_ _____ ___________________ WsLP PiO o POl.ICY RESEARCH WORKING PAPER 2003 Thailand's Corporate Weaknesses in corporate governance and the fragile Financing and Governance financial structure of many Structures corporations contributed to, Structures and deepened Thailand's recent financial crisis. Large Pedro Alba corporations need to reduce Stijni Claessenis their vulnerability to economic Simeon Dj'aniko shocks and improve corporate governance; smaller firms should achieve a more stable funding structure. The World Bank Finance, Private Sector, and Infrastructure Network Economic Policy Unit November 1998 POLICY RESEARCH WORKING PAPER 2003 Summary findings Alba, Claessens, and Djankov assess Thailand's policy related lending limits, violation of which contributed options for reducing large corporations' vulnerability to poor intermediation and the recent crisis. economic shocks and improving their corporate * Improving disclosure and accounting practices. Self- governance - and for providing smaller firms a more regulatory agencies may need to play more of a role, stable funding structure. possibly with more legal power to discipline violators. Using data for firms listed on Thailand's stock * Better enforcement of corporate governance rules. exchange, they empirically assess the relative importance The formal structure for corporate governance is of various factors determining the cost of capital, the standard but enforcement is weak. availability of financing, and policies and distortions that * Facilitation of equity infusions. Investors - affect corporate governance in nonfinancial firms. The especially minority shareholders - may need to play a empirical findings highlight weaknesses in corporate more direct role in monitoring and disciplining governance and the inherent risks in Thailand's managers. To attract new infusions of equity, new equity corporate financing structures. owners may need more-than-proportional representation They conclude that the most important task in on the board of directors until other investor protection improving the structure of corporate financing and the mechanisms are strengthened. framework for corporate governance is to change * Improving the framework for corporate governance. incentives. This will involve: A broad public discussion of corporate governance, - Accelerating legal reform, including reform of similar to recent discussions in the United Kingdom and bankruptcy and foreclosure laws. elsewhere, may be needed to clarify the distribution of * Improving bank monitoring of enterprise control in the economy's real sector. management and encouraging banks to develop more * Strengthening institutions responsible for gathering arm's-length relationships with firms. This will require and analyzing data on firms of all sizes and for greater transparency and disclosure of ownership monitoring firm performance and behavior. relationships and stricter enforcement of insider and This paper - a product of the Economic Policy Unit, Finance, Private Sector, and Infrastructure Network - is part of a larger effort in the network to study the performance and financing structures of East Asian corporations. The paper. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Rose Vo, room MC10-628, telephone 202-473-3722, fax 202-522-2031, Internet address hvol@worldbank.org. Stijn Claessens may be contacted at cclaessens@worldbank.org. November 1998. (27 pages) The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Exectutive Directors, or the countries they represent. Produced by the Policy Research Dissemination Center Thailand's Corporate Financing and Governance Structures Pedro Alba, Stijn Claessens and Simeon Djankov World Bank' JEL code: G32, G38. Keywords: Corporate finance, corporate governance, Thailand. ' We would like to thank Chintay Shih, Dong-Sung Cho, Akira Goto, Tawee Butsuntorn, Francis Colaco and Johanna de Witte for useful comments and Michelle Barnes for research assistance. Thailand's Corporate Financing and Governance Structures 1. INTRODUCTION The corporate finance structure in Thailand has not served the country as well as it could. Many corporates' financial structure was very fragile in 1997, which contributed to the depth and length of the financial crisis. In general, firms found themselves very exposed to the changes in economic environment following the financial crisis. Long term funds from local sources for every type of firm were scarce-due to the lack of institutional investors and the excessive reliance on bank financing. Both contributed to overextended offshore borrowing by Thai corporates. Small and medium enterprises (SMEs) in Thailand have had relatively little access to formal financing, as lending was skewed to large firms, and the cost of any financing for these firms has been high, with resulting constraints on SME growth. In addition to a lack of creditworthiness, poor information and high administrative costs, this is due to the limited forms of collateral that can be used or pledged and the insufficient skills of borrowers. The recent financial crisis and the slower economic growth in recent years relative to the level of investment have shown that the allocation of savings in Thailand has not been efficient, particularly for the