firm rotation, required periodic quality reviews of public accounting firms, and specified sanctions for infringement of the decree (Tas-Anvaripour and Reid 2003 pp. 44–45). At the same time, with support from the ADB, the government has prepared a draft law on the accounting profession that, if passed by parliament, will open the way for criminal prosecution of auditors that deliberately misrepresent or misstate information in financial reports (Jakarta Post, 5 July 2002). While such regulatory changes will make it easier for legal action to be taken against auditors where the political will exists, the fact that the politico-bureaucrats and the conglomerate owners continue to have significant political influence and in particular significant influence over the judiciary will mean that such political will is unlikely to emerge often. Case Study II: Bankruptcy Reform Under the New Order, Indonesia’s bankruptcy system provided little protection to creditors. The country’s bankruptcy legislation during this period, which was based on a Dutch colonial ordinance from the early years of the twentieth century, was formally pro-creditor in orientation insofar as it emphasized the liquidation rather than the reorganization of distressed debtors. However, as Linnan (1999, p. 112) has observed, “its enforcement through the court system was so poor that only 120 bankruptcy cases were brought during the five years preceding the enactment of the [1998-AR] emergency law”. As a result, rather than pursue distressed debtors through the courts, creditors preferred to work out difficulties with such debtors informally outside the court system (Cartwright and Boggs 1998, p. 13). Such a system clearly served the interests of the major domestic conglomerates and their politicobureaucratic patrons, and reflected their political dominance under the New Order. In the absence of an effective bankruptcy system, the major domestic conglomerates could avoid or delay repaying debts, particularly to state banks, without necessarily limiting their access to credit. While their political connections and the corrupt nature of lending processes at state banks enabled them to access generous amounts of state bank credit, often at subsidised rates, they could also tap into various private sources of credit. Many of them owned private domestic banks, effectively giving them inhouse sources of credit. Many of them were also able to borrow from international lenders that were willing to accept the risks stemming from the fact that the country’s bankruptcy system was weak in exchange for a higher

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return than they would have received by lending to companies in countries with stronger bankruptcy systems. With the onset of the Asian crisis in 1997, pressure mounted for the Indonesian Government to construct a more effective bankruptcy system. The collapse of the Indonesian currency in 1997–98 dramatically increased the rupiah value of the conglomerates’ foreign currency debts, forcing many of them to default on repayments. This in turn had serious consequences for international lenders, particularly in Japan where several major banks were highly exposed to Indonesian companies (Asian Wall Street Journal, 14 January 1998). The collapse of Hong Kong-based Peregrine Investment Holdings Ltd. in early 1998 because of bad loans to Indonesian companies illustrated the serious consequences of the situation for some lenders (Jakarta Post, 14 January 1998). In many cases, Indonesian conglomerates not only stopped repayments on their debts but also refused to negotiate debt settlement agreements with their creditors. Within this context, the IMF began pushing the Indonesian Government to reform the country’s bankruptcy system (Lindsey 1998, p. 119). As Linnan (1999, p. 112) has noted, the intended purpose of this reform was to force Indonesian debtors to deal with their foreign creditors. With the government desperate to stem capital flight and secure the IMF’s assistance, it had little room to manoeuvre. In April 1998, it issued Government Regulation in Lieu of Law (Perpu) No. 1/1998 to amend the country’s bankruptcy legislation and establish a new commercial court. This regulation became effective on 20 August 1998. Since its creation, however, the new bankruptcy system has proven ineffective as a means for resolving unpaid corporate debts. Within weeks of the establishment of the new commercial court, questions were already being raised about the quality of its decisions (Far Eastern Economic Review, 22 October 1999). Roughly thirty bankruptcy cases were filed with the court in 1998 and approximately one hundred per year were filed in 1999 and 2000. But very few of these cases were successful. According to George Fane (2000, p. 35), creditors only won about twenty per cent of all cases they brought against Indonesian companies, far fewer than they should have according to a number of commentators (see, for instance, Asiaweek, 31 March 2000). Even the Indonesian Bank Restructuring Agency (IBRA), which became the country’s major domestic creditor after taking over dozens of insolvent banks during the crisis, has reportedly had difficulty in securing favourable decisions from the court. More recently, the World Bank (2003a, p. 45) has suggested that the problem with the court is less the quality of its decisions in general than its decisions in particular “high-profile” cases: A recent study of commercial court decisions by a team including experienced

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foreign lawyers, it says, found that “up to 70 per cent of the commercial court decisions could be characterized as good law”. The government has introduced a variety of changes to the court’s operation to improve its credibility in creditors’ eyes such as appointing outside ad hoc judges, publishing all decisions, and introducing a mandatory code of ethics. Nevertheless, foreign creditors appear to have lost confidence in the court — since 2000, the number of bankruptcy cases that the court has handled has dropped from around a hundred to around thirty to forty per year (World Bank 2003b, p. 46; 2003a, p. 34). The problem for creditors has been that recalcitrant Indonesian debtors have reportedly been able to influence commercial court judges through bribery and intimidation. While the formal character of the bankruptcy system has changed, the nature of the Indonesian judiciary and its relationship to powerful businesspeople appear to have changed very little. In this respect, it is instructive to note that the commercial court has earned plaudits from foreign business groups for its decisions in intellectual property cases (Tahyar 2004; Jakarta Post, 16 March 2004). As I have argued elsewhere (Rosser 2002), large conglomerates have generally not been involved in the production of counterfeit goods, except in the pharmaceuticals industry where a few have had modest interests. It has thus been relatively easy in political terms for the government to introduce legislation prohibiting or reducing the scope for the production of counterfeit goods and for courts to find against Indonesian companies in intellectual property cases. This appears to be the case for the commercial court as well. Where the stakes for powerful Indonesian conglomerates are relatively low, as they are in intellectual property cases, the commercial court is able to produce decisions that favour foreign business interests. This strongly suggests that the commercial courts’ decisions in bankruptcy cases reflect less the technical ability of the judges and other factors related to institutional capacity than the structure of power and interest in which the court is located. CONCLUSION Indonesia’s system of corporate governance has clearly undergone substantial change since the mid-1980s, at least in terms of the formal laws and regulations that govern corporate governance practices within the country. Indonesia now has a set of accounting standards based on IASs, a “modern” bankruptcy law, regulations that protect minority shareholder interests by giving them veto authority over corporate takeovers and by providing for independent directors on company boards, and various other regulations

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that are broadly consistent with the Anglo-American model of corporate governance (Rosser 2003). Yet, the introduction of these regulations has clearly not been enough to generate confidence among mobile capital controllers and foreign donors in the country’s system of corporate governance. Although these regulatory changes have increased protection of mobile capital controllers’ interests on paper, implementation of these changes has been weak. This has reflected the political dominance of the politico-bureaucrats and their corporate clients, elements that are threatened by greater corporate transparency and accountability, during this period. In particular, it has reflected their ability to influence the operation of key financial sector regulatory agencies and the judicial system. As long as these elements remain powerful, it is difficult to envisage any improvement in the implementation of these regulations and, in turn, the extent to which the interests of mobile capital controllers are protected, not just on paper, but in practice as well. Notes 1. The Anglo-American (or outsider) model of corporate governance is generally defined as having the following features: a high reliance on equity finance; dispersed ownership; strong legal protection of shareholders, including minority shareholders; strong bankruptcy regulations and courts; little role for creditors, employees and other stakeholders in company management; strong requirements for disclosure; and considerable freedom to merge or acquire. It is generally distinguished from the “insider” model characteristic of Japan, Germany, and many East Asian countries. In contrast to the Anglo-American model, the insider model is seen as being characterized by a high reliance on bank finance; concentrated ownership; weak legal protection of minority shareholders; a central role for stakeholders (for example, creditors and employees) in the ownership and management of companies; weak disclosure; and limited freedom to merge or acquire (Rosser 2003, p. 319–20). 2. CLSA Emerging Markets’ corporate governance scores, for instance, are based on an assessment of fifty-seven issues under seven main categories. Six of these categories draw on the Anglo-American model of corporate governance — management discipline, transparency, accountability, responsibility, fairness, and independence. The final category “social awareness” is perhaps more closely associated with the “stakeholder” systems of corporate governance characteristic of Japan and Germany. The issues assessed under the “social awareness” category include whether or not a company employs under-aged people, has an explicit equal opportunity policy, and invests in countries where leaders lack legitimacy (for example, Myanmar). Yet, in calculating a company’s overall corporate governance score, CLSA Emerging Markets gives much greater weight to the

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first six categories than the “social awareness” category — a company’s score under “social awareness” only accounts for 10 per cent of its overall corporate governance score while its scores under the other categories account for 15 per cent each of its overall score, or 90 per cent in total. Furthermore, two particular issues closely related to minority shareholder interests — whether company executives have made decisions that have favoured themselves over shareholders, and whether executives have made any decisions that have favoured majority shareholders over minority shareholders — are given relatively high weights within the independence and fairness categories. The effect of this approach is to bias the overall score in favour of the concerns of outside/minority investors and establish those elements of corporate governance associated with the AngloAmerican model as the dominant criteria for assessing corporate governance quality. For an outline of CLSA Emerging Markets’ ratings system, see Gill (2001, pp. 8–12). 3. The PDI-P secured 34 per cent of the vote, more than any other party but not an outright majority. 4. Interviews with informed parties. See also Backman (1999, pp. 42–51). According to Hasan Zein Mahmud (1996, p. 62), President Director of the Jakarta Stock Exchange Company between 1992 and 1996, the local affiliate of Arthur Andersen audited the books of roughly 50 per cent of Indonesian companies that went public between 1992 and 1996, and the local affiliates of Deloitte Touche and KPMG roughly 28 per cent and 11 per cent of these companies respectively.

References Backman, M. (1999) Asian Eclipse: Exposing the Dark Side of Business in Asia. Singapore: John Wiley and Sons. ——— (2002) “What Does an Auditor’s Report Mean in Asia”. The Age, 11 April. Capulong M., D. Edwards, D. Webb and J. Zhuang (2000) Corporate Governance and Finance in East Asia: A Study of Indonesia, Republic of Korea, Malaysia, Philippines and Thailand — Volume One: A Consolidated Report. Manila: Asian Development Bank. Cartwright, R. and C. Boggs (1998) “New Indonesian Bankruptcy Rules Mark First Step”. International Financial Law Review (September): 12–16. CLSA Emerging Markets (2003) “CIO Notes: Investment Summary: CG Watch”, April. Economic Analytical Unit (2002) Changing Corporate Asia: What Business Needs to Know. Canberra: Department of Foreign Affairs and Trade. Fane, G. (2000) “Survey of Recent Developments”. Bulletin of Indonesian Economic Studies 36, no. 1 (April): 13–44. Gill, A. (2001) “Saints and Sinners, Who’s Got Religion?”. CLSA Emerging Markets Report.

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Hadiz, V. (2003) “Reorganizing Political Power in Indonesia: A Reconsideration of So-Called ‘Democratic Transitions’”. Pacific Review 16, no. 4: 591–611. Indonesia Corruption Watch (2002) Corruption Outlook 2002: Korupsi Gotong Royong: Mewujudnya Perlindungan Politik Bagi Koruptor. Jakarta: Indonesia Corruption Watch. Iu, J. and J. Batten (2001) “The Implementation of OECD Corporate Governance Principles in Post-Crisis Asia”, Journal of Corporate Citizenship 4 (Winter): 47– 62. La Porta, R., F. Lopez-de-Silanes, A. Shleifer, and R. Vishny (1998) “Law and Finance”. Journal of Political Economy 106, no. 6: 1113–53. ——— (2000) “Investor Protection and Corporate Governance”. Journal of Financial Economics 58: 3–27. Lindsey, T. (1998) “The IMF and Insolvency Law Reform in Indonesia”. Bulletin of Indonesian Economic Studies 34, no. 3 (December): 119–24. Linnan, D. (1999) “Insolvency Reform and the Indonesian Financial Crisis”. Bulletin of Indonesian Economic Studies 35, no. 2 (August): 107–37. Mahmud, H. (1996) “Persepsi Masyarakat Tentang Profesi Akutan”. Paper presented at the Konvensi Nasional Akuntansi, Semarang, 12–13 September. McKinsey and Company (2002) “Global Investor Opinion Survey: Key Findings”. WWW document, available at URL: , July. O’Sullivan, M. (1999) “Corporate Governance and Globalisation”. INSEAD Working Paper. Fontainebleau: INSEAD. Prawit, Ninsuvannakul (1988) “The Development of the Accounting Profession of the ASEAN Countries: Past, Present and Future”. In Recent Accounting and Economic Developments in the Far East, edited by V. Zimmerman. Urbana-Champaign: Centre for International Education and Research in Accounting. Robison, R. and V. Hadiz (2004) Reorganising Power in Indonesia: The Politics of Oligarchy in an Age of Markets. London: Routledge Curzon. Rosser, A. (2002) The Politics of Economic Liberalisation in Indonesia: State, Market and Power. Richmond: Curzon. ——— (2003) “Coalitions, Convergence, and Corporate Governance Reform in Indonesia”. Third World Quarterly 24, no. 2: 319–37. Sherlock, S. (2003) “Struggling to Change: The Indonesian Parliament in an Era of Reformasi”. Canberra: Centre for Democratic Institutions. Singh, A., A. Singh and B. Weisse (2002) “Corporate Governance, Competition, the New International Financial Architecture and Large Corporations in Emerging Markets”. ESRC Centre for Business Research, University of Cambridge, Working Paper no. 250. Soederberg, S. (2003) “The Promotion of ‘Anglo-American’ Corporate Governance in the South: Who Benefits From the New International Standard”. Third World Quarterly 24, no. 1: 7–27.

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Standard and Poor’s (2004) “Corporate Governance Scores — Frequently Asked Questions”. WWW document, available at URL: , downloaded 20 July 2004. Tahyar, B. (2004) “Shoring Up the Banyan Tree: Politics, Law and Legal Reforms in Indonesia”. Paper presented at the School of Oriental and African Studies, London, 11 May. Tas-Anvaripour, N. and B. Reid (2003) Diagnostic Study of Accounting and Auditing Practices in Indonesia. Manila: Asian Development Bank. World Bank (1993) Indonesia: Sustaining Development. Washington D.C.: World Bank. ——— (2003a) Indonesia Development Policy Report: Beyond Macroeconomic Stability. Washington D.C.: World Bank. ——— (2003b) Indonesia: Maintaining Stability, Deepening Reforms. Washington D.C.: World Bank.

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9 BUILDING GOOD CORPORATE GOVERNANCE AFTER THE CRISIS The Experience of Thailand Deunden NIKOMBORIRAK

INTRODUCTION Seven years have passed since the financial crisis in Thailand broke out in July 1997. During these years, thanks to the efforts of both local and international organizations, the concept of “good governance” has gradually permeated into the Thai society and has become almost a “mantra” when one talks about institutional reforms. Today, governance is among the key indicators of any public/private performance evaluation scheme and any respected businessperson would advocate and practice good corporate governance. In 2002, the current government of Prime Minister Thaksin has established a National Corporate Governance Committee chaired by himself or a designated deputy prime minister. The committee is responsible for overseeing work related to corporate governance in order to ensure that governance standard among listed companies in Thailand are comparable with international benchmarks. Although the committee still has to prove whether there is substance over form, its establishment does illustrate that corporate governance is at the central of a policymaker’s mind.

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That being said, various governance problems in the Thai corporate sector remain. This chapter examines the approaches and measures taken to improve corporate governance among listed companies in Thailand since the break out of the economic crisis in 1997. It also assesses the success or failure of these approaches or measures. The second section briefly describes the corporate ownership structure and governance problems among Thai corporations. The third section examines the approach and the initiatives taken by the state and other private organizations to address these problems and evaluates them. The fourth section addresses the bigger picture, the economic and political environment that may pose obstacles to the attainment of good corporate governance. The final section summarizes the lessons learned. THE FACE OF THE THAI CORPORATE SECTOR AND ITS GOVERNANCE Corporate Ownership The management of Thai business — pioneered by families of Chinese merchants — has been predominantly family-run. Many of such families have prospered and built their empires that cut across many sectors, in particular, banking, finance and securities, agro-industry, retail and telecommunications. When these family-run businesses become listed, the founder often keeps a controlling share within his/her family. As a result, the company is publicly owned in name, and privately run in practice. According to a study by the World Bank1 traced the origins of large shareholders in listed companies in several Asian countries, including Thailand as can be seen in Table 9.1. The result reveals that 62 per cent of the surveyed companies listed in the SET were controlled by a single family — that is, the family’s aggregated equity holding exceeded 20 per cent of total shares. Only 7 per cent of the companies were widely held by the public. This figure is lower than Indonesia and Malaysia, but higher than Singapore, the Philippines, Japan and Korea. The same study also shows that family shareholding in Thailand is not complex. Cross-holdings and pyramid schemes are rare in Thailand compared with other Asian countries included in the survey. As a result, the ratio of cash flow to voting rights for listed companies in Thailand is as high as 0.941, the highest in the samples covered by the study as shown in Table 9.2.

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TABLE 9.1 Control of Publicly Traded Companies in East Asia

Country Hong Kong Taiwan Korea Japan Indonesia Malaysia Singapore Philippines Thailand

No. of corporations surveyed

Widely held

Family

330 141 345 1,240 178 238 221 120 167

7.0 26.2 43.2 79.8 5.1 10.3 5.6 19.2 6.6

66.7 48.2 48.4 9.7 71.5 67.2 55.4 44.6 61.6

State

Widely held financial

Widely held corporations

14.4 2.80 1.6 0.8 8.2 13.4 23.5 2.1 8.0

5.2 5.3 0.7 6.5 2.0 2.3 4.1 7.5 8.6

19.8 17.4 6.1 3.2 13.2 6.7 11.5 26.7 15.3

Source: Claessens, Stijn, Simeon Djankov, and Larry Pang (2000) “The Separation of Ownership and Control in East Asian Corporations”, Journal of Financial Economics 58: 81–112.

TABLE 9.2 Separation of Ownership and Control in East Asia Country Hong Kong Taiwan Korea Japan Indonesia Malaysia Singapore Philippines Thailand

Ratio of Cash flow to voting rights

Pyramids with ultimate owners

Cross-holdings

0.882 0.832 0.858 0.602 0.784 0.853 0.794 0.832 0.941

25.1 43.3 62.6 36.4 66.9 39.3 55.0 40.2 12.7

9.3 8.6 9.4 11.6 1.3 14.9 15.7 7.1 0.8

Source: Claessens, Djankov, and Pang (2000).

To track more recent changes in corporate ownership, the author examined the average equity share of the top five shareholders in the 150 largest companies listed in the Stock Exchange of Thailand (SET) in 1999 and 2002. Table 9.3A indicates that the average shareholding of the top five largest shareholders increased from 9.42 per cent to 10.38 per cent during the three years. The increase can be contributed mainly to the rise in the average shareholding of foreign banks and nominees, private companies and individuals that more than compensated the fall in the average shareholding of banks and

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TABLE 9.3A Weighted* Average Ownership Share of Top Five Largest Shareholders among 150 Largest Listed Thai Companies, 1999 and 2002 Type of Investor

1999

2002

Foreign banks and Domestic banks Insurance Finance & securities Private companies Individual Government

0.60 0.42 0.28 0.28 4.80 1.15 1.89

0.88 0.18 0.05 0.29 4.93 2.11 1.91

Total

9.42

10.35

* Weighted by market capitalization. Source: Author’s calculations from Stock Exchange of Thailand data on listed companies

insurance companies. This reflected the fact that banks have been able to shed off their equity shareholding in listed companies accumulated from debtequity swaps that took place after the crisis. This is in compliance with the Commercial Bank Act that forbids a bank to hold more than 10 per cent equity share in any registered company. Due to the financial hardship, insurance companies were also forced to divest from the stock market. On the contrary, many business families were able to regain financial strength five years after the crisis and thus began to invest in the stock market once again. Foreign investment banks and nominees continue to increase their equity shareholding in Thai listed companies. At the sectoral level, individual and corporate ownership (mainly nonlisted companies) was found to be particularly prominent among the largest shareholders with the exception of banking and finance and securities that, since the crisis, has become markedly widely held. Energy is also widely held, except for state holding since most listed companies in the energy sector are partially privatized state enterprises. To summarize, despite increased business and financial sophistication, management among many listed companies in Thailand remain mainly family-run. The crisis has had an impact on the ownership structure of companies that faced financial difficulties, in particular in the banking, finance and — to a smaller extent — the property sector.

0.30 0.20

0.45 0.78

Commerce Year 1999 Year 2002

Communication Year 1999 Year 2002

0.02 0.00

0.07 0.00

Electronic Components Year 1999 2.33 Year 2002 14.68

Energy Year 1999 Year 2002

1.01 0.73

0.00 0.00

Electrical Products and Computer Year 1999 0.89 Year 2002 0.58

0.17 0.00

0.00 0.00

0.10 0.02

0.01 0.65

Chemicals and Plastics Year 1999 Year 2002

0.08 0.00

0.03 0.03

0.41 1.10

Banking Year 1999 Year 2002

0.00 0.00

Private Thai banks

Building and Furnishing Materials Year 1999 0.71 Year 2002 0.41

0.54 0.00

Foreign banks and nominees

Agribusiness Year 1999 Year 2002

Sector

0.00 0.00

0.00 0.00

0.51 0.79

0.00 0.00

0.00 0.03

0.00 0.00

0.01 0.00

0.01 0.01

0.03 0.03

Insurance

0.01 0.15

0.05 0.00

0.00 0.10

0.01 0.00

0.05 0.19

0.00 0.03

0.00 0.85

0.00 0.34

1.55 0.12

Finance & Security

2.01 0.46

8.00 8.00

15.42 10.53

5.04 8.36

5.14 6.52

5.45 8.58

2.65 1.51

0.77 0.07

6.38 5.78

Company

0.01 0.02

0.14 0.33

0.34 0.98

1.33 1.27

1.64 0.40

0.30 0.21

0.08 0.20

0.00 0.04

0.71 2.65

Individual

6.74 8.43

0.00 0.26

0.00 0.00

0.00 0.00

0.00 0.00

1.33 3.28

2.08 2.29

3.61 2.42

0.30 0.00

Gov’t

TABLE 9.3B Weighted* Average Equity Share of Top Five Shareholders by Sector in 1999 and 2002

0.00 0.00

0.00 0.00

0.00 0.00

0.00 0.23

0.19 0.17

0.00 0.00

0.00 0.00

0.01 0.03

0.03 0.03

Mutual fund

0 9.85 9.79

10.54 23.27

17.16 12.98

7 10.64

0 7.32 7.51

7.19 12.77

5.56 5.29

0 4.89 4.01

9.54 8.61

Total

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1.32 0.46

0.08 0.00

0.07 0.04

1.47 1.44

0.43 1.03

0.56 0.39

0.25 0.13

0.48 0.49

Foods and Beverages Year 1999 Year 2002

Hotels and Travel Services Year 1999 0.32 Year 2002 0.43

0.35 0.59

Finance and Securities Year 1999 Year 2002

Insurance Year 1999 Year 2002

Property Development Year 1999 Year 2002

Pulp and Paper Year 1999 Year 2002

3.39 0.33

0.34 0.62

0.18 0.39

Transportation Year 1999 Year 2002

Vehicles and Parts Year 1999 Year 2002 0.00 0.00

0.00 0.00

0.00 0.00

0.00 0.00

0.00 0.00

0.00 0.41

0.00 0.00

0.00 0.00

0.01 0.00

0.00 0.16

0.07 0.00

0.08 0.00

0.00 0.00

0.52 0.00

0.15 0.16

0.79 0.64

0.09 0.75

0.34 0.07

0.66 0.37

0.06 0.28

6.21 6.62

0.81 1.45

9.92 9.20

9.85 26.92

1.25 0.70

2.27 1.35

4.06 5.54

2.01 2.33

0.69 0.73

6.00 4.15

6.60 7.71

0.22 0.16

1.92 0.51

0.88 0.45

1.29 1.14

0.44 0.66

0.56 1.54

1.85 2.76

0.16 0.27

7.34 8.56

0.27 0.00

16.15 17.28

0.00 0.00

0.00 0.29

0.28 0.44

0.62 0.94

0.34 0.33

0.00 0.00

0.00 0.00

0.00 0.02

* Weighted by market capitalization. Notes: 1. Government including the Crown Property, the Financial Institute Development Fund, state-owned enterprises, foreign government. 2. Companies including holding companies, listed and non-listed companies. Source: Author’s calculations from Stock Exchange of Thailand data on listed companies.

0.00 0.00

0.37 0.34

Textiles, Clothing and Footwear Year 1999 0.64 Year 2002 0.00

1.30 0.00

0.06 0.02

0.00 0.26

Entertainment and Recreation Year 1999 0.49 Year 2002 0.29

0.00 0.00

0.00 0.00

0.00 0.00

0.44 0.00

0.05 0.03

0.00 0.15

0.28 0.19

0.08 0.00

0.00 0.00

0.00 0.00

13.33 14.72

20.99 19.84

12.85 10.05

13.47 28.15

3.33 2.62

0 5.94 6.18

5.72 8.82

4.92 5.55

3.27 2.86

13.89 13.72

Building Good Corporate Governance after the Crisis: Thailand 205

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Corporate Conduct A concentrated equity holding can contribute to both the strength and weakness of a company. Firms with concentrated ownership often possess a relatively stable ownership and durable relationships with suppliers, creditors and customers. That is why we rarely observe corporate takeovers in Germany and Japan where the ownership structure is concentrated. The opposite is true in the United States and the United Kingdom where the structure of the shareholding is dispersed. At the same time, however, firms with a large shareholder often lack transparent management and an effective internal control system. Thus, small shareholders are at risk of being marginalized. With a majority shareholding, the so-called “owner” has the power to appoint directors and managers, make major corporate decisions which require majority share approval, approve conflict-of-interest business transactions or even change the corporate charter. In short, such “owners” are able to run the company as if it still belongs exclusively to the family with little transparency and accountability to other small shareholders. Expropriation and misuse of company’s fund by major shareholders have thus been the most serious corporate governance problem in Thailand. These types of corporate abuses are different from those found in the United States (Enron, Adelphi, WorldCom, etc.) and Europe (Parmalat) that involved accounting tricks to boost corporate financial performance to which managers and directors’ payments or remuneration are tied. The nature of corporate abuses range from (a) those that are outright fraud such as embezzlement of company funds; (b) corporate abuses that are made legitimate through a shareholders’ resolution such as connected transaction that amounts to expropriation of company’s funds; (c) corporate abuses that are legitimate because of certain legal loopholes that are difficult to close.2 Most corporate abuses in Thailand are of type (b) and (c). Therefore, one cannot rely on legal sanctions alone to deal with such conducts. Rather, one needs to take a holistic approach in solving these problems. 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 the local culture that gives importance to personal ties. To bankers, lending to someone you know is less risky than to those you do not know. This logic does sound rational in a way, but alas, it does not hold true during hard times. These so called “clean loans” — that is, loans with only personal guarantee and no collateral — have been most difficult to recover.

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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 individual’s reputation, Thai banks failed to acquire solid technical skills in projects appraisal. Thus, the lending policy of commercial banks has always been intransparent, arbitrary and unpredictable and thus, conducive to abuse. Besides connected lending, another widespread corporate abuse is the siphoning of company’s fund by major shareholders through connected transactions. There has been a case where the local owner lured several foreign investors to invest in a significant equity share in his/her business. But that business never registered a profit as it was purchasing raw materials at very high prices from suppliers owned by the local partner. In the end, the plant had to be closed down. Foreign investors were shafted. Seven hundred workers lost their jobs. No one knows whether these people received their entitled severance payments. Such misdemeanour can be very damaging to various stakeholders involved. Insider trading is another common corporate abuse. On the eve of the collapse of many banks and financial and securities companies both before and after the crisis, major shareholders managed to sell off their equity shares to uninformed investors. Although securities transactions conducted by insiders are to be reported to the Stock Exchange Commission, few companies do. Most insider tradings are arranged through a nominee in order to escape the law.3 Insider trading problems are sometimes closely linked to share prices manipulations. (Faulty) rumours are sometimes leaked in order to steer share prices in a certain direction. For example, news of a pending merger can temporarily boost share prices. Under such a circumstance, it is very difficult to prove whether transactions undertaken by an insider are influenced by inside information rather than public rumours. Share price manipulations also occur when a large player in the market creates artificial demand for the particular stock in order to raise its prices. Thailand has had its share of share price manipulations recently, as will be addressed in greater detail in the following section. Indeed, there are numerous corporate malpractices that affect other stakeholders other than investors, such as employees, consumers and the society. For example, many companies fail to have their factories comply with the safety regulations, dodge tax obligations, pollute the environment and do not provide severance payments to employees. According to a survey conducted by the University of the Thai Chamber of Commerce (Poapongsakorn, Nipon, et al. 2000), one of the most important factors limiting a firm’s competitiveness in the market is the competitor’s greater ability to evade tax.

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Governance Performance The Institute of Management Development (IMD) ranks countries’ competitiveness each year according to several criteria, including those that concern governance issues. Although the scores are determined subjectively by a selected group of local executives through mail surveys, the consistency of the method and the evaluators (roughly the same group of executives respond to the survey each year) provide a basis for tracking the post-crisis development of corporate governance as shown in Table 9.4. From the table, it can be seen that Thailand has made great strides in enhancing rights and responsibility of shareholders, the quality of corporate TABLE 9.4 Thailand: Corporate Governance Ranking (IMD 1999 and 2004) Scores (ranking) Governance issue 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

Rights and responsibility of shareholders Credibility of managers Corporate boards Shareholder value Insider trading Social responsibility Labour relations Customer orientation Competition legislation Ethical practices Health, safety and environmental concerns Average (categories 1–9 only)

1998

2003

4.81 (43) 5.91 (32) 4.3 (43) 4.2 (42) 3.74 (45) 4.86 (40) 6.19 (24) 5.97 (31) 4.28 (39) na na

6.29 (31) 6.16 (30) 5.69 (27) 5.91 (28) 4.11 (55) 5.84 (25) 7.14 (25) 7.3 (16) 4.58 (47) 6.34 (29) 6.09 (31)

4.91 (37.66)

5.93 (31.55)

Note: Best ranking is 1, worst ranking is 47 in 1998 and 60 in 2003. Countries are ranked according to the extent to which: 1. Rights and responsibilities of shareholders are adequately specified. 2. The corporate enjoys public trust. 3. The corporate board can prevent improper practices in corporate affairs. 4. Managers are efficient to generate value for shareholders. 5. Insider trading is uncommon in the market. 6. Responsibility towards the society is given adequate attention. 7. Relations between managers and employees are generally productive. 8. Customer satisfaction is emphasized. 9. Competition legislation prevents unfair competition. 10. Ethical practices are implemented in companies. 11. Health, safety and environmental concerns are adequately addressed by management. Source: IMD, World Competitiveness Yearbook 1999 and 2004.

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boards, shareholders’ value, corporate social responsibility and customer satisfaction as evident in both the ranking in relative terms with other countries and the scores received in absolute terms. It should be noted, however, that the post-crisis recovery of the stock market may have contributed favourably to the shareholder value indicator, which measures the extent to which managers are efficient to generate value for shareholders. On the other hand, the credibility of managers in generating shareholders’ value improved only marginally over these years. The country continues to perform miserably in terms of insider trading and competition legislation. Insider trading problems seemed to have worsened over the years as the stock market flourished. Thailand ranked fifty-fifth out of sixty countries surveyed in 2003. In the absence of legal amendments that would provide the SEC with stronger investigative power and allow for civil sanctions instead of criminal ones so as to lessen the burden of proof on the part of the regulator, insider trading problems in Thailand remain untamed. Fair competition is another key component of good corporate conduct. While a company can expand its market share on the basis of its superior management, to do so by foreclosing competition by means of restrictive practices is considered bad governance if not illegal. To ensure that competition in the market is “fair”, an effective competition law is required. Unfortunately, due to political interventions and vested interests, the Thai competition law has not been properly enforced since its promulgation five years ago in 1999. More recently, the IMD also ranks company’s concerns over health, safety and environmental concerns as shown in Table 9.4. On this matter, Thailand receives a score of 6.09 out of 10 and a ranking of 31 out of 60. The overall picture is that governance among Thai companies has improved markedly over the years, at least according to the perception of the executives selected for the survey. During 1998–2003, the country’s average governance score for the nine indicators increased from 4.91 to 5.93 and the average ranking improved from 37.6 out of 47 to 31.55 out of 60. Nevertheless, the low scores received indicate that there remains much room for further improvements in this area. STATE AND PRIVATE SECTOR’S INITIATIVES IN PROMOTING GOOD CORPORATE GOVERNANCE The Stock Exchange Commission of Thailand (SEC) and the Stock Exchange of Thailand (SET) play the main role in promoting good governance among listed companies. While the roles of the state regulatory body and the private self-regulatory body sometimes overlap, there has been an attempt to draw

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the line. Basically, the SET is a “front-line” regulator. It plays an important role in detecting potential problems both at the market level and at the firm level and reports to the SEC. It also issues rules that will help ensure compliance to the relevant laws and promote good governance under the supervision of the SEC. The latter enforces the Securities and Exchange Act and thus, oversees corporate conducts that may constitute a violation of the law such as insider trading and connected transactions. Unlike the SET, the SEC has the power to prosecute directors through its power vested by the SEA. Over the years, these two bodies have initiated a variety of measures and activities as shown in Table 9.5. TABLE 9.5 Thailand: Recent Initiatives to Promote Good Corporate Governance by State and Private Organizations Measures

Status

Responsible authority

A. Regulatory disciplines A(1) Legal amendments of developments 1.

2.

Amendment of the Public Company Act to provide greater rights to minority shareholders.

Proposed amendment has been approved by the National Corporate Amendment of the Securities and Governance Board Stock Exchange Act to codify directors’ and is being responsibility and accountability. examined by the Council of State

3.

Amendment of the Securities and Stock Exchange Act to provide for civil lawsuits instead of criminal ones.

4.

Drafting a law that will provide for “class action lawsuits”.

5.

The establishment of the Director of Responsibilities Steering Group (DRSG), which has the authority to investigate improper transactions.

Department of Business Development, the Ministry of Securities and Stock Exchange Commission (SEC)

Proposed amendment Securities and is being examined by Stock Exchange the Council of State Commission (SEC) Created and implemented March 2004

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TABLE 9.5 – cont’d Measures

Status

Responsible authority

A. Regulatory disciplines A(2) Regulations 6.

Announcement of the Stock Exchange of Thailand (SET) on Information Disclosure and Connected Transactions

November 2003

7.

Announcement of the Stock Exchange of Thailand (SET) on Information Disclosure and Connected Transactions

8.

SET rule concerning the blacklisting of executives that were found to have violated the law.

June 2002

9.

SEC rule concerning the blacklisting of executives that failed to comply with the recommendations of the DRSG.

2004 (expected)

SET

SEC

10. Regulations requiring listed companies that want to call shareholders’ meetings in which connected transactions will be voted, will have to notify the Commission, with copies of the documents sent to the shareholders.

2004

11. Regulations requiring retail investors to deposit 10 per cent of total credit line for net settlement deals in cash in order to stem speculative day trading.

Effective 1 July 2004

SEC

2002

SET, SEC and IFC (International Finance Corporation).

B. Market Disciplines 12. The creation of Investors Association to promote investors activism. Initial endowment of ten million baht is used to buy shares in all listed companies.

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TABLE 9.5 – cont’d Measures

Status

Responsible authority

B. Market Disciplines 13. The creation of Institutional Investor Club in order to promote good governance.

July 2002

14. The establishment of “corporate 2002 governance rating project”, whereby companies that volunteered to be rated and received decent marks will obtain discounts in SET and SEC fees that will cover the cost of the evaluation.

Headed by the Civil Servant Pension Fund and joined by mutual fund, provident fund, life insurance and social security fund. SET and SEC

15. Disclosure awards and Popular awards provide to companies with good disclosure records according to documents and investors’ opinion. C. Self-Discipline 16. Establishment of the Thai Institute of 1998 Directors (IoD), which provide training courses for corporate directors.

SET, SEC, the World Bank and the Bank of Thailand

17. Subsidization for enrolment in directors’ 2002 training courses offered by the IoD.

SET

18. The establishment of a “corporate 2002 governance centre” that provides advice to companies on governance issues. 19. Self-assessment survey forms for companies on governance.

2003

20. Publication of 2002–04 • Good governance principles • Guidelines on Information disclosure • Guidelines on Arranging Shareholders’ Meeting • Code of Conduct for Auditors • Directors’ Handbook • etc. Source: SEC, SET websites, articles and interviews.

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The SET and the SEC have been taking a holistic approach in their quest to attain higher governance standards among listed companies. They believe that governance is supported by three pillars: regulation, market discipline and self-restraint. The first pillar, regulation, refers to laws and rules established by the oversight authority, namely the Stock Exchange Commission of Thailand, to which firms must comply. Strong laws and enforcement ensure that companies are kept in line. Market discipline involves empowering investors, large and small, to award companies with good governance — such as by paying a premium for the equity share — and penalize bad ones by discounting share values, divesting or by filing lawsuits against boards or executives. The more informed investors are, and the greater the rights minority shareholders hold, the greater the market discipline and hence, the less the regulatory burden. The third and final pillar, self-discipline, refers to corporate voluntary practice of good governance, perhaps out of genuine appreciation of the relative merit of good corporate governance. Upon examining the list of measures and activities in Table 9.5, it appears that Thailand has chosen to take “soft measures” towards building good corporate governance, in particular after the new business-oriented government of Prime Minister Thaksin came into power in 2001. Certain proposed amendments of the SEA that will strengthen the SEC’s power to prosecute have not yet been approved by the National Corporate Governance Committee, a body created by the government in 2002. These include, for example, the proposed amendments to: • •

Grant the SEC more power to file the case against an alleged violator of the ESA;4 Tighten rule on connected transaction by broadening the definition of “connected persons”5 and “connected transaction”,6 and allow such transactions that did not follow proper procedures for clearance and disclosure to be nullified.

Other proposed amendments have received approval from the National Corporate Governance Committee, and are being reviewed by the Council of State. These include the recommendations to: • • •

Provide greater rights to minority shareholders. Codify director’s responsibilities and clarify their accountability. Provide for civil sanctions instead of criminal ones for not-so-serious corporate misconduct in order to lessen the burden of proof for the SEC and hence, facilitate its ability to pursue legal cases against violators.

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It is unclear, however, how long the draft amendment of the SEA and the PCA will remain in the pipeline, unless the current government genuinely sees the urgency of the amendment. After all, these recommendations have been made available since 2001.7 In the absence of the necessary legal amendment to allow it to effectively enforce the law, the SEC has chosen to focus on “preventive” measures by intervening before the actual abuse may take place. At the same time, it also resorted to administrative sanctions instead of legal ones in an attempt to reign in corporate misconduct. For example, in the absence of a legal revision of the SEA concerning directors’ accountability and responsibility, the SEC has established Director Responsibilities Steering Group” (DRSG) in March 2004. The DRSG is assigned to investigate situations where any listed company has taken inappropriate action and to summon the directors of that company for interview. Depending on the outcome of the interview, the DRSG will then make recommendations to the SEC regarding any directors who have “failed to perform their duties”. The SEC will then consider whether to remove the names of those directors from the registered list of company directors. The consequence of this is that the companies will be compelled to dispense with the services of such directors, as any company having a director who is no longer included in the registered list of company directors will be unable to offer securities for sale, because the company will not then have the qualifications specified by the SEC to enable it to sell its securities. Similarly, the SEC has taken steps to prevent abusive connected transactions by requiring that all listed companies submit details regarding connected transactions that received approval from the board as well as from a shareholders’ meeting.8 This is because the current law on connected transaction is relatively weak in that it only requires conflict-of-interest dealings to be approved by the board of directors only. The SET realized the shortcoming of the PCA, and thus established rules that demand greater disclosure of connected dealings in 2001.9 It also requires that all connected dealings with substantial value must obtain approval from three-quarters of the shareholders. In addition, in calling a shareholders’ meeting to request for such resolution, the company has to provide an opinion of an independent financial advisor on the suitability of such transaction. While the more stringent SET rules helped deter undesirable connected transactions, shady transactions could still easily obtain favourable resolution from the shareholders’ meeting due to the absence of minority shareholders, or by intentional misinforming or not providing sufficient information to

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them. As a result, in 2004 the SEC began to screen connected transactions approved by the board as well as by resolution at a shareholders’ meeting. In case suspicious transactions are found, the SEC would refer the matter to the DRSG. In the same vein, the SEC has taken a proactive measure in reviewing auditors’ reports of all listed companies in order to identify potentially problematic cases. The measure — though no doubt time-consuming — has proved effective in preventing companies from window-dressing their financial reports by means of accounting tricks. While both the SEC and the SET have been extremely active in passing administrative rules and regulations as well as taking measures to address the problems, there are certain limitations as to how effective these non-legal measures can be in promoting better governance. For example, non-compliance to SET regulations carries no clear penalty. This is because the “biggest stick” that the SET holds is the power to de-list a company, but such a measure would potentially hurt small shareholders that are innocent of the wrongdoings of the executives. Similarly, while the SEC is struggling to push the limits of its administrative power, there are certain drawbacks. Indeed, administrative interventions and sanctions described above can be effective and less costly for both the regulatory body and the private business. However, they can be subjective, arbitrary and discriminatory in the absence of clear and transparent procedures. When the matter is settled out of court, the cases are never publicly disclosed. Thus, there are no precedent cases that can set clear regulatory approaches or standards and if the identities of the violators are never revealed, there are no social sanctions or market discipline. In parallel with the making of rules and regulations, both the SEC and the SET jointly devise schemes to provide incentives for listed companies to adopt good corporate governance principles. Several governance awards, such as the best governance award, disclosure award and popular (among investors) award are granted each year in the hope that these awards will generate certain stock price premiums for the winners. The problem is that governance rating is expensive. Listed companies are encouraged to voluntarily have their corporate governance rated by TRIS, the local rating agency, which has been rating governance of state-owned enterprises for years. Those that receive good marks will be entitled to a reduction in various fees collected by both the SEC and the SEC. Where the reduction in fee does not cover the cost of rating (in the case of small companies that pay a relatively small fee), the SET will pay the difference.