larger non-financial firms. It was also geared towards too risky activities. Our contention is that the financing and corporate governance structure of large corporates has led to inefficient investment, with excessive diversification and declines in profitability over the past few years. Looking forward, large corporates need to reduce their financial vulnerability to econormic shocks, and corporate governance needs to be improved to enhance the efficiency of investment. SMEs need to have better access to financing and a more stable funding structure. This study assesses the various policy options to achieve these outcomes. To do so, the study analyzes the financial structure of firms in Thailand, draws lessons from the intemational experience, and suggests possible improvements. It reviews the framework for corporate financing in Thailand, using interviews with financial and large non-financial firms and reviews of the legal and regulatory framework. The study assesses empirically the relative importance of various factors determining the cost of capital, the availability of financing, and the different policies and distortions affecting the corporate governance framework for non-financial firms. Using data for firms listed on the Stock Exchange of Thailand (SET), the structure of financing, the efficiency of investments, and the effectiveness of current corporate governance mechanisms are analyzed and compared with that in other economies. The empirical findings highlight the weaknesses in corporate governance and the risky corporate financing structures. The outline of the paper is as follows. Section 2 describes corporate performance and corporate financing pattems in Thailand during the 1994-97 period. The paper then reviews international experience with different financial structures and corporate governance mechanisms in section 3. It proceeds with reviewing the institutional framework for financing and corporate governance in Thailand in section 4. In section 5, some specific hypotheses are tested for Thailand 2 regarding the links between corporate governance, corporate financing and firm behavior. Section 6 reviews medium-term areas of possible policy action.2 2. CORPORATE PERFORMANCE AND CORPORATE FINANCING PATTERNS IN RECENT YEARS The recent financial crisis in Thailand revealed some of the weaknesses of the corporate sector.3 While the magnitude and severity of the crisis was unexpected, there were signs of deterioration in corporate performance before July 1997. This becomes clear once we consider the evidence on the performance of Thai corporates in the years before the crisis. Productivity growth slowed down starting in 1995, and leverage, already high by international comparison, increased significantly as early as 1995. Using data for all firms listed on the Thailand Stock Exchange for which financial statements are available, we can show that the deterioration in corporate performance started in 1994 using four indicators of enterprise performance (Table 1). First, we review the time series of the profits over interest expense ratios in 1994-97. In 1994, profits were 5.78 times higher than interest expenses for the average SET firm. By the end of 1995, this ratio fell to 4.01, by end-1996 to 3.11, and was then further reduced by half (to 1.49) in 1997. In other words, by the end of the period, two-thirds of all profits of Thai listed firns went to cover interest expenses. Table 1: Deteriorating Corporate Performance Period Number of Profits over No of firms Loans of Profits over Leverage Firms Interest with Profits Firms with Liabilities Expenses < Interest Profits < Expenses Interest Expenses (%) (%) 1997:Q4 356 1.49 114 36.4 7.3 2.95 1997:Q3 356 2.59 83 30.8 10.2 2.95 1997:Q2 357 3.18 71 18.4 N/A. 2.12 1997:Q1 353 3.66 54 16.2 N/A. 2.01 1996:Q4 354 3.11 49 11.8 14.9 1.90 1995:Q4 354 4.01 34 7.6 18.1 1.67 1994:Q4 352 5.78 18 1.4 24.0 1.50 Notes: Profit is defined as earnings before interest, taxes, depreciation, and amortization (EBITDA) Leverage is debt over equity. Source: SET database. 2 While the analysis is made in reference to Thailand's recent financial crisis, the paper does not discuss the issues of short-run (or medium-term) exchange and interest rate management that might be relevant for corporate financing developments. For this we refer to Dwor-Frecaut et al., 1998. 3 While the focus of the paper is on corporate governance in non-financial institutions, much of the discussion also applies to financial institutions. 3 The number of firms with interest expenses exceeding profits increased six-fold-from 18 to 114-during this same period. The reduction in profitability meant that for more than a third of all outstanding loans (36.4%), firms could not cover interest expenses in full, up from only 1.4% in 1994. The ratio of profits to liabilities also went down from 24.0% to 7.3%. Finally, leverage increased to an average of 2.95-twice as high as the 1994 value. The situation became particularly worrisome in the construction sector, which has now the highest leverage (5.25). Not just the listed firms, but also smaller Thai firms have seen a decline in financial profitability in the last few years. According to a survey of 842 firms, average firm profits have declined from 17% of capital in 1994 to 4% in 1996 (Dollar and Hallward-Driemeier, 1998). There also has been a sharp rise in leverage, especially of short-term foreign borrowings. The average debt-to-equity ratio in the survey sample is 200%, with almost three-quarters of liabilities short-term. While larger firms tend to have higher debt-equity ratios, smaller firms are thus also quite leveraged. The financial crisis has revealed these weaknesses. As is typical during a financial crisis, many Thai firms are- now complaining about the high cost of funds and the limited access to financing. The survey performed in the last quarter of 1997 and the first quarter of 1998, sheds some light on the nature of this credit crunch (Dollar and Hallward-Driemeier, 1998). In the responses, access to finance was mentioned more often in the first quarter of 1998 than six months earlier as a bottleneck facing firms. More larger firms than smaller firms reported problems with access to financing according to the survey, but firms of all sizes mentioned the cost of finance as a worry. Local firms mention cost as a worry more often than foreign firms in Thailand, but there is little difference between the two types of firms regarding their access to capital. The difference between exporters and non-exporters is more striking: access to capital is mentioned as a problem by non-exporters three times as often than by exporters, while costs of financing is mentioned two times as often. The survey also finds that SMEs were generally less likely than larger firms to mention access to finance as an obstacle to growth from a longer run perspective. This may be because SMEs received little external financing in the past and have been better able to adjust to tight liquidity conditions. This does not obfuscate the need for better financing of SMEs, of course, because they are likely to be the growth-engine in Thailand as they have been in other countries. Hence, both as a short-run and as a longer term development goal, particularly in an environment where firms are trying to expand, finance is an issue that needs addressing. One may wonder why some corrective measures were not taken prior to the financial crisis. While we discuss this issue at length in the coming sections, we would like to highlight two reasons. First, businessmen and financiers alike were likely blinded by the success of Thai corporates over the last decades that produced impressive economic growth rates. In spite of the recognition of some of the underlying fundamental weaknesses, most investors did not view the crisis as inevitable. Second, the significant concentration of ownership in the hands of family groups and the lack of counter-balancing forces-professional management, for example-reduced the corporates' ability to change their behavior and more generally their willingness to improve on some of the recognized weaknesses. Looking forward, it is important to identify the fundamental weaknesses of the Thai corporate sector that triggered this deterioration in performance. We discuss the weaknesses in corporate governance and corporate financing in section 4, while in section 5, we try to quantify the impact. First, however, we review the international experience with corporate governance and corporate financing. 4 3. THE INTERNATIONAL EXPERIENCE ON CORPORATE GOVERNANCE AND CORPORATE FINANCING The debate of the "model" The financing and governance of firms depends importantly on the institutional structure of the financial sector. International discussions regarding the "optimal" financial structure have often contrasted two models: bank-centered versus market-centered (see Prowse, 1994 and 1998). The former is typically associated with Japan and Germany (main-bank systems); the latter with the US and the UK. The differences between the two models center on the main agent who monitors the activities of the firm and takes the lead in disciplining management.4 Under the bank- centered model, banks play the lead role in the monitoring of firms. Under the market-based system, a broader range of investors plays this role through the pricing, trading and buying of the firm's securities. In both models, the monitoring activities of financial institutions or financial markets are complemented by those of many other agents: other firms (through competition, suppliers and buyers' contracts), labor, the government, etc. (see further Shleifer and Vishny, 1997 for a review). Bank-centered systems may have advantages in resolving informational asymmetries, and thus lead to less liquidity constraints in firms, particularly at times of distress (see, for example, Aoki and Patrick, 1994). There is some empirical evidence supporting the view that main-bank monitoring mitigates information problems in financial markets.5 Since information asymmetries are more likely prevalent at lower-income levels, bank-based systems may have advantages at early stages of development. Thailand can be characterized as a bank-centered financial system, given its high ratio of bank credit to the stock market capitalization. A priori, the bank-based system may thus remain appropriate for Thailand. There is no easy empirical answer to the question what type of financial system is associated with consistently higher economic growth.' Even for stable developed countries with well-defined financial systems, it has been difficult to "rank" the different governance systems that are in use now or have been in use in (recent) history in terms of their impact on the economy (see, among others, Allen and Gale 1995, Walter 1993, and Saunders and Walter 1994). The debate on whether there is a unique financial structure optimally suited to monitor and govern firms in a given country is therefore perhaps not very useful. There might simply not be any ideal system applicable to a specific country, since in practice the functions and effects of any financial system depend on a host of country-specific circumstances, including legal, social, cultural, and other factors. 