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While these incentive schemes are indeed interesting, participation has been limited. This is due perhaps to the fact that most companies’ internal procedures are not yet compliant to governance principles. In 2003, only seven companies volunteered to be rated. These are mainly large companies that are widely held. Most family-run companies prefer to keep their internal management simple and see no gain in having their corporate governance revealed and rated. With so few companies being rated, it is not possible to create pressures on those that opted not to be rated to do so. It should be noted, however, that the Thai Institute of Directors, with the support of the SEC and McKinsey and Company (Thailand) and funding from the World Bank, has been rating listed companies since 2001. In the first year, 133 largest companies were rated. In the year 2002, 234 companies were rated and almost all of the exchange listed companies, 334 of them, were rated in 2003. Unlike the rating by TRIS, however, the rating by the IoD is based only on public and non-confidential information the company submitted to the SEC. The individual governance ranking is not disclosed, however. Only aggregate results are published in the “Strengthening Corporate Governance Practices in Thailand”. The names of companies that made it to the top quartile are disclosed at . The report is very useful, nevertheless, in that it spells out governance problems among the listed companies. Besides the handling out of awards, the SET and the SEC have also jointly set up an Institutional Investor Club (IIC) and an Investor Association. The former is made up of the Civil Servant Pension Fund, mutual funds, provident funds and the social security fund. These institutions, which together controls over 1 trillion baht (US$25 billion) of investment funds, are expected to come up with joint investment criteria that includes governance on the part of the potential recipient of investment funds. But to date, the IIC has not announced any such criteria similar to those found among some foreign institutional investor such as CalPERS (California Public Employee Retirement System), which controls over US$150 billion of investment funds. In February 2002, CalPERS withdrew its investment port from Thailand, along with Malaysia, the Philippines and Indonesia, citing governance as being one of the deciding factors. The report conducted by Wilshire Associates commissioned by CalPERS, gave Thailand a low score on the issues of accounting standards, listing requirements of the stock exchange, adequacy of financial regulation, and transaction costs in the Thai capital market.10 The Investor Association, on the other hand, is designed to pursue shareholder activism by attending shareholders’ meetings. It has been granted seed money to acquire a small equity share in all listed companies in order to

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be eligible to participate in these meetings. The effectiveness of the association has yet to be proven. The shortage of skilled personnel who can not only detect potential corporate abuse, but also to be able to pin down the responsible parties is one of the main challenges faced by the Association. The nature of the task that may require confrontation with large and powerful corporations is also certainly unpalatable. Finally, the last, but not least, approach to building good corporate governance is through self-discipline. This is the area in which both the SET and the SEC have been very active. One of the major achievements in this area was the creation of the Thai Institute Directors . The institute was set up jointly by the SEC, the SET, the Bank of Thailand and the World Bank, shortly after the crisis. Its objective is to support the development of company directors and to provide a forum where directors may share their experiences and ideas concerning their roles and responsibilities as well as present recommendations and suggestions to relevant organizations so as to elevate the quality and the credibility of corporate directorship. Since its founding, the institute has played a major role in the development of corporate governance in Thailand as will be elaborated in greater detail below. Over the past few years, the SET has also focused on providing necessary information that a company would need to have to be able to adopt good governance principles, be it a director’s handbook, code of conduct for auditors, good governance principles, guidelines for information disclosure, etc. The list is endless. That is, one can say that Thai companies are relatively well informed about what constitutes good governance and how to achieve it. The remaining challenge is to ensure that good governance principles are put into practice. Another major programme the SET has implemented to promote greater corporate self-discipline is to subsidize the cost for having directors enrolled in training offered by the Thai Institute of Directors. Directors on the board of a listed company are entitled to be enrolled in the Director Accreditation Programme (DAP) free of charge. For those that prefer to enrol in a longer and comprehensive training course, the Directors Certification Programme, the SET will cover half of the applicable fee. These programmes helped directors to understand the scope of their responsibilities and accountability and learn how to effectively perform their duties as a director. ECONOMIC AND POLITICAL PROBLEMS Corporate governance problem in Thailand can be attributed to the lack of effective supervision by investors, both large and small, as much as the

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ineffective enforcement of the relevant laws that could have provided the much needed checks and balances in the system. Why are investors not concerned more about governance and the regulator tougher on enforcement? The answer to the first question is that there are very few institutional investors in the market. Most small investors simply aim for short-run capital gain from speculation. Even institutional investors rarely get involved with the governance of the companies in which they invested. Although the share of institutional investor has grown markedly in recent years as a result of the increased role of government pension, provident and equity investment funds, there is no indication that these institutions are imposing governance requirements on listed companies as discussed earlier. Recently, a measure to promote long-term investment in the stock market has been proposed. Investment made in equity funds would be tax deductible under the special condition that the fund is not withdrawn before five years. As for the second question regarding why the regulatory body has not been enforcing the law, the answer is that the legal procedures remain cumbersome, making it difficult to prosecute an alleged violator as explained earlier. But the key obstacle has been political intervention. The integrity and independence of the SEC — and at times the SET as well — have constantly been tested. The SEC, by structure, is not an independent body. This is because the minister of finance assumes that 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 political agenda rarely aligns with that of a regulator. During the economic downturn, the goal of the government is mostly to boost the economy and hence, its popularity. Hence, governance rules and regulations that impose additional burden on brokers, investors or listed companies may not be welcomed. For example, in November 2003, at the peak of the stock market boom, the SEC clashed with the prime minister over how to cool speculative fever in the stock market day trading that was estimated to represent 20–30 per cent of the turnover in the stock market. The SEC had wanted to impose the requirement that retail investors must pledge collateral worth 10 per cent of credit lines in cash accounts with brokers before making transactions by 1 December 2003. And on 1 January 2004, the size of the cash collateral would be raised to 25 per cent. Although the 25 per cent requirement was later rescheduled to May 2004 at the request of the SET, the PM rebuked SEC’s decision. The PM wanted the regulators to monitor specific troublesome stocks and brokers, rather than issue a blanket rule governing the whole market. Upon the end of the term of the secretary-general of the SEC and the

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replacement of the minister of finance, both of who spearheaded the cash deposit rule, the 10 per cent cash requirement was postponed until July 2004 and the 24 per cent requirement was abandoned altogether. 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 or politicians. The problem can be particularly severe when politicians are businessmen themselves. The SEC has had to handle a few politically charged cases, beginning with the alleged share price manipulation and insider trading of the prime minister. In October 2001, the National Counter Corruption (NCC) found that the prime minister had intentionally concealed his assets by failing to disclose a large amount of shares held by his servants. The case was thus submitted to the constitutional court. The court, however, ruled otherwise. It concluded that the household servants were holding shares in nominee for his wife, not the prime minister, since funds were transferred in and out of her account. Thus, the prime minister was unaware of all the transactions involving a large amount of equity shares that were undertaken by his servants on behalf of his wife. The court therefore concluded that he did not intentionally conceal these assets. Although the case was closed at the constitutional court, the SEC had had to determine whether the PM has been involved with share price manipulation and insider trading under the weight of political and public pressures. In the end, it concluded that the shares were held in nominee for his wife, not him, in keeping with the decision of the constitutional court. It also stated that no solid evidence were found to support a case for insider trading or share price manipulations.11 In the following year, the SEC conducted an investigation into the irregularities in issue of shares to politicians connected with the privatization of a large state-owned company.12 Again, the investigation did not find any conduct that constitutes a violation of the law. CONCLUSIONS The Thai experience illustrates that effective enforcement of the law governing corporate practices required independence of the regulatory body from political interferences as well as effective court procedures. However, it also shows that the “non-legal approach” in building good corporate governance which focuses on preventive regulations and interventions and awareness-building to promote corporate self-restraint, can go a long way in enhancing the quality of corporate governance among listed companies.

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But the administrative approach does have serious drawbacks. It can be subjective and discriminatory since administrative measures do not follow transparent procedures and are not disclosed to the public. The lack of precedence and public disclosure means that the public, investors and companies are unaware of “who violates what rule”. In the absence of market discipline and public sanctions, the task of governance oversight would fall particularly heavy on the shoulders of both the SEC and the SET. According to the author’s view, it is of utmost important that, after many hand-slapping behind doors and many carrots dished out, one needs to bring out the legal stick and set precedence with regard to corporate governance standard and conduct. The current secretary-general of the SEC ended his speech delivered at the Thai Institute of Directors Luncheon Briefing on 21 March 2004 on the note that “No amount of rules or codes can absolutely overcome greed and dishonest intentions. Only you, ladies and gentlemen, only you can make a difference.” The author cannot agree more with his statement, but note that basic rules and codes need to be properly enforced in the war against greed and dishonest intentions. ACKNOWLEDGMENTS The author would like to thank Mr Chalee Chantanayingyong, Senior Assistant Secretary-General, Securities and Exchange Commission (SEC) of Thailand, Mr Yuth Vorachattarn, Consultant, Corporate Governance Centre, and Ms Sopawadee Lertmanaschai, Chairperson, Capital Market Opportunity Centre and MAI, the Stock Exchange of Thailand (SET), for their valuable insights into the current governance problems and measures that have been taken to deal with them. The author would also like to thank Ms Saowalak Cheevasittiyanon for her assistance in information and data collection. Notes 1. Claessens, Stijn, Simeon Djankov and Larry Lang (2000). 2. For example, it is very difficult to define “connected persons”. Too broad a definition can impose unnecessary complicated procedures for well-intentioned transactions. On the other hand, too narrow a definition may leave out related parties representing a legal loophole. 3. As a breach of the law constitutes a criminal violation, it is difficult for the SEC to establish “beyond reasonable doubt” that an outsider had obtained information

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5. 6.

7. 8.

9. 10. 11. 12.

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from an insider, in particularly when it is deprived of the required investigative authority such as the police force. Under the current SEA, the SEC has no power to prosecute alleged violator in its own name. In order to criminally pursue the matter, a criminal complaint with the Economic Crime Investigation Division (ECID) of the Royal Thai Police Headquarters is required. As a result, if it is believed that a contravention has occurred, the matter will be forwarded by ECID to the Office of the Attorney General (OAG) for criminal prosecution. In the past, the SEC has submitted in several cases that it believed that sufficient evidence of violation to the ECID, but, bar trivial cases of failure to submit required documents, the public prosecutor decided not to pursue the case in court. Under the current law, large shareholders are not considered as a party whose interests may be in conflict with that of the company. Under the current law, connected transactions cover only loans extended to and sales or purchases of assets that involve a director. It does not cover other types of connected dealings such as debt forgiveness or gift of equity shares. Recommended amendments of the Public Company Act and the Report of the Working Group established by the SEC available in Thai at . The current law prohibits the company from providing financial or non-financial compensation to directors beyond what is specified in the company’s rules, unless the decision is endorsed by at least two third of shares present at the shareholder meeting. The following types of dealings obtain approval from the shareholders: — The sale or transfer of ownership of the business or a significant part thereof to another individual — The purchase or transfer of businesses from other private companies — The amendment, signing or canceling of major contracts — The decision to allow other entity or individual to manage the company — Mergers for the purpose of profit sharing — The signing of all contracts with conflict of interest involving directors must be announced in the company’s annual report. The rule was later amended in 2003. “SEC answer CalPERS,” The Nation, 28 February 2002. “CURTAIN DOWN ON SHARE SAGA: PM cleared, wife fined”, The Nation, 23 October 2001. “PTT SHARE OUTCRY: ‘Nothing illegal’”, 7 February 2002.

References Claessens, Stijn, Simeon Djankov, Joseph Fan, and Larry Lang (1999), Who Controls East Asian Corporations? Policy Research Working Paper Series 2054, The World Bank.

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IMD, The World Competitiveness Yearbook 1999 and 2004, Lausanne, Switzerland. Nikomborirak, Deunden (2003) “Corporate Governance of State-Owned Enterprises”. Presented at the ISEAS Workshop on Corporate Governance in Thailand, in Singapore, 8 October 2003. ——— (2001) “The Thai Corporate Governance: An Overview”. In Corporate Governance in Asia: A Comparative Perspective. OECD Publications. ——— “The Role of Board of Directors”. TDRI Quarterly Review, October. Poapongsakorn, Nipon et al. (2000) Anti-Corruption Strategy in Thailand in the Year 2000. TDRI Publications. SEC (2001) “The Proposed Amendment of the Public Company Act and the Development of the Capital Market” (in Thai only), available at . Tonakasem, Worapat (2002) “Are Thai Corporate-Governance Reforms Real or Just a Show?” The Nation, 12 March 2002.

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10 NATIONAL CORPORATE GOVERNANCE COMMITTEE Three Disciplines for Good Corporate Governance in Thailand Saravuth PITIYASAK

INTRODUCTION The “Tom Yam Kung Disease”,1 causing the Asia financial crisis in 1997, has shocked all Thais and foreign investors. The lack of corporate governance is one major cause blamed for the crisis. In response, the Thai Government has set up the National Corporate Governance Committee (“National CG Committee”) in 2002. The main objective of the National CG Committee is to set out policies and measures to strengthen good corporate governance. According to the National CG Committee’s policies,2 good corporate governance must be built on three disciplines, namely “self discipline”, “market discipline”, and “regulatory discipline”. And since the crisis, a number of measures have been launched to reinforce practices of the three disciplines. The chapter is aiming at exploring and examining the three disciplines and their related measures. NATIONAL CG COMMITTEE: THREE DISCIPLINES Since the Asian financial crisis in 1997, the Thai Government has given

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corporate governance very high priority in its national agenda. In its meeting on 5 February 2002, the Thai Government set up the National CG Committee to promote good corporate governance in Thai business. The National CG Committee is chaired by the prime minister or the assigned deputy prime minister and comprises a number of government and private leaders, such as the minister of finance, the minister of commerce, the permanent secretary of finance, the permanent secretary of commerce, the governor of Bank of Thailand, the secretary-general of the Office of the Securities and Exchange Commission, the president of the Stock Exchange of Thailand, the president of Thai Bankers’ Association, etc. The National CG Committee’s major responsibility is to establish policies and measures to promote good corporate governance among Thai institutions, associations, corporations and government agencies. According to the National CG Committee,3 good corporate governance is like a three-legged stool resting on the three basic disciplines: “self discipline”, “market discipline” and “regulatory discipline”. These three disciplines must work together in order to achieve protection of shareholders’ rights, board accountability and transparency. Regulatory Discipline

CG

Market Discipline

Self Discipline

SELF DISCIPLINE The first discipline of good corporate governance is “self discipline”. Good corporate governance will never succeed without “self discipline” of directors of the companies. Directors of the companies must exercise “self discipline’ by being highly ethical and treating all shareholders fairly. To this end, the Stock Exchange of Thailand (SET) has issued guidelines and principles of good corporate governance, and has established the Corporate Governance Centre. Besides, the Institute of Directors has developed training programmes to encourage directors to exercise their “self discipline”. These would be elaborated below.

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Guidelines, Code of Best Practices, and Principles of Good Corporate Governance

Best Practice Guidelines for the Audit Committee In January 1998, the SET required all listed companies to set up an audit committee4 and has established the “Best Practice Guidelines for the Audit Committees” in order to ensure that an audit committee has a good understanding of its duties.5

Code of Best Practices for Directors of Listed Companies In December 1997, the SET issued the “Code of Best Practices for Directors of Listed Companies” in order to ensure a high standard of management and to strengthen the confidence of the shareholders, investors and other related parties in the management of the company. According to the code, directors are responsible to conduct their duties honestly, comply with all laws, the objectives and the articles of association of the company, and the resolutions of any shareholder meetings in good faith, and with care to preserve the interest of the company.6 Moreover, directors are required to disclose in the company’s annual report whether they have been in compliance with the code and give reasons for any non-compliance.7

Guidelines for the Disclosure of Information on Financial Statements and the Summary Results of Business Operations of Listed Companies In 1997, the SET issued the “Guidelines for the Disclosure of Information on Financial Statements and the Summary Results of Business Operations of Listed Companies” in order to assist listed companies to be able to give investors a clear picture of their financial position.

Guidelines for Listed Company Shareholders In 2001, the SET issued the “Guidelines for Listed Company Shareholders”. This is to make sure that shareholders have sufficient information for making their decisions.

Principles of Good Corporate Governance In March 2002, the SET proposed the fifteen principles of good corporate

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governance selected from the best practices previously published in 2001. These principles serve as a set of guidelines for listed companies, which they must begin implementing. Companies must demonstrate how they have applied those principles, along with the reasons why they have failed to comply with them. Those fifteen principles include: policy on corporate governance; shareholders: rights and equitable treatment; various groups of stakeholders; shareholders’ meetings; leadership and vision; conflicts of interests; business ethics; balance of power for non-executive directors; aggregation or segregation of positions; remuneration for directors and the management; board of directors’ meetings; committees; controlling system and internal audit; directors’ reporting; and relations with investors. Corporate Governance Centre In 2002, the SET founded the “Corporate Governance Centre” to serve as an advisory and information centre by providing consulting and opinion exchanges about setting up corporate governance system, evaluating the operations of listed companies according to the guidelines of good corporate governance, and promoting activities for development in corporate governance.8 From August 2002 to April 2003, the centre had visited directors and executives of 129 listed companies (at present there are 418 Thai listed companies in the SET)9 to discuss and advise them on the benefits gained from practising good corporate governance.10 The centre has also prepared manuals on the best practices and guidelines on issues related to corporate governance such as examples on a good governance report, a self assessment form, a manual on good governance reporting, information on the directors’ and executives’ remuneration, the board’s self assessment and best practices of shareholders. Training Programmes The Institute of Directors (IOD) was established on 1 October 1999 with the support of SEC, the Bank of Thailand, and the World Bank. The IOD aims to develop curricula for the continuous development of directors. Since 2001, the IOD has introduced a number of classes conducted for various courses, for example, Directors Certification Programme (DCP) and Chairman 2000 Programme, Effective Audit Committee, Financials for Non-Finance Directors, Board Reporting, and Special Extension Class.11

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MARKET DISCIPLINE The second discipline of good corporate governance is “market discipline”. Recognizing the significant roles of market force and transparency in achieving good corporate governance, many institutions such as the SET and the SEC have launched a number of programs in order to strengthen “market discipline” in Thai listed companies. Thai Rating and Information Services’ Corporate Governance Rating The SEC has initiated an incentive for listed companies to practice good corporate governance by providing benefits to those with good corporate governance. In this regard, the Thai Rating and Information Services Company Limited (TRIS) has studied corporate governance rating models used worldwide and created a model of corporate governance rating methodology that meets international standards. Companies that achieve satisfactory scores on their corporate governance ratings developed by TRIS would receive the following benefits. Firstly, the SEC would grant companies with good scores a fast track process for their public offerings of securities and a reduction of the companies’ offering fees by 50 per cent. Secondly, the SEC would honuor the companies by publicizing their names via the SEC’s website. Thirdly, the SEC would reduce the companies’ annual fees by 50 per cent. Finally, the SET would offer a reduction of its annual fee by 50 per cent for two consecutive years.12 Good Corporate Governance Awards

Disclosure Report Award Information disclosure is one of the significant channels helping minority shareholders. The SEC has set a rule for listed companies to continuously disclose information about their company’s operation and offer disclosure award for corporations having an excellent information disclosure system. This award would motive other companies to realize the significance of information disclosure and to apply those good examples as their guidelines in the future.13 On 19 November 2003, the SEC hosted the “Disclosure Report Award 2003” for the second-consecutive year and sixty listed companies out of the total 123 applicants were qualified for the award as companies with good

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quality of information disclosure in the annual registration statements and financial statements. Also, the “Popular Award 2003” was given to four listed companies having good levels of information disclosure in the view of investors.

Corporate Governance Best Practices and Audit of the Year Award The Institute of Internal Auditors of Thailand (IIA) was set up after the Asian financial crisis with an aim to promote strong internal audit and effective risk management. IIA began to grant “Corporate Governance Best Practices and Audit of the Year Awards” to companies with best practices and best audit committees. In 2002, there were six winners in six categories, namely “major corporation”, “SMEs”, “subsidiary company”, “banks and financial institutes”, “state-owned enterprises”, and “audit committee of the year”.14

Board of the Year Award IOD presents “Board of the Year Award” to a listed company that is generally managed using the corporate governance principles developed by TRIS. The criteria for the Board of the Year Award selection are based mainly on the management of each company’s board of directors.

Thailand Productivity Institute’s Best Practice Award The Thailand Productivity Institute (TPI) was established by a resolution of the Thai Cabinet in 1995. It is an independent agency with objectives to increase productivity and its standards in the industry sector and business community; increase the competitiveness of Thai industries in the global market; and serve as the centre for coordinating and promoting productivity enhancement in Thailand.15

Q-Mark The Thai Chamber of Commerce and the Federation of Thai Industries have awarded the logo “Q-Mark” to “good ethics” companies.16 Goods and services of qualifying companies will receive a stamp of approval to certify their transparent and ethical quality. This would help improve the competitiveness of Thai goods and services in the international arena.

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Increasing Roles of Investors Another way of promoting good corporate governance through “market discipline” is by increasing roles of investors. Well-informed investors would play positive role on good corporate governance by voicing their concern on poor corporate governance, which would put pressure on directors or management teams in cases of poor corporate governance. To this end, the Investors Association was set up on 9 May 2002 in order to monitor companies and exercise rights in shareholders’ meeting. Secondly, the Institutional Investors Club was established on 22 July 2002 for the declaration of members to use corporate governance as part of investment factors to promote their own fiduciary duties to clients. Thirdly, the SEC has required Asset Management Company (AMC) to disclose of how corporate governance is used in its investment decision and voting policy.17 Finally, the Government Pension Fund, one of the big institutional investors, has become an active player in corporate governance of listed companies. REGULATORY DISCIPLINE The third discipline of good corporate governance is “regulatory discipline”. The regulatory framework of corporate governance of Thai listed companies comprises the principles derived from the Thai Public Limited Companies Act 1992 (B.E.2535) as amended by the Thai Public Limited Companies Act (No. 2) 2001 (B.E.2544) (the PCA), the Security and Exchange Act 1992 (B.E.2535) (the SEA) and regulations under the SET and the SEC. The PCA, the SEA, and the regulations under the SET and the SEC provide legal environment for promoting good corporate governance in five main issues, namely rights of shareholders, responsibilities of directors, check and balance mechanism, disclosure and transparency, and legal enforcement. Rights of Shareholders A main purpose of corporate governance is to protect owners of companies — the shareholders. Basic shareholder rights should be equally given to all shareholders.

Attending and Voting at Shareholder Meeting Section 102 of the PCA grants shareholders the right to attend and vote at

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shareholders’ meetings and allows them to authorize other persons as proxies to attend and vote at any meeting on their behalf. The instrument appointing the proxy shall be submitted to the chairman of the board or to the person designated by the chairman of the board.

Calling an Extraordinary General Meeting Section 100 of the PCA allows shareholders holding shares amounting to not less than 20 per cent of the total number of shares or shareholders numbering not less than twenty-five persons holding shares amounting to not less than 10 per cent of the total number of shares to submit their names in a request directing the board of directors to call an extraordinary general meeting at any time. The request must contain reasons for calling the meeting and the board of directors must call the meeting within one month of the date of receipt of such request. At present, a joint committee appointed from the Ministry of Commerce, the Ministry of Finance, the SEC, and SET is working on amending Section 100 of the PCA. In this matter, the joint committee views that the high requirement (shareholders holding not less than 20 per cent of the total number of shares or shareholders numbering not less than twenty-five persons holding shares amounting to not less than 10 per cent of the total number of shares) makes it difficult for minority shareholders to call an extraordinary meeting. Thus, the joint committee opines that the requirement on the total number of shares should be amended from 20 per cent of the total number of shares to 5 per cent of the total number of shares, without regard to the number of shareholders, so that minority shareholders holding shares amounting to only 5 per cent of the total number of shares would be able to call an extraordinary meeting.

Obtaining Relevant Information on the Corporation on a Timely and Regular Basis Section 101 of the PCA gives shareholders the right to obtain relevant information on the corporation on a timely and regular basis by requiring the board of directors, in calling a shareholders’ meeting, prepare a written notice calling the meeting that states the place, date, time, agenda of the meeting and the matters to be proposed to the meeting, deliver it to the shareholders for their information at least seven days prior to the date of the meeting and publish it in a newspaper at least three days prior to the date of the meeting. The place of the meeting shall be in the province in which the head office of

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the company is located or in a nearby province, unless otherwise stipulated by the articles of association. The joint committee is of opinion that the period of notification under Section 101 of the PCA should be amended from seven days to ten days in order to allow shareholders to have sufficient time to authorize other persons as proxies to attend and vote at the meeting on his or her behalf.

Changing the Sequence of the Agenda Section 105 of the PCA provides that the chairman of the shareholders’ meeting must conduct the meeting according to the articles of association of the company relating to meeting and follow the sequence of the agenda specified in the notice calling the meeting. Any change in the sequence of the agenda requires a vote of not less than two-thirds of the number of the shareholders present at the meeting. The joint committee opines that in order to provide better protection for minority shareholders, a change in the sequence of the agenda should be required shareholders attending the meeting of not less than 90 per cent of the total number of shareholders with a vote of not less than three-quarters or 75 per cent of the number of shareholders present at the meeting.

Electing Members of the Board Section 70 of the PCA grants shareholders the right to elect directors by providing that each shareholder shall have a number of votes equal to the number of shares held multiplied by the number of the directors to be elected and may exercise all the votes he or she has to elect one or several persons as director or directors. If the shareholder elects several persons as directors, he or she may allot his or her votes to any person in any number. The candidates shall be ranked in order descending from the highest number of votes received to the lowest, and shall be appointed as directors in that order until all the director positions are filled.

Removing a Director Section 76 of the PCA stipulates that the shareholders’ meeting may pass a resolution removing any director from office prior to retirement as a result of the expiration of the director’s team of office, by a vote not less than 75 per cent of the number of shareholders attending the meeting who have the right to vote and who have shares not less than 50 per cent of the number of shares.

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Section 76 of the PCA makes it difficult for shareholders to remove a director because a resolution for removing the director requires both not less than 75 per cent of the number of shareholders attending the meeting and not less than 50 per cent of the total number of shares. As a result, the joint committee opines that the provision should be amended by providing for the removal of directors by only not less than 50 per cent of the total number of shares instead of both not less than 75 per cent of the number of shareholders attending the meeting who have shares not less than 50 per cent of total number of shares, the latter being a higher threshold.

Sharing in the Profits of the Company Section 115 of the PCA grants shareholders the right to share dividend paid out of profit of the company. If the company still has an accumulated loss, no dividend shall be paid. Dividend will be distributed according to the number of shares, with each share receiving an equal amount. The payment of dividend must be approved by a resolution passed in the shareholders’ meeting and shall be made within one month of the date of the resolution of the shareholders’ meeting or of the meeting of the board of directors as the case may be. The Responsibilities of Directors Section 91 of the PCA clearly provides that all directors are jointly responsible to the company18 and the shareholders 19 for clear violation of the rules of law. When it comes to the board’s accountability to its fiduciary duty, however, the law is very much vague. Section 85 paragraph 1 of the PCA simply provides that “in conducting the business of the company, the directors shall comply with all laws, objectives and the article of association of the company, and the resolution of‘the shareholders’ meeting in good faith and with care to preserve the interest of the company.” There is no clear interpretation on what can constitute “in good faith and with care”. As a result, without fraud or a clear violation of the written rules and regulations, it would be difficult to prove whether a director has performed his duty in good faith and with care to preserve the interest of the company. In this regard, the joint committee opines that Section 85 paragraph 1 of the PCA is the main provision concerning roles and responsibilities of directors and, therefore, should be strengthened and modified to provide more illustration of directors’ responsibilities.

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Checks and Balances Mechanism

Audit Committee There is no requirement in the PCA that listed companies must set up an audit committee. However, in January 1998, the SET announced that all listed companies were required to establish an audit committee by December 1999 in order to create efficiency in the operation and add value to the organization.20 As a result, at present an audit committee is compulsory for all listed companies in Thailand. According to the SET requirements, an audit committee must compose of three directors with at least one director having financial and accounting knowledge. An audit committee director must not be an executive officer, an employee, or an advisor who receives a regular salary from the company, is free of any financial or other interest in the company’s management and business, and does not hold shares exceeding 5 per cent (including shares held by his or her related persons or members) of paid-up capital of the company.21

Independent Directors Independent directors are appointed to safeguard the interest of minority shareholders, as minority shareholders usually do not have their representative in the board of directors. They are not mandatory under the PCA, but in 1997, the SEC and SET require all listed companies to appoint at least two outside directors who are independent from the major shareholders and the management. According to the SET requirements, an independent director must not be an employee, staff member or advisor who receives a regular salary from the company, or its affiliated, associated or related company and does not hold shares exceeding 0.5 per cent of the company’s paid-up capital. An independent director has its duties to take care of all shareholders’ interest in a fair and equal manner, to prevent conflict of interest, and to attend the board of directors’ meetings.22

Remuneration Committee and Executive Remuneration In 1998, the SET has initiated voluntary remuneration committees by recommending all listed companies establish a remuneration committee, which determines executives’ pay. A remuneration committee should be made up wholly independent non-executive directors. Its objective is to enhance disclosure and accountability in executive remuneration. In addition, the present SEC disclosure requirement states that a listed company must

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disclose remuneration of the top fifteen highest-paid management teams in a lump sum amount.

Connected Transactions Connected transactions can be used to divert assets out of the company and to unfairly take advantage of minority shareholders who have no control of the company. There are several provisions under the PCA and the regulations under the SET to protect minority shareholders on connected transactions. 1. Section 80 of the PCA prohibits a director who has interest in any matter to vote on such matter. 2. Section 86 of the PCA prohibits a director to operate any business which has the same nature as and is in competition with the business of the company unless the director notifies the shareholders’ meeting prior to the resolution for his or her appointment. 3. Section 87 of the PCA prohibits a director to purchase property of the company or sell property to the company or do any business with the company without an approval from the board of directors. Any transactions violating the provision shall not bind the company. 4. Section 88(1) of the PCA requires a director to notify the company without delay any direct or indirect interest in any contract which is made by the company during a fiscal year. 5. Section 89 of the PCA prohibits a company to grant loan or guarantee to any director, staff member or employee of the company except for loan or guarantee in a welfare scheme or in accordance with the law relating to commercial banking, life assurance, or other laws. 6. The SET’s Rules and Procedures and Disclosure of Connected Transactions of Listed Companies23 requires a listed company intending to enter into connected transactions to comply with the prescribed procedures. Firstly, if the volume of the transaction is substantial (higher than ten million baht), the listed company is required to obtain shareholders’ approval by a vote of not less than 75 per cent of the total number of shareholders attending the meeting who have the right to vote. Secondly, if the volume of the transaction is not substantial (higher than one million baht but lower than 10 million baht), the company needs to prepare a report disclosing the decision to enter into such transaction to the SET but needs no shareholders’ approval. Thirdly, in some transactions24 and connected transactions lower than one million baht, the company is required neither to obtain the shareholders’ approval nor to prepare the report.

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Disclosure and Transparency One of the most important aspects of good corporate governance is “disclosure and transparency” since they would allow investors to have equal access to information in order to monitor the performance of the company. Section 40 of the PCA stipulates that the registration of a company must be made at the Company Registration Office, Ministry of Commerce so that interested persons would be able to inspect or examine the company’s information such as the objectives of the company, the shareholder names and addresses, the articles of association, etc. In addition, directors of the company have the duty to register all new regulations, addition or alteration within fourteen days of the date of amendment.25 Furthermore, the SEC and the SET require all listed companies to submit quarterly and annual financial statements conforming to the General Accepted Accounting Principle (GAAP) and being reviewed or audited by an auditor under the SEC approved list, and to disclose certain information in the annual registration statement filed with the SEC and the SET and in the annual reports sent to the shareholders. In addition, Section 58 of the SEA provides that if the SEC or the SET finds that the disclosed reports are incorrect, incomplete or ambiguous, or there is an urgent need of more information to protect investors, the SEC or the SET can request for additional reports or instruct the company to arrange for a special audit. THE LEGAL ENFORCEMENT Appointing an Inspector According to Section 128 of the PCA, shareholders aggregately holding shares amounting to not less than 20 per cent of the number of shares or combining in number of not less than one third of the number of shareholders may submit their names in a written application to the registrar to appoint an inspector to proceed with the examination of the business operation and the financial condition of the public limited company as well as to inspect the business conduct of the board of directors. Nevertheless, even though shareholders have the right to appoint an inspector, an individual shareholder is not entitled to examine books and records of account of the document of the company or request a copy of such documents. The joint committee views that each shareholder should be given the right to examine books and records of account of the company or request a copy of those documents.

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In addition, the Ministry of Commerce, the Ministry of Finance, and the SET have the power to monitor and enforce listed companies to act in accordance with the law and rules. Firstly, Section 129 of the PCA empowers the Ministry of Commerce as the registrar of companies to appoint one or more competent officers to be an inspector or inspectors to examine the business operations of the company when the registrar has a reasonable ground to suspect that: (1) the company has committed an act to defraud the creditors of the company or incurred debts that it knew it could not repay; or (2) the company has acted in contravention to the PCA or made false statement when applying for registration, in the balance sheet, in the profit and loss statement, or in the report submitted to the registrar or disclosed to the public; or (3) the directors or the staff member at the management level of the company have carried out the business in contravention to the objectives of the company or have carried out business dishonestly against the interest of the company or its shareholders; or (4) there was any act done to cause unfair disadvantage to minority shareholders; or (5) the management of the company may cause damage to the shareholders. Secondly, Sections 7 and 264 of the SEA empower the Ministry of Finance to appoint competent officers to examine any listed company when it has a reasonable ground to suspect that such company acts in contravention to the SEA. Finally, the SET will monitor and enforce listed companies to act in accordance with the listing rules.

Bringing a Lawsuit against Directors According to Section 85 of the PCA, shareholders holding shares amounting to not less than 5 per cent of the total number of shares may issue a written notice directing the public limited company to bring a lawsuit against the directors who failed to conduct their legal duties and caused damage to the company in order to seek for compensation or stop the action. If the company fails to do so, the shareholders may bring an action to the court to claim compensation on behalf of the company. Nonetheless, minority shareholders who bring a lawsuit against the directors are facing free rider problems. That is all shareholders would benefit from any successful action initiated by a few. Thus, the joint committee views that shareholders initiating a lawsuit against the directors should have the right to claim reimbursement from the company.

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Revoking a Resolution According to Section 108 of the PCA, shareholders of not less than five persons or holding not less than 20 per cent of the total number of shares may request the court to revoke a resolution passed at a shareholder meeting which was in contravention of the article of association of the company or the provisions of the PCA. The request for revocation of the resolution of the shareholder meeting has to be submitted within thirty days after the meeting.

Claiming Compensation According to Sections 82 to 85 of the SEA, shareholders who bought shares in a public offering and suffered damages from such purchase owing to prospectus containing false or misleading statements, are entitled to claim compensation from the directors and other persons who signed their names to certify the information in the prospectus.

Seeking Redress According to Sections 172 and 173 of the SEA, if a listed company was delisted because a company failed to comply with the SET’s order, the inflicted shareholders can seek redress from the directors or managers who caused such failure. CONCLUSION Good corporate governance is the combination of “self discipline”, “market discipline” and “regulatory discipline”. The three disciplines, if working together, will push Thai companies to behave more efficiently and to be able to compete at a global level. The National CG Committee is moving towards the right direction and this will bring benefits to not only Thai companies but also Thai capital market as a whole. Good corporate governance will create extra value for Thai companies on a sustainable and long term basis which will contribute to the development of the Thai economy. Notes 1. Tom Yam Kung is the name of a Thai sour and spicy shrimp soup. 2. National CG Committee’s website, available at .

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3. National CG Committee’s website, available at . 4. Please see in “Regulatory Discipline” topic. 5. SET “Best Practice Guidelines for Audit Committee”, p. 1. 6. SET ‘Code of Best Practice for Directors of Listed Companies”, 19 January 1998, p. 1. 7. Ibid., p. 3. 8. National CG Committee, “Mission” . 9. SET, “Market Statistics”, June 2004 . 10. Na Ranong, Kittiratt, “Governance Standard Thailand Stock Exchange” . 11. Thai Institute of Directors Association’s website at . 12. Thai Rating and Information Services, “Corporate Governance Rating” . 13. National CG Committee, “Disclosure Awards” . 14. Institute of Internal Auditors of Thailand (IIAT), “Best Practices Awards” . 15. Thai Productivity Institute’s website at . 16. National CG Committee, “Current Status” . 17. Ibid. 18. The PCA, Section 91 provides that the directors shall be jointly liable for any damage to the company in the following cases: (1) The calling for subscribers to make payment on share subscription or to transfer the ownership of the property to the company in a manner that does not comply with Section 37 or Section 38; (2) The spending of money for the payment on share subscription or the disposal of property received in payment for shares of the company in a manner which contravenes Section 43; (3) The performing of any act in contravention of Section 85; (4) …. 19. The PCA, Section 94 provides that the directors shall be jointly liable for any damage to the shareholders and persons concerned with the company in the following cases, unless it can be proven that they had no part in such wrongdoing: (1) Making false statements or concealing any information that should be disclosed about the financial condition and business operation of the company in the offer for sale of shares or debentures or other financial instruments of the company;

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(2) Presenting or filling out a document submitted to the Registrar containing false information or particulars or which does not correspond to the accounts, registers or documents of the company; (3) Preparing a false balance sheet, statement of profit and loss, minutes of a shareholder meeting or minutes of a meeting of the board of directors. SET, “Best Practice Guidelines for Audit Committee”, p. 2. SET, “FAQ’’ . Ibid. SET, “Rules and Procedures and Disclosure of Connected Transactions of Listed Companies” . For example, (1) an acquisition or disposition of goods or services between a listed company or any of its subsidiaries and connected persons in the ordinary course of business and under normal commercial terms and conditions of the listed company or the subsidiary; (2) A transaction between a listed company and any of its subsidiaries or a transaction between the subsidiaries themselves which involves the sharing of services or similar arrangements with such listed company or subsidiary in the ordinary course of business and under normal commercial terms and conditions of both or all the companies concerned. The PCA, Section 40.

References Asian Corporate Governance Association (2000) “Building Stronger Boards and Companies in Asia”. A concise report on corporate governance policies and practices, January. Department of Commercial Registration, Ministry of Commerce (2003) “Registration of Public Companies Establishment and Firms Turning Public (from the time of introducing the act up till 31 October 2003)’’ . ——— “Companies Registration, Dissolution and Survival (from the time of establishment of Registration Chamber up till 31 October 2003’’. Institute of Internal Auditors of Thailand (IIAT). “Best Practices Awards’’ . Na Ranong, Kittiratt. “Governance Standard Thailand Stock Exchange” . National Corporate Governance Committee. “Current Status” . ——— “Mission’’ . ——— “Disclosure Awards’’ . OECD (1999) “Principles of Corporate Governance”, May. ——— “Definition of Corporate Governance” .

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Official Gateway and Guide to Thailand for Investors. “Corporate Governance” . Pitiyasak, Saravuth (2001) “Corporate Governance in Family Controlled Companies: A Comparative Study between Hong Kong and Thailand”. Sukhothai Thammathirat Law Journal, December. SET (1998) “Best‘Practice Guidelines for Audit Committee”, January. ——— “Code of Best Practice for Directors of Listed Companies”, 19 January. SET. “Market Statistics” . Stock Exchange of Thailand (2001) “Report on Corporate Governance’’, August. Thai Rating and Information Services. “Corporate Governance Rating” . Thai Productivity Institute’s website, at . Thai Institute of Directors Association’s website, at . Thai Public Limited Companies Act 1992 (B.E.2535) as amended by the Thai Public Limited Companies Act (No. 2) 2001 (B.E.2544). ThaiPR.net: Government Press Release (2003) “State and Private Sectors Joined Hands in Promoting Corporate Governance to Further Develop Thailand’s Capital Market”, 11 April. Thai Farmers Research Centre Co., Ltd (2002) “Enron Lesson Stirs Movement toward Corporate Governance Promotion in Thailand”, 25 March. Urapeepatanapong, Kitipong (2003) “Special: Shareholders and their Rights”. The Nation, 9 June.

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11 CORPORATE GOVERNANCE REFORMS IN SINGAPORE Economic Realities, Political Institutions, and Regulatory Frameworks Kala ANANDARAJAH

1. OVERVIEW The last half a decade or so more than any other period in Singapore’s history has seen the expression “corporate governance” being utilized in almost every business arena, by almost every accounting and legal professional, and by academics in multi-disciplines. The phrase is used as part of the daily parlance of improving better corporate behaviour, reducing misappropriation of shareholder and creditor funds by insiders, eliminating abuses by insiders of corporate opportunities for their own prosperity, and increasing overall shareholder value. The fame of the phrase “corporate governance” has also been fuelled by the regulators with the passing of new and, if already introduced, tweaking of existing corporate legislation with a view to improving corporate governance. The process is ongoing, and necessarily so as laws and rules must always be updated to keep in sync with the evolving business and commercial climate.

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The reform process has picked up momentum in recent years. Any corporate practitioner in Singapore will be ready to espouse voluminous rhetoric about the difficulties in keeping up with all the changes that have been going on and which continue on. Yet they shoulder on with the official tagline that such reforms are necessary and important to bolster a disclosure based business environment where greater transparency rules the day. The question that is reviewed in this chapter is whether the reforms to date have been necessary, whether the move to achieve greater disclosure and so transparency has been effective, whether the business arena has been transformed into a more ethical one, and whether further reforms are or should be required. It is important to state upfront that the views stated in this chapter are entirely the writer’s own and intended purely to provoke for discussion purposes. The chapter begins by reviewing very quickly developments taking place in the global arena, then doing the near impossible of setting a framework as to what corporate governance means, next, looking at some of the recent changes that have taken place in Singapore, and within that discussion, reviewing the effectiveness of the changes, and superimposing a discussion of whether corporate governance is invariably influenced by the prevailing economic realities and political institutions, and finally, considering whether further changes, if at all, are necessary. In examining these issues, the focus is necessarily but not exclusively on the public listed company, as that is where the greatest risk of fraud and abuse of shareholder funds exists; the chapter also touches on corporate governance and its impact on private companies, small and medium enterprises, as well as the “mom-and-pop-shops”. It will be seen through the discussion in the chapter that it is impossible to regulate the different sizes and types of companies through a single approach, and invariably variance is required. The chapter does not purport to review the alleged weaknesses that have surfaced as a consequence of the Asian financial crisis in the late 1990s as much has already been written about that; in any event, there appears to be consensus that Singapore survived the crisis relatively unscathed. 2. GLOBAL REFORMS — WHAT IS HAPPENING? What is happening in Singapore is merely a microcosm of what is happening at a global level. The United States, in particular, has been paving the way for radical innovative legislation to take root since the year 2002 when the collapse of the Enron Empire occurred. The Sarbanes-Oxley Act of 2002 which took effect on 30 July 2002, and perhaps most well known for the

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severe certification requirements by CFOs and CEOs of corporations,1 is now the topic of discussion of many a jurisdiction at regulator as well as corporate and business forums. Its effectiveness is the key topic of discussion at such forums. In the United Kingdom, the Higgs and Smith reports commissioned in 2002–03 and which have resulted in a revised Combined Code of Corporate Governance being adopted in November 2003 is less radical, but also a reflection of the changes that have been ongoing. Key changes introduced by the 2003 Combined Code include more extensive guidance on the role of non-executive and independent directors, including the lead independent director, the role that institutional investors can play, and institutionalizing the whistle-blowing process within the company. Adding to this is the current review of the appropriateness of the Turnbull guidance on internal control and risk management, which was first published in 1999. The review has started, and the intention is that revised guidance to directors will take effect for accounting periods commencing on or after 1 January 2006. The review will include full consultation on any proposals to revise the guidance. In Australia, a new Code of Corporate Governance was introduced in 2003. The approach adopted is one of compliance or disclosure. In Hong Kong too, a slew of changes have been introduced in the last few years. Most recently in January 2004, the Hong Kong Stock Exchange (HKEx) introduced a draft Code of Corporate Governance for consultation. The Code is expected to be finalized very shortly and be effective in Hong Kong from 2005. The Code takes into account the latest developments in corporate governance, and is benchmarked against the 2003 Combined Code. Failure to comply with the Code provisions will not be regarded as a breach of the HKEx Listing Rules, but failure to explain the reasons for any non-compliance or deviations from the Code provisions will be a breach of the HKEx Listing Rules. At an international level, the Organization for Economic Cooperation and Development (OECD) reviewed and through an extensive consultation process, issued a new set of Principles of Corporate Governance in April 2004. The revised principles respond to a number of issues that have undermined the confidence of investors in company management in recent years. Accordingly, they call on governments to do the following: • •

Ensure genuinely effective regulatory frameworks and for companies to be truly accountable; Advocate an increased awareness among institutional investors and an effective role for shareholders in inter alia board nominations and executive compensation;

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A strengthening of board oversight of management; and Strengthened transparency and disclosure to counter conflicts of interest.