4 Three types of monitoring and related disciplining actions can be distinguished (see Aoki, in Aoki and Patrick, 1994): ex-ante, when investment decisions by the borrower are being reviewed; interim, during the life of the investment or in the day-to-day operations of the borrower; and ex-post, during periods of financial distress and possible bankruptcy. 5 Hoshy, Kashyap and Scharfstein (1990) compare the strength of the relationship between investment and measures of internal finance, such as cash flow, for Japanese firms who have strong relationship with banks against firns without such ties. They find that cash flow is a more important determinant of investment for independent firms than for those firms who are members of a keiretsu group with a main bank. Hoshi, Kashyap and Scharfstein (1995) find that keiretsu firms which weakened their ties to banks by raising money directly from capital markets became more liquidity constrained than before. 6 In part this is because it is hard to characterize a financial system or a reform model adequately. Many countries combine elements of both bank- and market-based systems. 5 However, there is recent evidence that bank-centered systems may be more likely to lead to non-market based lending. Basically, as corporates mature, their needs for outside finance for investment purposes decline as they can rely more on internally generated finance (Jensen, 1986). As "free" cash flow builds up in corporates, banks lose their disciplining influence over firms and firms are more likely to engage in inefficient investment and excessive diversification. The once favorable reviews of the Japanese and German bank-based system are being revised in light of recent experiences given excessive diversification of some German firms and the poor recent performance of corporates (and banks) in Japan. Bank-centered countries like Germany have begun to make the switch to a more open, market-based system, but this has not been without pain and has been a process underway for a decade. Japan is still in the early stages of its transformation process and has had several years of low growth and a weakening banking system.7 The issue of an optimal financial system may thus rather be better put as: is the system able to adapt to new circumstances in the real and financial sector? In summary, there may not be a preferred financial structure and mix between banks and capital markets for Thailand to aim at. Across the globe, there is growing evidence that banks and capital markets do not substitute but rather complement one another (Demirgu9c-Kunt and Levine, 1996). In the short-run, Thailand's circumstances may well continue to favor banks over capital markets. Banks are relatively well developed, are closer to enterprises, as they have more information than capital markets do, and can perform a useful function in the necessary enterprise restructuring in Thailand. Capital markets, on the other hand, depend on corporate law, civil code, and institutions such as courts that are generally perceived as weak in Thailand. Some time will thus be needed before capital markets can play a stronger role in corporate governance. But, as noted, there is the risk of slower adaptation, and in the currently globally financially integrated world, the time to adjust has become more compressed. It is therefore all the more important to move quickly towards a flexible system that includes both well functioning capital markets and banks. Such market-based financial systems tend to have greater flexibility in adapting and provide greater risk sharing. Internationally, market-based financial systems with a greater role of capital markets in the governance and financing of firms have been the general aim. Financing structures The starting point for discussing financial structures should be how a financial sector develops for a typical country. Low-income countries are characterized by reliance on informal finance: lending for small investments is secured through a network of social relationships and peer-group monitoring, which often is linked to trading and agriculture and mainly involves advances for trade from one firm to another. Foreign banks may play a large role in financing foreign trade, but much less so in domestic trade. As the economy develops and urbanizes, some of these networks formalize themselves into neighborhood lending associations or banks. This process of more formal financial intermediation is often accelerated when there are major new developments in the economy, for example, opening up of new trading opportunities or new industrial enterprises, which generate concentrated wealth. During most of this process, financial intermediation is dominated by banks. Capital markets only come to play a role in the later stages of development, when legal systems and reputational capital are established and people have enough confidence to trade pieces of papers which just represent promises to pay. 7 Fukao, 1998, draws attention to the relationship between poor corporate governance of banks and corporates, and the current weakness of Japan's banking system. 