It is pertinent that the OECD review, whilst it resulted in some key changes relating to institutional shareholders, largely retained the principles it introduced in 1999. This point will be revisited later in this chapter. The discussion thus far represents only a tip of the emerging changes globally, and it is beyond the scope of this chapter to touch on all the changes, let alone at any length. Singapore has also followed suit in introducing various changes and reviewing laws and rules recently introduced. Some of the key changes are discussed further at Section 4 below. The intent of the changes introduced is to ensure a continued robust environment from which companies can effectively do business. 3. DEFINITION OF CORPORATE GOVERNANCE There have been many definitions of corporate governance promulgated over the years by different quarters. A favoured definition is that of Sir Adrian Cadbury:2 Corporate governance is holding the balance between economic and social goals and between individual and communal goals. The governance framework is there to encourage the efficient use of resources and equally to require accountability for the stewardship of those resources. The aim is to align as nearly as possible the interests of individuals, corporations and society. The incentive to corporations is to achieve their corporate aims and to attract investment. The incentive for states is to strengthen their economics and discourage fraud and mismanagement.

Y. C. Richard Wong3 offers a different perspective by identifying what in his view corporate governance is not: Corporate Governance is not about the relationship of corporations to society. Nor is it about the regulation of corporations in the interest of society: regulation backed by the force of law is the domain of civil government and political economy, not of corporate governance. Equally important, corporate governance is not about fostering economic growth through the development of business operations that can allow companies and economies to compete successfully. Corporate governance is neither the study of economic competitiveness and development strategy nor the promotion of enterprise and growth. Conversely, corporate governance is not just about administrative rules that are imposed on corporations independent of shareholders’ wishes or corporate circumstances.

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Properly understood, corporate governance refers simply to ways of ensuring that a corporation’s agents, actions, and assets pursue the definitive corporate ends set by the corporation’s shareholders.

A similar definition is contained in the Singapore Report (“Report”) of the Corporate Governance Committee (“Committee”) on the Code of Corporate Governance issued on 21 March 2001, which provides that corporate governance refers to: the processes and structure by which the business and affairs of the company are directed and managed, in order to enhance long term stakeholder value through enhancing the performance and accountability, whilst taking into account the interests of other stakeholders. Good corporate governance therefore embodies both enterprise (performance) and accountability (conformance).

Viewed as such, it is clear that corporate governance is about how insiders behave. It is for this reason that a number of the rules and laws are directed at controlling insider behaviour from the requirement to obtain requisite approvals to making adequate disclosures. This narrow approach of what corporate governance means provides visible goal posts within which to regulate, thus making it a lot more manageable in ensuring better standards generally. Yet, such a definition assumes that a company operates in isolation away from society and more importantly, economics and the state. This is not reflective of reality. There is definitely much influence that a company does have over society and the economics of the country, just as society and the economy impact upon the company’s operations. The business turnover of a company invariably contributes towards the prosperity of the country. A company also offers employment to the people of the country, resulting in economic contributions. A badly managed company, where lack of accountability and fraudulent practices abound, could result not only in lost of shareholder value, but also lost of jobs, consequential losses to creditors and non-shareholder investors, and possibly even ruin in a non-robust economy. This is reflective of the Enron collapse which had a multiple domino effect, as is also reflective, closer to home, of the Barrings debacle which had its roots in Singapore in the mid-1990s and the Asian financial crisis in 1997. Thus, whilst for discussions purposes it might be useful to use the definition of Professor Wong and that in the Report, the reality is that Sir Cadbury’s definition is more reflective of the workings of corporate governance. But this is for the regulatory authorities to study and ensure adequate fit of

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relevant rules to ensure a composite whole. Any regulator promulgating laws and rules, and any professional adviser aiding with implementation and compliance, must bear in mind the cross implications of rules introduced and ensure that the composite whole is met. Of course, there is also much overlap between corporate governance and national governance, as well as corporate social responsibility4, which is a term much bandied around now. 4. RECENT CHANGES IN SINGAPORE The Singapore Code of Corporate Governance (Code) was adopted on 4 April 2001, and kicked into force on 1 January 2003. Listed companies in Singapore are required pursuant to Rule 710 (1) of the Singapore Exchange Listing Manual (Listing Manual) to describe its corporate governance practices with specific reference to the principles of the Code in its annual report and disclose any deviation from the Code together with an appropriate explanation. Although only coming into force about two years ago, the Code was introduced over three years ago. The economic environment has since changed, as have global rules, upon which the Code is based. Given this, the Council of Corporate Disclosure and Governance (CCDG) has announced a review of the Code. In the words of the CCDG, “the review is intended to introduce improvements to the Code, taking into account feedback received since the inception of the Code and international developments in corporate governance.” A review committee has been formed for this purpose. The revised Code is expected to be introduced in the first half of 2005. Apart from the introduction of the Code and the proposed changes to it, numerous other changes have been instroduced to strengthen corporate governance practices in Singapore companies. These include (together with the provisions of the Code): •

• • • •

Provisions to ensure the constitution of an effective board, including provisions on independent directors and executive directors, separation of chief executive officer and chairman, right skills of the board members, and adequate access to information. Director training, especially for first time appointees. Ability of directors to rely on employees and professional advisers. Adoption of international accounting standards, with the shift of setting such accounting standards away from the accounting profession. Enhanced listing procedures, with a particular focus on disclosure and accountability, including, enhanced duties when due diligence is conducted.

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More effective shareholder participation provisions. Proposed introduction of Corporate Governance Regulations for the Banking and Insurance Sectors.

The changes have been introduced by amendments to the Companies Act and the Securities and Futures Act, modifications to the Singapore Exchange Listing Manual, the issuance of various practice notes and guidance notes, and a motley of other legislation. Sections 5 to 10 below discuss some of these key changes in no particular order of priority. The discussion also considers whether the changes are positive or should be subjected to further refinement. 5. BOARD EFFECTIVENESS 5.1. Overview Evidently one of the crucial elements of ensuring good corporate governance is the presence of an effective board.5 There are many theories as to how an effective board is constituted, and the discussions continue despite the suggestions provided in the Guidance Notes to Principle 1.1 of the Code as to how a board can be effective. These include: • • •

•

•

Requiring the board to meet regularly and as warranted by particular circumstances, as deemed appropriate by the board members. To allow for telephonic and video-conference meetings. To disclose the number of board meetings held in the year, as well as the attendance of every board member at those meetings and meetings of specialized committees established by the board, in the company’s annual report. To adopt internal guidelines setting forth matters that require board approval, and specify in their corporate governance disclosures the type of material transactions that require board approval under such guidelines. To require every director to receive appropriate training (including his or her duties as a director and how to discharge those duties) when he is first appointed to the board.

Whilst some of the suggestions are prescriptive, they do act as a good reminder of what board members should be doing and how they should be conducting themselves. The concern, however, is that many boards merely follow the form rather that substance of these requirements. Taking the requirement to meet regularly as an example, it is not unusual for the whole board to meet at regular intervals. But the meetings are commonly punctuated with small talk and quick discussions of non-business matters. It is also not

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unusual to find the directors frequently attending these meetings without sufficient background information. But if the question is posed as to whether this calls for reform of these rules, the answer must be in the negative. The manner of conducting meetings, the precise discussions that take place at meetings and how debate occurs cannot be regulated by detailed rules as these involve individuals and how they conduct themselves. These are changes that can only take place as a paradigm shift in culture sets in. Increased trainings and discussion forums can induce such culture change,6 but time is required. 5.2. Board Composition Although the Code does not expressly allude to this fact, the board composition is an essential element to ensuring that an effective board is constituted. Indeed, this is a key feature that determines effectiveness. Whilst much attention has been paid to this element, it has proven to be the most elusive element to satisfy. What exactly comprises the right composition for the board? This must include having the right mix of independent and executive directors on the board, presumably having the offices of the chief executive office and chairman separate, having directors with the right skills and knowledge, and having directors with the appropriate commercial experience and business acumen. The next few sub-sections discuss the problems associated with attempting to satisfy each of these elements. As a precursor, an observation — it is still very common for directors to be appointed from amongst friends and acquaintances, as is it commonplace that the old schoolboy networks still predominate.

5.2.1. Right Mix of Directors on The Board What comprises a right mix of directors on the board is difficult to ascertain. Should a board comprise entirely of independent directors; should it be comprised of 50 per cent independent directors, or is one-third of the board being independent sufficient? A number of boards of the larger companies have moved towards having a primarily independent board with perhaps the chief executive officer and or the managing director as non-independent executive. What is clear is that there has been a call to have a larger number of independent directors on the board, perhaps almost in a knee-jerk reaction to the developments ongoing in other jurisdictions. This writer believes that whilst it is important to have a board with a strong independent element, this ought not to be at the expense of one of the primary roles of a board, which is to set strategy and ensure that it is

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adequately executed. This calls for some management functions as well, which is best executed by the persons who in fact sit on the board as well. Indeed the Companies Act vide an amendment introduced in 2003, expressly provides that “the business of a company shall be managed by or under the direction of the directors”.7 It does not say that management is to undertake this task, although it is commonly understood that the management’s role encompasses, inter alia, the day-to-day running of the company’s operations. It remains the board’s role to be engaged in management but not the nuances of daily operations. Given this, it is submitted that a board with at least one-third independent directors who are effective is apt to ensure that sufficient oversight is maintained. In the Singapore context, this will also ensure that the limited resources are not overly stretched. As such, this writer does not advocate any further reform on this front. Additionally, to ensure an effective board, one factor often overlooked is to have a board comprising of personnel with the right skills mix, comprising both independent and executive directors. This is not an easy task to achieve, and certainly not an area that can be legislatively or through code provisions be dictated. It is a task that the nominating committee must perform in the best interest of the company when nominating directors to the board, or be subjected to a breach of fiduciary duties. What is called for here then, is increased awareness whether through formal trainings or briefing papers. Hence, no attempt should be made to modify the rules in this area, save perhaps for the introduction of a requirement for the nominating committee to disclose the nomination process. This is a sensitive issue in a small country such as Singapore, but can nevertheless contribute towards enhanced corporate governance. It also contributes towards greater transparency and provides shareholders with an indication of how many candidates were considered and why the specific candidate was eventually selected. It does not, however, call for the name of the directors to be mentioned. This is a process that has been introduced in the United States, for instance.

5.2.2. Independence of Independent Directors A key element of ensuring board accountability and so effectiveness is a sufficient degree of independence on the board of directors. This requirement transcends each of the different codes of corporate governance in the Asian countries and the United Kingdom, Australia and United States, although the specific definition of independence and the number of independent directors expected on the board varies from country to country. In Singapore,

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the Code requires that at least one-third of the board comprise independent directors. The Code defines an independent director as one who has no relationship with the company or its affiliates that could interfere, or be reasonably perceived to interfere, with the exercise of the director’s independent business judgement with a view to the best interests of the company. As guidance, the Code expressly provides that a director would be deemed not to be independent if the following relationships exists: • •

•

•

A director is employed by the company or any of its affiliates for the current year or any of the past three years; A director accepts any compensation from the company or any of its affiliates other than compensation for board service for the current year or any of the past three years; A director being a member of the immediate family of an individual who is, or has been in any of the past three years, employed by the company or any of its affiliates as an executive officer; or A director being a partner in, or a significant shareholder with five per cent or more in shareholdings, or an executive officer of, any for-profit business organization to which the company made, or from which the company received, significant payments in any of the past three years. For this purpose, payments for transactions aggregated over the current financial year in excess of S$200,000 are deemed significant.

Malaysia additionally takes the view that a representative of a major shareholder cannot be an independent director. Specifically, the Malaysian Code of Corporate Governance provides that the term “independence” encapsulates independence from management and independence from a significant shareholder. The purpose of the latter requirement of independence in the words of the high-level Finance Committee on Corporate Governance in Malaysia “is to ensure in general terms that there is a component of the board, at least in number, generally reflecting the investment of the public or the minority shareholder in the company, which is not related to either the significant shareholder or the company”. Similar approaches are taken in the United Kingdom (with the introduction of the recent Combined Code) and in Australia. Should Singapore also adopt a similar approach? This depends on the rational for the requirement. The question of whether a major or significant or controlling,8 not substantial,9 shareholder10 should be regarded as not being independent is not one that is easy to answer. On the one hand, given the view that independence is at the end of the day a state of the mind, there

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is no reason to prohibit a substantial shareholder, but not a controlling shareholder, from being regarded as an independent director. On the other hand, in the realms of corporate governance, perception seems to be all important, and if so, perhaps it is better to be conservative and go with the approach that has been adopted in Malaysia, which is also mirrored in the United Kingdom and Australia. This is an area that requires further study, and perhaps one where rules should be introduced to manage the perception.

5.2.3. Chief Executive Officer Separate From Chairman The Code requires there to be a clear division of responsibilities at the top of the company. The intent is to ensure a balance of power and authority, such that no one individual holds a considerable concentration of power. A dualleadership structure is said to reinforce the independence brought about by the presence of independent directors. Yet, the flip side of this argument is that merely having a division of responsibilities is insufficient if collusion occurs at that level. What would, perhaps, be helpful is for guidance to be provided as to who can be appointed to each of the two positions, and to clearly mandate that no collusion will be tolerated, spelling out penal sanctions for such collusion.11 A radical suggestion indeed, but one that will ensure an effective discharge of the functions.12 The dual leadership structure is to a large degree already a practice in many large private and public companies in Singapore. But anomalies are impossible, and a number of companies do continue to have a single person holding both positions. Does this reflect poor corporate governance? Hardly, if having the two positions fused means greater business efficacy for the company, and increased shareholder value. Should there nevertheless be further reform? Yes, perhaps in the manner of the UK Combined Code where the appointment of a lead independent director is recommended, particularly where the two positions are fused. This is certainly an area where further reform may be necessary. A further point of interest and where contention has arisen is to have the two roles in separate persons but with the chairman being an executive chairman. Such an approach has been criticized on the ground that that the chairman must be independent to effectively exercise his oversight role and as an effective leader of the independents. The view is that if he is executive and receiving an income from the company, he cannot be considered independent. Whilst this is on the face of it true, an appreciation of the role of a chairman, particularly in larger companies, will show that it can be quite extensive and does require a person working full time to be present to

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perform the functions. Anything less and the quality of the corporate performance could suffer. It is thus submitted that that any call for the separation of the roles of the chief executive officer and the chairman, with the requirement that the latter cannot be an executive, must not be absolute. There should be recognition, and this is a role which should be performed by the nominating committee, that the independence of the chairman should be examined on a case-by-case basis. 5.3. Board Access to Information In order to fulfil their responsibilities, board members should be provided with complete, adequate and timely information prior to board meetings as well as on an ongoing basis. This obligation is placed on the management. The Code also recommends that the information provided should include background or explanatory information relating to matters to be brought before the board, copies of disclosure documents, budgets, forecasts and monthly internal financial statements. In respect of budgets, any material variance between the projections and actual results must also be disclosed and explained. However, as reliance purely on what is volunteered by management is unlikely to be enough in all circumstances, further enquiries may be required if the particular director is to fulfil his or her duties properly. Such information may also not be forthcoming because of the presence of a domineering board leader or chief executive officer. Hence, the Code rightly recommends that the board should have separate and independent access to the company’s senior management. In addition, the board should have a procedure for directors, either individually or as a group, in the furtherance of their duties, to take independent professional advice, if necessary, at the company’s expense. Where such independent professional advice is taken at the company’s expense, particularly by a single director, that director must be able to justify the reason for seeking the advice in order to prevent any abuse of the liberalization. Is this, however, sufficient? This may be sufficient in the large professionally managed companies, which already practise good corporate governance. The same does not necessarily hold in the majority of the companies, where management tends to jealously guard information to be provided to directors. This is an area where there should be reform calling for a more prescriptive approach in detailing what sort of information should be readily provided to the board of directors, and perhaps even to have this legislated, so that noncompliance will result in penal consequences. Such an approach will make it difficult for management to hold back on information.

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5.4. Training The Code recommends appropriate training for directors, including training on the person’s duties as a director and how to discharge those duties, when the person is first appointed to the board. The Code further recommends regular relevant training, particularly on relevant new laws, regulations and changing commercial risks. Whilst these are pertinent recommendations, the problem has been with compliance. The voluntary and flexible nature of the training stipulations mean that a number of directors do not necessarily undergo training in Singapore. There have been some calls for reform on this front, including discussions as to whether training should be made mandatory. Malaysia introduced mandatory training for directors both when they first became directors and on a continuing basis effective in 2003. The latter continuing training required directors to accumulate a predetermined number of points before they continue to act as directors. Given much feedback, over the last couple of years, the mandatory continuing training requirement will be removed with effect from 1 January 2005. The mandatory training approach is also unlikely to be suitable for Singapore given the nature of the companies, the culture of the key officers of the companies and the current economic state of the country. Hence, a voluntary approach is still preferred. In any event, Practice Note 2.1: Equity Securities Listing Procedure release by the Singapore Exchange in May 2004, requires the applicant for listing to release a statement on MASNET identifying the prior directorial experience of each of its directors, or if a director has none, what training, if any, he has undertaken in the roles and responsibilities of a director of a listed company. This approach of public disclosure of the capabilities of the directors of a company being newly listed is in keeping with the disclosure based regime, and seeks to stem the problem from the outset when a company is made public. 6. BOARD COMMITTEES One of the key changes introduced by the Code was to suggest the formation of board committees, in addition to the audit committee, which is statutorily mandated by the Companies Act. The purpose of such committees is to ensure greater deliberation and a smoother function of the board operations, to prevent concentration of powers in select groups of directors, particularly non-independent directors, and to bring an independent element to bear on key issues affecting the board directly, such as appointments and remuneration.

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The Code specifically recommends the formation of the audit committee, the remuneration or compensation committee, and the nomination committee. While such committees are now a common feature in companies in Singapore, their true effectiveness remains questionable, with anecdotal evidence suggesting that their formation is but the payment of lip service to the rules. Additionally, there is a perceived increase in the cost of running the company by requiring the formation of these committees, particularly given that it will call for additional meetings to be held, and potentially an increased number of independent directors to be appointed. Doubtful though the effectiveness of board committees remains, the call for and the setting up of such committees is increasing. More importantly, greater independence of members who sit on such committees is constantly called for. The Code currently provides for the following composition for the three key committees: • • •

Remuneration Committee — majority, including chairman, non-executive directors independent from management; Nominating Committee — Majority, including chairman, independent directors; Audit Committee — All non-executive, majority, including chairman, independent directors. 7. SPECIFIC CHANGES AFFECTING DIRECTORS

7.1. Directors of a Company can Rely on Advice and Information from Others It is not unusual for directors to delegate a variety of tasks to committees of directors or to management, including administrative staff. Indeed, in an old English case,13 it was held that directors may rely on the opinion of an outside expert, and if they did not obtain such an opinion in the appropriate circumstances, they may be negligent. A more recent Singapore case affirmed that a director was entitled to rely on his subordinates to keep him properly informed so long as there was nothing to indicate that the subordinate was a rogue.14 A new Section 157C was introduced into the Companies Act on 15 May 2003 to codify this common law rule that a director is entitled to rely on information. However, the new section identifies specific persons that the director can rely on, specifically the following persons: •

An employee of the company whom the director believes to be reliable and competent;

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A professional advisor or an expert in relation to matters which the director believes to be within the advisor’s or expert’s competence; or Any other director or a committee of directors in relation to matters within the director’s or committee’s designated authority.

The section makes clear that the relying director must nevertheless show that he has acted in good faith, has made proper inquiry where the need for inquiry arises, and has no knowledge that the reliance was unwarranted. This statutory codification is definitely to be welcomed, if anything, at least for clarity that a director can effectively delegate and reasonably rely on such delegations. 7.2. Director Declaration when Consenting to Act as Director A director is required to sign a consent form when he agrees to accept a directorship. The relevant consent form was amended to include a statement that the director is aware of and undertakes to abide by his duties, responsibilities and liabilities under the Companies Act and common law, including the following: • • •

• •

•

Discharge his responsibilities in the company; Ensure that he has a reasonable degree of skill and knowledge to handle the affairs of the company; Act honestly and be reasonably diligent in discharging his duties and act in the interest of the company without putting himself in a position of conflict of interest; Employ the powers and assets that he is entrusted with for the proper purposes of the company and not for any collateral purpose; Ensure that he and the company comply with all the requirements and obligations under the act, including those relating to meetings, accounts and filing of documents; and Account to the shareholders for his conduct of the affairs of the company and make the requisite disclosures required of him under the act.

This requirement, which applies to all companies, is certainly welcomed as it at the very least acts as a reminder to directors, especially first time directors, about the nature of the role they are undertaking and a quick understanding as to their responsibilities. Such an undertaking ensures that a director cannot even remotely plead ignorance of the exact scope of what was expected from him in a fiduciary capacity. This also puts the onus on him to ensure that he raises his awareness of his role and responsibilities by attending trainings or through other means.

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7.3. Nominee Directors A nominee director is a person who is appointed to the board of directors of a company by a certain appointor. The appointor is usually a person with a large shareholding in the company and the nominee represents that appointor’s interests. This happens most frequently in joint venture companies and in group companies where the parent company nominates individuals to sit as directors on its subsidiaries. Where the nominee does not participate in the day-to-day running of the company, he is, as a general rule, regarded as nonexecutive, but not independent. The two issues which plague nominee directors are whether they can or should ever be considered independent and whether they can provide their appointor with information about the company on which they sit as directors. On the latter issue, a new Section 158 was inserted into the Companies Act. This change puts Singapore in line with Australia and New Zealand. Under Section 158, a nominee director is permitted to provide information about the company to which he is appointed (appointee) to his appointor, whether an individual shareholder or a corporate shareholder or to someone pursuant to whose directions he is accustomed to act, provided the following conditions are satisfied: •

•

• •

The director declares at a meeting of the directors of the company the name and office or position held by the person to whom the information is to be disclosed; The director declares the particulars of such information to be disclosed and the information is recorded in the minutes of the meeting of the directors; The director is authorised by the board of directors to make the disclosure; and The disclosure will not be likely to prejudice the company.

While the new Section 158 is to be welcomed, the application of the section proves to be tricky. For one, it is not always easy to ascertain whether the disclosure of certain information would prejudice the company as the scope of what amounts to prejudice is unclear. There is no case law which aids interpretation. Moreover, a fiduciary duty is now placed upon the company’s board, in addition to the director proposing to make the disclosure, to review the disclosure to be made to the director’s appointor and to provide approval if it finds that the disclosure will indeed not be prejudicial to the company. To ascertain whether the directors of the appointee have exercised their obligations under Section 158 effectively, they will need to show that on the facts before

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them, any reasonable director would have arrived at the decision to allow the information to be disclosed. Of course, if they had negligently omitted to consider certain information, or the lack of consideration of the information was a direct consequence of shortcomings in the skill and diligence of the director, then liability could be found at common law as well as under Section 157 of the Companies Act. This is a duty which is not easy to perform. Another problem pertains to whether a blanket approval can be provided for certain types of information to be disclosed. The views are divided, but given the way in which the section has been framed, a sensible argument can be made that a blanket approval can be obtained for certain types of information to be disclosed. Such an argument also accords with commercial realities. These are issues which should be subjected to review and reform if necessary. 7.4. Business Judgement Rule It is a clear principle of law in Singapore that a court will be slow to interfere with the decision of a director made commercially. Specifically, there have been some recent cases which have discussed this issue at length. In ECRC Land Pte Ltd (in liquidation) v Wing On Ho Christopher and Others,15 the Singapore Court of Appeal endorsed the high court’s view that the “court should be slow to interfere with commercial decisions taken by directors (see Intraco v Multi-Pak Singapore). It should not, with the advantage of hindsight, substitute its own decisions in place of those made by directors in the honest and reasonable belief that they were for the best interests of the company, even if those decisions turned out subsequently to be money-losing ones”. More recently, in Vita Health Laboratories Pte Ltd & Ors v Pang Seng Meng,16 the Singapore High Court endorsed the views in the ECRC decision and noted: This judicial endorsement of the sanctity of business judgment is underpinned by strong policy considerations. It is the role of the marketplace and not the function of the court to punish and censure directors who have in good faith, made incorrect commercial decisions. Directors should not be coerced into exercising defensive commercial judgment, motivated largely by anxiety over legal accountability and consequences. Bona fide entrepreneurs and honest commercial men should not fear that business failure entails legal liability. A company provides a vehicle for limited liability and facilitates the assumption and distribution of commercial risk. Undue legal interference will dampen, if not stifle, the appetite for commercial risk and entrepreneurship.

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This is the first time that the phrase “business judgement rule” has expressly found its way into a local judgement. By way of background, the business judgement rule, which finds its origins in the United States, and which has now found its way into the Australian Corporations Act, essentially provides directors with “safe harbours” from personal liability in relation to informed business decisions that are made in good faith and in the best interest of the company. There is merit to legislating for the business judgement rule. It will also provide greater certainty to directors in the exercise of their functions as to the precise scope of their duties. 8. DISCLOSURE, TRANSPARENCY, ACCOUNTING STANDARDS AND ACCOUNTABILITY Financial information constitutes the bedrock of disclosure. For many investors, the quality of financial disclosure is cent ral to their investment decisions. Yet it was not unusual to find in the 1990s inadequate disclosure, with highly misleading financial statements. This has, however, gradually changed. Singapore has in the last few years introduced more rigorous disclosure rules, including the adoption of international accounting standards. Even quarterly reporting is now required in Singapore. In addition, many of the Asian countries show a semblance of greater assertiveness in monitoring and enforcing rules and regulations. Governments aside, the corporate sector is also paying heed to the need for more extensive disclosure, including disclosure made on a continuous basis. This trend is matched by higher shareholder demand for information and business news. 8.1. Establishment of Accounting Standards Body The Companies Act was amended to establish an accounting standards committee in line with leading jurisdictions such as the United States, the United Kingdom and Australia, where accounting standards were not decided by the accounting profession alone but by independent bodies comprising members from businesses, professional organisations, academic institutions and the government. A reform definitely to be lauded, as the separation of the rule creating body from the rule implementing body can only spell greater accountability. In Singapore, the CCDG has been tasked to do this. The CCDG is made up of businessmen, accountants, academics and civil servants appointed by the finance minister. In the parliamentary debate before the passing of these changes, the then Deputy Prime Minister and Finance Minister, Lee Hsien

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Loong, said that the new council, to be set up in August 2002, would be a means for the private and public sectors to collaborate, “to continuously review and improve Singapore’s corporate governance and regulatory framework”. 8.2. Prescribed Accounting Standards The Companies Act was amended to provide that the profit and loss account must “comply with the requirements of the Accounting Standards”, in addition to giving a true and fair view of the profit and loss of the company. The “Accounting Standards” to be complied with are those that are prescribed by the CCDG. The only exceptions to complying with the prescribed accounting standards are where: • •

The company has obtained the approval of the Registrar of Companies and Businesses to such non-compliance; or Compliance would result in the accounts not giving a true and fair view of any matter required to be dealt with in the accounts, in which case, the accounts need not comply with the prescribed accounting standards to the extent necessary for them to give a true and fair view of the matter.

Where the accounts cannot comply with the prescribed accounting standards in order to give a true and fair view of the company’s profits and losses, the accounts must include the following: •

• •

A statement by the auditor of the company that he agrees that such noncompliance is necessary for the accounts to give a true and fair view of the matter concerned; Particulars of the departure, the reason for the departure and its effect, if any; and Such further information and explanations as will give a true and fair view of the matter.

The accounting standards adopted is the IASs issued by the International Accounting Standards Board, which after a review for suitability, are adopted as the standard for Singapore. The standard is known as the “Financial Reporting Standards (Singapore)” (FRS(S)). The changes introduced in this area are positive and puts Singapore on the international map of accounting standards. 8.3. Disclosure of Non-Financial Information Given that financial statements do not present all information that is material to investors, comprehensive disclosure also includes non-financial information.

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Such non-financial information often proves fundamental to understanding the opportunities and risks of investing in an enterprise. Recent reforms in Singapore has, in theory at least, improved nonfinancial disclosure. For example, Singapore now requires disclosure of corporate governance measures and practices that have been implemented and directors’ remuneration, as well as non-financial information relating to operational issues. Additionally, through an amendment to the Listing Manual, listed companies are also required to disclose their operating procedures, including risk management concerns. 8.4. Quarterly Reporting for Listed Companies Quarterly reporting was introduced for listed companies with a turnover of over S$75 million as at 20 March 2003 with effect from the current financial year. During the parliamentary debate on this matter, the Minister for Finance, Lee Hsien Loong, noted that, “It’s an issue where there are trade-offs but on balance, [it was] felt that quarterly reporting would benefit the listed companies in the long run as investors would gravitate towards more transparent companies.” 8.5. Directors’ Report The Companies Act was amended to remove many confirmation items that were required to be stated in the directors’ report accompanying a company’s audited accounts. It was noted that these confirmations did not add any value to the information contained in the financial statements and were therefore superfluous, and had suggested their complete removal. Certainly a change to be welcomed. 8.6. Auditor Independence With the collapse of Enron and the ensuing elimination of Andersen, auditor independence became an issue of grave importance across the world. The Sarbanes-Oxley Act 2002 saw a number of stringent changes introduced, along with modifications to the New York Stock Exchange Rules. The aim was to enhance auditor independence. Broadly similar changes were also introduced in the United Kingdom and Australia. Likewise, in Singapore, a number of changes were introduced to heighten auditor independence. These changes were enacted inter alia through changes to the Companies Act as well as the Public Accounts Rules. A point to note, however, is that Singapore had

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embarked on making these changes even before the Enron collapse in 2002. These changes are a positive step in ensuring greater independence in the entire audit process, which is one of the most crucial components of monitoring corporate performance and governance. 9. SHAREHOLDER PARTICIPATION AND COMMUNICATION A frequent complaint by shareholders is that they are not provided with sufficient information about the company’s performance nor given opportunities to participate effectively at meetings. In recognition of this, the Code, when first introduced, called for more frequent contact and exchange of information between shareholders and the company. The following sections discuss some of these points further. 9.1. Electronic Distribution of Statutory Reports Permitted The Code in the interest of greater shareholder participation recommends the electronic distribution of statutory reports and other financial information through electronic means. This has now also been codified into law. Sections 387A and 387B of the Companies Act allow for the electronic transmission of the following documents to members or officers or auditors of a company provided certain specified conditions are met: • •

Notices of meetings; and Accounts, balance-sheets, reports and any document required or permitted to be given, sent or served under the act or memorandum or articles of the company. This is certainly a positive step.

9.2. Minutes One key request that shareholders in Singapore, through inter alia, the Securities Investors Association of Singapore, have been making a call for more comprehensive minutes to be drawn up by companies of the annual general meetings. The Companies Act currently only requires companies to keep very basic minutes, which are available for inspection by shareholders. The call for more comprehensive minutes stems from the fact that shareholders feel that their views made at an annual general meeting are not necessarily followed up upon, and they are unable to officially verify if this is so. The request is legitimate, but the practicality of complying is not easy, particularly if very detailed minutes are required. This despite the fact that

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there is technology that allows for verbatim transcribing. Perhaps this is an area that should be studied further and a happy balance found where companies are required to maintain slightly more detailed minutes of key discussion points as follows: • • •

The issue raised in point form; The name of the person raising the issue; and The conclusion reached.

Some companies already maintain such minutes. 9.3. Voting Methodology The Code has also provided that voting methods be extended to include telephonic, electronic, or other modes of absentia voting as well. The intention was to encourage greater participation. Whilst laudable, there does not appear to have been much take-up in Singapore as yet. 9.4. Effective Shareholder Remedies There is constant lament that shareholders, and especially minority shareholders do not have sufficient avenues to pursue remedies where they have been unfairly treated or prejudiced against. Whilst they have recourse to the law, the argument raised is that the process can be expensive, although in Singapore’s case not long drawn. Another area of contention involves the difficulty encountered by shareholders in commencing derivative actions purportedly in the interest of the company for and on behalf of the company.17 Additionally, shareholders of public listed companies in Singapore are not entitled to even commence a derivative action on behalf of the company.18 There is merit in the argument that shareholders should be better empowered to commence actions on behalf of the company, particularly where the directors are defrauding the company, or where as a consequence of derelict performance of duties, the directors fail to protect the interest of the companies. It is submitted that this is an area that should be subjected to reform, to empower shareholders, without having to go through the rigorous process now spelt out in the companies, to take steps to protect the interest of the company. There is likewise merit in the argument that shareholders of listed companies should also be empowered to bring derivative actions on behalf of the company.

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10. LAWS INTRODUCED FOR SMALLER BUSINESSES The reforms taking place in Singapore have laudably recognized that smaller companies, especially non-listed companies, should also be encouraged to have good corporate governance, but with simplified requirements more suitable for them. This does not necessarily mean that the requirements are more relaxed. The next few sections provide a quick overview on this. 10.1. One-Director Companies On the face of it, the recent introduction of permitting companies to run with one director and one shareholder seems suggestive of poor corporate governance. This is particularly so since even public listed companies, which are usually at the centre of scandals, can theoretically run with just one member on the board. Is this then a law that should not have been introduced and should now be subjected to reform? Given that the reality is quite different, this writer would argue that no reform is required. The rationale for the introduction of this law was to enable the cost of doing business to be reduced for businesses and to promote greater entrepreneurship. The changes were targetted at the smaller companies, which were unlikely in the near term to raise any form of finance from the public. 10.2. Lack of Professionally Qualified Company Secretaries The company secretary for a private company need no longer be required to meet prescribed minimum professional qualifications. Public listed companies, however, must continue to appoint professionally qualified company secretaries. Again, this was a change motivated by cost savings and the practical approach of balancing regulatory compliance with the way business is undertaken. Hence, once again, the changes are to be welcomed. 10.3. Audit Exemptions The Companies Act was amended to exempt dormant companies and private exempt companies with a turnover of less than S$5 million from having to comply with audit requirements. As a corollary, a company which is exempt from audit requirements, is exempt from complying with the requirement to appoint auditors. Private exempt companies would, however, have to continue to file a declaration of solvency and an annual return. As a safeguard, however,

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the Registrar of Companies may require such an exempt company to lodge audited accounts if there has been a breach of the provisions on maintaining and laying accounts or if it is otherwise in the public interest to do so. 10.4. Dispensing With AGMs As a further cost-saving measure, private companies were empowered to elect by unanimous agreement to dispense with the holding of annual general meetings. As a safeguard, however, any shareholder can request that a full annual general meeting be held. 11. WHISTLE-BLOWING19 With the Enron fallout, the Sarbanes Oxley Act 2002 was enacted in the United States to inter alia introduce a law to prevent the company or any office or agent of the company from in any way demoting, discharging, threatening or discriminating against an employee who provides information about a potential breach or in any way assist in investigations. Such an employee, if unfairly treated by his employer, can bring a civil claim to ensure reinstatement to his original position and to all back-pay that he may have lost. Whilst the United Kingdom has had the Public Interest Disclosure Act 1998, the Combined Code adopted in November 2003 also provides for whistle-blowing. There is merit for the adoption of whistle-blowing provisions in Singapore too. 12. EFFECTIVENESS OF CHANGES OR A CASE OF FORM OVER SUBSTANCE The rate of perceived buy-in into corporate governance by the various companies in Singapore has been positive. Many companies have the following introduced: • • • • •

The separation of the chairman and the chief executive officer; The requirement for a minimum number of independent directors on the board; The formation of audit, compensation and nomination committees; Adequate communication with shareholders; and Audit and risk management requirements.

Yet, the perceived level of the actual existence of good corporate governance within the companies varies considerably. Although, in corporate governance

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studies undertaken amongst Asian countries, Singapore emerges at the top, this is reflective of the top few companies only. Indeed, many view the attempts at reforming corporate governance as half-hearted, intended purely as a public relations exercise to deflect criticisms of the way in which companies still conduct their business where traditional family ownership and interlocking structures abound, treating with contempt transparency and accountability in the management of company affairs. Put another way, many are content with just ticking off check boxes as to what elements of the Code they have complied with without due regard to the actual substance of compliance. This is certainly an area that requires more efforts to be put into. But this can only be handled through education and eventual cultural changes. Any other method will not result in improved substantive compliance. 13. OWNERSHIP AND THE DIFFICULTY OF IMPOSING CORPORATE GOVERNANCE The typical Singapore corporation generally grow out of a majority familyowned environment or government-controlled entity. Until recently, when increased privatization has been occurring, such government ownership was also a key feature of the corporate landscape in Singapore. Up to 80 per cent of some government-linked corporations are directly and indirectly controlled by the government while a smaller percentage of major nongovernment-linked companies in the banking, shipping and technology sectors are controlled indirectly through inter corporate equity shares between government-linked and non-government-linked corporations. One of the key structures that should undergo changes is the familyowned structure; but there has been considerable resistance from some companies. This resistance stems from the cultural mindset of the individuals who helm the companies, and is unlikely to see actual changes soon. Given such deeply entrenched family ownership structures of companies, it is clearly not easy to impose globally espoused corporate governance standards. Indeed, it has been said that, in essence, a system of checks and balances is being grafted onto a pre-existing, perhaps somewhat autocratic, corporate framework, while leaving real power in the hands of existing owners and ignoring the cultural context in which companies operate. For example, even if Asian companies do appoint new independent directors to the board, there is no guarantee that boards will be more independent than the present boards; especially where these directors are nominated and appointed by the existing board, and not nominated and elected by the general shareholders. Given such a background, the new independent directors

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will only be able to initiate changes if they are strong minded and, more importantly, willing and able to act without fear of reprisal, including not having their appointment renewed. The reality is that such an approach among independent directors is still fairly rare and so the style of management in family-owned companies is likely to remain the same. Yet, this is no reason for not moving forward. Instead ways and means must be identified to coax and educate the stakeholders and corporate governance guardians to change their approaches and mindset. This is an area that the authorities in Singapore appear to be acutely aware of, as a consequence of which when changes are introduced, they have always been tempered with lengthy implementation periods. There is also the issue of the cost of compliance. Where family-owned companies were previously run on a cost minimalist approach, introducing corporate governance measures would mean increased costs, at least in the short term. This serves as a deterrent to wanting to implement corporate governance measures. 14. POLITICAL MOTIVATIONS Singapore, unlike many countries, has approached good corporate governance by leading through examples. Public governance is taken very seriously by the government, with transparency ruling the day. It is also evident that a number of changes were introduced in line with a fundamental shift in emphasis away from the one-size-fits-all regulation of institutions to risk-focused supervision, and from a merit-based regulation to a disclosure based regime. The intent was to ensure greater corporate governance, but tempering this with a need to ensure greater competition and dynamism. This called for some rules, which on the surface did not appear to favour good corporate governance, yet effectively ensured improved business activities. More importantly, whilst the government has had to introduce numerous changes, which were at times painful, these changes were sold as a necessary evil of increasing greater opportunities and prosperity. Time has always been provided to companies to comply with newer stringent rules or where disclosures were necessary. At the same time, prior changes introduced which were found to be not working, were fine-tuned and improved upon. 15. CONCLUSION Many of the changes introduced in Singapore have been effective. The regulatory authorities have become increasingly more receptive to problems

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with rules implemented, if such exists, and are willing to modify or even completely remove some changes. The approach has also been positive in that the country has taken baby-steps and adopted from countries where changes appear to work. They have also not merely adopted from foreign countries just because a change has been introduced; the various changes introduced by the Sarbanes-Oxley Act 2002 being an example in point. Specifically, for instance, the requirements for CEO and CFO certification of the design and implementation of internal controls and the hefty penalties for non-compliance have not been adopted. The changes in Singapore have not seen their end. There is recognition that the environment is not static and reforms will prod on. With globalization, Singapore’s economy, and so the various companies whether or not they have regional exposures, does depend on factors outside Singapore and the control of the authorities. Whilst sometimes bad, the changing global environment means that Singapore must adopt an approach of rule-setting which adapts to new developments. This would mean regular review of existing rules, tweaking of some, throwing out of others, and introducing new changes. The process cannot stop, and reform must continue. Notes 1. Broadly similar, but less stringent requirements have also been introduced in the United Kingdom, Australia. In Singapore, any two directors are required to certify the accounts audited by the auditors. 2. See Chapter 2, paragraph 1 of Anandarajah on Corporate Governance Compliance, first published in 2003. 3. Professor of Economics and Director, Hong Kong Centre for Economic Research, The University of Hong Kong in an article titled “Family Networks, Corporate Governance, and Economic Performance in East Asia”, published in Asian Economic Recovery — Policy Options for Growth and Stability, The Institute of Policy Studies, 2002. 4. Corporate social responsibility will not be discussed further in this chapter. Suffice to say that whilst it is essential that companies exhibit social responsibility, it should not be something that should be prescribed by rules. This view is adopted by this writer despite a global push for CSR rules presently, including in Singapore. 5. The Singapore Code of Corporate Governance in Principle 1 requires that “every company should be headed by an effective Board to lead and control the company”. 6. See further the discussion at Section 5.4 under “Training”. 7. Section 157A of the Companies Act, which is actually a codification of the common law position.

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8. A major or significant shareholder is used in this chapter in the context of a shareholder who holds over 25 per cent of the shares of the company. A controlling shareholder is someone who owns over 50 per cent of the shares in a company. 9. A substantial shareholder is defined in the Companies Act as someone who holds five per cent or more of the shares of the company. 10. A question can also be raised as to whether a major shareholder can himself be an independent director. The issues and concerns are slightly different from the position of a representative of a major shareholder. This writer is inclined to the view that it is possible. 11. There are currently no such provisions calling for penal sanctions, save for the general provisions in the Companies Act which deal with breaches of fiduciary duties. 12. Note that what is intended to be prohibited is the collusion and the mere fact of having the two positions fused in a single person. 13. Re Duomatic Ltd [1969] 2 Ch 365. 14. Personal Automation Mart Pte Ltd v Tan Swe Sang Suit No 777 of 1999 (unreported). 15. [2004] 1 SLR 105; [2003] SGHC 298. See also Intraco v Multi-Pak Singapore [1995] 1 SLR 313. 16. [2004] SGHC 158. 17. Section 216A of the Companies Act. 18. Section 216A of the Companies Act. 19. For a more complete discussion of whistle-blowing, please refer to Anandarajah on Corporate Governance Compliance 2003 at Chapter 7, paragraphs [102] to [154].

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12 CORPORATE GOVERNANCE REFORM AND THE MANAGEMENT OF THE GLCS Pressures, Problems, and Paradoxes HO Khai Leong

“There is no original sin attached to being in the GLC family, which taints a GLC from birth and prevents it from doing certain types of business.” — Lee Hsien Loong, Deputy Prime Minister, Singapore

INTRODUCTION Singapore’s standard of corporate governance was been largely due to the reforms instituted by the state, as well as external pressures from the private sector and corporate organizations. The pressure ranged from constructive advice to pointed criticisms which appeared in reports or instantaneous response to events and procedures of significance. By and large, however, it was the state that initiated many of the proceedings, albeit vigilantly. In building a network of relationships including regulatory and legal framework, the state shows that it still plays integral roles in supporting the corrective forces of markets and enhancing incentive structures. This seems to be the position taken by policymakers in Singapore, who view corporate reforms as

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inevitable. Despite the preponderance of this view, the policymakers are cautious as to the reforms’ possible impact on the share and substance of government-linked corporations. Given this, the extent to which reforms on government-linked companies (GLCs) are affected by the state’s focus on corporate governance ought to be considered. In that past decade, it has become increasingly clear that the Singaporean state-led development model could not keep up with the pressure of global market forces. In order for Singapore to remain truly competitive within the first league, its mode of corporate governance must be improved; and for corporate governance reform to be truly effective, the GLCs must embrace these reforms wholeheartedly (Brancanto 2003). One observer advocates urgency in reform: “Singapore companies are long overdue for a shakeup, especially given the economy’s fragile state.” (Shari 2002). These considerations have resulted in a series of government-formed committees making recommendations. While some progress has been made thus far, these efforts have fallen short of legislative enactment or re-enactment of legal framework that would have been able to guide corporate practices. However, in Singapore, studies have found that the GLCs’ less-than-excellent performances may be due to the fact that they have not incorporated the best practices in corporate governance. Park (2000), for example, reports that the corporate culture in GLCs and statutory boards does not differ significantly from the public sector. As large players in the Singaporean economy, the GLCs have contributed substantially to the city-state development as a business, financial and trading hub in the Asia-Pacific region since the city-state’s independence in 1957. Similarly, their scopes, functions and sectors have also expanded in the last two decades. While their contributions to Singapore’s economy were widely acknowledged by both officialdom and academics, they have now come under increasing criticisms from the private sector and strategists concerned about the future directions of the city-state vis-à-vis the pressure of global liberalization and the onslaught of free capital flow. Specifically, critics have charged that the GLCs have become a burden upon the developed Singaporean economy, as they lack the entrepreneurial depth and local capital necessary for the sustenance of long-term economic development. This flaw is particularly glaring in light of emerging capital-intensive markets, the distorted capital distribution and lowered economic efficiency brought about by the GLCs’ continued receipt of fiscal advantage from the state-run financial sector. In short, the viability, transparency and accountability of the GLCs have remained significant. Many of these criticisms directed at the GLCs are largely related to the outcome of their success (for example, crowding out the local capitals) rather than their failures (corruptions or frauds). To be more precise, this is the

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approach taken by government committees given the task of examining the problems and proposing solutions. Short of identifying the emergent problems in the GLC organizations, these consensus-driven committees tend to speak from the perspective of the government. Observers were, therefore, disappointed when the committee’s proposal fell short of identifying the GLC features that should be targetted for reform (Dow Jones International News, 30 May 2002). It is not surprising, however, that Singapore’s Government has often taken an unbending attitude towards changes in the government’s proposals. For instance, in response to legislative changes, a minister was quoted as saying: “I guess I can live with the changes if they are just commas and full-stops.”1 In that context, approaches that are more innovative, perhaps radical, need to be considered if corporate Singapore is to be reformed. This chapter examines the challenges and the problems faced by GLCs as giant corporations, and the impact of corporate governance codes on them. In analysing the paradoxes, successes and failures of these corporations and through the decipherment of corporate governance culture, their accountability and strategic responses will be assessed. In doing so, the chapter will focus on the corporate level challenges confronting GLCs at the dawn of the new millennium. The PAP government, in its ever pragmatic and eager efforts to reform itself and work with the corporate sector, especially MNCs, faced several paradoxes. The first was the dual need to cultivate and control private sector activities in order to replace the diminishing role of GLCs. The second paradox lay in the GLCs themselves. Like power, they are almost impossible to shrink once expanded to the present extent where they view checks and balances as unnecessary. EVOLUTION OF THE GLCS The works done by a number of scholars managed to identify the sectors in which the GLCs are involved. The GLCs are involved in airlines, shipping, banking, computers, hotels, supermarkets, etc. They are huge corporations, managed by Temasek Holdings, which by one account has total assets of S$181 billion. How did such a huge business corporation evolve? If we were to look at GLCs as MNCs in terms of management culture and mentality, we may utilize the seminal work of Howard Permutter (1969) in tracing the evolution of GLCs in the city-state. Permutter held that management culture and strategies evolved from ethno-centrism or poly-centrism to geo-centrism, with a regioncentric mentality as an intermediate state. The third phase is the most complex as it encompasses technological development, multilateral trade and investment liberalization expanding beyond the region into the global domain.

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TABLE 12.1 Characteristics of GLCs Evolution Strategic Trust

Prevailing Orientation

1. Multi-domestic 2. Regional coordination/integration 3. Global coordination

Poly-centric Region-centric Geo-centric

Accordingly, the characteristics of GLC evolution can be summarized in Table 12.1. As regional economies expand and free trade becomes the norm, the evolution appears logical. If Singapore GLCs are to compete, they must think beyond the region. Although the GLC managements are fully aware of this development, they are somehow reluctant to conceptualize timely strategies to consolidate their resources to focus on development and coordination. Perhaps this could be attributed to the fact that global coordination is still under continuous adjustments. Given this then, it is inevitable that they have come under increasing criticisms from all sectors. What distinguishes Singapore’s government corporations from those of Malaysia, Taiwan and China, is the fact that Singapore’s political business is government run, whereas the other countries’ political businesses are managed by political parties. Neither public nor private, the dominant political parties in Malaysia (United Malays’ National Organization or UMNO) and Taiwan (Kuomintang or KMT) and the highly autonomous military in China (People’s Liberation Army or PLA) each own and operate sprawling networks of productive enterprises and other assets. In turn, these assets position each of these political conglomerates as one of the largest business groups in their respective economies, thus providing them with tremendous political clout. In Singapore, however, the political economy is linked to the government, and not the party. While the distinction is sometimes blurred by the fact that the government has once declared, “PAP is the Government, and Government is the PAP,” a case still can be made that it is necessary to separate the government and the party as far as ownership of these giant corporations are concerned. The present cynicism that such a separation is still problematic relates to a lack of transparency in the accountability as well as operations of these companies. The government’s use of bureaucratic mechanisms to prevent certain measures from becoming public information has taken away some of the credibility that it should rightly enjoy vis-à-vis the other East Asian states mentioned. Indeed, there is a growing recognition that the government’s control of the monopoly enables it to grant legal privilege to

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special interests in the economy. In so doing, the process may work in the interests of the party instead of the nation. It is not surprising therefore to find a strong voice in the private sector calling for a strict separation of business and state. THE GLCS AND THEIR CONTRIBUTIONS Dispute over Percentage of GLCs in GDP It is important to recognize the significance of the GLCs in Singapore’s economic development. If we assume that the GLCs are concurrently a contributor to and a problem of the economy, we must have a comprehensive picture of the GLCs. In other words, we must first define the problem so as to arrive at a true and comprehensive picture on the data surrounding the GLCs. Information on the GLCs, however, is extremely difficult to obtain — we only have estimates, and that there is a widespread disagreement on the percentage of GLCs in Singapore GDP, ranging from 12.9 per cent (Singapore Government’s figure) to 60 per cent (United States Embassy’s figure). The Temasek Holdings website states: “The listed companies in the Temasek Group represent about 21 per cent of the market capitalization of the Singapore Stock Exchange.”2 The Business Times (24 January 2004) estimates that stakes in listed companies owned by Temasek amount to almost S$60 billion, “making up around 20 per cent of the total market capitalisation of all companies listed on the Singapore stock exchange” (Business Times, 24 January 2004).3 Table 12.2 shows some details. Such non-official estimates are reflective of the government’s reluctance to publish figures and data, which would clearly show the state of the GLCs. If the government is committed to reforming the GLCs, it must first produce comprehensive and accurate data on them, instead of providing statistics that are, at best, incomplete. So far, these statistics are indications of reluctance rather than anticipation of or incremental disclosure. The government tends to view the details of government investments and operations as commercial secrets. It also believes that it is not in the state’s national interests to reveal these figures. Furthermore, it maintains that there are enough existing mechanisms within the government to maintain accountability of the state business investments. Lee Kuan Yew, the Chairman of GIC and then Senior Minister, was interviewed by a foreign correspondent in 2002 on the accountability of the GIC, and he responded: We are managing over US$100 billion. The assets have steadily increased in value over the years. The returns are adequate. We are a special

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investment fund. The ultimate shareholders are the electorate. It is not in the people’s interests and the nation’s interests to detail our assets and their yearly returns. The accounts of GIC are checked by the AccountantGeneral, Auditor-General and examined by the Council of Presidential TABLE 12.2 Temasek Holdings’ Stakes in Key Listed Companies (%) As at 31 May ’02 (%)

As at 15 Jun ’04 (%)

As at 15 July ’04 Market Cap (S$m)

Value (S$m)

CapitaLand The Ascott Group Raffles Holdings

63.2 68.9 63.4

62.69 68.83 68.07

4,254.30 659.3 1,112.80

2,667.02 453.80 757.48

Chartered Semiconductor Mfg

60.8

60.35

4,534.90

2,736.81

34

28.77

22,490.80

6,470.60

Keppel Corp Keppel T&T Keppel Land K1 Ventures

32.2 67.4 53.7 59

31.78 81.16 53.71 45.09

4,921.70 461.2 1,235.20 351.8

1,564.12 374.31 663.43 158.63

Neptune Orient Lines

32.6

26.83

3,155.40

846.59

21

0

806.9

0.00

Sembcorp Industries SembCorp Marine SembCorp Logistics

57.9 63.2 63.4

51.5 63.45 62.88

2,368.30 1,377.60 1,672.80

1,219.67 874.09 1,051.86

Singapore Airlines Singapore Airport Terminal Svs SIA Engineering Co

56.3 87.2 87.3

56.76 87 86.63

13,277.8 2,252.80 1,928.40

7,536.48 1,959.94 1,670.57

Singapore Telecommunications

79.7

64.95

34,058.50

22,121.00

SMRT Corp

62

62.29

877.5

546.59

SNP Corp

49

54.7

152.9

83.64

71.9

66.22

2,497.9

1,654.11

56.11

55.89

5,974.20

3,338.98

75

75

361.7

271.28

DBS Group Holdings

Natsteel

ST Assembly Test Svs ST Engineering Singapore Food Industries TOTAL

Source: Business Times, 24 January 2004.

59,020.99 Compiled by BT

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Advisors. There is total accountability. (Quoted in Parliamentary Report, 16 May 2001)

Lee Hsien Loong, then Minister for Finance, also defended the government’s position in parliament: “It [the government] does not stand up and say, ‘Here are all the things; here are all the data; here are my national secrets; here are my defence secrets; here are my foreign-policy moves; and here are my innermost reserves’.” (Parliamentary Report, 16 May 2001) Given such a robust respond to outside queries about investment details, returns, and answerability, many analysts do not expect a generous release of more information about these government-run corporations in the near future. Temasek Holdings Temasek Holdings, established in 1974, is the investment holding company of these government-linked companies. It is involved in a wide range of business activities ranging from port, shipping and logistics, to banking and financial services, airlines, telecoms and media, power and utilities, and rail (see Table 12.3). TABLE 12.3 Singapore: Temasek Group of Companies Port • PSA Corporation Marine • SembCorp Marine • Keppel Offshore & Marine Shipping & Logistics • Neptune Orient Lines • SembCorp Logistics Property • CapitaLand Airline • Singapore Airlines

Telecom & Media • Singapore Telecoms • Media Corporation of Singapore Banking & Financial Services • DBS Bank Power & Utilities • Singapore Power • PowerSeraya and Senoko Power • Tuas Power Technology • Chartered Semiconductor Manufacturing • ST Assembly Test Services Engineering • SembCorp Industries • ST Engineering Rail • SMRT Corporation

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In 2000, Asiaweek listed the top twenty enterprises in Singapore. Six of them are Temasek-linked companies, with Singapore Airlines ranked third and Neptune Orient Lines ranked sixth. As a listed company, the nature of Temasek Holdings is not easy to fathom. An ordinary observer would have to draw connections between loaded legal terms and business jargons in order to compose a vague picture of the huge conglomerate. The following description is abstracted from Temasek Holdings’ website: There are many subsidiaries and associates in the Temasek group. Under Section 7 of the Companies Act, Temasek Holdings is, in general, considered to have deemed interest in a listed company if any of Temasek’s subsidiaries or associates (as defined in that section) has any voting shares in that listed company. The diagram below illustrates the difference between a “direct interest” relationship and a “deemed interest” one that Temasek can have with a listed company. Temasek Holdings (Pte) Ltd

Temasek Subsidiaries and Associates

Direct Interest

Deemed Interest Listed Company

Under the Companies Act of Singapore, a substantial shareholder of a listed company must notify the listed company of any change in its direct and deemed interests. Although Temasek Holdings is not involved in the investment decisions of its subsidiaries and associates, we are required by law to report their investment transactions. These are known as “deemed interest” transactions. (Temasek website)

As Table 12.2 shows, Temasek Holdings is a behemoth, comparable with some of the world’s largest conglomerates, such as General Electric (GE) of the United States. and Germany’s Siemens AG (SI). The listed and private portfolio value of Temasek’s assets amounts to S$90 billion, with 52 per cent of the assets in Singapore (Temasek Holdings 2004). Temasek Holdings has twenty-one managing directors, which makes up 10 per cent of its 200-plus

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staff (Temasek Holdings 2004). It has never disclosed the compensation of directors or senior management. A Temasek Holdings spokesman cited this as the reason: “Information on the compensation of board directors and senior management is not relevant to our performance.” (Business Times, 13 Oct 2004). Figure 12.1 shows the organizational chart of Temasek Holdings.

FIGURE 12.1 Singapore: Temasek Organizational Chart Executive Office

STRATEGIC DEVELOPMENT ASIA

Capital Resources Management

FUND MANAGEMENT

STRATEGIC DEVELOPMENT ASEAN

STRATEGIC DEVELOPMENT GLOBAL

PRIVATE EQUITY FUND INVESTMENTS

Corporate Development

Internal Audit

Risk Management

Temasek Management Services

Organisational Development & Corporate Services

Finance

Strategic Relations

Sources:

POLITICAL ACCOUNTABILITY OF THE GLCS In general, the parliament, the cabinet and the Ministry of Finance play both direct and indirect roles in the governance of the GLCs through Temasek Holdings. At the level of the corporations, the boards of directors are directly responsible for management and control. The government’s role, therefore, is that of a shareholder. In the words of Ho Ching, the Executive Director and CEO of Temasek Holdings: As the monitoring arm of the Ministry for Finance, we were responsible for tracking the performance of the various investments and companies,

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and for reviewing and appointing directors and chairmen to the boards of various companies to represent the government’s interest as a shareholder. This…clearly separated the incidental role of government as an owner and shareholder, from its over-arching responsibility as policymaker and market regulator. A mandate was thus tacitly given for government-owned companies to operate purely as commercial enterprises, and for Temasek to deliver value as an investment holding company. (Ho 2004)

In that rare public appearance, Ho Ching also made another interesting point: Temasek holds and manages its investments for the long-term benefit of Singapore, as distinct from the Singapore Government per se. The PAP government is simply the shareholder representative. “The ultimate shareholders of Temasek are the past, present and future generations of Singapore.” (Ho 2004). There are two additional issues to be considered: First, Temasek’s accountability to the president. Temasek is classified as “Fifth Schedule company”, which comprises seven entities. “Fifth Schedule” refers to the Fifth Schedule of the Constitution, which was a constitutional amendment introduced in 1991. The same amendment provides for the direct election of the president by the citizens. The appointment, re-appointment and/or removal of a board member or its chief executive require the approval of the president acting at his own discretion (Temasek Holdings 2004). The second issue meriting consideration is Temasek’s utilization of Singapore’s reserves. The country’s reserves have been managed by the Government of Singapore Investment Corporation. In April 2004, a constitutional amendment that allowed the government to transfer reserves to key statutory boards and companies, and the transfer of reserves among them with the approval of the president, was introduced. Temasek Holdings has acknowledged that it can access the reserves (Temasek Holdings 2004). Both Temasek’s chairman and chief executive also have to annually certify its statement of reserves and past reserves to the president. The intricate relationships between the government, the president, Temasek Holdings (GLCs), shareholders and the Singapore citizens can be illustrated with Figure 12.2. The parliament is responsible for approving the financial appropriation to GLCs. It exercises control over the expansion of GLCs. The cabinet, led by the prime minister, appoints Temasek Holdings’ chairman and board of directors. In general, the chairman has had experiences in the government and industry as well as public service and is politically affiliated to the government. Members of the board of directors are selected from various sectors.

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FIGURE 12.2 Chains of Accountability — Corporate Governance of Temasek Holdings in Singapore President Government of Singapore (Cabinet Government)

Accountable to

Accountable to

Ministry of Finance (Minister for Finance)

Parliament Accountable to Approves

Citizens of Singapore Appoints Temasek Holdings

Performance of GLCs

• Chairman • Board of Directors • Chief Executive Officer

Accountable to

Shareholders

The Ministry of Finance reviews and approves corporate plans of the holdings; these plans are prepared by the management of the corporations and approved by the board of directors. The minister for finance is accountable to parliament for all aspects of the corporation’s performance, and answers any queries from the legislators. He can propose restructuring, acquisition, strategies of privatization, set goals, etc. for the holdings, to be debated and voted on in the legislature. The president, elected by the citizens, approves the appointment, reappointment and/or removal of a board member or its chief executive. The responsibility for commercial performance rests with the corporation. The role of the government is limited to that of shareholder and the usual functions of the state. The CEO is accountable to the board of directors, and the chairman is accountable to the shareholder. The mandate for the board of

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directors appears to minimize political interference. The corporate business plan prepared by the management and approved by the board states the goals and objectives in terms of strategies and long-term performance, and the quarterly financial reporting system seems to enable both the corporation and government to monitor performance. From this perspective, the role of the government is limited to shareholder functions and to the usual regulatory function of the state. MAJOR ISSUES/CONTROVERSIES The government has always been concerned with the efficient running of GLCs. Lee Hsien Loong, then Deputy Prime Minister and Minister for Finance, explained that the internal operations and performance of the GLCs are utmost in the government’s priority. He states: As the economy grows, and the private sector expands, the shape of government in business will change. The key is not whether companies are government owned, but whether they are well run, entrepreneurial and profitable. We have every intention of ensuring that GLCs are as well run, entrepreneurial and profitable as private companies. That is the way to build an efficient and vibrant economy. (Lee 2003)

While the contributions of the GLCs must be acknowledged, their continued presence and traditional mode of operation is questionable in the new economy. Indeed, the contributions of the GLCs were not questioned during economic boom. On the contrary, the government was extremely happy with the strategies as well as the performance of the GLCs. The efficient, poker-faced bureaucrat-manager and their technocratic management styles seem particularly first rate in time of less competitive environments. So long as the GLCs produced enough returns to contribute to a growth rate acceptable to the government while keeping their flaws and mistakes to a minimum, the GLC network continues to support the government leadership structure. However, in the face of intense competition and economically improving neighbours, the seemingly flawless efficiency and organizational competence are insufficient. In contrast, they suddenly became either negative symbols of conservatism at best or reactionary at worst. Unable to engage with the consequences of such a dramatic and sudden alteration in perception, policymakers were unable to effectively conceptualize solutions in response. Although they were defensive when persistently questioned, they quickly promised change. Yet, changes have not come as dramatically as the sudden

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change in perception of the GLCs’ competence. Hence, there is unrelenting pressure on the government to act. The following discussions highlight some of the major issues surrounding the operations of the GLCs. Clouding Out of Talents or No Entrepreneurial Talents at All? The most severe criticism of the GLCs has to do with their habitual recruitment of a majority of the talent pool in Singapore so much so that the private sector is exhausted of able managers and employees. Both private sector employers and Members of Parliament in the private sector have complained of their inability to recruit the best. To policymakers, these cries against state monopoly of talents were irksome. The government denied that there was no lack of talents; it claimed that even if such a drain were true, it was not of the government’s doing. In defending this view in the parliament, Lee Hsien Loong pointed out that the government does not have a monopoly of top talents as scholarships given are few (300) and of those who returned to serve, only forty per cent remained in service. Typically, a scholar leaves the government services after three to five years. If this is true, it is even more disturbing than the initial criticism on the government’s supposed monopolization of talent. In other words, it is assumed that there are indeed talents, specifically entrepreneurial talents, to be tapped. But according to Lee, the talent pool is extremely small and short-lived. Hence, there is no “clouding out” in the first place. The implication is that there is indeed a lack of talents in both the public and private sector. As such, the question is: Other than outsourcing foreigners, where does Singapore find talents in the New Economy? These efforts to groom competent managers are incapable of grooming the entrepreneurs that the Singapore economy urgently needs. If government were to continue this present line of thinking — grooming talents to manage, value-added for having a stint in civil service — it is unlikely that the so-called talents for the private sector will emerge in the near future. The rationale is simple enough: Entrepreneurial talents cannot be groomed, just as creative thinking cannot be taught. While primary and secondary school curricula are revamped to include the imparting entrepreneurial skills, there are no results to speak of. Instead, we see parents complaining about schools teaching children to be calculating and concerned with the cost-and-effects of daily behaviours when they should be concentrating on developing analytical and cultural skills as well

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as moral values. It could be argued that the root of the problem perhaps lies not in the educational system but in a controlled and stiffening cultural environment. This, then, is ultimately a political issue the top political leadership must address. Crowding out Private Sector or Ineffective Private Sector? The increasing cry about the GLCs crowding out the private sector is another sphinx. It is a fact that Singapore lacks home-grown corporations the size of multinationals with the capabilities of achieving cross-border deals of a considerable size and scale to compete in the region with global players. This situation has its historical roots in the PAP’s strategy in promoting the GLCs in the face of inadequate local capital to boost the economy to a desirable level. The state not only uses the GLCs, but the MNCs as well, in supplementing indigenous developmental effort. With the dismantling of trade barriers and production controls, MNCs and foreign investment will inevitably gain greater sanctity and power. Such a process will further inhibit local capital from effectively dealing with the intense competition for resources and alliances. One criticism of the GLCs is their unfair advantage in government tenders. They are “sheltered” as they are given preferential treatment — this criticism is similar to that of the bumiputera policy in Malaysia. While there is scant evidence on this matter, parliamentarians have nonetheless been voicing this concern as they believe it is an important sentiment among private businesses in the republic. There are also complaints about preferential treatment given to the MNCs and the GLCs at the expense of local companies. Anecdotal evidence suggests that the GLCs and the MNCs win tenders even though local companies offer a lower tender. Later, the MNCs would sub-contract the job to the local companies. This story is awfully similar to the Malaysian Ali-Baba transactions. In other words, this is a question of unfair competition (unfair market practices, inside track, cheap funding, cartels, predatory pricing, abuse of dominance). In response, Lee Hsien Loong offered no apology for the government’s position. He argued that it is impossible to get rid of competition. Even if it is possible, it is undesirable for the Singapore economy. He said: Let’s be quite honest and adult about this. Competition is a fact of life. Even if we privatize GLCs and the Government washes its hands altogether and find a good private owner and manage it, they will still be formidable competitors to the SMEs.

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He continued: They are well-organized, bigger, have depth of management, expertise and able to deliver the services or goods and get the job done. So whoever owns the GLCs, the SMEs are still going to face severe competition. (Channelnews Asia, 15 May 2002)

It is clear the government is unwilling to admit that the threat of the GLCs vis-à-vis the growing needs of the private sector. Instead, the government views it as a matter of competition, for the retreat of the GLCs would not necessarily lead to a mushrooming of private sector, which has been lagging behind the GLCs in the first place. Divestment or Over-Divestment? Many analysts have argued that the GLCs have been half-hearted in its divestment exercise. There were queries about the Temasek Holdings’ commitments in The Straits Times Forum pages. In response, Temasek released some information about the divestment of the GLCs (see Table 12.4). Temasek Holdings, however, left the timeframe for divestment open. It is unclear if there will be more divestments in the future. Temasek’s chairman, S. Dhanabalan, said in 2002: “It all depends on whether the companies are ready or whether the market is ready. In any case, why should we let our competitors know our plans?” (Business Times, 24 January 2004). However, it TABLE 12.4 Singapore: Divestment of the GLCs Government’s share

Singapore Telecom SNP Corporation (1st company on SESDAQ) Singapore Airlines Ltd Neptune Orient Lines Ltd Keppel Corporation Ltd Ethylene Glycols (S) Pte Ltd Cerebos Pacific Ltd The Polyolefin Company (S) Pte Ltd Yaohan Singapore Pte Ltd Acma Electrical Industries Ltd United Industrial Corp Ltd Source: Temasek Press Release, 4 May 2000.

Before

After

100.0 100.0 77.0 62.0 58.5 50.0 45.0 25.0 15.0 12.2 10.9

78.2 49.0 56.3 32.6 31.7 0.0 0.0 0.0 0.0 0.0 0.0

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remains to be seen whether Temasek is committed to an approach where it has to provide some degree of predictability in business transactions. While risks and hazards loom large in a capitalist economy, the normal expectation has been that certain unreasonable factors should be removed from the dealings. At present, the Temasek management leaves the issue wide open. Lack of Transparency or Unnecessary Disclosure? The issue of transparency, or the lack of it, has been a major concern with government critics. Even PAP backbenchers in parliament were voicing concern. Leong Horn Kee, for example, argued that in order to foster trust of the GLCs, the government and Temasek should publish an annual report to promote greater transparency. While the issue of transparency is apparent, it has to be acknowledged that disclosure is also a problem. Alan Greenspan made a distinction between the two: In the minds of some, public disclosure and transparency are interchangeable. But they are not. Transparency implies that information allows an understanding of a firm’s exposures and risks without distortion. The goal of improved transparency thus represents a higher bar than the goal of improved disclosures. Transparency challenges market participants not only to provide information but also to place that information in a context that makes it meaningful. Transparency challenges market participants to present information in ways that accurately reflect risks. Much disclosure currently falls short of these more demanding goals. (Greenspan 2003)

There has been market pressure for GLCs to be more open and forthcoming in releasing organizational and financial information.4 The Singapore Government realized it has to release more information to boost the confidence of foreign investors in order to make the capital market more attractive. Thus, it declared mandatory quarterly reporting beginning in 2003. In fact, the Council on Corporate Governance and Disclosure finally made the decision to move to a quarterly reporting regime in September 2002 after protracted negotiations with various market participants.5 Temasek Chairman, S. Dhanabalan, however, was reportedly against the idea. He expressed dismay over the decision to make publicly listed companies issue quarterly reports in a speech at the Asian Business Dialogue on Corporate Governance in November 2002, where he said, “I am dismayed that we, in Singapore, have decided to impose this practice on listed companies. We

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seem to have tilted in favour of traders in stocks rather than investors in stocks.” (Reuters, 31 October 2002). The government, however, was steadfast in its position. Tharman Shanmugaratnam, Senior Minister of State for Trade and Industry, said the mandate quarterly reporting for listed companies would help reduce speculative behaviour among investors, thereby bringing Singapore in line with best practices elsewhere. This was an implied rebuke of the GLCs. One can therefore detect resistance on the part of the GLCs in implementing a practice believed by the market to be necessary for the improvement of corporate governance. In addition to the above statement, in a parliamentary debate on the amendments on the Companies Act in April 2003, Lee Hsien Loong both opined his confidence in quarterly reporting boosting transparency and disclosure, while conceding that it is a burden on small firms in these difficult times. In that regard, the government extended the one-year waiver to more listed firms. It has lifted the threshold for quarterly reporting requirement from a market value of S$20 million to S$75 million. This means firms with a market capitalization of S$75 million or below that from March 31 need not report their financial performance quarterly. The government also deferred mandatory quarterly reporting for a newly listed company whose initial public offer (IPO) market value is S$75 million or below. With the changes, the number of firms exempted from quarterly reporting will rise from 100 to 300 (Business Times, 25 April 2003). GLCs: High Positions as Political Appointments? Many analysts have argued that the GLCs act as the institutional glue keeping Singapore leadership together. Essentially, this is a two-way process: One, relatives of senior government officials, current and former government officials, former senior military commanders, and current and former MPs of the PAP serve as executives or directors. Two, the PAP recruits political workers from the ranks and file and leadership of the GLC managements. Ross Worthington presented the argument of the core-executive where the interlocking membership of GLCs and government enabled the PAP to extend its control in the business empire, thereby further strengthening the regime interests. Despite repeated reform attempts, ownership/management separation is still ambiguous. The line between official and businessman is indistinct at best, as most of the managerial level positions are state-appointed. There seems to be a small managerial market in Singapore, with appointments

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dominated by state officials. The appointment and dismissal of top management in the large GLCs also seem to be solely controlled by government officials. In addition to the corporate management of the GLCs, these appointed managers are responsible for transmission of corporate information to the government bureaucracy. GLCs’ Image Problem? While a number of GLCs have tried to venture beyond the ASEAN shores, there were not very successful. For example, SingTel made a failed offer for the shares in Australia’s Cable & Wireless Optus Limited (Optus) in 2001. Analysts have questioned the background of GLCs, and political oppositions were surprisingly objectionable to the deal precisely because of their belief in the existence of a political agenda behind the GLC takeover attempt. Also, Hong Kong legislators and newspaper columnists warned that if SingTel, which is almost 80 per cent owned by the government, merged with HKT, Singapore would thwart the territory’s bid to become the region’s telecommunications hub. Prime Minister Goh Chok Tong admitted recently in Hong Kong: “It’s a perception problem. We have to over time convince people outside that there is no political agenda” (The Straits Times, 29 April 2000). But the GLC tag also proved a liability for SIA when it tried to buy a 40 per cent stake in Air New Zealand. New Zealand Premier Helen Clarke objected on the grounds that it would make people think that the national carrier was “effectively controlled by the Singapore Government”. When asked to comment on the “perception problem”, Temasek, which owns controlling stakes in SingTel, SIA and other major Singapore companies, made the following statement: “External parties find it difficult to accept that we do not interfere with the operations of our GLCs.” However, it went on to say that it recognizes that GLCs may make foreign investments in sectors deemed sensitive, such as telecommunications: “In such cases, GLCs will have to assess these investment opportunities from the commercial perspective, bearing in mind local sentiments” (The Straits Times, 29 April 2000). This is an “image problem” connected with the “image” of the government, which many outsiders perceive as an authoritarian figure overreaching into the society. In a capitalist market, it is fundamental to possess confidence and image. Having connections with the state in this regard may have put GLCs at a disadvantage.

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Inability to Go Offshore? Most of Singapore’s GLCs operate at the local level. Some have ventured offshore, but only at the regional level. Few have actually gone beyond the Asia-Pacific region. This probably is normal in the first stage of economic development of the city-state, but regional outreach was given priority in the second stage of economic development. Unfortunately, the GLCs did not develop a strategy capable of leading them beyond this regional circle. Before the FTA was signed, United States Ambassador to Singapore, Steven Green, posed the question: Where are Singapore’s firms in the United States economic recovery? There were huge opportunities to be seized but the Singapore GLCs were nowhere to be found. Even after the FTA was signed, agreements on removal of tariffs, and stricter enforcement of intellectual property rights, etc. will presumably work both ways, enabling the two countries to pursue their own “national interests”. The general perception has been that it will more beneficial to U.S. MNCs than Singapore GLCs. Significantly, other sources of local capitals were almost silent as they lack the resources to compete in the U.S. market. At the same time, there were criticisms from the PAP backbenchers that the GLCs could not compete effectively in the global environment as they were “taken for a ride” in many high profile transactions. Inderjit Singh, a PAP backbencher MP, argued in parliament that GLCs were simply too incompetent. “Our GLCs are late in going global and the consequences of it can be seen in their failure to compete successfully and being “taken for a ride” in certain high-profile acquisition transactions” (South China Morning Post, 1 September 2002). Recent data in 2004 indicate that the TLC and GIC have targetted Malaysia as an investment destination. They have invested in Road Builder Sdn Bhd, UMW Holdings, Telecom Holdings Bhd., Gamuda Bhd, City Square Mall, Royal Dutch/Shell Malaysia and others. Temasek and GIC investments have accounted for about two-thirds of a recent flow of investment capitals cross the causeway. Shareholders’ Rights? According to the OECD Principles of Corporate Governance, shareholder rights include, but are not limited to: 1. Secure methods of ownership registration 2. Convey or transfer shares

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3. Obtain relevant information on the corporation on a timely and regular basis 4. Participate and vote in general shareholder meetings 5. Elect members of the board 6. Share in the profits of the corporation. The listed companies are subject to intense pressures to enhance shareholder value. The corporate governance system can support a working relation between boards and shareholders, even in the form of “partnership”. However, it is equally important to note that such a partnership can only be functional in conjunction with quality standards and market regulation. More importantly, senior management must be committed and willing to take into consideration the mediations between the claims of different stakeholders. Hiring of Foreign CEOs In order to change their image so as to render them more global and responsive, the government has hired a number of foreign talents in GLCs such as DBS and Neptune Orient Lines. Lee Kuan Yew, at one point, acknowledged that he was instrumental in hiring the foreign CEO at DBS. While public sentiments were not too favourable to such a move, they become even more hostile during period of readjustments when certain public interests were hurt. Government backbenchers were quite vocal on this issue. NCMP Steve Chia raised the following questions in a parliamentary session which forced the government to respond: (a) what is the number of chief executive officers employed by government-linked companies and the Temasek Group in the last six years; and (b) of the number employed, how many are still in Singapore and serving with these companies. Lim Hng Kiang, Deputy Minister for Finance, replied: “The government does not keep track of CEOs of government-linked companies. The respective Board of Directors is responsible for the selection and replacement of its CEOs.” (Parliamentary Debates Singapore, Official Report, 11 November 2003).6 Apparently the government exercises a hands-off approach to executive hiring in the GLCs. Privileged Knowledge and Information? Private sector has complained that GLCs were able to get inside information enabling them to compete unfairly. Although the government has denied

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this, the perception has persisted. Studies on government enterprises have also shown that there is evidence suggesting that GLCs were able to acquire advance knowledge for strategic purposes in some industries. “There may be a situation of imperfect spread of information, that is, asymmetric knowledge, of the governmental programmes, such that the GLCs actually have an edge over private firms in utilizing government assistance” (Goh, Sikorski, and Wong 2001). Sikorski, in his study of the Singapore’s marine industry, speculated that the Singapore Government was an “insider” and was therefore able to acquire certain advantages in planning for the GLCs (Sikorski 1999). State Ownership and Control and the GLCs All the above issues are directly and indirectly related to state ownership of these corporations. Much attention has been given to the state as the owner rather than regulator. Inadequate consideration given to the state’s dual role as an owner and regulator; this has given rise to the misunderstanding that the state, once disarmed from the ownership of business, will have no role to play, and therefore rendering its legitimacy increasingly questioned. As a regulator, the state provides an advantageous investment environment for healthy private-state partnership. The GLC sector has been problematic in dealing with reform; unlike the relatively new private sector, the GLC sector is firmly rooted in the government’s paternalistic political ideology and is torn between market and political influences. As a consequence, government officials’ overt concerns with the ideological implications of capitalization of the traditionally trading economy as well as the political consequences of losing control of business ventures have resulted in the administrative level’s resistance to GLC reforms. It has not been noted whether the Singapore Government is more likely to accept “disciplinary” takeover/actions rather than “strategic” takeovers/ actions. Organizational restructuring of GLCs can be accepted and may even be necessary as a political process. Strategic takeovers or selling-off necessitates the gradual easing and eventual surrender of government control. At this point of reform, it seems unlikely that the government would entertain such a radical idea. In fact, the Singapore opposition party Singapore Democratic Party (SDP) has proposed a radical scale-back of the GLCs. The SDP advocates that, with the exception of PSA and SIA, the Government privatises all other GLCs within the next five years. Every year the PAP drags its feet is every year Singapore loses its ability to compete at the international level.7

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The key issue, however, is whether the GLCs are committed to the government’s notion of good corporate governance, as it would necessarily require the GLCs to be more transparent, accountable and responsible. This is the subject we are to discuss next. CORPORATE GOVERNANCE REFORM AND THE GLCS The relevance of corporate governance on the GLCs is underscored by the fact that the latter must be accountable to the shareholders, that is, the people of Singapore. “Corporate governance addresses the issue of how outside investors in the firm (creditors and shareholders) ensure that the managers, or insiders of the firm, act in their best interests” (Prowse 2000). GLCs are financed by government (through taxpayers perhaps), and their returns will be invested or returned to the national treasury in the appropriate proportions owned by the government. Citizens as shareholders and investors, therefore, need to ensure that the managers are making decisions and engaging in activities in their best interests. They are, however, not “shareholders with voting rights”, but voters who can only make the government responsive and responsible. They are “passive investors” at best. The indirect connections are weak connections. Hence, the seldom heard rationale that “GLCs should be ultimately responsible to the people” needs to be reinforced. The politics of corporate governance, therefore, addresses the accountability of GLCs managers to the people of Singapore, albeit indirectly. While GLCs were developing strategies to bring them to greater heights, internally the focus was on improving corporate governance. This is in line with the government and private sector’s expectation that the corporate world be more transparent and accountable. Hence, it is unsurprising to find Temasak Holdings, the investment arm of the government, emphasizing the importance of corporate governance. Its chairman, Dhanabalan, noted: Governance issue are often seen as arising from clear separation of ownership from management. Several pertinent issues that immediately come to our minds are: To whom are the board of directors and management accountable? What are the appropriate levels of shareholder involvement? What safeguards can shareholders rely on to ensure the protection of their interest? But governance is more than a shareholder relationship issue. It is a great determinant of the actual business performance of a company. (Dhanabalan 2002)

This was in October 2002; prior to that, the management did not seem to pay much attention to the subject. These issues have increasingly become

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more important as the management realizes that it must focus on the improvement and reform of corporate culture and system if it wants to be taken seriously in an era of free global trade. The Temasek Charter Perhaps the most important document so far reflecting the strategic thinking of corporate reform of GLCs is the Temasek Charter. The Temasek Charter was a result of important changes at the top hierarchy of GLCs management. The most significant change has been the appointment of Ho Ching to the executive office. The private sector was rife with the speculation that Ho Ching, with her close connection to the highest office in Singapore, was appointed for the sole purpose of overhauling the corporate system in Temasek. Her appointment, however, met with widespread critical analysis by the foreign media and private sector. Although Goh Chok Tong publicly stated his personal approval of the appointment, he admitted that the arrangement is “awkward” especially for the Deputy Prime Minister (Lee Hsien Loong). Many analysts believe that the Singapore Government does not think an outsider would have the political power to implement radical changes (Shari 2002). Within a year after her appointment, Ho Ching and her management team came up with the Temasek Charter, which was published in July 2003. It was the product of decisions made at the organization under a new management. The purpose was to provide some directions to the GLCs as to their future plans. It specifically highlighted several areas. TABLE 12.5 Temasek’s Board of Directors Chairman

S. Dhanabalan, Chairman, DBS Group Holdings

Deputy Chairmen

Kwa Chong Seng, Chairman and Managing Director, ExxonMobil Asia Pacific

Directors

Lim Siong Guan, Permanent Secretary, Ministry of Finance Sim Kee Boon, Chairman, Council of Presidential Advisors Fock Siew Wah, Deputy Chairman, Fraser & Neave Ltd Koh Boon Hwee, Chairman, Singapore Airlines Ltd Kua Hong Pak, Managing Director and CEO, Delgro Corporation Ho Ching, Executive Director and CEO, Temasek Holdings Ng Kok Song, Managing Director (Public Markets), Government of Singapore Investment Corporation

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After its publication, the charter attracted both admiration and criticisms from various sector, especially private sector analysts and observers. Criticisms were levelled mainly directly at the charter’s vagueness and its ambiguity. It was said to resemble another bureaucratic document in need of innovative and radical ideas. For example, The Economist remarked: Temasek’s new charter, published in July, is not helpful either. Using ambiguous jargon (“rationalise”, “consolidate”, “strategic development”), it says that the government will keep some companies, allow others to find foreign partners, perhaps divest a few, start a few others, and so on. All possibilities are covered. (The Economist, November 28, 2002)

The government has justified the GLCs as the private sector’s commercially run entrepreneurs. Many critics believe that such a notion of business and entrepreneurship is misconceived as GLCs compete with the private sector for resources on an uneven ground. It is “the first among equals” so to speak. Indeed, many argue that GLCs should not seek to grow and expand into new products, markets or service at the private sector’s expense. Rather, GLCs should direct their energies toward outreaching strategic business offshore. On the other hand, instead of helping these GLCs, the government should first direct its energies toward achieving greater efficiencies in performing inherently governmental functions before channelling its resources to develop programmes that make the best use of private sector capabilities. Impact of Corporate Governance on GLCs It has been widely acknowledged that GLCs should move beyond its concern with improving economic returns; they should be vigorously reformed. The strategic readjustment of the GLCs’ economic structure — the acceleration of the strategic readjustment of layout and the reorganization to ensure that Singapore remains ahead of others — should be the main premise of the reforms. The impact of corporate governance reform on GLCs so far have been mixed. The important thing to note, however, is that Singapore’s policymakers have generally realized that they must start somewhere. According to Lee Hsien Loong, Deputy Prime Minister and Minister for Finance, reform is required to build business confidence: To position Singapore as a key business and financial centre, we need to give investors the confidence that companies registered in Singapore present true and fair financial statements that are in accordance with international accepted accounting standards. (Lee 2002)

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One major way of building business confidence is to improve on corporate governance, not only the private sector, but also the GLCs. It appears that the most suggested format to resolve the question of corporate governance in the GLCs, which is invariably related to the performance and accountability questions, is to shrink the state’s role in the market through divestment and strategic external economy. Indeed, the major debate has been on how to reduce the quantity and improve the quality of GLCs. Consequently, much of the recent economic reform has been focused on transforming GLC sector dynamics. These approaches did not meet with the wholehearted acceptance of all the top policymakers. It is not surprising, therefore, to find that an important aspect of the debate regarding the existence and performance of GLCs remains unanswered. This pertains to the inability of interested parties to gauge performance in the GLCs and to identify those that need to be abandoned and those to be expanded. Policymakers have acknowledged the first issue as a non-issue. They believe that the accountability mechanisms instituted through legislative check and public scrutiny are adequate for the purpose. The new management of Temasek Holdings has attended to the second issue. While the Temasek Charter has begun to make such identification, many remain sceptical as to whether the policy is reflective of the needs and aspirations of beneficiaries, shareholders and policymakers. The several ways through which the GLCs can move forward by systematically breaking from monopoly practices are outlined below: • • •

•

Implementing a “dual-system” started in 1998, allowing the GLCs to act as both private and public enterprises; Breaking away from the state, easing into market practices and acting as a regulator; Putting a wholly competition policy in place by 2005, an important step permitting the GLCs, joint ventures and private interests to compete on equal footing; and Establishing a set corporate system of open transactions for the sale and distribution of power in GLCs.