6 This pattem of financial development at the macro country-level mirrors in many ways the financial life cycle of a typical firm. For example, a firm may start as a family-owned business, using the family's own resources as well as savings collected through a network of social contacts. It will then typically grow from its retained earnings and funding from its suppliers. Risk-capital will thus mainly come from outside the formal financial system. At some point, when it has established a sufficient business record, it may be able to get a loan-often only on a highly secured basis-from a local bank. As it grows and expands its relationships, it will typically be able to attract funds from a wider circle of financial intermediaries, including other banks, venture capital and leasing companies. Over time, it may be able to go to the capital markets, first to the private placement markets; and later to organized, publicly traded bond and equity markets. This process can be hastened by improving the accuracy and reliability of information, reducing the costs of contract enforcement, and encouraging greater transparency. Also, reducing uncertainty at the macro level, such as by encouraging govemments to maintain credible and consistent policies, and at the micro level, by encouraging more stable industry regulation, will bolster the evolution of firms along this 'life cycle'. Building in part on these insights, part of the literature investigates (both analytically and empirically) the "optimal" liability structure for firms. Rather than try to summarize this literature, which mainly focuses on developed countries, we refer to the review by Harris and Raviv, 1991. We wish to highlight two aspects stressed by recent literature: the liability structure of a particular firm is endogenous to its characteristics; and the importance of the liability structure in disciplining management. The optimal debt to equity ratio, for example, is not just a function of the risk characteristics of a particular firm, but also of the difficulty outsiders have in controlling the behavior of managers. Debt, for example, can be a disciplining device for firms with few investment opportunities, but with good profitability (e.g., firms with so-called free cash flow). In other words, corporate financing structures perform important corporate governance functions. The empirical literature on developed countries has indeed found evidence of many relationships between the liability structure and the behavior of managers. Empirical work for developing countries on liability structures on non-financial institutions is sparse. Important contributions are Demirgu-Kunt and Maksimovic, 1994, Glen and Pinto, 1994, Singh and Hamid, 1992, and Singh, 1995. These authors have found that firms in developing countries make more use of external financing than firms in developed countries (this somewhat surprising finding may reflect the fact that the firms investigated in developing countries are typically both larger and "younger" than firms in developed countries, and may thus have relatively easier access to and rely more on outside financing). More detailed analysis suggests, however, that firm financing in developing countries is not that different from that in developed countries once one corrects for a number of factors. These include the sector in which the firm operates, its riskiness, years of existence, etc. Importantly, one needs to control for the institutional development (for example, quality of the legal framework and the enforcement of laws and regulations), the level of financial development and other macro factors in each country which matter importantly for financing pattems. It has also been found that when more extemal financing, including from stock markets, is available, firms grow faster (Demirgiiu-Kunt and Maksimovic, 1994). Firms in developing countries use generally much less long-term financing than comparable firms in developed countries (Caprio and Demirgui,-Kunt, 1997). At the same time, increased long-term finance and 7 financing from active stock markets is associated with higher productivity in both developing and developed countries. These findings suggest some government intervention to stimulate long-term debt financing and financing from equity markets. It has been found, for example, that subsidies and directed credit do not benefit smaller firms, even in developed countries, and while they can lengthen the maturity of loans, they do not necessarily lead to more efficient investment, or higher productivity growth. Indeed in most cases, subsidies are associated with lower productivity growth (Demirguei- Kunt and Maksimovic, 