It has been officially acknowledged that the GLCs did crowd out local capitals. A sub-committee of the Economic Review Committee, chaired by Raymond Lim, Minister of State for Trade and Industry, recommended strong anti-cartel laws as a cure. While Singapore, one of the freest economies in the world, has a very competitive environment, the SMEs are not accorded any protection in their competition large corporations.

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Opportunities and Challenges As far as the restructuring and reforms of the GLCs are concerned, Singapore’s policymakers have to wrestle with two problems. First, in what ways and how far should GLCs be reformed and restructured? Recent policies suggest some retreat by the uncertain authorities who tend to protect rather than confront GLCs. Second, who should own and control the GLCs once they privatized? There appears to be a strong policy commitment to sell off GLCs — but who will be the buyers, and how will the best practices in corporate governance be achieved? Given the lack of local capitals, foreign buyers appear to be a logical and only probable choice. However, there are at least three problems to this solution. First, those GLCs released for sale may not interest foreign investors. Second, it may unleash a xenophobic feeling among the citizenry who think that foreign ownership of the local market is already too substantial. Third, vested bureaucratic interests may not be willing to give up power over GLCs management and decision making at the expense of their own developmental and other objectives. Despite such denial of networking within the bureaucracies and promises of not keeping present or ex-bureaucrats in GLCs, there are apparently few changes in the arrangement. The GLCs’ top administrators proved wellconnected, and not surprisingly flexible enough to shift authority to other statutory boards and rely on clientele in other state-sponsored agencies. In light of the formidable constituency of bureaucrats, semi-bureaucrats and retired bureaucrats created during the expansion period of the 1960s–80s, there is little doubt that these GLCs will be able to survive: Large GLCs conglomerates with sunk costs will mean employees with money at stake in future sales, and an increasing pool of interested foreign investors. Even critics of Singapore’s political economy could not fail to admit that the abilities of top management in GLCs are redoubtable indeed. Ross Worthington (2002, p. 219), for example, observed that: “The major characteristics for inclusion in the management of boards and GLCs are personal attributes; (sic) management ability, intellectual ability and loyalty to the government.” Despite the effort to run the GLCs like private organizations, there is evidence suggesting that the private sector’s perceptions of the GLCs’ supposed efficient running are not so positive. Sim Wong Hoo, Chairman and CEO of Creative Technology, perhaps the most celebrated Singaporean businessman, was not impressed by the operations of the GLCs. He was quoted as saying:

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Join forces with GLCs? I am not very keen. They deal in big infrastructural projects like power stations. Small hi-tech firms like us are not suitable partners. Besides, we need to move fast because the market is moving too rapidly; we do not want to be bogged down by too much coordination and red tape. (Business Times, 11 January 1993)

Despite the fact that this remark was made almost a decade ago, present events have evinced the veracity of his statement. A decade later, in 2003, a Chinese business leader leading a group of powerful Chinese corporate businesses to Singapore complained of his dealings with the GLCs. He was totally unimpressed by the efficiency of these giant corporations (Lianhe Zaobao, 24 October 2003). It is difficult to do business with the GLCs, the headline said, quoting this supposedly less experienced businessman from a state-controlled economy, because they were always “one-step behind” (Man ) in terms of decision making and strategizing. yi pai At present, the gaps between good corporate governance at the rhetorical level and practice are huge. Good corporate governance is, of course, desirable, and for many Southeast Asian countries, its achievements are still many years away. The important thing is not to embrace it all at once, but to realize its complexities and formulate strategies to achieve the desired objectives step by step. Procter (2002), for example, suggested that Southeast Asian policymakers should do things one step at a time, instead of rushing to do everything at once. The best first step to get there, he suggested, is through improved corporate disclosure, that is, disclosing information that is timely and accurate. This should probably be the short-term target of governments and corporate sectors in the crisis-stricken Southeast Asian region. This advice, however simple and elementary, is applicable to Singapore too. Information about the procedural safeguards, the protection of stakeholders, and data about GLCs in the republic is wholly inadequate. Private researchers, small investors and academics have long complained about the lack of information on vital statistics of the Singapore’s economy. This lack of information can impede understanding and even worse lead to conclusions and judgements which may harm relationships and interactions in the political economy. Corporate disclosure should indeed be the first item on the reform list. CONCLUSIONS Corporate governance reforms are unable to offer any guarantee for economic performance for Singapore, as it cannot reverse the expansion or restructuring of the state-linked corporations on its own. Institutional and legal reforms

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coupled with cultural change can facilitate a gradual transition of corporatized GLCs into more efficient and market-influenced entities. The strategies designed by the GLC managements will no doubt affect the sector’s economic relevance, but whether it will meet with enhancement or further irrelevance is difficult to tell at the moment. The determination shown by the Temasek Holdings management seems forceful and compelling (Sabnani 2003), yet the perceptions from the rest of the economy in the private sector seem equally doubtful. The political aspects of GLCs reform, undoubtedly, require further and substantial adjustments. It is, of course, difficult to advocate a complete withdrawal of political and bureaucratic control of these corporations. The GLCs entrenched interests, which are already so deeply embedded in the republic’s economic history, will probably take greater societal effort and political will to be significantly altered for the future development of the economy. A strategic reformulation is in order if a healthy private-public partnership is to emerge and flourish. The problem lies in the lack of such strategic reformulation. At the moment, the momentum for such a change exists. Hopefully, it does not require another financial crisis such as the 1997 one to galvanize policymakers to fundamentally rethink the impact global transformations on regional and domestic political economy. Notes 1. Surprisingly, this is a criticism coming from a PAP backbencher. See Tan Soo Khoon, “Why are People Cynical about Politics? Are We Missing Something?”, Straits Times, 4 April 2002. 2. Temasek Corporate backgrounder. . 3. It added that these computations took “into account direct and deemed shareholdings that Temasek has in these companies. They may be some double counting because of ownership through subsidiaries”. 4. One such call came from Alison Chow, CEO of irasia.com, who is an advocate of quarterly reporting. She was quoted as saying: “‘I believe sophisticated and educated investors would take into consideration that information available on a quarterly basis reflects a cyclical element…and would do their analysis and make their investment decisions accordingly…Quarterly information should help investors stay more informed — whether they choose to utilize or ignore this information in their analysis is entirely up to them, but at least they have that option.” Ironthenet, . 5. “Dissent over Quarterly Reporting in Singapore”, . 6. Readers can access parliamentary debate official reports with this website: . 7. The Singapore Democratic Party (SDP) proposed the following radical solution: “Scale back the GLCs. Pretend as they might, GLCs cannot provide, much less sustain, economic development in Singapore. They must be dismantled and, in their place, local private companies must be allowed to surface and be given the chance to compete internationally, with the government playing only a supporting role. The SDP advocates that, with the exception of PSA and SIA, the Government privatises all other GLCs within the next five years. Every year the PAP drags its feet is every year Singapore loses its ability to compete at the international level.” From SDP’s 5-Point Economic Plan For Singapore. .

References Brancato, Carolyn Kay (2003) Singapore Corporates and Investor Confidence. New York, N.Y.: The Conference Board. Dhanabalan, S. (2002) “Why Corporate Governance — A Temasek Perspective”, 31 October. Goh, Mei Lin, Douglas Sikorski, Wong Wing-Keong (2001) “Government Policy for Outward Investment by Domestic Firms: The Case of Singapore’s Regionalisation Strategy”. Singapore Management Review 23, no. 2. Greenspan, Alan (1998) The Current Asian Crisis And The Dynamics of International Finance. Testimony before the Committee on Foreign Relations, U.S. Senate, 12 February 1998. Ho, Ching (2004) “Temasek Holdings: Building Sustainable Value”. Institute of Policy Studies, 12 February, published in Straits Times, 13 February 2004. Ho, Khai Leong (2003) Shared Responsibilities. Unshared Power. The Politics of PolicyMaking. Singapore: Eastern Universities Press. Lee Hsien Loong (2002) “Second Reading Speech on the Companies (Amendment) Bill 2002”, . ——— (2003) “Motion on Temasek Charter and EISC’s Recommendations on Government in Business — Speaking Points for DPM’s Round-up Speech”. Singapore Government Press Release, . Park, Donghyun (2000) “Singapore Corporate Cultures: An Introductory Overview”. International Area Review 3, no. 2 (Winter). Perlmutter, Howard (1969) “The Toutous Evolution of the Multinational Corporation”. Columbia Journal of World Business 4: 9–18. Procter, Andrew (2000) “Comments on Corporate Governance in East Asia: A Framework for Analysis by Stephen Prowse”. In Asian Economic Crisis: Causes, Consequences and Policy Lessons. New York: United Nations.

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Prowse, Stephen (2000) “Corporate Governance in East Asia: A Framework for Analysis”. In Asian Economic Crisis: Causes, Consequences and Policy Lessons, New York: United Nations. Sabnani, Mano (2003) “Restructured GLCs Set to Lead any Market Recovery”. . Shari, Michael (2002) “Can Ho Ching fix Singapore Inc?” Business Week, 24 June. Sikorski, Douglas (1999) “Singapore Public Enterprise in the Marine Industry”. Asian Academy of Management Journal 4, no. 1: 35–54. Temasek Holdings (2004) Investing in Values. Temasek Review 2004. Singapore Temasek Holdings (Private) Limited. Worthington, Ross (2002) Governance in Singapore. London: RoutledgeCurzon.

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13 FROM THE INSIDE OUT Reforming Corporate Governance in the Philippines by Engaging the Private Sector Felipe B. ALFONSO, Branka A. JIKICH, ~ René G. BANEZ

INTRODUCTION Corporations worldwide are currently undergoing extensive restructuring and reform in their governance practices. In the post-Enron era, Western governments have acted quickly to impose swift and stringent new regulation on corporations, in an effort to prevent future corporate fall-outs. In emerging and developing countries, governments have instigated corporate governance reforms as a means to enhanced economic growth, by encouraging a responsible private sector and deepening capital and financial markets. SETTING THE STAGE FOR REFORMS IN ASIA The Asian financial crisis of the latter part of the 1990s is generally recognized as the major impetus for corporate governance reforms. The collapse was characterized by inadequate resource allocation, over-investment in profitable

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industries, unsustainable financial leverage and overexposure to foreign shortterm borrowing, among others.1 Other forces at work on the international stage at the start of the millennium included the spectacular collapse of Enron and the other corporates that followed suit, as well as the reality of increasingly interconnected capital and financial markets, which have promulgated growing convergence in accounting and governance standards. In the Philippines, opaque financial reporting, conciliatory boards of directors, poor internal controls, haphazard disclosure, and substandard audits were largely entrenched in the corporate structure. Largely family and stateowned enterprises typified (and still typify) the business sector.2 Moreover, a weak regulatory framework circumscribed the power of enforcement to ensure compliance. The combination of these factors made for an undesirable environment in terms of accountability, and transparent mechanisms for good governance. A change in the perception, regulation and practice of governance was long overdue. Yet the Philippines was among the last countries in the region to undertake sorely needed corporate governance reform initiatives. Neighbouring countries like South Korea, Singapore, even Thailand were vulnerable and over-leveraged as a result of having attracted substantial foreign capital inflows — the fallout from the crisis had left them high and dry. Seeing there was no other way out, they embarked on incisive and sometimes painful reform measures across the board. The Philippines, a laggard economic performer by comparison and less captivating investment destination than its booming neighbours, suffered a 5 per cent real GDP output drop from 1997 to 1998. In comparison to the 9, 10 and 11 per cent output tumble experienced by Korea, Singapore, and Thailand respectively,3 the fall was hardly as staggering. Wholehearted efforts to refocus and reform governance structures, then, were precipitated by internal events. INTERNAL FORCES AS CATALYSTS FOR CHANGE IN CORPORATE GOVERNANCE: SELF-REFLECTION AND ACTION In effect, the Philippines embarked upon the winding journey of corporate and financial system reforms in 2000. The process was put into motion by the Central Bank of the Philippines (Bangko Sentral ng Pilipinas, BSP) when it created the Central Monetary Authority, an act that enabled the BSP to impinge upon a poorly regulated banking system vulnerable to political influences. Concurrently, the Securities Regulation Code of 2000 was put into place, prompted by a stock market scandal involving a listed company on the Philippine Stock Exchange, BW Resources. The scandal, which was

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perpetrated by allegations of insider trading and price fixing, shook investor confidence and threatened to close down the exchange. The time had come for swift change. The code greatly extended and enhanced the regulatory power of the Philippine Securities and Exchange Commission (SEC). REGULATORS STEP UP TO THE CHALLENGE Backed by a World Bank review of standards on corporate governance in 2001,4 and the formation of the presidentially mandated Capital Markets Development Council, the BSP and SEC consequently lead the corporate governance reform effort in the Philippines. The predominant issues at hand were based on globally-accepted good governance principles, namely protection of shareholder rights; commitment to installing sound corporate governance structures (accountability and ethics in business practices); effective board governance (to uphold shareholder value); transparency and disclosure in financial and non-financial reporting; and the external audit function.5 The locus of initial reforms by the BSP and SEC focused on all-out compliance, emphasized the oversight function and responsibilities of the board of directors, and aimed establish an infrastructure for improved governance through director training, the introduction of codes and the application of scorecards based on self-evaluation. THE PHILIPPINE SECURITIES AND EXCHANGE COMMISSION AND THE 2002 CODE OF CORPORATE GOVERNANCE Our analysis centres on the discussion on the reform effort undertaken by the SEC, which is embodied in its 2002 Code of Corporate Governance. The code became effective on 5 April 2002 and is applicable to listed and public Philippine corporations. The approach taken by the SEC is essentially rather balanced; it specifies corporate governance best practices but allows companies to depart from these if they explain their reasons for doing so (within certain limits). Corporate governance codes worldwide have utilized this method as a way to improve transparency and force companies to think carefully in explaining any departures from the code. This method is contingent upon the ability of the regulator to ensure and enforce these disclosures by corporations.6 We regard the code as an important step in the Philippines’ commitment to improved corporate governance, though the SEC must be flexible and willing to adjust it according to the needs reflected in the private sector. Indeed, the Philippine corporate sector has received the Code of Corporate Governance with varying degrees of enthusiasm, citing the SEC’s over-

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reliance on OECD-style corporate governance best practices in formulating its basic tenets. According to Manuel V. Pangilinan,7 “A number of new regulations and laws in the Philippines are what we call aspirational, which tend to be — at least for the moment — not at par with the reality of Philippine business.” Pangilinan, Chairman of the Board and former CEO at PLDT (the country’s telecom giant) believes that the reality will catch up nonetheless. He points out that regulation is critical to instilling good corporate citizenship into the business culture: “There is a moral underpinning to transparency and accountability — good management also means people being honest financially and mentally,” he posits. Other members of the corporate community share this view and perceive the code as an attempt to formalize and structure the governance mechanism within an organization, essentially reinforcing good governance behavior that may already be in place. “Corporate governance is a natural progression of the elements we already embody — we see it as a positive change for our company and for Philippine business practices,” cites Mercedita S. Nolledo,8 Senior Managing Director and General Counsel at the Ayala Corporation (the Philippines’ largest conglomerate). Helen T. de Guzman9 states: “Though we (myself, the corporate secretary and chief legal officer) faced pressure (from the board) to basically adhere to a minimum compliance standard, we saw corporate governance as a way to sustain the growth and success of the company.” De Guzman, who is head of corporate audits and compliance officer for the Manila Electric Company (MERALCO), the country’s largest electricity provider, feels strongly that good governance will enable the company to successfully continue its hundred-year legacy. Still, the majority of corporations have adopted the code at a minimum compliance level. The real implications and spirit of reforms will require both time and a true belief that so called corporate governance best practices necessarily go hand in hand with good business practices. Antonio G. Pelayo,10 Vice President for Finance at the Petron Corporation, believes that changes in corporate governance will require some getting used to: “We can adopt the best practices of the U.S., and Europe, but they may not necessarily work in the Philippines — and you cannot implement all the practices you would like to implement from day one — there must be a transition.” Carlos Arguelles,11 VP and compliance officer for the PHINMA group of companies, concurs: “Maybe I’m generalizing,” he notes, “but we Filipinos are like a diesel engine, and it takes a while for us to heat up. Corporate governance is being implemented, but I am differentiating implementation and effectiveness — for it to really make an impact on capital markets, it has to change the way

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directors think — and I think it will be a while before this happens — it has to sink in and become operational.” Lilia R. Bautista, the commission’s chairperson and chief architect of the code, iterates that the code’s aims are positive and is confident that active promotion of corporate governance in the country will raise investor confidence, develop capital markets and achieve sustained economic growth. “We have to admit that we lack capital resources, and to improve and mobilize, we need to have the confidence of investors — both domestic and foreign — in our markets.”12 In a broad sense, Bautista’s concerns are valid. The Philippines has much to gain through an accountable corporate sector — one that investors perceive to be associated with fewer economic risks. If this goal is to be achieved, the SEC must be willing to improve the code, so that it ultimately complements the environment within which Philippine corporations operate and their way of business. Fortunately, corporations seem open to an ongoing dialogue with the SEC, as top executives and board members have shed necessary light on the realities and ramifications of the Code of Corporate Governance. THE CODE OF CORPORATE GOVERNANCE: ROOM FOR IMPROVEMENT? The code is divided into nine major categories; definitions; board governance; supply information; accountability and audit; stockholders’ rights and protection of minority stockholders’ interests; evaluation systems; disclosure and transparency; commitment to corporate governance; and administrative sanction. In the following sections, we provide a broad overview highlighting the specific items in the sections we believe merit discussion — we also include perspectives from key executives within Philippine corporations. Definitions An extensive list of definitions specific to the basic framework of a corporation is presented in this initial section. The more poignant definitions involve the board of directors, corporate governance, and independent director. The board of directors is described as a “collegial body that exercises the corporate powers of all corporations formed under the Corporation Code. It conducts all business and controls or holds all property of such corporations.” This definition introduces the idea of the board of directors as an oversight body, looking into the decisions of management and the CEO. The concept

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that the board possesses any real power is relatively new in the Philippines. Helen T. de Guzman notes: “In the Philippines, it was management who is all-powerful, not the board. It used to be that the board meeting was just an occasion for the members to greet each other.” In fact, she welcomes the idea of a more powerful board as a way to keep management on its toes by overseeing its activities. Corporate governance is defined as a “system whereby shareholders, creditors and other stakeholders of a corporation ensure that management enhances the value of a corporation as it competes in an increasingly global market place.” Though enhancing the value of a corporation is certainly a key element of the governance mechanism, a more comprehensive definition would give some relevance to the procedures for making decisions on corporate affairs, and a shared role among the board, management, and stakeholders in ensuring the corporation’s success. According to the code, an independent director is: a person other than an officer of employee of the corporation, its parent or subsidiaries, or any other individual having any relationship with the corporation, which would interfere with the exercise of independent judgement in carrying out the responsibilities of a director. This means that apart from the directors’ fees and shareholdings, he should be independent of management and free from any business or other relationship which could materially interfere with the exercise of independent judgement.

The presence of an independent director should provide an objective, unconstrained opinion on the board. The Asia Business Council points out that “competent and genuinely independent directors on a corporate board signal to the marketplace that the corporate leadership is serious about protecting the rights of all shareholders and the integrity of the company.”13 The idea of independent directors then, is logical. Luis A. Maglaya,14 Corporate Secretary at the Petron Corporation, believes that independent directors provide an objective viewpoint during board meetings: “Independent directors do provide an objective viewpoint. It is in the interest of publicly listed companies to have an independent voice — one that doesn’t represent the major shareholder, and I believe that’s worthy.” Opinions as to the effectiveness of independent directors on Philippine boards, however, are quite varied. Washington SyCip,15 one of the country’s best known executives and founder of the SGV Group, posits that the presence of independent directors — along with a confrontational style of

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Western business practices — would be counter-intuitive to the synergy and harmony that is characteristic of Asian boards. Taking into account a culture that emphasizes the development of lifetime relationships in business and private spheres, the idea of inviting a complete stranger to sit on a board — qualified as he or she may be — is alien to many companies. Though Carlos Arguelles recognizes the inherent benefit of having an independent view on the board, he is sceptical that companies would appoint independent directors off the street. “You get these people because you know them, and in my personal opinion, you appoint them because later on, they can give you some business — it’s networking,” he reasons. Board Governance

Board Size and Composition Effective board structure entails the review of size and composition of the board. The number of members on the board must allow for a meaningful, lively discussion and efficient decision-making. Composition should be dispersed among shareholders, management, and an appropriate number of independent directors. The code endorses this general idea by mandating that the board be comprised of at least five (5), but not more than fifteen (15) members, who are to be selected by shareholders. With respect to composition, the code requires that boards of public companies be comprised of a minimum of two (2) or 20 per cent independent directors, whichever is the lesser. This falls in line with the idea that boards must incorporate a certain degree of independence to fulfil their fiduciary duties. In the Philippines, boards are still warming up to the idea, as the size of corporate sector remains a relatively small, enclosed circle. “The only mandate in the code we see as a challenge is having a certain amount of independent directors — because we are a group of companies, finding an independent directors isn’t always easy — but we’ve done well,” maintains Ayala’s Mercedita Nolledo. PHINMA’s Carlos Arguelles has a more pessimistic outlook: “In the Philippines, it is very difficult to get an independent director — one who will say in a board meeting ‘No, I don’t agree with this.’” Given this scenario, the code should focus less on the number of independent directors on boards and more on ensuring an independent mindset for directors. At the end of the day, it is the integrity of board directors that is critical when they are performing their duties.

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Duties, Functions, Responsibilities The roles and responsibilities of management and the board of directors are in essence the building blocks of corporate operations. The board provides the vital link between shareholders and managers. Its responsibilities centre around ensuring that strategy is developed, looking after the long-term competitiveness of the company, overseeing management, guarding compliance and safeguarding internal controls. The Board and Management: A Balancing Act Board of Directors

Shareholder Rights

Balance

Rights of Other Stakeholders

CEO & Management

The CEO and management in turn are responsible for the day-to-day operations of the company through a volatile business climate. They design a cohesive strategy, maximize company value, and uphold the reputable standing of the company in the community. The combined efforts of the board and management are designed to be complementary in nature and protect shareholder value. This value is rooted in fair and equitable treatment, the freedom to exercise rights and equal access to available information on the financial standing of the company. The management and the board must also ensure that dominant shareholders do not exploit their power by benefiting at the expense of the minority. Together, the roles, responsibilities and rights of the main players provide the vital balance in a corporation. This balance is sustained by the idea of stewardship. The code encourages this balance and maintains that the board’s main responsibility is to foster the long-term success of the corporation. The board must do this in a manner that is consistent with its fiduciary responsibility, which it should exercise in the best interest of the corporation and its shareholders.

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Board Committees The use of committees is also an important element of effective board governance. Committees must have clear mandates or charters that outline how they are to be set up and members are selected, and should be guaranteed access to all required information and resources to carry out their functions. The code recognizes that board committees are useful tools for effective governance, recommends the formation of audit, compensation and nomination committees within boards. Utmost importance is placed on the audit committee, as its members are responsible for providing oversight of the credit, market, liquidity, and risk management activities for the corporation. Depending on the risk profile of the corporation, the code also recommends the formation of a separate risk management committee. The use of committees on Philippine boards is relatively standard practice. Many in fact have formed committees specific to the needs or profile of the corporation — beyond the standard audit, nomination and compensation functions outlined in the code. MERALCO’s board features a management committee, which is headed by the CEO and composed of a cross-functional set of corporate officers and executives of the company. The committee’s core function is to provide the board with a comprehensive and objective view of the company’s operations and day-to-day management. It must also ensure that relevant information reaches the board in a timely and systematic manner. Ayala’s board includes a Proxy Validation Committee. Table 13.1 outlines TABLE 13.1 Committees within the Boards of Major Philippine Corporates AB San Ayala MERALCO Bacnotan* Capital* PLDT Petron Miguel Committee Advisory Executive Risk Management Finance Management Retirement Trust Proxy Validation Audit Compensation Nomination Governance/Nomination

✓ ✓

✓ ✓ ✓ ✓

✓

✓ ✓ ✓ ✓ ✓

✓ ✓ ✓ ✓

✓ ✓ ✓

*Part of the PHINMA Group of Companies

✓ ✓ ✓

✓ ✓ ✓

✓ ✓ ✓

✓ ✓ ✓

✓ ✓ ✓

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the various committees present within the boards of major Philippine corporates. Accountability: The Basis for Disclosure and Transparency Accountability refers to a facet of governance underscoring the idea that corporations must be held responsible for the manner in which they run their business. More concretely, they are bound by a commitment to generate value to shareholders (majority and minority), other stakeholders, and society at large. The underlying behaviours or practices consistent with this notion involve transparency and disclosure. Both elements are beneficial to good governance. They inspire trust, confidence and credibility, allow shareholders and would-be investors to make informed decisions about a company, and help to prevent economy-wide anomalies and possible economic downturns. The code recognizes the critical importance of disclosure and transparency for good governance, and states that the more transparent the internal workings of a company are, the more difficult it is for management and controlling shareholders to misappropriate company assets or mismanage the company. Proper and timely disclosure thus plays a vital role in discouraging corruption within corporations, helping to allocate funds to their proper uses and earn higher rates of return. The positive spillover effects of curbing private sector corruption include lower consumer prices, enhanced efficiency and an increase in direct investment. CORPORATE CULTURE AS A CATALYST FOR GOOD GOVERNANCE While the mechanics of governance we have described are useful in addressing the control structure in an organization, there is a missing link — corporate culture, which is crucial to ensuring that good governance is carried out. Corporate culture involves the moral, social and behavioral norms of an organization based on the beliefs, attitudes and priorities of its owners, managers and employees. It guides how employees think, act and feel. Corporate culture also encompasses ethics, responsibility, and leadership. “It is my belief that corporate governance thrives in an ethical culture, and those core values really promote ethical culture,” cites Helen De Guzman of MERALCO. Insofar as governance, a befitting corporate culture gives rise to internal codes of governance, which are good instruments for internal control. The

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Structure and Soul: Elements of a Resilient Corporation

Changing Economic Conditions

Regulatory Pressure & Demands Checks & Balances

Corporate Culture & Collaboration Accountability

Effective Board Structure

Changing Market and Competitive Conditions

absence of ethical business practices in the corporate culture of the fallen Enron has been linked to its demise. Senior executives of the former energy giant, though certainly competent managers, lacked scruples and ethics — a sense of right and wrong. They essentially knew how to get around the rules. According to PLDT’s Manuel V. Pangilinan, “corporations with the right values actually are the ones who will survive in the long run.” The synthesis of accountability, checks and balances, effective board structure and corporate culture contribute to a successful organization. Thus, it is the structure and soul in governance that work in unison to form a resilient corporation. Such a corporation is flexible enough to adapt quickly to external conditions and exogenous shocks (that is, changing macroeconomic conditions, regulatory pressures and competitive forces). A positive attitude toward governance also implies that corporations are more likely to work with regulators in improving codes and regulations. As Carlos Arguelles of Phinma notes, “If Philippine corporations don’t truly want to practice good governance, it won’t work. It has to come from the board — and their determination that yes, this is a good thing.”

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STRENGTHENING THE INSTITUTIONAL CAPACITY FOR REGULATION The effectiveness of any new regulation will undeniably be determined by the enforcement capacity of the Securities and Exchange Commission. While political will to undertake corporate governance legislative reforms is important, the enactment of new securities rules would be a more welcome change. Beyond these, the greater concern of investors and the public in general is the institutional capacity of the SEC to implement such reforms. Without this ability, any reform initiatives are unlikely to make an impact. Given this scenario, the SEC can improve its mechanisms for corporate governance administration. First and foremost, it must ensure that any regulation enacted is consistent with corporate values, and thus provide an incentive for companies to abide by it. Second, it must be consistent in maintaining strict alignment with policies and procedure, without any special treatment or exceptions for certain corporate players. It must also provide adequate training and development to improve and enhance personnel competencies. Finally, the SEC must not shy away from invoking penalties for violations when deemed necessary. It must realize that improving governance within companies is constantly evolving, and thus adjust its reform initiatives accordingly. As René Bañez notes, “Corporate governance has no defined end-state. It is a continuing process of defining and refining the rights and responsibilities of the various stakeholders to achieve excellence in business.”16 ROADMAP TO IMPROVED GOVERNANCE: PRIORITIZING REFORMS We recognize the important strides taken by the Securities and Exchange Commission in championing corporate governance reform. The 2002 Code of Corporate Governance addresses the key paradigms and themes outlined by global best practices. It is evident however that the code must be streamlined and tailored to the needs of the corporate sector in the country. In the two years since the code’s implementation, the commission has had ample time to absorb the reactions of its listed companies — the scene is ripe for transition, and a crucial first step is to prioritize its governance reforms in order of relevance. Improved transparency and disclosure go a long way in building investor confidence and enhancing competition. The formalization of board functions through committees is an ideal mechanism for providing structure and disciplining management activities.

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True independence on boards, however, might be unrealistic for the time being. Mandating that boards incorporate a fixed number or percentage of independent directors seems ambitious, given the scarcity of qualified independent directors in the country. In an attempt to gauge the level of compliance of publicly listed companies with the code, the SEC requires completion and submission of a Corporate Governance Self-Rating Form.17 The CG-SRF contains a checklist of ninety-nine leading practices and principles of good governance, and is based on a 0–5 rating scale, with a score of five indicating the highest level of compliance with a particular item. The Self-Rating Form can indeed serve as a tool to ascertaining the degree to which companies practice good governance if it is thoroughly reviewed and analysed. It can then be used to provide feedback to companies, accentuating strengths and outlining areas of weakness. The form can also serve as a starting point to developing a scorecard for governance performance indicators specific to the Philippine business setting. A customized scorecard can be used to effectively measure corporate governance activities within Philippine corporates. The scorecard can aid international rating agencies in assessing the genuine nature of corporate governance reform in the country, rather than solely comparing reforms to those of other developing or emerging economies. As an internal, sustainable culture of good governance emerges, it’s better to “enforce basic reforms vigorously than to adopt requirements that go unheeded”.18 Whatever these reforms end up being, they must allow corporates to thrive and compete in the global market while innovating and developing in a distinctly Filipino way. The relationship between regulators and corporations must be symbiotic, based on the mutual goals of sustainable economic development and enhanced competitiveness through stable capital and financial markets. Notes 1. Suto, Megumi, “A Study o f Corporate Governance Before the Crisis”. Corporate Governance, An International Review 11, no. 1 (January 2003). 2. The Philippines’ top five families control close to 43 per cent of total listed company assets, the highest proportion in East Asia. Government still owns and manages 179 state owned enterprises. Australian Department of Foreign Affairs and Trade, “Changing Corporate Asia, What Business Needs to Know”. Economic Analytical Unit 2, Regional Economic Studies. Australia National Library, February 2002.

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3. International Monetary Fund, World Economic Outlook: Recessions and Recovers, USA, April 2002. 4. Review of Observance of Standards and Codes (ROSC), carried out by the World Bank in 2001. 5. As emphasized by the Capital Markets Development Council, 2004. 6. Paul Coombes and Simon Chiu-Yin Wong, “Why Codes of Governance Work: Corporate Governance Code are Definitely Effective-Within Limits”, McKinsey Quarterly, 2004. 7. Manuel V. Pangilinan, interview by Branka Jikich, 23 June 2004, Makati, tape recording, Ramon Cojuangco Building. 8. Mercedita S. Nolledo, interview by Branka Jikich, 18 May 2004, Makati, tape recording, Tower One Ayala Triangle. 9. Helen T. de Guzman, interview by Branka Jikich, 7 May 2004, Pasig, tape recording, Manila Electric Company Ortigas. 10. Antonio G. Pelayo, interview by Branka Jikich, 26 May 2004, Makati, tape recording, Petron MegaPlaza. 11. Carlos Arguelles, interview by Branka Jikich, 20 May 2004, Makati, tape recording, PHINMA Building Rockwell. 12. Lilia R. Bautista, A Regulator’s Perspective: Better Governance for Greater Economic Growth, in Managing Corporate Governance in Asia by AIM-RVR Publication no. 6, September 2003. 13. Asia Business Council, A Floor, Not a Ceiling: A Report from the Asia Business Council’s Corporate Governance Task Force, Hong Kong, November 2003. 14. Antonio G. Pelayo, interview by Branka Jikich, 26 May 2004, Makati, tape recording, Petron MegaPlaza. 15. Washington SyCip, in a keynote address in Felipe B. Alfonso and Branka Jikich, eds., Managing Corporate Governance in Asia: Options, Position, Emerging Markets, AIM-RVR, 2004. ~ 16. René G. Banez, “Corporate Governance Discussion: Is the Philippines Ready for Corporate Governance?”, in Managing Corporate Governance in Asia by AIMRVR Publication no. 9, June 2003. 17. Issued by the SEC in memorandum Circular No. 5, 3 April 2003. 18. Barton Dominic, Paul Coombes and Simon Chui-Yin Wong, “Transparency: Asia Governance Challenge”, The McKinsey Quarterly, no. 2 (2004).

References Arguelles, Carlos. Interview by Branka Jikich, tape recording, PHINMA Rockwell, Makati, 20 May 2004. Asia Business Council (2003) A Floor, Not a Ceiling: A Report from the Asia Business Council’s Corporate Governance Task Force, Hong Kong, November.

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Australian Department of Foreign Affairs and Trade, Changing Corporate Asia, What Business Needs to Know- Economic Analytical Unit, vol. 2, Regional Economic Studies. Australia National Library, February 2002. Bañez, René G. “Corporate Governance Discussion: Is the Philippines Ready for Corporate Governance?”. In Managing Corporate Governance in Asia. AIM-RVR Publication no. 9 (June 2004). Barton, Dominic, Paul Coombes and Simon Chui-Yin Wong. “Transparency: Asia Governance Challenge”. The McKinsey Quarterly, no. 2 (2004). Bautista, Lilia R. (2003) “A Regulator’s Perspective: Better Governance for Greater Economic Growth”. In Managing Corporate Governance in Asia. AIM-RVR Publication no. 6 (September). Capital Markets Development Council (2004) Corporate Governance Reform: The Second Round (2005–2008), CMDC Proposal in the Next Round of Corporate Governance Reform, May. Coombes, Paul, and Simon Chiu-Yin Wong. “Why Codes of Governance Work: Corporate Governance Codes are Definitely Effective-Within Limits”. McKinsey Quarterly (2004). De Guzman, Helen T. Interview by Branka Jikich, Pasig, tape recording, Manila Electric Company, Pasig, 7 May 2004. International Monetary Fund (2002) World Economic Outlook: Recessions and Recovers. USA, April. Nolledo, Mercedita S. Interview by Branka Jikich, tape recording, Tower One Ayala Triangle, Makati, 18 May 2004. Pangilinan, Manuel V. Interview by Branka Jikich, tape recording, Ramon Cojuangco Building, Makati, 23 June 2004. Pelayo, Antonio G. Interview by Branka Jikich, tape recording, Petron MegaPlaza, Makati, 26 May 2004. Republic of the Philippines Securities and Exchange Commission (2002) Code of Corporate Governance, SEC Memorandum Circular no. 2. Suto, Megumi (2003) “A Study of Corporate Governance Before the Crisis”. Corporate Governance, An International Review 11, no. 1 (January). SyCip, Washington (2004) Keynote address in Managing Corporate Governance in Asia: Options, Position, Emerging Markets, edited by Felipe B. Alfonso and Branka Jikich. AIM-RVR.

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14 CORPORATE GOVERNANCE OF FINANCIAL INSTITUTIONS The Philippine Case Mario B. LAMBERTE and ~ Ma. Chelo V. MANLAGNIT

INTRODUCTION In an economy where the capital market is underdeveloped, enterprises depend heavily on credit institutions like banks for external financing. Financial intermediaries, as the name implies, mobilize funds and allocate them to those who can make the best use of them. Efficient intermediation guarantees profitability of financial institutions in a sustainable manner and raises the value of the institutions’ shares. As creditors, financial institutions have some control rights in enterprises. They can discipline firms for doing something that will endanger their viability by not renewing loans. In the absence of a well-functioning capital market, this penalty can mean life or death to a firm, especially if it operates in a competitive environment. Debt can therefore be an effective mechanism for instilling corporate governance on borrowers. However, the effectiveness of this mechanism depends on the quality of the monitoring financial institutions do. Lending institutions that have weak

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corporate governance will likely perform badly as monitors of corporate governance of non-bank enterprises, making the economy more vulnerable to shocks. Indeed, weak corporate governance is believed to be one of the major contributors to the building up of vulnerabilities in the affected countries that finally led to the East Asian financial crisis in 1997 (Zhuang et al. 2000). This chapter focuses on corporate governance of financial institutions, namely commercial banks, cooperative rural banks and credit unions. These financial institutions have different governance systems. Banks, like other corporations, are owned by shareholders whose voting power is proportionate to the number of shares they own. They are governed by a board of directors representing stockholders and managed by a team of professional managers. As corporations, they operate under the existing Corporation Code, and as a bank, under the General Banking Law. At the other end of the spectrum are credit unions, which are mutual savings and credit institutions, wherein a “one-man-one-vote” applies regardless of the number of shares held by a member. They are governed by the Cooperative Code and the Cooperative Development Authority Act. In the middle are the cooperative rural banks, which are governed by both banking laws, specifically the Rural Bank Act and the General Banking Law, and cooperative laws.1 The shareholders of cooperative rural banks are non-financial cooperatives and credit unions, and, like corporations, the number of votes each cooperative has is proportionate to its shares. The Philippine financial system is dominated by the banking system. The commercial banking system’s assets comprise approximately 90 per cent of the total assets of the banking system. On the other hand, the shares of cooperative rural banks and credit unions less than 3 per cent and less than 1 per cent, respectively. Albeit small in assets, both cooperative rural banks and credit unions have large outreach especially among small enterprises and individuals. The next section reviews recent efforts to improve corporate governance of banks.2 The third section provides estimates of profit efficiency of commercial banks, cooperative rural banks and credit unions and examines how certain correlates, such as corporate governance, agency costs and market conditions, affect measured profit efficiencies. The last section concludes. GOVERNANCE FRAMEWORK FOR BANKS Having gone through a crisis in the mid-1980s that resulted in the weeding out of weak banks, the Philippine banking system faced the challenges of the

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TABLE 14.1 Number of Closed PDIC Member Banks, Philippines, 1970–2003* 1970–80

1983–87

1981–90

1991–2000

2001–03

Commercial banks Thrift banks Rural banks Specialized government banks

3 3 42 —

3 26 102 —

3 36 182 —

2 13 122 —

— 2 38 —

Total

48

131

221

137

40

* Includes Overseas Bank of Manila which was closed in 1968. Source: Philippine Deposit Insurance Corporation.

1990s with healthier balance sheets. However, not all banks were able to weather the East Asian financial crisis. In 1998, one small commercial bank was closed by the Bangko Sentral ng Pilipinas (BSP), the Philippines’ central bank. In 2000, a medium-sized commercial bank collapsed, which caused a bank run on some small commercial banks. Both banks were brought down by their heavy exposure to the real estate sector, which went into a slump since 1997. In all, 137 banks were closed in the 1990s. Bank closures continued in the 2000s although no commercial bank was involved (Table 14.1). During the crisis, a number of large and medium-sized non-financial enterprises that were highly leveraged went bankrupt and had adversely affected banks’ balance sheets. Thus, non-performing loans (NPLs) of the banking system rose from 2.8 per cent of total loans in 1996 to 17.4 per cent in 2001. Although some improvements in NPLs can be observed in 2003, it was still high at 14 per cent. Clearly, the monitors of corporate governance in a bank-dependent economy are showing weaknesses in their corporate governance. The central bank gained formal independence with the passage of the new Central Bank Act in 1993. Aside from conducting monetary policy, the Bangko Sentral ng Pilipinas (BSP), which is the country’s central bank, is also given the responsibility of regulating and supervising banks. Since the onset of the financial crisis, the BSP has introduced a number of measures to strengthen corporate governance of banks. In April 2000, the new General Banking Law of 2000 (GBL 2000) was passed. The long delay in the passage of said law turned out to be a blessing in that the framers of the law were able to take into account major lessons from the recent crisis. Thus, the law

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includes several provisions aimed at strengthening corporate governance of banks. The following discusses some key provisions of the GBL 2000 and some measures adopted by the BSP that have direct bearing on corporate governance of banks. There is now widespread acceptance of the important role independent directors can play in enhancing good corporate governance. The GBL 2000 recognizes this and explicitly provides for an inclusion of two independent directors in the board of directors of a bank.3 There was heated argument at the Philippine Senate when this provision was discussed. Sceptics argued that the country does not have a tradition of having independent-minded people looking after the interests of minority shareholders. Also, independent directors cannot substitute for the supervision function of the BSP. Proponents of this provision, however, countered that such tradition has not been developed because there is no legal framework that encourages it. Although they admitted that in the short term, banks will not be able to find real independent directors, in the long run, the market for independent directors will be developed, and it is to the interest of banks to get people from a pool of qualified independent directors. They also pointed out that independent directors will not supplant the supervision function of the BSP, but they can complement it. The GBL 2000 broadens and strengthens the authority of the Monetary Board to prescribe, pass upon and review the qualifications and disqualifications of individuals elected or appointed bank directors or officers and disqualify those found unfit. In the past, the “fit-and proper rule” was hardly given any importance in the selection of board of directors or officers of banks. Under the new law, the Monetary Board is mandated to constantly monitor the performance of bank directors and officers to ensure that the latter make prudent decisions for their banks. It can disqualify, suspend or remove any bank director or officer who commits or omits an act which renders him unfit for the position. The BSP issued a circular in 2001 requiring all bank directors to attend a special seminar on corporate governance conducted by accredited training institutes within six months from the date of the issuance of the circular or from the date of their election, as the case may be. The financial market is very fluid. Naturally, the true financial position of banks can change frequently. It is, therefore, crucial that board of directors frequently meet to monitor and assess the financial position of their banks. In this regard, the GBL 2000 allows banks to utilize modern technologies such as teleconferencing and video-conferencing in conducting board meetings, which can be more convenient and less costly.

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Bank loans and credit guarantees to its directors, officers, stockholders and their related interests (DOSRI) was a major contributory factor to past bank failures and undermined the banks’ role as monitors of corporate governance of their debtors. To avoid this problem, the GBL has tightened the rules and ceilings on connected lending and stipulates that such lending be done in an’“arms-length” manner as banks do with their ordinary clients. Violation of this regulation is enough ground for removing a bank director or officer. The BSP has been regularly revising upward the minimum capital requirements of banks. In 1998, it mandated another round of increases in the minimum capital requirement of banks to be gradually implemented over a two-year period. Universal banks, that is, banks with expanded commercial banking functions, are supposed to raise their minimum capital by 20 per cent and ordinary commercial banks by 40 per cent during this period. The GBL enjoins the Monetary Board to adopt internationally accepted standards in determining risk-based capital adequacy of banks. Thus, it is no longer enough for banks to identify, quantify and manage risks, but that their owners must be ready to put extra capital to cover additional risks they want to take. As part of its effort to improve the transparency of banks, the BSP issued new rules on reporting the quality of the assets of banks to reflect their true financial conditions. The loan classification system has been improved and appropriate specific loan loss provisioning has been prescribed for the different loan classifications. In addition, the BSP has required banks to put a two per cent general loan loss provision. The definition of past due loans has also been tightened. To enhance transparency, the BSP started to require listed and nonlisted banks to disclose to the public more detailed information relevant to their financial health in a manner understandable to laymen. This includes vital information such as non-performing loans, total classified loans and other classified risk assets, loan loss reserves, connected lending and return on equity. These are supposed to be reported together with the banks’ balance sheet and off-balance sheet conditions to the general public every quarter. Market discipline can exert pressure on banks to improve corporate governance. Key to this is a credible policy of allowing weak banks to fail and/ or to be taken over by other investors or other banks. This has been the policy of the BSP since the 1990s. In fact, the BSP closed several banks in the 1990s and 2000s as mentioned earlier.

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Another measure adopted by the government to enhance market discipline was to improve the competitiveness of the domestic banking system through the liberalization of the entry of foreign banks. Foreign banks are supposed to have better corporate governance and are well regulated in their home countries. In 1994, a law was passed allowing the foreign banks market access through three modes: establishment of a branch; establishment of a subsidiary (that is, up to 60 per cent control); and acquisition of an existing domestic bank (up to 60 per cent control). As of 30 June 2000, there were thirteen branches of foreign banks and six subsidiaries of foreign banks.4 The GBL 2000 has further liberalized this law by allowing foreign banks to have wholly-owned subsidiaries. Although the total number of foreign banks already accounts a little over one-third of the total number of commercial banks in the country, their combined assets are still less than one-fifth of the total assets of the banking system. The BSP has been encouraging domestic banks to merge and/or consolidate to strengthen further the balance sheet of banks and attain a certain size that will enable them to compete with foreign banks and project themselves as regional, if not international, players. The upward adjustment in the minimum capital requirement was one of the instruments used by the central bank to encourage banks to merge and/or consolidate. Although there were several banks that merged to comply with the new minimum capital requirement, however, there were also mergers that occurred among large domestic banks, suggesting that banks do not only want to hurdle the new minimum capital requirement or to achieve bigness but also to broaden market reach and improve the depth and breadth of the range of their services to be able to gain competitiveness as they participate in the process of globalization (Table 14.2). Needless to say, the need for these banks to strengthen their corporate governance is much more urgent. CORPORATE GOVERNANCE AND PROFIT EFFICIENCY OF FINANCIAL INSTITUTIONS 5 This section estimates profit efficiency of banks, cooperative rural banks and credit unions and examines whether potential correlates can help explain the variation in measured efficiencies. Model and Data Structure This chapter uses a frontier analysis, which is a means to measure the relative performance of firms by objectively providing a numerical efficiency value

Equitable Banking Corp Prudential Bank Global Bank Global Bank Bank of the Philippine Islands Metropolitan Bank & Trust Co. Bank of Commerce Banco de Oro BPI Family Bank (Thrift Bank) Bank of Commerce ABN AMRO Bank, Inc. Metropolitan Bank & Trust Co. Banco de Oro Banco de Oro

September 1999 February 2000 May 2000 October 2000 April 2000 October 2000 September 2000 July 2000 August 2001 December 2001 1st quarter 2002 September 2002 September 2002 July 2003 Philippine Commercial International Bank Pilipinas Bank Philippine Banking Corp. AsianBank Corp. Far East Bank & Trust Co. Solidbank Corp. Panasia Banking Corp. Dao Heng Bank DBS Bank Philippines Traders Royal Bank TA Bank of the Phils., Inc. Global Bank First e-Bank Banco Santander

Acquired bank

Source: BusinessWorld Fourth Quarter Banking Report (2003), 10 February 2004.

Acquiring bank

Date acquired

TABLE 14.2 Philippine Commercial Bank Mergers, 1998–2003

Equitable PCI Bank Prudential Bank Global Bank Global Bank Bank of the Philippone Islands Metropolitan Bank & Trust Co. Bank of Commerce Banco de Oro BPI Family Bank (Thrift Bank) Bank of Commerce ABN AMRO Bank, Inc. Metropolitan Bank & Co. Banco de Oro Banco de Oro

Surviving bank

320 ~ Mario B. Lamberte and Ma. Chelo V. Manlagnit

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and ranking them accordingly. It shows how close firms are to the “best practice” frontier. Compared to the generally used standard financial ratios from accounting statements, frontier efficiency offers a superior measure because it uses statistical techniques that eliminate the effects of differences in input prices and other exogenous market factors affecting the standard performance ratios (Bauer et al. 1998). Such analysis proves to be significant in providing information that is useful in improving the performance of a firm by distinguishing the “best practices” and “worst practices” associated with the respective efficiency levels. For this chapter, efficiency measure is calculated using the stochastic frontier approach (SFA). Under this approach, a financial institution is considered inefficient if its profits are lower compared to those predicted for an efficient financial institution given the same existing conditions. The SFA, which is also referred to as the econometric frontier approach, specifies the relationship between output and input levels and decomposes the error term into two components: (a) a random error; and (b) an inefficiency component. The random error which is assumed to follow a symmetric distribution is the traditional normal error term with a zero mean and a constant variance while the inefficiency term is assumed to follow an asymmetric distribution and may be expressed as a half-normal, truncated normal, exponential or twoparameter gamma distribution. Instead of using the standard profit function, we use the alternative profit function, which relates profit to input prices indicating that output is held constant while output prices vary and may affect profits.6 Berger and Mester (1997a), using banking institutions, have pointed out that the alternative profit function may be helpful when one or more of the following conditions hold: (a) there are substantial unmeasured differences in the quality of banking services; (b) outputs are not completely variable so that a bank cannot achieve every output scale and product mix; (c) output markets are not perfectly competitive so that banks have some market power over the prices they charge; and (d) output prices are not accurately measured so that they do not provide accurate guides to opportunities to earn revenues and profits in the standard profit function. We believe that these conditions exist in the case of the Philippines, hence the use of the alternative profit function. The alternative profit function is written in logarithmic terms as:7 ln (p + q) = f(w, y, z, v) + ln eap – ln uap

(1)

where p denotes the variable profits of a bank; q is a constant added to every

~ Mario B. Lamberte and Ma. Chelo V. Manlagnit

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bank’s; y is the vector of outputs that yields different values for the inefficiency, ln uap, and random error term, ln eap.. The alternative profit efficiency is expressed as the ratio of predicted actual profits to the predicted maximum profit for a best-practice bank and this is represented as follows: {exp[f(wb, yb, zb, vb)] ¥ exp[ln ûpb]} – q apb = ————————————————– Alt p EFFb = ——– apmax {exp[f(wb, yb, zb, vb)] ¥ exp[ln ûapmax]} – q

(2)

The value of Alt p EFF b gives the proportion of maximum profits that can be earned. Its value can be equal to or less than one, with one being the profit efficiency of the best practice bank. For example, a bank with Alt p EFF b = 0.85 means that it is 85 per cent profit efficient, or it is foregoing 15 per cent of its potential profits through excessive costs, deficient revenues, or both. To estimate the alternative profit frontier functions, a transcendental logarithmic functional form is chosen. This functional form is widely used because it allows some flexibility when estimating the frontier function.8 Assuming for the sake of convenience three inputs, three outputs, and three other exogenous variables, the profit function for bank k can be expressed as: 3

3

3

3

1 Â Â a ln y y + Â b ln w ln pkt(y, w, z) = a0 + Â ai ln yikt + — ikt jkt i ikt i=1 2 i=1 j=1 ij i=1 3

(3)

3

1 Â Â b ln w + c ln z + — 1 c (ln z )2 =+— ikt 0 kt kt 2 i=1 j=1 ij 2 1 3

3

3

+ Â Â dij ln wikt ln yjkt + Â ei ln wikt ln zkt i=1 j=1

i=1

3

+ Â fi ln yikt ln zkt + ln ec + ln uc i=1

The e and u are the inefficiency and random error term, respectively. Following Berger and Mester (2001), one of the changes in the specification of the alternative profit function is on the dependent variable. For the profit function, ln p is replaced with ln [p + /pmin/ + 1], where /pmin/ indicates the absolute value of the minimum value of the profit over all

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banks for the same year. Since profits can be negative, the addition of the value, q = /pmin/ + 1, to every bank’s dependent variable will allow for the natural log to be taken as a positive number. Aside from this change, there is also a slight change in the above specification for the alternative profit function where the dependent variable is replaced with net profits and the inefficiency term is –u. The variable inputs and outputs used in this chapter are defined using the intermediation approach suggested by Sealey and Lindley (1977). According to this approach, banks as financial intermediaries use labour, capital, deposits and other borrowed funds to produce earning assets.9 Since this approach takes into account the overall costs of banking, it is then the most suitable approach to tackle concerns regarding the economic viability of banks (Ferrier and Lovell 1990). The same can be said of cooperative rural banks and credit unions. The variables for the profit function and data structure are presented in Table 14.3. The efficiency scores obtained by using the model described above are regressed on potential correlates. Three sets of potential correlates that can help explain variations in measured efficiencies among banks are being examined in this chapter. These are: Market characteristics, corporate governance and agency costs. However, not all of these correlates are applied to all three groups of financial institutions due to lack of data and in some cases they are not relevant to the financial institutions concerned. The correlates are shown in Table 14.4.10 Coelli’s (1994) Frontier Version 4.1 was used to estimate separately the profit efficiency of commercial banks, cooperative rural banks and credit unions. This programme estimates the profit model as well as the equation relating efficiency measures with a set of potential correlates using maximum likelihood estimation (MLE) procedure. Results11 The estimated average measured profit efficiency of the commercial banks is 0.85, implying that on the average the commercial banks are using only 85 per cent of their resources efficiently compared to the best practice commercial bank in the system producing the same output and facing the same conditions. Credit unions obtained an estimated average measured profit efficiency of 0.86, slightly higher than commercial banks. The cooperative rural banks appear to be the most profit efficient with estimated average measured profit efficiency of 0.90. Measured profit efficiency is

~ Mario B. Lamberte and Ma. Chelo V. Manlagnit

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TABLE 14.3 Profit Function: Definition of Variables and Data Structure Items

Cooperative rural banks

Commercial banks

Credit unions

A. Variables 1. Dependent variables

Profit

Profit

Profit

Loans

Loans

Loans

Securities

Securities

Securities

Wage rate

Wage rate

Wage rate

Price of capital

Price of raw materials

Price of deposits

2. Dependent variables (a) Outputs

Contingent liabilities (b) Input prices

Price of deposits Price of other financial obligations Price of other inputs B. Data structure 1. No. of institutions

44

50

134

2. No. of observations

388

216

338

3. Structure of data

Unbalanced

Unbalanced

Unbalanced

4. Time period

1990–2002

1995–1999

1990–1999

5. Sources

Bangko Sentral ng Pilipinas; Securities and Exchange Commission

Agricultural Credit Policy Council

National Confederation of Cooperatives

Note: Except for the case of commercial banks, all variables are expressed in real terms using CPI (1994 = 100). For commercial banks, CPI (1994 = 100).

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TABLE 14.4 Definitions of Correlates of Profit Efficiency Measure Correlates of market and macro-economic characteristics RURAL

Dummy variable: 1 if located in a rural region, 0 elsewhere.

RGDP

Real GDP growth rate, in per cent.

GRDPGRW

Real GDP growth rate of the region, in per cent.

POPBANK

Banking density (Population/Number of banks), in thousands; lower banking density means greater competition.

Memtype

Membership Type: indicates the degree of openness as far as membership is concerned.

Correlates of corporate governance SHRDUM

Dummy variable: 1 if the proportion of capital total liabilities is greater than the median, 0 elsewhere. Measure the degree of diffusion of control, which reduces potential capacity of stakeholders to influence managers.

DEPLIAB

Proportion of deposits to total liabilities, a higher ratio means greater diffusion of control.

AVGSHR

Diffusion of ownership: Average value of shareholdings, in million pesos. A higher value is associated with potentially greater influence of shareholders over managers.

GVTINT

Dummy variable: 1 if the government intervened in the current year.

MGTWAGE

Top manager salary as a proportion of total assets (in thousands) of the institution.

WOMMEM

Proportion of women in the total membership.

WOMEMP

Ratio of the number of women to the total number of employees or staff.

Correlates of agency costs ASSETMEMB

Average quantity of assets (in millions of pesos) by member.

FIXASSETS

Proportion of fixed assets total assets. A higher proportion means assets are diverted into unproductive uses of funds, in percentage.

SUFMARG

Sufficiency of financial margin: (Financial income = financial costs) / Operational costs. Measures the proportion of operational costs covered by the financial margin. A higher ratio is associated with more efficient management, in percentage.

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TABLE 14.5 Correlates of Profit Proficiency Cooperative rural banks

Commercial banks

Credit uions

Sign Significance Sign Significance Sign Significance Correlates of market and macroeconomic characteristics RURAL RGDP GRDPGRW POPBANK MEMTYPE Correlates of corporate governance SHRDUM DEPLIAB AVGSHR GVTINT MGTWAGE WOMMEM WOMEMP Correlates of agency costs ASSETMEMB FIXASSETS SUFMARG

–

–

(*)

+

(*)

+ –

(*) (*)

+ +

(***)

+ – + + +

(***)

+ – +

–

(*)

– –

(*) (*)

+ –

(*) (*)

+ + –

(*) (*) (*)

(***) (**)

(**) (***)

Note: Blank means that the variable concerned was not included in the model for the type of blanks. * Significant at 1 per cent level. ** Significant at 5 per cent level. *** Significant at 10 per cent level.

positively correlated with rate of return on assets (r = 0.65 for commercial banks; r = 0.58 for cooperative rural banks; and r = 0.60 for credit unions). These results imply that our findings on efficiency measures are robust and are not simply the consequences of the specifications or methods we applied. In a nutshell, a profit efficient financial institution is also financially sustainable. The results on the correlates of measured profit efficiency are summarized in Table 14.5. Note that only the signs of the coefficients of the correlates and their respective statistical significance are presented because they are the ones relevant to the analysis that follows.

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Market Conditions Although commercial banks have nation-wide branch network, however, their headquarters are all located in the Metro Manila. Thus, the relevant indicator for the state of the economy for commercial banks is the country’s GDP. On the other hand, cooperative rural banks and credit unions are spread throughout the sixteen regions of the country. Since they have purely local operations and do not have branches, the regional gross domestic product can be used as a proxy for the state of the economy where these credit institutions operate. For commercial banks, the coefficient of Real GDP growth rate (RGDPGRW) does not have a significant effect on profit efficiency. This implies that their profit efficiency is unaffected by the general condition of the economy. On the other hand, the regional GDP growth rate (GRDPGRW) has a statistically significant positive effect on cooperative rural banks’ profit efficiency measure. For credit unions, the coefficient of RGDP is negative and statistically significant. This means that credit unions in poorer regions tend to be profit efficient compared to those located in richer regions. This raises the issue of why inefficient credit unions exist in more developed and sophisticated regional economy. It could be that certain people who are considered high credit risks are being left out by the banking system, and the credit unions are the only means for them to have access to financial services. On the other hand, credit unions operating in less developed regional economy tend to be profit efficient as they are likely to deal with people who are better credit risks but left out by the banking system. Banking density (POPBANK) serves as an indicator of competitiveness in the market: The lower the ratio, the more competitive the market is. POPBANK exerts a significant negative effect on the measured profit efficiency of commercial banks and credit unions. It means that as POPBANK declines as a result of a more rapid increase in the number of banking offices relative to the country’s population, banks and credit unions are encouraged to improve their profit efficiencies. However, the same variable has no significant effect on the measured profit efficiency of cooperative rural banks. The variable, membership type (MEMTYPE), applies only to credit unions. It indicates the degree of openness of a credit cooperative as far as membership is concerned. More specifically, institution (or office)-based credit cooperative is less open compared to community-based credit cooperative. It has two competing hypotheses. On one hand, institution-

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based credit cooperative is likely to be associated with lower monitoring cost of their borrowers than community-based credit cooperatives. Thus, it tends to raise profit efficiency of credit cooperatives. On the other hand, institutionbased credit cooperatives will less likely be subject to market discipline than community-based credit cooperatives. Thus, the former will likely have lower profit efficiency than the latter. The coefficient of MEMTYPE is negative and statistically significant. The result therefore supports the second hypothesis. This indicates that market discipline is also important in improving profit efficiency of credit unions. Corporate Governance For commercial banks, the correlate for bank governance is represented by a lone variable, DEPLIAB, which is the proportion of deposits to total liabilities. This draws on Jensen’s (1989) free cash flow theory, which states that an appropriate policy to control agency costs is to limit free cash flows available to constrain the expense preference behaviour of managers. Increased concentration of ownership, as in the case of Philippine banks, and greater financial leverage limit managers’ incentives to spend on perks and other wasteful activities. Thus, DEPLIAB will likely be positively correlated with profit efficiency measure. The effect of DEPLIAB on measured profit efficiency, as shown by the result, appears to be consistent with the free cash flow hypothesis. This result suggests that bank governance can explain to a greater extent the differences in the efficiency among commercial banks. Because of availability of more detailed data for cooperative rural banks, we tested three hypotheses: free cash flows hypothesis; managers’ compensation hypothesis; and large shareholders hypothesis. DEPLIAB appears to have no statistically significant effect on profit efficiency. Thus, the free cash flow hypothesis is not supported in the case of cooperative rural banks. However, we found that a higher compensation for managers, as indicated by MGTWAGE, tends to increase profit efficiency of cooperative rural banks. This is consistent with the managers’ compensation hypothesis, which states that a higher compensation for managers may give them sufficient incentives to improve profit efficiency. AVGSHR, which measures the average value of shareholdings, increases profit efficiency of cooperative rural banks. This supports the large shareholders hypothesis, which states that concentration of ownership induces managers to be more efficient. This is because major stockholders have stronger negotiating power when they face managers and also have the incentive to keep track of major decisions made by managers. The result with respect to the variable

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SHRDUM, which measures the degree of diffusion of control, is not consistent with a priori expectation. For credit unions, we analyse gender-related governance issues. The gender aspect of governance includes two indicators. The first is WOMMEM, which is the proportion of women in the credit union’s membership. As members of credit unions, women are not only borrowers but are also shareholders who are keen to take part in shaping policies as well as in monitoring performance of their credit unions. Being meticulous, women keep credit union managers always on their toes. It is therefore expected that women-dominated credit unions tend to have higher profit efficiency. The result confirms this hypothesis. The second indicator is WOMEMP, which is the proportion of the number of women to the total number of employees or staff of a credit union. Access to credit is not the only way to empower women. Women can participate in the management of credit unions. In a credit union where interpersonal relationship, leadership and trust are of paramount importance, women can stand out as better managers. Thus, it is expected that WOMEMP will have a positive effect on profit efficiency. The result, however, does not support the hypothesis. On the contrary, it suggests that credit unions that are managed predominantly by women would unlikely pursue greater profit efficiency.

Agency Costs Two agency cost variables (that is, FIXASSETS and SUFMRG) are tested for commercial banks and three variables (that is, FIXASSETS, SUFMRG, and ASSETMEMB) for cooperatives and credit unions. FIXASSETS is defined as the ratio of fixed assets to total assets. It measures the extent to which management uses funds for unproductive uses. Thus, higher values of FIXASSETS will likely lower profit efficiency of commercial banks. The effect of this variable on profit efficiency of commercial banks and credit unions is statistically significant but negative. This does not support the agency cost hypothesis. Given the fact that Philippine banks are tightly controlled and managed by their owners, it could be that investment in fixed assets by banks are meant to improve bank efficiency, rather than to satisfy non-pecuniary needs of bank managers. It is to be noted that fixed assets on the average accounted for only 2.8 per cent of the total assets of banks in the sample. For credit unions, the proportion of fixed assets averaged only 5 per cent of total assets. For cooperative rural banks, however, the result is consistent with the a priori expectation.

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SUFMARG is arrived at by taking the difference between financial income and financial cost and dividing the result by the operational costs. It measures the proportion of operational costs covered by the financial margin. A higher ratio is associated with more efficient management. Thus, SUFMARG will likely be correlated with profit efficiency. The results, however, do not support this hypothesis. The coefficient of this variable for commercial banks and credit unions are statistically significant but negative, which is contrary to the hypothesis. In the case of cooperative rural banks, the coefficient is not statistically significant. ASSETMEMB is arrived at by dividing total assets by the total number of members of a cooperative. It is a measure of the degree of portfolio diversification. Having more assets will permit the cooperative rural banks and credit unions to go into product diversification. Thus, this correlate is expected to be associated with profit efficiency. Results for both cooperative rural banks and credit unions support this hypothesis. CONCLUDING REMARKS It is important to strengthen the corporate governance systems of financial institutions because they are heavily relied upon by enterprises for external financing, especially in an economy where the capital market is underdeveloped. As creditors, financial institutions can be effective monitors of the corporate governance of non-financial enterprises. Failure to as act as effective monitors of non-bank enterprises can spell economic disaster, as the recent East Asian financial crisis has demonstrated. Much has been done recently to improve corporate governance of financial institutions, particularly banks, which are the dominant financial institutions in the Philippine financial system. A new law on banking was passed that incorporates best practices corporate governance, and the BSP has been issuing prudential rules and regulations to implement such law. However, formal laws and regulations cannot automatically improve corporate governance of financial institutions. It is important to understand the behaviour of financial institutions and factors that condition such behaviour. Thus, in this chapter, we examined the extent to which financial institutions are profit efficient and in what way profit efficiency is affected by three sets of correlates, namely market conditions, corporate governance, and agency costs. Results of the empirical analysis yield two important findings. First, banks, cooperative rural banks and credit unions have still much room for improving their profit efficiencies. Second, although some of the results do not conform to our a priori expectations, however, they

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generally point out the importance of market conditions, corporate governance and agency costs in explaining variations in profit efficiencies across financial institutions. These findings can help shareholders, regulators and the general public in monitoring performance of financial institutions as well as in shaping measures to improve further the corporate governance systems of financial institutions. Notes 1. 2. 3. 4. 5. 6. 7. 8.

9.

10. 11.

Cooperative Rural Banks are considered part of the rural banking system. There were no recent efforts to reform the credit unions. The number of board of directors of a bank can be between five and fifteen. Branches of foreign banks can have up to six sub-branches. This part draws partly on Lamberte and Desrocher (2002), Manlagñit and Lamberte (2003) and Manlagñit and Lamberte (2004). In contrast, the standard profit function relates profit to output prices. For ease in exposition, we use banks, but the model is applied to the two other types of financial institutions as well. Some authors claim that specification bias may result from using a translog function over a sample of banks with different size and product mix but the study of Berger and Mester (1997a) found that both the translog and Fourierflexible functional forms generate basically the same average level and dispersion of measured efficiency. The study also shows that both functional forms ranked the individual banks in almost the same order. The production approach is another method, which views banks as producing demand deposits, savings and time deposits, commercial loans, real estate loans and installment loans using capital, labour and materials as inputs. In the final run, the variable “Rural” was dropped from the equation of cooperative banks. The estimated profit functions are not presented here to conserve space. Interested readers may request the author for a copy of the estimated profit functions.

REFERENCES Bauer, P., A. Berger, G. Ferrier, and D. Humphrey (1998) “Consistency Conditions for Regulatory Analysis of Financial Institutions: A Comparison of Frontier Efficiency Methods”. Journal of Economics and Business. Berger, A. (2000) “The Integration of Financial Services Industry: Where are the Efficiencies?” North American Actuarial Journal 4, forthcoming. Berger, A. and L. J. Mester (1997a) Efficiency and Productivity Change in the U.S. Commercial Banking Industry: A Comparison of the 1980s and 1990s. Federal Reserve Bank of Philadelphia Working Paper no. 97: 5, May.

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——— (1997b) “Inside the Black Box: What Explains Differences in the Efficiencies of Financial Institutions”. Journal of Banking and Finance 21: 895–947. Berger, A. and D. B. Humphrey (1997) “Efficiency of Financial Institutions: International Survey and Directions for Future Research”. European Journal of Operational Research 98:175–212. Coelli, T. (1994) A Guide to Frontier Version 4.1: A Computer Program for Stochastic Frontier Production and Cost Function Estimation. University of New England Department of Econometrics, October. Ferrier, G. and C. A. K. Lovell (1990) “Measuring Cost Efficiency in Banking: Econometric and Linear Programming Evidence”. Journal of Econometrics 46: 229–45. Jensen, M. C. (1989) “Eclipse of the Public Corporation”. Harvard Business Review, pp. 61–74. Lamberte, M. B. and M. Desrocher (2002) “Efficiency and Expense Preference in the Philippine Cooperative Rural Banks”. PIDS Discussion Paper no. DP2002-12. Philippine Institute for Development Studies, Makati, Philippines. Manlagñit, M. C. and M. B. Lamberte (2003) “Integrating Gender Perspectives in Evaluating the Efficiency of COFI: The Case of Credit Cooperatives in the Philippines”. Philippine Institute for Development Studies, Makati, Philippines. ——— (2004) “Evaluating the Impacts of Competition Policy Reforms on the Efficiency of Philippine Commercial Banks”. PIDS Discussion Paper no. DP200441. Philippine Institute for Development Studies, Makati, Philippines. Sealey, C. W., Jr. and J. T. Lindley (1977) “Inputs, Outputs, and a Theory of Production and Cost at Depository Financial Institutions”. Journal of Finance 32, no. 4: 1251–66. Zhuang, Juzhong, D. Edwards, D. Webb and M. V. Capulong (2000) Corporate Governance and Finance in East Asia. Asian Development Bank, Manila.

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15 PROMOTING GOOD CORPORATE GOVERNANCE PRACTICES IN VIETNAM A New Element in the Economic Reform Agenda Nick J. FREEMAN

INTRODUCTION “There is virtually no good corporate governance in Vietnam.” A private equity investor in Ho Chi Minh City.

The above comment succinctly summarizes what is probably the consensus view of institutional investors; that the current standard of good corporate governance (CG) practices in Vietnam is relatively low, or at best, entails some rather unconventional CG practices. Where some local companies do pursue good CG practices, they tend to be the exceptions that prove the general rule, it is widely perceived. Such a popular perception — whether accurate or not — should not come as a complete surprise. Vietnam’s economic transition process from a centrally-planned economy is still less than twenty years old, its first

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strident steps towards developing a robust and viable corporate sector are even more recent, and the country has only hosted a stock market for the secondary trading of shares since mid-2000. Most large companies in Vietnam are still state-owned enterprises (SOEs), and the vast majority of private companies (as well as many SOEs) are very small firms indeed, by whatever yardstick one employs. In this context, it is to be expected that CG principles like protecting minority shareholder rights and maximizing shareholder value have yet to gain much of a foothold in Vietnam. In a country where minority shareholders and institutional investors are not particularly abundant, the theory and practices of good CG are not very well understood, their value not well recognized, their pursuit not widely enacted, and their stipulations not strictly enforced. Corporate governance can be roughly translated into Vietnamese as “quän tr¸ cong ty” (literally, administration [of a] company), but has yet to take hold as a popular term and is not (yet) to be found in the dictionary.1 But looking ahead, this current state of affairs will almost certainly change for the better, as a cumulative result of a number of factors, including: i)

ii)

iii)

iv)

v) vi) vii)

More state-owned enterprises are “equitized” (that is, fully or partially divested from state ownership) through a combination of both public and strategic share sales; Company managers and shareholders become more cognisant of the benefits to be derived from good CG, partly through linkages with foreign companies and other institutions; Policymakers seek to introduce higher standards of CG through regulatory and other means, in a bid to reduce the occurrence of corporate scandals and financial crises; Foreign and local institutional investors press for better CG standards in Vietnam, and “reward” companies that strive to have higher CG standards with higher valuations; The stock market burgeons, along with the general investor base in Vietnam; Elements of the donor community provide useful guidance, technical assistance, and support; and Various advances in the wider regulatory framework (and the various institutions that implement it) provide a more conducive environment for the promotion of good CG practices.

While the issue of CG may be becoming rather passé in some other Southeast Asian countries, the effective pursuit and utility of good CG is becoming

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more prominent in policy circles in Vietnam. Indeed, at the time of writing, CG is one element of the current consultative process in preparation for a revised and unified Enterprise Law. For example, one government agency and member of the foreign donor community has recently commenced a collaborative research project to examine the issue of CG in Vietnam, and conduct the first empirically survey of CG practices (both good and bad) in its corporate community. In short, CG is becoming part of the economic reform agenda in Vietnam for the first time. This chapter comprises four main sections. The next section briefly profiles the current state of CG in Vietnam at present, followed by a section that seeks to identify and depict the current obstacles and constraints to improving CG standards in Vietnam. The third section discusses the current costs being incurred, and various risks being run, by the corporate sector in not having higher CG standards in Vietnam.2 The fourth section suggests ways in which the promotion of good CG might best be approached in Vietnam in the years ahead. A brief fifth section has a few concluding remarks. As Nguyen Van Thang’s chapter on CG in Vietnam focuses primarily on CG practices in SOEs, and equitized former state-owned firms in particular, this chapter will focus more on the burgeoning private sector in Vietnam. As chapters presented earlier in this volume have already cogently articulated and discussed the fundamental concepts underlying the pursuit of good CG, this chapter will dispense with such a discussion. CORPORATE GOVERNANCE PRACTICES IN VIETNAM TODAY As noted in the introduction, the concept of good CG is not well understood, pursued or enforced in Vietnam, relative to most other countries in Southeast Asia. The kinds of systems and structures currently in place inside many Vietnamese companies, used to direct and control their operations, tend to have been developed over time in a somewhat piece-meal fashion, rather than a more systematic way. The specific rights and responsibilities of managers, shareholders, directors3 and other stakeholders is often not clearly defined or differentiated, and as a consequence, decision-making processes within firms are often opaque and ad hoc. Although some basic CG principles are legislated for in the current Enterprise Law and its various implementing regulations, these are generally not comprehensive. For example, the law states that all limited liability and joint stock companies with more than eleven shareholders must have an

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Inspection Committee, which could be likened to an internal audit committee. But the law is not clear on the precise role and responsibilities of this committee. For joint stock companies, many CG-related issues should be addressed in each firm’s own company charter. Unfortunately, the overall quality of company charters in Vietnamese joint stock companies is often quite low, with insufficient time invested in drafting a robust, pertinent and clear document that can guide firms’ decision-making processes.4 It should also be noted that while the Enterprise Law pertains to local private companies, different laws currently regulate the activities of SOEs (under the relatively recent State Enterprise Law) and foreign-invested companies (under the Foreign Investment Law).5 And these different laws are not compatible on some issues pertaining to good CG. For example, the rights and protection of shareholders are poorly defined in the Foreign Investment Law, relative to the Enterprise Law (which itself has different shareholder/membership rights set out for limited liability companies and joint stock companies) and the State Enterprise Law. Conversely, the Foreign Investment Law is more clear than the other two laws on issues relating to the dissolution of the business.6 The rights and powers of minority shareholders are articulated in the Enterprise Law, broadly ignored in the Foreign Investment Law, and are deemed irrelevant in the case of the State Enterprise Law. Similar differences are evident on such issues as: the types of shares that can be issued; the process by which shares can be issued and transferred; dividend payments; provisions on the management structure; decisions that require a general meeting of shareholders; the process by which shareholder meetings are convened and conducted; the rights and responsibilities of the Board of Management and its chairman; convening and holding meetings of the Board of Management; the rights and responsibilities of the company general director; the rights and responsibilities of the inspection committee; and so on. Ironically perhaps, the one issue where the three laws appear to be in greatest alignment is on the provisions for company bankruptcy. Recent legislative changes should also see a greater degree of consistency across the corporate spectrum on issues relating to financial disclosure and auditing. Looking ahead, there are tentative plans to revise and expand the current Enterprise Law, to become a Unified Enterprise Law, which would cover all businesses in Vietnam, including foreign-invested projects. (And a Common Investment Law may also be introduced, to span both domestic and foreign investors, in what would be, in effect, an investment promotion law.) For the

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small number of listed companies (just twenty-five firms at the time of writing), there are also some CG-related provisions included in Decree 144 (issued in late November 2003) that pertains to securities and the stock market, primarily relating to minority shareholder rights (in chapter XI) and financial information disclosure (in chapter VI).7 But neither in their design, their adherence or their enforcement, could it be asserted that Vietnam’s current regulations pertaining to CG meet international best practices. Nor does Vietnam compare very favourably with its regional peers in the recent survey of CG regulatory frameworks in Asia, as reported in the OECD’s “White Paper” on CG in Asia (2003).8 CURRENT OBSTACLES AND CONSTRAINTS TO IMPROVING CG STANDARDS IN VIETNAM In terms of constraints in the pursuit of good CG practices in Vietnam, the country has lacked a strong standard bearer for the promotion of improved CG standards. In other countries, this role has often been taken up by the stock exchange and/or the securities market regulator. But Vietnam’s stock market, which only commenced operations in July 2000, remains young and relatively inexperienced, as does its regulator, the State Securities Commission (SSC) (established a few years earlier). The SSC has also been regarded by some external observers as a relatively weak government agency, compared with larger and more well-established ministries, and appears to have encountered some difficulty in effectively pushing forward pertinent policies and regulations. (It is also not clear if the SSC’s mandate extends to issues such as CG.) However, this may now change, following the SSC’s formal merger into the Ministry of Finance, in early 2004. Nonetheless, the SSC remains quite young and inexperienced, and has not been in an ideal position to serve as an effective advocate of better CG standards in Vietnam. Another body of proponents for good CG in Vietnam would be expected to emanate from the community of institutional investors. But again, just as the stock market is still taking its first baby steps, the institutional investor base in Vietnam is very small. The first formal, onshore investment fund management company (VietFund Management) was only established in 2003 (as a joint venture between a local private bank, Sacombank, and a foreign boutique asset management firm, Dragon Capital), and its first fund (VF1) was only launched in 2004. A number of foreign asset management companies and investment funds have been operating in Vietnam since 1991, but these have tended to be private equity funds, and

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have primarily focused on acquiring stakes in unlisted companies since this became possible in 1999. The first foreign investment fund focusing exclusively on listed companies (PXP Vietnam Fund) was launched as recently as mid-2003. It is clearly early days in the development of an institutional investor community in Vietnam, and it will take time for this group to develop an effective lobby voice on issues such as good CG practices. That said, the recent establishment of the Vietnam Association of Financial Investors (VAFI) is a welcome — and potentially important — step in the right direction. Vietnam also does not (yet) have an Institute of Directors, or its equivalent, able to promote greater awareness of — and help promote the pursuit of better — CG standards, or assist in the provision of practical and pertinent training for company directors.9 Until such an institute is established, this role might best be assumed by the Vietnam Chamber of Commerce and Industry (VCCI), possibly in collaboration with some of the burgeoning Business Associations (BAs) springing up in Vietnam, and VAFI. As is discussed later in this chapter, any concerted initiative on advancing good CG in Vietnam would probably require a series of coordinated initiatives, as it is not simply a case of injecting a set of CG principles into the current regulatory regime. One important constraint that has inhibited the pursuit of good CG in Vietnam has been current regulatory and institutional inadequacies in areas as diverse as accounting and auditing, taxation, and property rights. It should also be recognized that capacity constraints faced by policymakers and government agencies in enacting a wide spectrum of economic reform initiatives has meant that not all issues could be addressed simultaneously, and some degree of prioritization had to occur. With the vast majority of the corporate sector in Vietnam made up of informal, household, or small- and medium-sized enterprises, the relevance of a widespread good CG campaign has been, at least until recently, of dubious merit. Only now that the a community of larger corporates is beginning to burgeon has the need for improved CG practices become a more pressing need. Indeed, it is testament to the success of the economic reform and business liberalization programme in Vietnam thus far that we are now able to say that CG has come on to the “radar screen” of policymakers and other stakeholders, as an issue that needs to be addressed. To paraphrase Tenev et al. (2003), market-oriented reforms have brought corporate governance issues to the forefront. … The current emphasis on corporate governance reflects the significant progress that Vietnam has made in building market institutions, but also the limited success of

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past reform efforts in changing corporate behaviour, particularly in the SOE sector. In terms of actual obstacles inhibiting the development of good CG in Vietnam, it should be recognized that a number of vested interests will view the introduction of better CG standards and practices as a potential threat to informal or illicit privileges they currently enjoy. Nguyen Van Thang’s insightful chapter identifies some of these vested interests in the SOE sector. It is not unfair to assert that senior personnel in some SOEs have sought to personally benefit from their positions, using undesirable or fraudulent practices that can only be pursued in an opaque corporate environment. Clearly, the prevalence of kickbacks and other rent-seeking activities serve to undermine the optimum use of resources, and thereby the creation of value in state enterprises, and therefore are not in the interests of their shareholder — the state. But when official salaries in the state enterprise sector are quite low, clearly the temptations of doing so are strong, and the relative risk-reward ratio is deemed attractive to some SOE managers. But it would be incorrect to suggest that such illicit practices are wholly confined to the SOE sector, as similar activities in private companies and banks have also been reported (and which are clearly not in the interests of their shareholders either). With regard to private companies, the biggest obstacle to improved CG standards — and greater corporate transparency in particular — is almost certainly the current tax regime. A number of inadequacies in the current tax regime, most notably relating to the administration and enforcement of corporate income tax and value-added tax, have served to make tax avoidance or reduction a common feature for many private firms in Vietnam. It is often quipped that companies in Vietnam have at least three different sets of financial accounts: One for the shareholders, one for the bank, and one for the taxman. As a partial legacy from the days when corporate income tax rates were high (the standard rate was lowered to 28 per cent in early 2004), firms have often sought to hide a substantial proportion of their profits from the tax authorities, through various accounting and other means. For such companies to now embrace best practices in corporate transparency and financial disclosure would not only expose them to a much higher tax bill for the past fiscal year, but the apparently sudden jump in profits could well trigger an intensive tax audit of the company for previous years, and the prospect of a back-dated tax bill that could potentially push them into bankruptcy. Having lived in the shadows for so long, the notion of boldly stepping into the light is (quite rightly) deemed to be fraught with peril. Therefore, some form of tax amnesty

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for good CG-compliant companies may be the only way forward, if Vietnam wishes to improve corporate transparency and financial disclosure practices by private firms. COSTS AND RISKS OF VIETNAM’S INADEQUATE CG STANDARDS “Poor corporate transparency is probably the single biggest obstacle that we face in Vietnam.” A private equity investor in Ho Chi Minh City

The cumulative costs and risks that Vietnam faces, as a result of inadequate CG standards, is potentially considerable and probably under-estimated by most policymakers and business people alike. In terms of costs, it would obviously be difficult to provide an accurate indicative figure, but the specific areas where poor CG standards are impacting adversely on the country’s economy can be quite readily identified. Within individual companies, there is often a high degree of managerial inefficiency resulting from inadequate delineation and definition of responsibilities and accountabilities. The objectives of the company are often not well defined, or communicated within the management, nor are the means of attaining these objectives clearly articulated or understood, in most cases. Accounting systems inside private firms are often inadequate, and as a result, accurate and insightful monitoring of company performance tends to be quite rare. This often leads to production and other inefficiencies, a suboptimal pursuit of value creation by management, and ultimately a lower rate of return for shareholders (including the state, in the case of SOEs and partially-divested enterprises). When this is extrapolated across the corporate sector as a whole, the costs to the Vietnamese economy are not inconsiderable. (From the perspective of the government, corporate profits foregone through inefficiencies also mean lower budget revenues through reduced corporate income tax receipts.) The low level of CG standards — notably in terms of insufficient investor protection and a lack of financial transparency in particular — is also incurring a cost in terms of foreign investment inflows foregone. Not only do foreign direct investors hesitate to establish joint ventures with opaque local firms, preferring instead to locate elsewhere or establish whollyowned ventures, but most foreign portfolio investors (including private equity firms) have also tend to give Vietnam a wide berth. Those portfolio investors active in Vietnam tend to be specialist, boutique investors, rather than the big institutional names.

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In terms of risks, a simple review of the local media in Vietnam would serve to illustrate the considerable perils that are being run by not having a better standard of CG practices in the country, as evidenced by corporate and financial scandals. Most recently, the widening fraud scandal at one of Vietnam’s largest and most high-profile corporates — PetroVietnam — where numerous senior executives are alleged to have committed serious fraud against the firm, indicates the scale of the problem. Recent months have seen similar allegations of management impropriety at a number of other state-owned firms, including Seaprodex and Vinapco, amongst others. The kinds of risks that are prevalent in Vietnam’s corporate sector at present, for both private and state-owned firms, as a consequence of having insufficient CG standards include (but are not limited to):10 i)

Loans being given to a related party of the company, at a rate of interest that is below the market rate, unsecured by adequate collateral, or on terms that do not adequately reflect the level of default risk; or conversely ii) The company receiving a loan from a related party at a level of interest that is markedly higher than market rates; iii) Informal commissions being paid to a related party of the company on purchases or sales (particularly common in SOEs); iv) Unapproved or fraudulent transfers of the company’s assets or cash by a senior manager, without the knowledge of the shareholders (‘asset stripping’); v) The sale of company assets (or shares) to a related party at prices below fair value; or conversely vi) The acquisition by the company of assets (or shares) belonging to a related party at prices above fair value; vii) The sourcing of inputs or services for the company through related parties, at prices above market prices; or conversely viii) The sale of products or services by the company to related parties at prices that are below market value; ix) The hiring of family or friends to positions in the company that they are unqualified to assume. Thus far, no corporate or banking scandal has led to a more systemic crisis, but such a scenario is not wholly inconceivable. The cumulative effect of these risks is to render many companies — and Vietnam’s corporate sector as a whole — less robust, inefficient, and to undermine attempts to maximize shareholder value. Needless to say, Vietnam’s experiences in this regard are certainly not unique. But as a developing, transitional economy that is seeking to rapidly develop its economy and corporate sector to a level where

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it can compete internationally for export markets and compete effectively in the domestic market against an increasing number of foreign firms, this is a luxury that Vietnam can not readily afford, and therefore needs to address. HOW BEST TO APPROACH GOOD CG IN VIETNAM “There is no single model of good corporate governance.” Organization for Economic Coperation and Development (2004)

The track record of economic reform and business liberalization in Vietnam shows that some of the most successful reform measures — and the ones to gain most “traction” within the wider business community — are those that have been promoted from the grass roots, and not imposed from the top. Put simply, “bottom-up” economic reforms tend to have a better success rate than “top-down” reforms. In a country where the legal and regulatory regime still needs to be further developed, and the various enforcement and oversight institutions require considerably more strengthening, it is always better to convince people of the merits of a specific policy, rather than resorting to the use of stern edicts that rapidly prove to be impractical in their enforcement. In the specific case of improving CG standards and practices in Vietnam, such an approach entails convincing companies of the merits and benefits of good CG, rather than solely issuing regulations that command firms to conform to various rules and edicts. Put another way, the strategy should be to promote the pursuit of good CG, as much as command that firms meet a (potentially long) list of good CG requirements. Besides, the latter would probably mutate into a jaundiced “box ticking” exercise, at best, with many companies seeking to bypass a set of requirements, for which they envisage little direct utility. Most private firms in Vietnam already feel overwhelmed with the number of regulatory requirements, inspections and other demands placed on them by government agencies (although there has been some marked improvement in this area since 2000). Not surprisingly, many firms seek to duck these regulations if they can, and the capacity (and executive power) of state agencies — such as the local offices of the Ministry of Planning & Investment (DPIs) — to enforce such regulations, is currently inadequate. Anyone familiar the business environment in Vietnam will testify to the breathtaking rapidity with which new regulations (laws, decrees, decisions, circulars, official letters, ordinances, etc.) are introduced by various

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government agencies, and the labyrinthine complexity of the regulatory patchwork that this has created. In this context, to load up Vietnam’s corporate sector, comprising largely of very small SMEs, with an additional package of CG requirements — even those that meet international best practice standards — could prove to be counter-productive, if not done carefully, and in a manner that is commensurate with the realities of the business environment. There is also some danger entailed in the actual promulgation of pro-CG regulations. Experience would caution that Vietnam’s track record in the drafting of business-related legislation — with the notable exception of the Enterprise Law of 2000 — has been mixed. Indeed, some regulations have resulted in unintended and adverse consequences to their intended aim, while others have been too vague or generic to have any positive effect. Where regulations are unclear, this opens up the opportunity for arbitrary decision-making and rent-seeking activities. Therefore, a badly drafted set of CG regulations could actually be detrimental to good CG standards, as companies find themselves resorting to corruption in a bid to meet difficult or impossible demands. There is also some question as to whether Vietnam yet has an adequately robust legal system in place — and the institutional capacities to support it — that could effectively and fairly enforce a new set of regulations pertaining to good CG practices. As noted earlier, the advancement of good CG practices in Vietnam also requires coordinated interventions in improving accounting and auditing standards and the better protection of property rights. The pursuit of CG in Vietnam therefore needs to be done in a multi-faceted manner, and cannot be done by importing an “off-the-shelf ” set of regulations that lack the kind of robust regulatory and institutional platform in which they can take proper root. Conversely, an emphasis on promoting the pursuit of good CG at least has some prospect of prompting companies to follow both the letter and the spirit of the good CG concept, having been convinced of its tangible merits, and cognizant of the real benefits to be derived. Given the above, one might ideally wish that market factors and actors — rather than heavy-handed regulatory and legislative interventions — could drive the rise of good CG standards in Vietnam. But, as noted earlier, the market itself in Vietnam remains at a fledgling stage, notably in terms of the primary and secondary markets for company securities, and the small community of institutional investors may not yet be able to lead the charge. Bluntly, the prospect of CalPERS (California Public Employees’ Retirement System) blackballing specific listed Vietnamese companies for insufficient CG standards is a dim and distant prospect.11

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But there are business organizations active in Vietnam — in addition to VAFI, the VCCI, and various BAs referred to earlier — that could potentially play an important role in promoting good CG in Vietnam, notably in the fields of banking (that is, the provision of credit to local corporates) and private equity (that is, directly investing in local corporates). Banks and private equity investors could play an important catalytic role in advancing the promotion of good CG in Vietnam, in a manner that is wholly congruent with market principles. In the case of banks, which have increasingly recognized the important growth opportunities that can arise from providing loans to the burgeoning number of private companies, they are currently faced with a number of challenges in extending credit to such firms. (This is particularly true for the joint stock banks, which have found this to be one of the few market niches where they can compete with the larger state-owned commercial banks and the foreign bank branches.) But one of the main challenges that banks face in lending to private firms — other than the lack of adequate assets to provide as collateral and insufficient property right protection — is difficulty in assessing the financial standing of these companies, where the level of corporate transparency and financial disclosure is poor. As a result, the commercial banks either tend not to lend to these firms, or (since the introduction of variable interest rates a few years ago) provide credit of short-term maturity (for example, one year loan tenor) and/or at high levels of interest. One policy option here would be to introduce a set of guidelines on financial disclosure practices, which if adequately implemented by a company would then make it eligible for longer-term bank loans and/or at slightly lower rates of interest. Such an initiative could be introduced as a collaborative exercise by a syndicate of banks, possibly with the collaboration of an approved credit ratings agency. As Jordan and Lubrano (2002) note, some CG factors should be important elements of credit rating. Although Vietnam does not yet have a viable domestic credit ratings agency, there is an initiative to establish one in the near future.12 In addition to credit ratings, such an agency might also be able to provide CG ratings for larger corporates. As Jordan and Lubrano note, such ratings can “… be a more valuable tool for encouraging better [CG] practices where the number of [share] issuers is relatively small …”. In the case of private equity and venture capital investors (which remain small in number in Vietnam, but seem destined to burgeon), they could probably do more to show companies that the adoption of better CG standards can be of benefit when attracting equity investors. As noted

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earlier, a major problem that private equity investors face is the lack of corporate transparency, which obliges them to undertake intensive investment appraisal and due diligence exercises. This in turn often obliges them to make investments of no less than US$1 million in each company. Given that all private equity investors at present are foreign, and foreign equity stakes in local companies is currently capped at 30 per cent, this means that only companies valued at US$3 million or above can be considered. The current universe of private companies in Vietnam that can be valued at over US$3 million at present is surprisingly small.13 But if potential investee companies had better CG standards, and the costs of investment appraisals and due diligence were therefore lessened, then the minimum investment size could be reduced, and the universe of potential investee firms should expand markedly. Further, companies with good CG standards would be rewarded by equity investors with higher share valuations. A number of studies (McKinsey, CLSA, Klapper and Love, Durnev and Kim, and others) have clearly shown that a strong correlation exists between higher CG standards and higher valuations, improved performance ratios (such as EVA and RoE), and higher rates of return for shareholders. They also show that institutional investors are willing to pay a not inconsiderable premium for the lower level of risk that stems from investing in a company with good CG practices, particularly in emerging markets. By investing in and supporting local companies that displayed a willingness to implement higher CG standards, private equity investors would have an opportunity to build up portfolios of investee companies that could have a potent demonstration effect. If they are then able to exit from these investee companies at substantial premiums to their initial investment, having increased shareholder value through initiatives such as advances in CG practices, then the “proof would be in the pudding” for all to see.14 Such market-oriented initiatives would also be preferable to the introduction of various fiscal incentives for companies that met a minimum standard of CG. Although Vietnam’s policy makers have a track record of being keen dispensers of fiscal incentives (such as the two year tax holiday provided to companies that agree to list on the stock market), these kinds of incentives have a tendency to distort the market, for gains that are often far from quantifiable. This chapter would also argue that the use of the stock market as an instrument for promoting higher CG standards in Vietnam should be done with some care, and limited expectations. Although stock markets and their regulators are often at the forefront of initiatives to improve CG standards

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and practices in countries — notably through the regulations they issue on IPO procedures and placing documentation, as well as initial listing and subsequent reporting requirements — this may not be wholly appropriate for Vietnam at present. This is primarily because Vietnam’s stock market is still at such a fledgling stage, with just twenty-five firms listed. Indeed, despite recently relaxing the listing requirements, many eligible companies in Vietnam are not willing to list on the stock market, deterred by the existing listing requirements, and the heightened levels of financial disclosure required in particular. As a result, trading in a far larger number of company shares occurs in the (largely unregulated) informal equity market, where regulations on issues such as corporate disclosure and the rights of minority shareholders are few, and the risk of corporate fraud is markedly higher. In this context, to reconfigure the formal stock market’s listing and reporting regulations, in a bid to similarly raise CG standards, could potentially be counter productive, in that it would result in even more companies keeping away from the official equity market. But this is not to suggest that the stock market regulator, the SSC, should not be actively involved in any initiative to promote and adopt good CG practices in Vietnam. If the stock market is to develop (in terms of becoming more liquid, trade more company shares, and increase its capitalization), then it is important that CG standards are raised, so as to attract major institutional investors. Such institutional investors will be needed if the government’s plan to accelerate the equitisation programme, and partially divest stakes in some of the country’s largest corporates, is to have a good chance of success. Perhaps the best entry point for any concerted push towards the raising of CG standards in Vietnam’s corporate community should focus on an area where tangible benefits could be fairly immediately seen by the managers and shareholders of numerous firms. In conjunction with initiatives to improve the quality of accounting and auditing standards, as well as corporate tax compliance, initial efforts to promote good CG would perhaps focus on helping companies to put in place internal systems and controls that would help them lower their exposure to risks of internal theft and fraud, increase their managerial efficiency and utilization of resources, and thereby increase their returns on assets and raise shareholder value. Once the case for such actions had been proven, through improved performance, subsequent initiatives to promote good CG practices could then shift their focus towards issues such as improved financial disclosure, shareholder protection, and other ownership issues. There might also be a

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role for complementary initiatives in tangential areas, such as the promotion of stock options schemes for senior personnel. To date, formal stock option schemes for employees in private companies are not at all common, but they could help promote the pursuit of good CG practices in Vietnam by better motivating and aligning the long-term interests of managers with those of shareholders — in maximizing shareholder value.15 CONCLUDING REMARKS At the risk of appearing heretical, this chapter suggests that promulgating a series of regulations intended to promote good CG practices (probably as one or more implementing regulations under the impending revised Enterprise Law) is probably not the optimum way for Vietnam to proceed. Or at least, not the best way to proceed in isolation. Rather, there needs to be a more holistic approach adopted in any bid to raise the standards of CG in Vietnam, which emphasizes as much on raising awareness of how better CG standards can be of real value to companies (as well as the costs and risks associated with poor CG), and is supported by tangible initiatives in areas such as assistance and training. In short, the pursuit of good CG as a benefit, and not a burden, to companies. Such an initiative also needs to be pursued in tandem with efforts to improve the general quality of auditing and accounting standards in Vietnam, as well as other regulatory and enforcement issues necessary for good CG to gain a firm foothold. Crucially, any drive for improved corporate disclosure and financial transparency would be an uphill task unless marked improvements were made to the corporate tax regime in Vietnam, given the current extent of corporate income tax avoidance. For most companies at present, the “savings” made from reporting artificially low profits would far outweigh any efficiency and other gains made from the implementation of good CG practices, particularly in terms of improved financial disclosure. While it may take some time to “sell” the concept of good CG to “Vietnam Inc.” in specific areas like protecting minority shareholder rights, a more rapid conversion process could be expected in demonstrating how the introduction of good CG principles can have a positive (and fairly immediate) impact on a company’s bottom line. It is in this area, of improving the internal management processes of local firms, and combating their current exposure to the risks of internal fraud and theft, that a programme promoting good CG might be expected to gain the greatest degree of traction in the near term. If so, it would echo the experience of other successful economic reforms

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in this transitional economy, where the greatest degree of success has tended to come from bottom-up rather than top-down initiatives. There also probably needs to be an effective organization or institution that can lead and coordinate multiple initiatives intended to advance the standard of CG practices in Vietnam. In the medium term, some consideration of an Institute of Directors or “CG Centre” would be desirable, ideally working in close consultation with other pertinent organizations, such as VCCI, VAFI and some state agencies, including the SSC and Ministry of Finance, Central Institute of Economic Management and the Ministry of Planning & Investment. The fact that Vietnam has a long way to go in establishing good CG standards and practices within its corporate community should not discount the considerable distance that local companies have already come in improving their competencies and capacities over the last decade or so. Despite being on a steep learning curve, the private sector in Vietnam has burgeoned considerably. Data from the General Statistics Office suggest that around 75,000 new companies were established in Vietnam in the four years between the Enterprise Law being introduced in January 2000 and the end of 2003. (The National Business Information Centre at the Ministry of Planning & Investment puts the figure at over 128,000.) This is phenomenal growth, by any standards. But it comes from a low base point, and reflects the mushrooming of small SMEs, many of which were pre-existing informal household enterprises, and a substantial proportion conduct fairly basic trading activities. Rather than re-investing in existing successful firms, there is also a tendency for companies to expand horizontally by setting up a diverse array of affiliates, all small enough not to attract too much attention from government agencies, such as the tax department. Clearly, this kind of phenomenon whereby the corporate sector does not so much expand as become sliced and diced into smaller pieces, is neither desirable nor sustainable in the long term. Therefore, the next important step in the development of Vietnam’s corporate sector will be the consolidation of this corporate growth, and the creation of larger, more efficient and competitive manufacturing firms — both state-owned and private — that are able to compete both in overseas markets and at home. With Vietnam’s accession to the WTO anticipated before the end of 2005, this is a fairly urgent goal as the government commits to liberalizing the domestic market as part of its terms of entry to the organization. Good CG can play an important role here in providing the kind of internal “soft architecture” that will allow firms to expand and diversify in a much more coherent and sustainable manner. It will also assist them in accessing the

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right kind and scale of long-term financing they need in order to develop into more robust and competitive entities. Notes 1. Sometimes also referred to as “quän tr¸ doanh nghiÆp” (administration [of a] business). 2. Although this chapter refers to CG in Vietnamese companies, much of this is also relevant to CG issues in local banks as well. 3. Somewhat confusingly, the term “Board of Directors” in Vietnam is known as the “Board of Management”. 4. A sample company charter can be downloaded from Mekong Capital’s website, at: . 5. The author is indebted to Ray Mallon for his insights on the issues raised in this paragraph, and the current differences in the three laws on various CG issues. 6. This probably reflects the fixed life-span that all foreign-invested projects are given at the time of initial licensing. 7. This relatively new decree (144/2003/ND-CP) replaced the earlier Decree 48. 8. See Appendix A for the comparative table, pp. 60–90. 9. Such training might include guidance on how to read and analyse company balance sheets, profit and loss statements, and cash flow statements. 10. The author is indebted to the insights of Chris Freund of Mekong Capital for the risks identified in this paragraph. 11. See CalPERS (2004) for details of its most recent “permissible equity market” review. 12. The Credit Information Centre, under the State Bank of Vietnam, has experimented with credit ratings, and already provides loan-related information on companies to commercial banks, albeit of mixed quality and utility. 13. The profile of Vietnam’s corporate sector is, like a number of other developing and transitional countries, shaped like that of an hour glass. There are millions of informal household businesses, and tens of thousands of small SMEs, mostly run as private family businesses, and a substantial number of large corporations, which are mostly SOEs. But there are surprisingly few companies in the middle, which could be described as medium-sized private companies. This “missing middle” should gradually develop, but is small at present. 14. The concept of building up long-term shareholder value has not been very well established in Vietnam, as yet. This is arguably because company owners and shareholders have placed greater emphasis on increasing annual income and dividends, rather than raising the value of the underlying shares in the long term. But this is changing, thanks in part to the opening of a stock market.

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15. It should be acknowledged, however, that probably the single biggest perceived virtue of stock option schemes in Vietnam would be to attract and retain skilled and senior employees in a labour market that has become extremely tight, and where job-hopping is very common.

References Allen, Jamie (2004) “Corporate Governance for Venture Capital and Private Equity Investors in Asia”. Presentation at Dibb Lupton Alsop in Hong Kong, 10 February. Asian Development Bank (2000) Corporate Governance and Finance in East Asia. Manila: Asian Development Bank. Bai, Chong-En, Qiao Liu, Joe Lu, Frank Song and Junxi Zhang (2003) “Corporate Governance and Market Valuation in China”. William Davidson Working Paper no. 564, May. Berglof, Erik and Stijn Claessens (undated) “Enforcement and Corporate Governance”, draft discussion paper. Downloaded from the Global Corporate Governance Forum website . CalPERS (2004) “Permissible Equity Market Analysis Update”, 17 February. Downloaded from The CalPERS Shareowner Forum website . Claessens, Stijn (2003) “Corporate Governance and Development”. Global Corporate Governance Forum, Focus 1. Washington DC: World Bank. Coombes, Paul and Mark Watson (2001) “Corporate Reform in the Developing World”. McKinsey Quarterly, no. 4. ——— (2002) “Global Investor Opinion Survey”. McKinsey Quarterly, July. Credit Lyonnais Securities Asia (2001) “Saints and Sinners: Who’s Got Religion?” In CLSA Watch: Corporate Governance in the Emerging Markets, edited by Amar Gill, April. Durnev, Art and E. Han Kim (2003) “To Steal or Not to Steal: Firm Attributes, Legal Environment, and Valuation”. William Davidson Institute Working Paper no. 554, April. Institute for International Finance Inc. (2002) “Policies for Corporate Governance and Transparency in Emerging Markets”. Report by the IIF’s Equity Advisory Group, February. Jordan, Cally and Mike Lubrano (2002) “How Effective are Capital Markets in Exerting Governance on Corporations?” In Financial Sector Governance: The Roles of the Public and Private Sectors. Washington: Brookings Press. Klapper, Leora and Inessa Love (2002) “Corporate Governance, Investor Protection, and Performance in Emerging Markets”. World Bank Policy Research Working Paper no. 2818, April. Mekong Capital (2003) “Recommendations on Good Corporate Governance Practices in Vietnam”. (11 January 2003 version). Downloaded from Mekong Capital website: .

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Newell, Roberto and Gregory Wilson (2002) “A Premium for Good Governance”. McKinsey Quarterly, no. 3. Organization for Economic Cooperation and Development (1999) OECD Principles of Corporate Governance. Paris: OECD. OECD (2003) “White Paper on Corporate Governance in Asia”, 15 July. ——— (2004) “OECD Principles of Corporate Governance: Draft Revised Text”, January. Schipani, Cindy A. and Liu Junhai (2001) “Corporate Governance in China: Then and Now”. William Davidson Institute Working Paper no. 407, November. Sun, Laixiang, ed., (2003a) Ownership and Governance of Enterprises: Recent Innovative Developments. London: Palgrave Macmillan. Sun, Laixiang (2003b) “Adaptive Efficiency and the Evolving Diversity of Enterprise Ownership and Governance Forms: An Overview”. In Laixiang Sun (2003a), pp. 1–35. Tenev, Stoyan, Chunlin Zhang and Loup Brefort (2002) Corporate Governance and Enterprise Reform in China: Building the Institutions of Modern Markets. Washington D.C.: World Bank and IFC.

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16 CORPORATE GOVERNANCE IN VIETNAM’S EQUITIZED COMPANIES Progressive Policies and Lax Realities NGUYEN Van Thang

INTRODUCTION Reforming the state-owned enterprise (SOE) sector has been a key element of the economic renewal process in Vietnam, underway since the late 1980s. A relatively recent key reform issue in this sector is the so-called equitization programme (broadly similar, but not identical, to privatization) of the country’s SOEs.1 One objective of the reform of Vietnamese SOEs is that of creating an appropriate corporate governance (CG) policy, which provides: sufficient incentives for managers and employees to work hard, prevents them from asset appropriation, and replaces them if they are found incompetent. Different from privatized companies in Eastern Europe, equitized companies in Vietnam are operating under the formal domination of socialist ideology. Thus, Vietnam presents a bit of a puzzle for both researchers and practitioners regarding CG in equitized companies — how does a market type of CG work under the formally dominant socialist ideology?

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Another challenge of — and motivation for — studying CG in Vietnam’s equitized companies is that these companies are in a process of transition from their former SOE status. In contrast, CG theories have generally been developed for well-established private businesses. This raises a number of questions, such as which CG theory is more pertinent to the reality of Vietnamese equitized companies? How applicable are these theories to equitized companies? And do they change as the companies move from one stage to another in their transition process? The objectives of this chapter are: 1) to provide an analysis of current policy and reality of CG in Vietnamese equitized companies; and 2) to offer some implications and suggestions for policy makers and investors in Vietnam. The chapter could also serve as a starting point for more detailed empirical research addressing some of the questions raised above. The chapter takes a broadly micro approach towards CG (that is, focusing on the firm level), and relies mostly on secondary data (for example, various government regulations, newspapers, various issues of Stock Investment (an official journal of the Ministry of Planning & Investment), and three interviews conducted with managers of equitized companies. The chapter starts with a very brief review of the main CG theories followed by an overview of SOE reform in Vietnam, corporate governance policies and practices, and problems of the current CG policies. A discussion of the implications for researchers, policymakers, and investors concludes the chapter. THEORETICAL BACKGROUND Definition of Corporate Governance Corporate governance (CG) is an institutional arrangement by which suppliers of finance to corporations ensure a proper return on their investment (Shleifer and Vishny 1997). There are two common approaches to corporate governance: the micro and the macro approaches. The micro approach views corporate governance as mainly about the structure and function of boards of directors, and the rights and prerogatives of shareholders on boardroom decision making. This approach often focuses the discussion around such issues as 1) the relationship between shareholders’ meeting, the supervisory board and CEO; 2) the function, size, and structure of the board; 3) board and executive compensation; and 4) board and managerial ownership. The macro approach, on the other hand, refers to corporate governance as the whole set of legal, cultural, and institutional arrangements that determine

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what private companies can do, who controls them, how that control is exercised, and how the risks and returns from the activities they undertake are allocated (Blair 1995). According to this approach, effective CG is contingent on the business systems of countries (Pedersen and Thomsen 1999). Thus, this approach focuses more on issues of how social institutions (for example, government regulation, the financial system, labour-market institutions, culture, etc.) influence corporate governance. Though both have different focuses, the two approaches do complement each other. In both approaches, good CG should enhance long-term shareholder value, through enhancing corporate performance and accountability, while taking into account the interests of other stakeholders. In other words, good CG facilitates the development of the corporation and protects shareholders’ interests. This chapter largely takes a micro approach in discussing the corporate governance in equitized companies in Vietnam. The macro issues will be viewed as contextual factors, and discussed wherever relevant. Corporate Governance Theories

Agency Theory Agency theory is concerned with the “agency problem” that exists when there is an agency relationship. In an agency relationship, one party (the principal) delegates decisions and/or work to another (the agent). The agency problem occurs when the principal and the agent have different goals (Eisenhardt 1989; Jensen and Meckling 1976). The underlying assumption of the agency theory is that agents are self-interested, risk-adverse, and rational actors. In the agency relationship, two typical problems could arise. The first is the monitoring problem that arises when the principal cannot verify if the agent behaved appropriately. The second is the problem of risk-sharing that arises when the principal and the agent have different attitudes toward risks (Eisenhardt 1989). The relationship between firm owners or shareholders (the principal) and the top management (the agent) is a typical principal-agent relationship. Agency theory sheds important light on how to design effective management control of such a relationship. First, agency theory implies that agents’ selfinterests can be monitored by information systems (Eisenhardt 1989). Thus, formal information systems, such as budgeting and management reporting, and informal information sources, such as managerial observation and surveillance are important aspects of control. Second, agency theory views control system aspects of compensation and incentive schemes as tools for

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better aligning an agent’s motives with organizational goals. This explains the importance of share options or management ownership in the management control system of a company (Ekanayake 2004).

Stewardship Theory Scholars have recently been critical of the agency perspective in CG studies (Hoskisson et al. 2000; Blair 1995; Perrow 1986), largely because of its limited ability to explain sociological and psychological mechanisms inherent in the principal-agent relationships. Stewardship theory is proposed as an alternative perspective to agency theory. The underlying assumption of the stewardship theory is that managers are good stewards of firms. They are trustworthy and work diligently to attain high corporate profits and shareholders’ returns (Donaldson and Davis 1994). Instead of focusing on “goal conflict”, stewardship theory proposes that the principal and the steward can cooperate with each other and achieve a “goal alignment”. Thus, stewardship theory focuses on developing mutual trust and cooperation between principals and stewards. Indeed, the stewardship theory proposes that trustworthy and cooperative relationships between principals and stewards are positively correlated with firm performance (Tian and Lau 2001). This has several important implications for management control systems. First, trust and cooperation can be enhanced by having effective information sharing mechanisms. Under the stewardship theory, information systems are primarily for the principal to share information with — and not necessarily to monitor — the stewards. Second, arrangements that foster understanding and identification between principals and stewards will increase the degree of trust between them, thereby leading to better firm performance. Stewardship theory differs from agency theory in several key aspects. Instead of relying on the premise that managers (agents) are opportunistic and self-serving, stewardship theory assumes that these managers are trustworthy and cooperative. Instead of emphasizing the need for monitoring and control, stewardship theory directs our attention to trust and relationshipbuilding between principal and stewards. Thus, while agency theory focuses on the independence of different groups (for example, board members, monitoring committee, and management), stewardship theory underlines understanding and identification between them. Table 16.1 contrasts the two perspectives in the context of CG. Although agency theory has been dominant in CG studies, scholars have argued that stewardship theory may be a better theory in certain contexts. In transitional economies such as Vietnam, where economic, institutional and

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TABLE 16.1 Two Perspectives in Corporate Governance Agency Theory

Stewardship Theory

Assumptions of human behaviour

Agents are opportunistic and self-serving

Trustworthy and work for the benefit of the corporation

Primary role of supervisory board

Board members are to control and monitor managers

Board members provide managers with resources, expertise, network and power

General advice

Arrangements that enhance principals’ control and monitoring of agents have positive impacts on firm performance

Arrangements that enhance trust and cooperation between principals and stewards have positive impacts on firm performance

Number of affiliated board members

Negatively related to firm performance

Positively related to firm performance

CEO-chairperson duality role

Negatively related to firm performance

Positively related to firm performance

Board diversity (women, foreigners)

Positively related to firm performance (push for more strict control)

Positively related to firm performance (provide more expertise and resources)

Managerial ownership

Inverse U shape relationship with firm performance (optimal level of managers’ motivation and being controlled)

Positively related to firm performance (increase identification of managers with firm)

Large shareholders

Positively related to firm performance (strong control and monitoring)

Positively related to firm performance (provide expertise and resources)

Development of stock market

Positively related to firm performance (push managers to focus on share price)

Not clear

Development of the job market for managers

Positively related to firm performance (easier to replace managers)

Negatively related to firm performance (lost expertise, experience, and bonding)

Government shares

Negatively related to firm performance (because nobody actually owns the government share)

Inverse U shape relationship with firm performance (optimal level of resources provided)

Some propositions

Source: Based on existing literature, for example, Tan and Lau (2001); Ekanayake (2004).

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social environments are very different from those of developed countries, the assumptions of agency theory need to be carefully reviewed (Phan 2001). Thus, which theory better explains corporate governance in transitional countries remains an unanswered question. OVERVIEW OF VIETNAM’S SOE REFORM — EQUITIZATION Vietnam has begun to reform its SOE sector since the introduction of “Doi Moi ”, or “market economy under socialist orientation”, formally unveiled at the Sixth Congress of the Vietnamese Communist Party in 1986. The focus of the economic reform process has been to gradually reduce the intervention of the government in the economy, and to create an environment that promotes innovations in all areas of business, including SOEs. The priorities have been to give SOEs more autonomy and responsibility for their performance (since 1987), to re-organize and consolidate the SOE sector (since 1991), to establish a Law on SOEs (1995), to group select strategic enterprises into industry conglomerates, and to introduce the “equitization” programme (broadly similar to privatization, entailing the partial divestment of state-owned corporate assets) (CIE 1998). Despite this reform effort, SOEs still contribute a significant portion of Vietnam’s total GDP. The state sector has consistently contributed 39–40 per cent of GDP since 1993, and the contribution of SOEs was about 28 per cent in 2003. In addition, even if the government completes its equitization plan, the capital mobilized from society (for example, through public share issues) still only accounts for 6–7 per cent of the total state capital in the SOE sector in 2003 (Le 2002). Thus, the direct impact of equitization has not been particularly significant. On the other hand, the number of SOEs in Vietnam has been reduced from about 12,000 companies in the late 1980s to nearly 6,000 companies by 2002, as a result of various initiatives. It is planned that Vietnam will have under 4,000 SOEs by 2005 (MPI 2002). Given the government’s plan to radically accelerate the equitization programme in the next few years, including the partial divestment of some of the largest enterprises and banks currently owned by the state, the CG issues become increasingly important. Right now, it’s relatively bearable if one or two small firms encounter crises, but it will be a major problem if a large corporate entity — in which many people have invested personal savings — does so. Failure to overcome existing weaknesses in the current CG practices could store up some problems for the future.

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Overview of Equitization Process in Vietnam “Equitization” is a term unique to Vietnam. Indeed, it is still under debate if “equitization” is the same concept as “privatization”. While the precise nature of equitization in Vietnam has not always been clear (MPI 2002), there are several distinct features of this process. First, the key objective of this process is an apparent desire to diversify the ownership of companies. Most importantly, it is for the workers in SOEs to become “real” owners of their own respective companies. Thus, companies’ workers and management often own a large proportion of the shares in equitized firms. Second, the state often retains a considerable proportion of the shares. In some cases, the State holds the majority of the shares, and only in very rare cases has the State sold its entire equity stake in former SOEs. Third, other large parties (such as institutional or strategic investors) are rarely major owners in equitized former SOEs (MPI 2002). After ten years of equitization (that is, since the first SOE was partially divested in 1992), 930 companies have reportedly been equitized (see Figure 16.1). However, the whole process has been slow, and the number of newly equitized companies has dropped since the year 2000 (MPI 2002). Similarly, many equitized companies do not want to be listed on the relatively new stock exchange (see Stock Investment, 16 Feb 2004), which FIGURE 16.1 Vietnam: Number of SOEs Equitized, 1990–2002 300 300 250 250

250 250

212 212

204 204

200 200 148 148

150 150 100 100

100 100 50 50 0 0

2 2

1 1

3 3

5 5

7 7

93 19

94 19

95 19

96 19

97 19

0 0

92 19 – 90 19

98 19

Source: Vietnam Economics Times, 3 October 2003.

99 19

00 20

01 20

02 20

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opened in July 2000. At present, Vietnam has only twenty-four listed companies on its stock exchange, all of which are former SOEs that have equitized. For equitized (and listed) companies, the change in ownership structure has been the key reform. However, the precise implications of ownership changes on management are not always transparent. Many equitized companies are operating in broadly the same way as they were when SOEs, without any notable improvement in their level of entrepreneurship or innovation in management (Vietnam Economics News, 3 October 2003). In addition, the whole concept of shareholders’ interference, corporate disclosure and transparency are alien to most existing managers. Fostering effective CG has become a timely and important issue for both policy makers and equitized companies’ stakeholders. Corporate Governance — Progressive Policies The government has issued a number of laws and regulations pertaining to equitized and listed companies. These policies initially appeared to be comprehensive to many observers, given the nascent nature of Vietnam’s market economy (Nguyen 2002). At the policy level, the equitization process has three key objectives (see Decree 64 CP 2002): • • •

To encourage companies’ effectiveness by fostering innovation and entrepreneurship; To mobilize society’s idle capital for technology development; To give workers, shareholders a true sense of ownership, and reinforce the monitoring and controlling activities on companies’ management.

Thus, CG of equitized companies should address at least two issues: 1) help facilitate the companies’ development; and 2) practice better monitoring and controlling activities over management decisions. From a micro view of CG (that is, structure of board, management), Vietnam tends to follow the common structures and procedures found in the West. Current regulations concerning CG for equitized and listed companies can be found in the Enterprise Law (1999), Decree 64 CP (2002) on equitization of the SOEs, and Decree 144 CP (2003) on stocks and the stock market. These regulations can be briefly described as follows: •

Shareholders’ meeting is the highest decision maker of an equitized or listed company.

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•

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Shareholders’ meeting votes for (or against) members of the Supervisory Board and Monitoring Committee (in case the company has more than ten shareholders). The Supervisory Board should not have more than eleven members. There is no regulation on how many managers or outside shareholders should be on the board. The Supervisory Board appoints the CEO and other important management positions of the company. The CEO can be a member of the Board of Governors. If the company has more than ten shareholders, it must have a Monitoring Committee. The Monitoring Committee should have from three to five members, of which at least one member has a background in accounting. Members of the Supervisory Board, the CEO, chief accountant, and their related people cannot be members of the Monitoring Committee. A detailed definition of “related people” is not provided. The Monitoring Committee is not required to have outside members (not currently employees of the company).

Theoretically at least, this arrangement gives shareholders some mechanisms to control the Board of Directors. They can vote for the Supervisory Board, Monitoring Committee, and major strategic decisions of the companies. However, in practice, this largely depends on how independent the Supervisory Board, Monitoring Committee, and Board of Directors are from each other. Corporate Governance — Lax Realities Equitized companies in Vietnam are currently facing two main challenges in following the policies and designing an effective CG arrangement. First, property rights have not been made clear for the state ownership of companies. Although one objective of the equitization programme is to diversify ownership, the state (government and its various organizations) remains as a key owner of the companies. A number of issues have been raised related to how to enforce the role of state as a true “shareholder”. Second, the objectives of the equitization programme have tended to be too ambitious and unfocused. And as a consequence, several objectives are not necessarily compatible with each other. For example, to mobilize society’s idle capital, and to encourage innovation and entrepreneurship, but at the same time, to retain the state’s controlling role, and give a high priority to selling shares to employees and management. These kinds of contradictions and discrepancies are reflected in the following specific problems.

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The Role of the Shareholders’ Meeting Shareholders of equitized companies comprise: the state, management, companies’ employees, and outside shareholders. Table 16.2 provides an estimate of the aggregate share structure of equitized SOEs, in 2002. According to the newest regulation (Decree 64 CP 2002), outside shareholders can buy up to 30 per cent of the shares in an equitized company. In practice, however, the portion of shares sold to outsiders is about 14 per cent on average (MPI 2002). While (non-management) employees as a group account for a significant percentage of the shares (40 per cent), they in fact buy shares individually. Each individual employee owns a very small number of shares. Depending on their tenure with the company, employees can sometimes buy some shares at subsidized prices. By regulation, such subsidized shares can not be sold within three years of the equitization. However, scholars have pointed out that these shares have been traded on the grey market less than three years after they were issued as part of an SOE equitization. This implies that some employees may only be nominal shareholders, who formally have shareholder rights, but are no longer the true owners of the shares. And conversely, some outsiders have become the true owners of the shares, but cannot exercise their shareholder rights. As a result, the state (the government and various organizations) often are the controlling shareholders of the equitized companies. Note that the “state shareholder” is actually an imprecise concept, as the ultimate owners of state shares are the public. But the public have no effective rights or means for TABLE 16.2 Vietnam: Shares Structure at the Time of Equitization (%) Group of shareholders

At the time of equitization (% of total)

Management Employees Central government Local government State corporations Other SOEs Other Vietnamese individuals Other Vietnamese organizations Foreign investors

188.9 40.0 2.0 14.5 14.0 3.7 13.1 3.6 0.2

Total

100.0

Source: Ministry of Planning & Investment Survey (2002).

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either monitoring the companies’ performance, or having an active voice in their governance. Such rights are vested in the government (that is, central and local government, or other relevant state institutions), who then delegate this to appointed individuals, who act as representatives of “state shareholders”. These individuals are given the shareholders’ rights, but they do not personally own the shares. Put another way, they are not the “principals” in the classical term; rather, they are “agents”. This has an important implication on who is appointed to the Supervisory Board and management positions of equitized former SOEs. Most of the time, however, shareholders’ meetings are used to formalize decisions already made beforehand by controlling shareholders (that is, the state and management). As discussed, both the Enterprise Act and companies’ own charters stipulate that the chairman of the Supervisory Board is to be elected by the shareholders’ meeting. In practice, the process often involves the controlling shareholders (that is, state and management) agreeing on the Supervisory Board’s chairman and CEO, then notifying the other shareholders accordingly, and subsequently getting it approved (or “rubber-stamped”) at the shareholders’ meetings. Other board members are appointed by major shareholders (including controlling shareholders), sometimes discussed with the workers’ representatives (the party’s and union’s representatives). Consequently, shareholders’ meetings will occasionally vote for just one or two board vacancies left. Similarly, shareholders’ meetings rarely contribute much to the company’s long-term business strategy. Unique contributions should come from outsiders (such as strategic shareholders). However, these strategic shareholders are limited in both the number and percentage of the shares they hold (see Table 16.2), and so their voice is expected to be limited when discussing the company’s long-term strategy. Thus, shareholders’ meetings often are for approving what has already been decided by a limited number of board members and management. Role of the Supervisory Board in Working with CEO The Supervisory Board members have two important roles in their relationship with the CEO: Controlling and supporting. First, the board members ensure that there is an appropriate alignment between shareholders’ interests and management decisions. This requires board members to perform substantive oversight functions over the CEO and senior management, such as ensuring management follows existing laws and regulations, the company’s own charter, and decisions made at shareholders’ meetings. Second, the board members

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should provide the necessary resources (for example, business and personal networks, power, information, and expertise) to help the CEO and senior management manage the company effectively. In almost all equitized companies, the Supervisory Board and the executive board are largely inter-mingled. In almost all cases, at least two thirds of the Supervisory Board members serve as senior management. The CEO is usually either the chairman or vice chairman of the Supervisory Board. This pattern also holds with the twenty-four listed companies. Logically, the controlling or monitoring role of the Supervisory Board is expected to be limited. Moreover, the big overlap between the Supervisory Board and management also means that the Supervisory Board may not add much in the way of additional resources, expertise, or network to management. Rather, the dual CEO-chairperson (or CEO-vice chairperson) role gives the CEO strong power to make critical management decisions. Arguably, that strong power may be necessary to manage the change process from an SOE to an equitized companies. The role of state shareholder representatives should also be noted. In many cases, the state shareholder representatives are elected as members of the Supervisory Board. However, the roles of these representatives are currently under debate. There is no clear regulation on what rights these individuals have, and on what issues they need to consult with their supervisory authorities prior to voting in a shareholders meeting or Supervisory Board meetings (MPI 2002). The risk that these representatives under- or over-utilize their roles is transparent for both state and equitized companies. As result, how these board members (as state representatives) actually work with management remains unclear. Role of the Monitoring Committee In eighteen of the twenty-one listed companies in 2003, most members of the Monitoring Committee are currently managers or employees of the companies. The member(s) who has the required accounting background is usually the former accountant(s) of the company. In these cases, the concern is how a group of employees can monitor their bosses. There is hardly any evidence of the Monitoring Committee performing oversight functions over the CEO and senior management. According to Stock Investment (6 October 2003) — an official publication of the Ministry of Planning & Investment — at least six listed companies were discovered to have financial irregularities in the period 2000 to 2003. Yet, in only one company (Bibica in 2002) did the Monitoring Committee have an active voice in the discovery of such irregularities.

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ADVANTAGES AND PROBLEMS OF THE CURRENT CORPORATE GOVERNANCE LEVELS IN VIETNAM The Advantages The current level of CG in Vietnam allows a greater degree of stability and smoothness in the transition process from state-owned to equitized companies. As discussed, there is a big overlap between the members of the Supervisory Boards and management, and as a result, the relationships between the Supervisory Board and management have tended to be smooth. In addition, outside shareholder interference has been kept to a minimum, especially for non-listed equitized companies. The CEOs retain strong power to direct the companies, including through the challenging process of equitization itself. The companies with little change in management are able to keep existing networks with government officials and traditional partners. Such a stable and smooth transition process is arguably favourable for the government and companies’ management during the early stage of equitization. As the managers of many equitized companies will testify, divesting from the state can be a difficult exercise, fraught with a range of obstacles and difficulties, including potential opposition from some quarters. This often requires the CEO to have sufficient power to overcome such obstacles, in order to keep the momentum necessary to successfully equitize. To then add an additional set of new (and relatively alien) CG regulations into the equitization process might be sufficient to derail some SOE divestments. Another factor in favour of the current CG standards is that they provide an opportunity or incentive for SOE managers to equitize. With current CG, the managers can see personal gains to be derived from equitization, from gaining greater autonomy to run the company as a commercial business, through to acquiring a fairly large equity stake in the firm. But if equitizing SOEs had to conform to higher standards of CG, then most managers would prefer to have their companies remain as SOEs. While these advantages may be considerable, they are probably outweighed by the number of problems that the current level of CG in Vietnam creates. Problems The current policy and practice of CG in equitized companies raises a number of concerns. In fact, available evidence suggests that corporate governance in equitized companies suffers from two basic types of problems: 1) development problems; and 2) agency problems. These problems have

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seriously and adversely affected the development of the nascent stock market in Vietnam (Stock Investment, 3 March 2003). Development Problems A key objective of equitization policy is to foster companies’ innovation and entrepreneurship (see Decree 63 CP 2002). But this objective is far from being satisfactorily achieved. Wishing for as little outsider shareholder interference as possible, equitized companies also tend to get few resources from them. The number of shares sold to outsiders often accounts for just a small percentage of total shares. Equitized companies also rarely get strategic shareholders — such as experienced, professional organizations and individuals — to contribute ideas, expertise and networks to their development. This is unfortunate, as strategic shareholders often bring in new ideas and markets for the investee companies. Without a strong contribution from outside shareholders, the companies have to rely primarily on internal management for innovative and entrepreneurial ideas. According to a recent survey by the Ministry for Planning & Investment (2002), about 90 per cent of equitized companies retained their CEO and other key managers during equitization. These managers’ roles in their past stateowned companies were biased towards administrative functions and a liaison role with whichever national or provincial government agency they reported to. These managers are often political appointees, rather than being “trail-blazers” of business activity. They gained the position of CEO as a reward for being a loyal follower, rather than as someone willing to take business risks and think “out of the box”, as entrepreneurs often must do. In equitized companies, however, these same managers are expected to act more innovatively and entrepreneurially. This appears to be a very challenging, if not impossible, shift for these so-called state-owned managers. The public media and newspapers have repeatedly warned that these same management teams rarely propose new business approaches (see Stock Investment, 2 February, p. 23 for examples). As a result, after equitization, many companies still operate in the same way as they did when state-owned companies. Agency Problems

Excessive Powers of CEOs and Insiders Control A key characteristic of CG in equitized companies is the excessive power of CEOs and insider control. This is carried over, at least in part, from the

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traditional management system of the preceding SOEs. The system of “one man rule” by a powerful CEO has dominated the control and management of many Vietnamese SOEs. Although the Party and Union theoretically could have some voice in the management, the CEO is practically the ultimate decision maker in many SOEs. In most SOEs, the Party and Union are effectively “captured”, in that they become part of the management group and identify with their interest. A strong degree of interference may come from the direct supervisory government authorities (for example, the relevant ministry or local government). However, these authorities do not “own” the companies; rather, they monitor the companies on behalf of the public. “Good” managers know how to work with the relevant authorities to minimize the government’s interference. Thus, strong support from government authorities, absolute power of management, and minimum interference from outsiders are dominant characteristics of many SOEs’ corporate governance. This can become an implicit management philosophy, and managers of SOEs need to be skilful in achieving these conditions. After being equitized, these SOEs retain nearly ninety per cent of their key managers, implying a strong inertia in their management approaches. The CEOs and their management teams try hard to retain their excessive power. Tactics used by management include limiting shares being sold to outsiders, applying the CEO-chairperson (or CEO-vice chairperson) dual role, and working closely with the state as a controlling shareholder. On a related matter, the safeguards for outsider and minority shareholders are inadequate in many cases. The CEO is first and foremost the agent of the controlling shareholders and should broadly follow the latter’s instructions, in terms of the company’s long-term strategy issues. In this context, the Supervisory Board serves as a forum for balancing the interests of major shareholders. It is doubtful whether the Supervisory Board has any effective role in representing the interests of minority shareholders, including employees and outsiders. It is worthwhile to reiterate here that the role of the board members who represent the state is not clear. A key question that has been repeatedly asked is when can these state representatives decide themselves how to vote on specific issues, and when must they consult with the relevant supervisory authorities that they represent. There exists the risk that even the state shareholders are not adequately protected. The common management view of outside shareholders should be noted. According to Stock Investment (see, for example, the issues of 3 and 10 March, 18 August 2003; and 16 February 2004), the threat or fear of greater outsider control has caused a number of SOEs to delay their equitization, and for a number of equitized companies to delay their IPO. In many cases, outside

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investors are not welcomed if they are not previously known by the management. These outside shareholders are viewed by numerous managers as “outsiders”, “interferers” and/or sources of “chaos”.

Weak and/or Non-Transparent Managerial Incentives Managerial incentives have not been a key reform element in many equitized companies, and especially for companies that still have the government as a controlling shareholder (that is, more than 50 per cent). In these companies, formal management salaries have little or no correlation to the companies’ profits or share price. The salary scheme is largely based on the government’s guidelines for state-owned enterprises, and uses these as a benchmark. As a consequence, management incentives and motivation for taking greater business risks and acting innovatively — in search of greater business success, as reflected in higher profits and/or share price — remains low. The payment for state shareholder representatives has also not been made clear under current regulations. Representatives who also work for companies can only get their salaries as employees. There is no clear payment for them in fulfilling their representative role. This raises a question of what motivates these representatives to actively monitor and control managers, who, at the same time, are their immediate bosses.

Lack of Transparency and Disclosure Auditing. In traditional SOEs, internal auditing has tended to be a rather alien concept. This has been carried over after some SOEs have been equitized. According to Stock Investment (10 March 2003), some companies still hold the view that: “the chief accountant assists the CEO in organizing and conducting internal auditing.” Thus, the role and effectiveness of internal audits are circumscribed by the excessive power of the CEO (and chief accountant), who has the means and authorities to influence the reports of internal auditors. The role of the external auditor is therefore critical in ensuring at least some degree of transparency and disclosure of equitized companies. But as in other countries, external auditors can only perform their audits on the information provided by the company. There have been cases that external auditors had to re-do their audits due to inaccurate information provided by client companies. There have also been cases where external auditors were effectively “bought” by the companies’ management. The following examples serve to illustrate some of the limitations of external auditing in Vietnam:

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Incident 1: Bibica (Bien hoa Confectionary Corporation) is an equitized and stock market listed company. This company provided its financial report five times, with five different numbers for profit/loss for the year 2002. The first report — written by the chief accountant and signed by the CEO — said Bibica made a profit of VND 8.9 billion (around US$567,000). The second draft (primarily written between the auditing company and Bibica’s management) said Bibica lost VND 2.7 billion (around US$172,000) in 2002. Next, the auditing company released a report saying that Bibica actually lost VND 5.42 billion (around US$345,000). But the Monitoring Committee disagreed with this report, and they argued that Bibica actually lost VND 12.3 billion (around US$783,000). The auditing company re-did their audit, and released another report, saying that Bibica lost VND 10.086 billion (around US$642,000). By this point, investors were unsure what was the correct number. This is particularly worrisome, as Bibica is one of a relatively small elite of companies that have successfully listed on the stock market, and as such, are exposed to meet a higher degree of corporate accounting and other standards than most other companies in Vietnam. Incident 2: Canfoco (Ha Long Canned Food Stock Corporation) is another equitized and stock market listed company, operating in the fisheries processing sector. In 2001, its management engaged in illegal conduct: signing a number of fake bills to help partnering private companies avoid paying tax. The external auditor somehow by-passed this activity in his auditing, and the scandal was only discovered later. Both the CEO and external auditor were found guilty of their actions.

These anecdotal cases illustrate why external auditing cannot, by itself, ensure appropriate corporate disclosure and transparency in Vietnam. Quality of information. Another concern for outside investors is the actual quality (as well as quantity) of information disclosed. Listed companies are strictly required to regularly provide information to investors. We therefore expect listed companies to be better than the average of equitized companies in information provision. Analysing the quality of information provided by listed companies should shed some light on how well equitized companies as a whole provide information to their investors. According to current regulations, listed companies are required to provide quarterly and yearly financial reports. The quarterly reports need to be released within the first half of the following month. The yearly reports are to be published within the first quarter of the following year. Besides this, listed companies are required to issue press releases on any (substantive) unexpected changes in their business development, and answer investors’ queries (although

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few, if any, listed firms have an investor relations capability). In practice, the investors of many listed companies have been disappointed with information provided in all three areas: its timeliness, accuracy, and sufficiency. Delays in providing periodic reports have been the norm, rather than the exception, for listed companies. These companies often delay providing quarterly reports until late in the following month. Taking the most recent quarter, at the time of writing — that is, the first quarter of 2004. Most listed companies submitted their report for the first quarter between three to five days late. By 22 April (a week later than the deadline), four companies (of twenty-four companies) had still not submitted their quarterly reports. This delay has been repeated in every quarter. Other information, such as new plans, projects, business partnerships, and personnel changes, have not been provided in a timely manner (Stock Investment, 28 April 2003). What seems to concern investors is that no legal punishment or penalty for these kinds of reporting delays has been proposed by the relevant authorities, such as the State Securities Commission. Companies always cite reasonable explanations for their delays. The most commonly used reasons include slow integration of data from branches, slow auditing process, information technology breakdown, changes related to the company’s accounting procedure, and slow response of the Stock Exchange information system. Related parties, such as auditing companies and the Stock Exchange also have their reasons. In other words, it is rarely anybody’s fault. Investors are the ones who suffer. Let’s take an example. Incident 3: As noted in Incident 2, Canfoco had a scandal resulting from an illegal act in 2002. On 25 February 2003, the Supervisory Board had its regular meeting. One of the decisions of this meeting was to change the Board’s chairman. But only on 5 March were the investors were informed of this decision. The new chairperson said that the company notified the Stock Exchange of its decision on 26 February but he did not know why the Stock Exchange delayed informing the investors. In the end, nobody took responsibility for the delay.

Accuracy of the information provided by listed companies is another concern of investors. Besides the infamous Bibica incident, at least five other listed companies have been found guilty of some irregularities in their business and financial activities. According to Stock Investment (18 April 2003), about one quarter of listed companies have been discovered as “having problems” with their financial reports. Related to accuracy, the sufficiency of the information is sometimes violated. Changes and unusual numbers in financial statements often require explanations, and this rule has not been strictly followed in

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Vietnam. This may mislead investors, and cause unnecessary surprises (or shocks) in the market. The following are three examples of companies providing inaccurate and/or insufficient information to investors. Incident 4: REE Corporation was a relatively successful listed company. In 2002, its financial statements for the first three quarters looked very good (growing in revenue and profitable). Suddenly, the fourth quarter reported a loss of VND 4.6 billion (around US$300,000), even though its revenue was about the same as it had been in the third quarter. This incident raised several questions from investors: 1) why had the reports of the first three quarters been so good? and 2) since just before the fourth quarter report was released, REE’s share’s price had been continuously declining, had there been any insider trading? Incident 5: GEMADEPT (General Forwarding and Agency Corporation): According to the company’s reports, the company paid 32 per cent of its income in corporate income tax. However, according to the company’s charter, the company only had to pay an income tax rate of 25 per cent for nearly 90 per cent of its various businesses, and 32 per cent for the rest. Thus, what income tax did the company actually pay? Incident 6: GILIMEX (Binh Thanh Import-Export Production and Trade JSC). 2002 was a great year for this company, with after-tax profits of VND 14.338 billion (nearly US$1 million); more than triple that of 2000. After paying dividends, the retained profits were VND 10,844 billion. Yet, owners’ assets increased by only VND 2.226 billion. Where did the other VND 7.4 billion go? There was no explanation.

Again, all these anecdotes come from companies listed on the stock market, which therefore are obligated to meet higher corporate accounting standards than non-listed firms. If these kinds of difficulties are being encountered by listed companies, what must be occurring in smaller and unlisted companies in Vietnam? In summary, the CG standard of equitized companies in Vietnam at this stage is largely designed for a smooth transition from their past SOE status. The companies are making changes in their ownership structure, and yet maintaining a high level of stability at the same time. The downside of this approach is two-fold. Firstly, radical changes in companies’ strategies and management practice are rarely introduced. And consequently, improvement in levels of management innovation and entrepreneurship tend not to be significant in most equitized companies. Secondly, control mechanisms have not been well enforced in practice. This appears to be due to a great fear of disclosure and outsider interference from the management side. Equally,

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there is an apparent — and probably justified — lack of investor confidence in the listed companies. DISCUSSION Corporate Governance in Transitional Stages Studies of corporate governance in Vietnamese equitized companies should take into account the transitional nature of the economy and corporate sector. The key focus that dominates most of government discussion to date appears to be the number of companies being equitized. Changes in the quality of these companies (for example, company strategies, management practices, and performance) have been largely overlooked. The changes have not resulted in either radical change in business strategies, increased level of disclosure and transparency, nor increased outside shareholders’ pressure on (and support for) the management team. At the policy level (that is, government and companies’ policies), guidance from agency theory seems to have been taken into account. In other words, there has been a strong effort in designing effective controlling and monitoring systems. In reality, however, companies tend to follow the guidance of stewardship theory. The practical governance arrangements ensure smooth relationships between the supervisory board and management, minimize interference from outside shareholders, and retain excessive power of the CEO and senior managers. Arguably, such arrangements have contributed to a smooth transition of these companies from SOEs to partially private firms, within the equitization process. Whether or not these arrangements contribute to — or undermine — firms’ long-term performance remains to be seen. The evidence available thus far has served to caution investors on agency problems. To positively influence equitized firms’ long term performance, the current arrangements will need to be changed. The key is to develop CG standards that enforce a high level of disclosure and transparency, and encourage effective changes in companies’ strategies. The current arrangements in most equitized companies do not support these requirements. The role of strategic shareholders (that is, outside, major non-government shareholders) is critical in this respect. Without strong voices of strategic shareholders it is unlikely that new, innovative and entrepreneurial management teams will develop or be appointed. Without new, innovative management teams, it is unlikely that the companies will be able to come up with effective changes in their strategies. Similarly, strategic shareholders need to put more pressure for greater corporate disclosure and transparency standards.

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Another research direction should be noted at this point. In transition economies, effective corporate governance appears to be contingent on the stages of economic transition. From this research, it is reasonable to hypothesize that agency and stewardship theories are dominant at different stages of equitization (privatization), and firm performance is contingent on the fit between corporate governance and stages of the transition process. Implications for Policymakers This chapter offers some implications for policymakers. First, reactions from the majority of SOE managers — the ones who actually implement the equitization programme — should be noted. Most progressive economic reforms to date (for example, granting autonomy to SOEs, fostering the private sector, granting land use rights to farmers) in Vietnam have been influenced from the bottom up (Nguyen 2003). In these programmes, the managers or farmers expected or even lobbied for these reforms. Equitization, on the other hand, is currently a top-down process. There is a strong resistance from a majority of SOEs’ managers to equitization, largely because it brings uncertainty for their careers (Stock Investment, 2 February 2004). For such managers, the risk-reward ratio of equitizing is weighted too heavily towards the risks. This explains in part the slow progress in the equitization programme. It also implies that even in successfully equitized companies, these unchanged managers will try hard to sustain their power and management approaches. In many equitized companies, fostering effective corporate governance has largely been compromised or undermined by the perceived priority of retaining the current management power. Second, the lack of law enforcement related to information provision, disclosure and transparency (especially for listed companies) has given the impression to investors that the government places a higher priority in protecting companies’ management than minority shareholder rights. Investors, especially minority and outside shareholders, do not feel that they are adequately protected in practice. This partly explains the current lack of public interest in the stock market as a vehicle for investment. Arguably, this is not simply a technical or competency problem. Rather, this is an attitudinal problem. For the long-term and sustainable development of the equitization programme and the stock market in Vietnam, investors need to be well protected. Government officials, stock exchange officials and company managers should take this simple concept more seriously. At the policy level, outside investors have been given more access to buy shares. In reality, they are sometimes blocked in getting access to companies’

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information (Stock Exchange, 26 April 2004). This is especially true for well performing SOEs. To encourage greater participation of outside investors, especially strategic investors, there needs to be a clear and specific policy on information provision for shareholders. Implications for Investors This chapter also offers some implications for investors in Vietnam. Investing in companies, shareholders always expect a high level of disclosure and transparency of companies’ businesses. In addition, they have a right to influence the companies’ long-term strategies and management practices, through shareholders meetings. Disclosure, transparency, and the influence of outsiders are a new reality that managers of equitized companies have to cope with. In addition, the fact that the CEO is actually hired and directed by shareholders (through the Supervisory Board), and has to report to shareholders (including employees and outsiders), is quite a strange concept for many managers. Many managers are not technically or psychologically ready to accept these requirements. The traditional attitude in managing SOEs is largely unconsciously held by managers. Going from managing SOEs to managing equitized companies entails a fundamental change in management practice and style, and simply improving management knowledge and skills is not enough. It requires a “paradigm jump” in management, which may not be learned effectively on rational grounds. This suggests that the new model of corporate governance and management may then only replace the existing model, when a new cognitively uncommitted generation gradually comes to make its own choices. Retraining and re-educating existing managers may be of little avail. Rather, only carefully crafted strategies that help a new generation of managers to be in positions of power can hope to do the trick. ACKNOWLEDGMENT The author thanks Nick Freeman and Jerman Rose for their valuable comments on an earlier draft of the chapter. Notes 1. In general, equitization in Vietnam has entailed the partial — but rarely the full — divestment of non-essential state-owned enterprises by the government, with the majority of shares being sold to managers, employees, customers, or other

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individuals and organizations with connections to the SOE concerned. Large public share issues by equitizing SOEs remain relatively rare. The state retains a substantial stake in most equitized SOEs.

References Blair, M. M. (1995) “Rethinking Assumptions Behind Corporate Governance”. Challenge 38, no. 6: 12–17. CIE (1998) Enterprise Reform Project. Canberra and Sydney: Centre for International Economics. Donaldson, L. and J. H. Davis (1994) “Boards and Company Performance: Research Challenges the Conventional Wisdom”. Corporate Governance 2, no. 3: 151–60. Eisehardt, K. (1989) Agency Theory: An assessment Review. Academy of Management Review 14, no. 1: 57–74. Ekanayake, S. (2004) “Agency Theory, National Culture and Management Systems”. Journal of American Academy of Business (March): 49–54. Hoskisson, R. E., L. Eden, C. M. Lau, and M. Wright (2000) Strategies in Emerging Economies. Academy of Management Journal 43, no. 3: 249–67. Jensen, M. C., and W. H. Meckling (1976) “Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure. Journal of Financial Economics 3: 305–50. Le Dang Doanh (2002) Equitization Policies and Solving Post Equitization Problems. Paper presented at the conference “Equitization and Post Equitization — Reality and Solutions”. Ministry of Planning and Investment, Hanoi, 29–30 August 2002. Ministry for Planning & Investment (2002) Equitized Companies in Vietnam: A Pre and Post Equitization Research on Performance, Difficulties, and Policy Implications. Ministry of Planning and Investment, Hanoi. Nguyen, T. V. A. (2002) Unpublished doctoral dissertation. Graduate School of Law, Nagaya University, Japan. Nguyen, V. T. (2003) Managing Changes in Vietnamese State-Owned Enterprises: What’s the Best Strategy? Human Resource Management Review 13: 413–38. Pedersen, T. and S. Thomsen (1999) “Business Systems and Corporate Governance”. International Studies of Management and Organization 29, no. 2: 43–59. Perrow, C. (1986) Complex Organizations: A Critical Essay. New York: McGraw-Hill. Phan, P. H. (2001) “Corporate Governance in the Newly Emerging Economies”. Asia Pacific Journal of Management 18, no. 2: 131–36. Shleifer, A. and R. W. Vishny (1997) “A Survey of Corporate Governance”. The Journal of Finance 52, no. 2: 737–83. Stock Investment [Dau Tu Chung Khoan], various issues. Tian, J. J. and C. M. Lau (2001) “Board Composition, Leadership Structure and Performance in Chinese Shareholding Companies”. Asia Pacific Journal of Management 18, no. 2: 245–63. Vietnam Economic News (Vietnamese version), 10 March 2003.

Index

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INDEX

Ahold, 4, 14 Allied Irish Bank, 58 Agency for Financial and Development Supervision (BPKP), 192 analysts salary, 10 annual general meetings dispensing with, 264 notice, 120 annual reports printed, 106 Anderson, 14 Anti-Monopoly Law, 175 Arthur Andersen, 14 Asian Bond Market Fund, 74 Asian Development Bank (ADB), 186, 188 Asian financial crisis banks, impact on, 60–62 corporate governance, motivation for, xxiii corporate governance, weak, 39 policymakers, response of, 62–64 Asian Roundtable on Corporate Governance, 46 asset management companies, 63, 64, 69–71, 142, 229

asset protection provisions, 123 audit committees, 86, 130, 254 function, 131 Thailand, in, 233 audit companies increasing revenues, 3 audit firm rotation, 193 auditors compliance with approved standards, 112 duty to report defect, 108 external, 137, 138 independent and external, 107, 108, 260 penalty for breach of duty, 108 warning letters, 192 watchdogs, as, 138, 139 auditor’s report, 107 audit partner rotation, 193 audits exemption for certain companies, 263, 264 Vietnam, 367 Australia Code of Corporate Governance, 243

376

award of damages statutory derivative actions, 45 back-door listing abuse of minority, 135 Bangko Sentral ng Pilipinas (BSP), 316 reporting quality of bank’s assets, 318 Bank for International Settlements, 66 banking reforms, xxvi Bank Indonesia promissory notes, 160 banking crises cost, 55 Bank Negara Malaysia, 141 directives, 152 Loan Monitoring Unit, 142 bankruptcy reforms Indonesia, 193–95 banks agency costs, 329 borrowed funds, 60 capital adequacy, 65 capital to assets, percentage of, 61 consolidation, speed of, 77 corporate governance, 51 debt-to-equity ratio, 176 detection of problems, timely, 73 fee based services, 77 loan portfolios, difficulty in assessing, 58, 69 non-performing loans, 62, 69, 70 number and concentration, 76 problems facing, 52 recapitalization, 63, 79 transparency, lack of, 69 Bapepam, 184 Barings Bank, 58 Barings plc, 39 Bassel II Accord, 66 implementation, 65, 79 best practices Malaysia, 89

Index

Best Practice Guidelines for Audit Committee, 225 board committees, 130, 131, 253, 307 board of directors access to information, 252 accountability, 308 composition, 129, 172, 248, 305 duties, 306 effectiveness, 247 election, 231 innovation, 10 shareholders’ right to elect, 39 structure, 129 Boeing, 4 bond markets development, 74 borrowers small, 142, 143 bribery activities, 33 Indonesian courts, 195 business elite involvement in politics, 18 business judgment rule, 257, 258 Cadbury Committee, 85 Cadbury, Sir Adrian, 244 California Public Employee Retirement System (CalPERS), 216, 343 Capital Markets Development Council, 301 capitalist multilateral system pressure on governments, xxiii, xxiv Central Bank Act, 316 Central Bank of The Philippines (Bangko Sentral ng Pilipinas), 300 Central Monetary Authority, 300 Chiang Mai Accord, 79 Chief Executive Officer separate from Chairman, 251 Chinese Indonesians role, 165 Citibank, 5

Index

civil law tradition Indonesia, 185 class action lawsuits, 47 Code of Corporate Governance (Philippines) definitions, 303 independent directors, 304 Code for Good Corporate Governance, 180 Code of Best Practices for Directors of Listed Companies, 225 Code on Takeovers and Mergers Malaysia, 89, 103, 148 Combined Code of Corporate Governance, 243 common law creating company law, 38 derivative action, 44 remedies for shareholders, 125, 126 companies control, separation of , 20, 21, 202 listed, see listed companies one director allowed, 263 ownership, concentration of, 19, 32 Companies Commission of Malaysia, 86, 91, 103 enforcing shareholders’ rights, 127, 128 company law common law, creation of, 38 company secretaries, 136, 137 professional qualification not needed, 263 compensation claiming, 237 Computer Associates, 14 conflicts of interests directors, 114, 115 connected lending, 207 connected transactions, 234 consent to act directors, 255 consolidated accounts, 108

377

Continuing Education Programme, 91 Cooperative Code, 315 Cooperative Development Authority Act, 315 core corporate law, 103 corporate debt restructuring committee, 141 corporate abuses, corporate elite access to state facilities, 187, 206 corporate governance administrative approach, drawbacks of, 220 alternative model, xxv Anglo-American model, 196 banks, in, 59 corporate culture as a catalyst, 308, 309 cultural dimension, 93 definition, xxi, xxii, 244, 352 economic dimension, 93, 94 employment generation, importance in, 167 executing, problems with, 11 framework for banks, 315, 316 gender related issues, 329 global view, xxiv improving standards, 48 inner value system, 12 measuring performance, 24 performance, 23 perspectives, 356 Philippines, in, 299–313 political institutions, xxv politicization, xxvii, 183 principles, xxii progressive policies, 359 ranking, 208 ratings, 24, 25 regulatory framework in Malaysia, 86, 87 share price performance, 24, 25 social dimension, 93, 94

378

Southeast Asia, in – motives, xxiii Corporate Governance Centre, 224, 224 training programmes, 226 Corporate Governance Self-Rating Form, 311 corporate governance theories agency theory, 354 stewardship theory, 355 corporate ownership Asian companies, 20 corporate power abuse, 39 corporations relationship with society, xxi corruption, 32, 163, 164, 165 detrimental effects, 164 cost of capital financial intermediaries, 72 Council of Corporate Disclosure and Governance, 246 establishment, 258, 259 court rulings remunerations of CEOs, 8 courts bribery and intimidation, 195 slow to interfere with director’s commercial decision, 257 Credit Lyonnais Securities Asia (CLSA), 24 basis of scores, 196 Emerging Markets, 180, 181, 186 creditors governance by, 139, 140 Credit Suisse First Boston (CSFB), 5 Danaharta, 142 debt instilling corporate governance, 313, 314 definitions corporate governance, xxi, xxii, 244, 352

Index

substantial shareholder, 112 Delaware Court of Chancery, 8 derivative actions common law, under, 44 minority shareholder, by, 126 Director Accreditation Programme, 217 Director Responsibilities Steering Group (DRSG), 214 directors advice and information from others, 254 appointment, 132 bank loans, 318 Code of Best Practices, 225 conflicts of interest, 114, 115 consent to act, 255 credit guarantees, 318 criteria for independence, 133 declaration when consenting to act, 255 duty to act honestly, 134 independent, see independent directors lawsuit against, 236 nominee, see nominee directors non-employee, see independent directors reasonable diligence, use of, 134 registered list, 214 removal, 133, 231 remuneration, 172 responsibilities, 232 training, 13, 91, 253 directors’ report, 260 disclosures chief executive, by, 114 directors, 114 financial institutions, reforms in, 66, 67 initial public offering, 105 non-financial information, 259 periodic and continuous, 105, 106

Index

prospectus, in, 114 quality of information, 368 related party transactions, 115, 117 Thailand, in, 235 timely and accurate, 42 Disney former CEO’s remuneration, 8 economic development Asian model, 16 Economic Intelligence Unit Transparency and Fairness of Legal System Rating Score, 67, 68 Economic Times, 7 Enron, 7, 14, 39 Equitable Life, 14 Evolutionary Stable Strategy (ESS), 171, 174 executive remuneration, 233 fair competition, 209 family dominance, 22 family-run companies Thailand, in, 201 Farmer’s Bank, 61 Federation of Thai Industries, 228 Finance Committee Report on Corporate Governance, 90, 91, 93, 94 financial accounting reforms Indonesia, 189–93 financial institutions, see also banks challenges in governance, 57 differences in governance, 57 disclosure reforms, 66, 67 governance, 53–60 governance reforms, 64–77 profit efficiency, 319 regulation, 66, 67 financial intermediaries governance, 54, 55 Financial Reporting Act 1997, 86, 110

379

Financial Reporting Foundation, 86, 88 Financial Reporting Standards, 259 Financial Sector Assessment Programme (FSAPs), 66 Financial Services Authority, 5 financial statements annual audited, 106 certification by auditor, 107, 108 electronic despatch, 261 interim, 106 statement of compliance, 150 fines differing standards, 5 foreign exchange reserves Indonesia, 159 volume, growing, 77 Foreign Investment Committee, 136 Foss v Harbottle, 43, 44, 126 France concentration of ownership in companies, 20 fraud occurrence and reporting, 5, 6 fraudulent transfers, 341 Gandhi, Mahatma, 13 General Banking Law of 2000, 316 Generally Accepted Auditing Practices (GAAP), 111 Germany concentration of ownership in companies, 20 globalization, xxiii challenges of diversity, 12 converging of norms, 17 Indonesia, effects in, 166–68 global reforms, 242 government bonds Indonesia, 160 government-linked companies, xxviii, 269–98 challenges, 294 contribution to development, 270

380

corporate plans, review of, 279 corporate governance reforms, 290, 291, 292, 293 criticisms against, 281–90 divestment, 283 evolution, 271–73 foreign CEOs, 288 image problem, 286 opportunities, 294, 295 percentage in GDP, 273–77 political accountability, 277–79 problems, 271 shareholders’ rights, 287 state appointed managers, 285, 286 state ownership and control, 289 transparency, lack of, 284 governments adoption of best practices, xxiv initiatives, dominating, 95 policy implementation, 27 proactive role, 14 Guidelines for Listed Company Shareholders, 225 Guidelines for the Disclosure of Information on Financial Statements, 225 Higgs, Sir Derek, 6, 94 HIH Insurance, 39 Hollinger, 4 Hong Kong banking system, 73 quarterly reporting, 40 Hong Kong Stock Exchange, 243 income statements, 106 independent directors definitions, 304 effectiveness, strengthening, 145, 146 empowering, 133. 134 remuneration, 8 role, 129

Index

Philippines, in, 317 Singapore, in, 248, 249 Thailand, in, 233 Indonesia administrative procedures, complicated, 184 Anti-Monopoly Law, 175 banking crisis, cost of, 56 bankruptcy reform, 193–95 banks, consolidation of, 63 banks, reforms for, 176 civil law tradition, 185 CLSA Emerging Market ranking, 180 collapse of banking system, 59 commercial court, new, 194 corporate elite, 187 corporate governance, politicization of, xxvii, 180–99 corruption, 163, 164 Dutch colonial rule, 166 financial accounting reforms, 189–93 foreign exchange reserve, 159 globalization, effects of, 166, 167 inflation rate, annualized, 158 institutional capacity, lack of, 183, 184 investments, 161, 162, 169 judicial system, 184 laws, amendment of, 170 law enforcement, weak, 170 macroeconomic stabilization, 158 National Committee on Good Corporate Governance, 171, 172 oil production, 159 open economy, 164 policymaking process, control over, 188 privatization of banks, 73 pungli payments, 33 reforms, low speed of, 157–78

Index

short-term programme of actions, 174 stock market, 173 unemployment, 161 weaknesses, 160 Indonesia Banking Restructuring Agency (IBRA), 160, 162, 189, 194 Indonesian Accounting Association (IAI), 190 Indonesian Accounting Principles (PAI), 190 Indonesian Democratic Party of Struggle (PDI-P), 189 Indonesian Institute of Corporate Directorship, 175 Indonesian Institute of Corporate Governance, 175 informal commissions, 341 initial public offering disclosures, 105 insider trading Marks & Spencer, 6 Thailand, in, 207 inspector appointment, 235 Institute of Directors, 224 Institute of Management Development, 208 Institution of Shareholder Services, 9 Institutional Investors Club, 216 institutional investors, 96 insurance institutions directive, 152 interested party transactions legislative provisions, 123, 124 internal ratings based approach, 65 International Accounting Standards, 16, 109 information to be disclosed in statements, 116 related party disclosures, 116 International Auditing Guidelines (IAGs), 111

381

International Federation of Accountants (IFAC), 111 international financial institutions, 185 International Monetary Fund (IMF), 66, 186, 188, 191 International Standards on Auditing, (ISAs), 111 investments sustainable, 169 investors private enforcement capacity, 147 Investors Association, 229 JP Morgan Chase, 10 Kuala Lumpur Stock Exchange (KLSE) regulation and enforcement, 94, 95 taking action against directors, 151 KLSE Listing Requirements, 89, 91, 106 annual report, 150 independence, definition, 129 Korea quarterly reporting, 40 lending connected, see connected lending listed companies control, 202 directors, disclosure by, 114 disclosures, 106, 107 quarterly reporting, 260 major shareholders siphoning of company funds, 207 Malaysia audit committees, 86 banks, consolidation programme for, 63 best practices, development of, 152 concentrated shareholding, 143 corporate governance regulatory framework, 86, 87

382

Code on Corporate Governance, 16, 89, 91, 95, 129–31, 149, 151 codes of conduct, development of, 89 Companies Act, 87, 88, 103, 105, 109, 144 directors, training of, 91 Finance Committee Report, 88 government-led initiatives, 95 High Level Finance Committee, 95, 250 industry best practices, 89 institutional reforms, 90, 91 market, role of, 92, 93 Minister of Finance Inc., 104 poor quality enforcement, 30 quarterly reporting, 40 reforms, types of, 87 Securities Commission Act, 87, 88, 105 Securities Industry Act, 87, 104 statutory reforms, 87, 88 Malaysian Accounting Standards, 109 Malaysian Accounting Standards Board (MASB), 86, 88, 106, 110 Malaysian Association of Certified Public Accountants, 110 Malaysian Association of the Institute of Chartered Secretaries and Administrators (MAICSA), 90, 98 Malaysian Central Depository, 118 Malaysia Code on Corporate Governance, 250 Malaysian Generally Accepted Accounting Principles, 109 Malaysian Institute of Accountants (MIA), 110 Malaysian Institute of Corporate Governance (MICG), 91 management oversight, 128, 129 Mandatory Accreditation Programme, 91 Manila Electric Company, 302 market structures

Index

complicating corporate governance in banks, 59 Marks & Spencer takeover battle, 9 memorandum and articles of association, 103 alteration, 104 Merrill Lynch, 5 minority shareholders rights, 124 minority shareholder suits protecting, 98 security for costs, 47 Minority Shareholder Watchdog Group (MSWG), 91, 95, 96, 148, 152 minutes comprehensively drawn, call for, 261 Moody’s Weighted Average Bank Financial Strength Index, 66, 71, 72 monitoring committee role, 363 National Association of Pension Funds, 9 National Corporate Governance Committee, 200, 223, 224 National Counter Corruption, 219 New York Stock Exchange (NYSE) Richard Grasso, remuneration of, 4 nominee directors, 256, 257 Nominating Committee, 254 non-executives remuneration, 7 non-governmental organizations (NGOs) Indonesia, 175 non-performing loans asset management companies, 63, 64, 69–71 bank provisions, 62 commercial banking system, in, 70 magnitude, 56

Index

Philippines, 316 notices annual general meeting, of, 120, 121 electronic despatch, 261 substantial shareholders, 113 oil prices collapse, 187 oil production Indonesia, 159 one-director companies, 263 Organization of Economic Cooperation and Development (OECD), xxi, xxii Codes on Good Corporate Governance, 170 Principles of Corporate Governance, 182, 183, 186, 243 ownership definition, 20 separation from control, 21 Parmalat, 4, 14 People’s Republic of China quarterly reporting, 40 penalties auditor’s breach of duty, 108 non-disclosure, 150 substantial shareholders, 113 periodic disclosures shareholder interest, 114 Perwaja Steel, 39 Petron Corporation, 302 Philippines banks, capital requirements of, 318 banks, competitiveness of, 319 banks, corporate governance of, 328 banking density, 327 bank mergers, 320 board size and composition, 305 catalysts of change, 300, 301 Code of Corporate Governance, 301, 303

383

credit unions, 327 financial institutions, corporate governance of, 314–32 findings to help monitor performance of banks, 331 market conditions, 327 Monetary Board, authority of, 317 police credibility, 28 reforms efforts, xxviii reforms, prioritizing, 310, 311 strengthening institutional capactiy Philippine Securities and Exchange Commission, 301 Philippine Stock Exchange, 300 PHINMA group of companies, 302 Policies and Guidelines on Issue/Offer of Securities, 89, 98 political institutions differences, 34 veto power, 27, 28 profit efficiency alternative profit function, 321, 322, 324 banks, 323, 324 definition of correlates, 325, 326 model and data structure, 319, 320 Projek LebuhRaya Utara-Selatan Berhad (PLUS), 104 prospectuses disclosure by directors and officers, 114 proxy appointment, 120 Public Accounting Reform and Investor Protection, see SarbanesOxley Act Public Accounting Report findings, 3, 4 Q-Mark, 228 quarterly reporting costs, 42 dangers, 11

384

leading to short-termism in investing, 41 listed companies, 260 Malaysia, in, 106 merits, xxv, 40 Southeast Asia, in, 41 rating agencies, 71–73 ratings, 24, 26 recalcitrant debtors, 195 reconstructions, 140, 141 redress, 237 reforms shareholder activism, to facilitate, 45 regionalization, xxiii regulatory bodies enforcement capability, strengthening, 146, 147 politicization, xxvi related party transactions disclosure, 115–17 legislative provisions, 123, 144, 145 remuneration element of corporate governance, 172 risk-sensitive system, 177 Remuneration Committee, 233, 254 reporting transparency, 9 resolutions member of companies, 122 revoking, 237 restructuring small borrowers, 142 reverse takeovers abuse of minority, 135 rules changes, predictability in, 28 Rules of High Court Order 24, 44, 45 shareholder actions, 126

Index

Salomon v A Salomon & Co Ltd, 38 Sarbanes-Oxley Act, 3, 6, 10, 192, 242, 260, 27 auditor’s independence, 260 increasing cost, cause of, 4, 5 whistle blowing, 264 schemes of arrangement, 140 Schmidt, Paul, 4 Securities Commission, 104 Securities Industry Development Centre, 91 securities market regulator independence, 135, 136 shareholder agreements, 103 shareholders activism, 45, 97 asking questions at AGMs, 122 asset protection provisions, 123 attending meetings, 229 calling extraordinary general meeting, 230 communications, 121, 122 enforcing rights, 125–28 foreign, 120, 121 major, see major shareholders meetings, 361, 362 remedies, 262 requisitioning meetings, 121 rights, 117–28, 229 right to elect directors, 39 right to vote, 119, 145 securing methods of ownership registration, 117, 118 sequence of agenda, changing, 231 substantial, see substantial shareholder obtaining information, 118, 119, 230 participation, 261 profits, sharing of, 232 public enforcement of rights, 127 taking legal action, 46

Index

transferring shares, 118 share price performance, 24–26 share registrar independent, 137 Shell, 5, 14 Singapore banking system, 73 changes, effectiveness, 264, 265 corporate governance, difficulty in imposing, 265, 266 disclosure based regime, xxviii Financial Reporting Standards, 259 government-linked companies, xxviii, 269–98 political motivation, 266 quarterly reporting, 40 recent changes, 246, 247 reform process, 242 Report of the Corporate Governance Committee, 245 Singapore Code of Corporate Governance, 246 Skandia, 4, 14 social scientists corporations and society, relationship between, xxi societal needs models for engagement, 11, 12 Southeast Asia corporate governance, motivation for, xxiii reforms, modest progress in, 17 Sovereign Ratings, 75 Special Shareholder, 104 Standard & Poor’s (S&P), 186 state control, 22, 23 statement of compliance, 150 state-owned enterprises, 334 equitization, 334, 353, 357–59 reforming, 352 statutory derivative actions award of damages to company, 45

385

action under name of company, 44 reasons for implementing, 44 remedying deficiencies in common law, 48 merits, xxv obstacles to shareholder action, 43 Stewart, Martha, 6 Stock Exchange Commission of Thailand (SEC), 209, 213, 218 auditor’s reports, reviewing of, 215 Stock Exchange of Thailand, 16, 209 rules, stringent, 214 largest companies, 202 stock market Indonesia, 173 substantial shareholders definition, 112 notices, 112 participation on boards, 133 penalty, 113 supervisory board role, 362 Susilo Bambang Yudhoyono, 189 Taiwan quarterly reporting, 40 takeovers hostile bids, 134, 135 reverse, see reverse takeovers Temasek Holdings, 271, 275, 276 board of directors, 291 charter, 291 organizational chart, 277 stakes in listed companies, 274 Tenaga Nasional Berhad, 104 Thai baht speculative attack, 61 Thai Chamber of Commerce, 228 Thai Institute of Directors, 216, 217 Thailand amendments, proposed, 213 audit of year award, 228

386

banking crisis, cost of, 56 banks, privatization of, 73 board of the year award, 228 corporate conduct, 206, 207 corporate governance best practices award, 228 corporate governance, disciplines for, 223–40 corporate ownership, 201 corruption, 219 Disclosure Report Award, 227 family conglomerates, 30 finance companies, closure of, 63 governance performance, 208, 209 initiatives to promote corporate governance, 210–12 National Corporate Governance Committee, xxvii politics affecting corporate governance, 29 shareholders, largest, 203–05 Thailand Productivity Institute Best Practice Award, 228 Thai Rating and Information Services Company Limited (TRIS), 227 Thaksin Shinawatra, 30, 200 share price manipulation probe, 219 training role, 13 UNCTAD, 169 unemployment public works solution, 161 United Kingdom Financial Services Authority (FSA), see Financial Services Authority Vietnam lack of political will, xxix veil of incorporation, 38 Vietnam agency problems, 365, 366

Index

corporate governance practices, 333– 51 advantages, 364 best approach, 342–47 constraints in improving, 337 costs of inadequate standards, 340, 341 lax realities, 360 problems, 364, 365 progressive policies, 359 transitional stages, 371, 372 corporate tax regime, improvements to, 347 development problems, 365 economic reform agenda, 335 Enterprise Law, 336, 343 Foreign Investment Law, 336 fraudulent transfers, 341 informal commissions, 341 investors, implications for, 373 listed companies, information about, 369 non-transparent managerial incentives, 367 private companies, size of, 334 policymakers, implications for, 372 related party loans, 341 State Enterprise Law, 336 state-owned enterprises, 334, 352, 353, 357–59 State Securities Commission, 337, 369 transparency and disclosure, lack of, 367–70 Vietnam Association of Financial Investors, 338 Vivendi, 14 vote buying, 29 voting mail, by, 120 methodology, 262 types, 119 voting arrangements, 103

Index

voting rights shareholders, 119, 145, 229 special, 104 whistle blowing, 264 winding up, 140 Wolfensohn, James corporate governance, definition of, xxi

387

Wong, Y. C. Richard, 244 World Bank, 186 rating listed companies, 216 World Business Environment Survey, 33 WorldCom, 7, 14, 39 World Trade Organization agreement on financial services, 77