1996). Diversification The high degree of diversification of Thai firms raises specific questions regarding the benefits and costs of diversification. The effect of diversification on enterprise performance has been a long studied subject for developed countries. An increasingly skeptical view has developed about the efficiency of diversified conglomerates. There is much evidence that diversified groups in developed countries tend to trade at a discount relative to a portfolio of independent firms in related industries; have on average lower market to book values (Tobin's Q). Moreover, they tend to be broken up, and their share price significantly increases when that occurs (for a review, see Rajan and Zingales, 1997).8 The leading explanations for such underperformance have focused on the agency conflict between investors and empire-building managers (Jensen, 1986). More recently, some authors have argued that poor internal management, including power conflicts, forces inefficient redistribution of resources to less performing divisions (Lang and Stulz, 1994). In contrast, industrial-financial groups persist and often prosper in many developing countries (see, for example, Khana, Tarun and Palepu, 1996), where private sector activity is often dominated by diversified business groups. Theoretical rationales for such corporate structures have pointed to the incentive to resolve scarcity in the capital and the intermediate product markets in emerging markets. The emergence of such groups may also be a function of the weak institutional environment in these economies. In countries with weak law enforcement, unstable regulatory system and widespread corruption, groups may have extensive governance functions. They may support internal trade, ensure close monitoring of management decisions and manage a privileged access to political favors, such as subsidized credit, favorable regulation and licensing, and access to strategic resources. In conclusion, groups may emerge to capture scarcity rents or compensate for lack of markets, or both. A recent paper (Fan and Lang, 1998) distinguishes between two types of diversification: related diversification - for example, joint procurement of inputs, the sharing of marketing and distribution services, or integrating vertically; and unrelated diversification - when the newly acquired or developed business is run separately and does not complement the already existing segments of the corporation. For a sample of US corporates, they find that diversification into 8 Studies include the following: Scharfstein (1997) studies investment patterns across divisions in conglomerate firms, and conclude that they appear to practice some form of suboptimal "socialist" reallocation of resources across divisions, moving funds from profitable firms in high Q industries to support investment in lower Q sectors. Rajan, Servaes, and Zingales (1997) find that diversified firms misallocate investment funds; the extent of mis-allocation is positively related to the diversity of investment opportunities across divisions; and the discount at which these diversified firms trade is positively related to the extent of the investment mis-allocation and the diversity of the investment opportunities across divisions. Lang and Stulz (1994), and Doukas and Lang (1998) find that corporate diversification through mergers and acquisitions and direct investments reduces performance for US firms. 8 related industries is associated with increased corporate value. The authors hypothesize, however, that in times of financial crises unrelated diversification may be more value-enhancing since different segmnents are affected differently by the financial crunch and the collapse of demand. It is clear, nevertheless, because of the many cross-ownership and other relationships among members (including banks) of a conglomerate in developing countries, that the normally assumed disciplinary role of corporate debt is likely to be much weaker. The effect might even be perverse for family-controlled firms, i.e., more debt may lead to more risk-taking. Moreover, any positive view on the benefits of conglomerates in emerging markets has to be balanced with the potential cost in terms of slower adaptation of a financial system to new circumstances when insiders dominate. Investor Protection An important factor influencing external financing patterns is the degree of protection from abuse by corporate insiders, provided by legal and regulatory mechanisms to outside providers of funds. Securities have rights attached that protect investors: equity shares give investors the right to dismiss management if performance is not satisfactory, while debt gives creditors the right to repossess collateral or more generally drive a company into bankruptcy if debt obligations are not met. The legal and regulatory frameworks will determine to what extent these rights can be exercised and investors protected from potential abuse. There is growing international evidence that the quality and efficacy of these protection mechanisms influence whether and at what cost outside investors are willing to fund corporations, and hence, the development of capital markets. La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1998) find that there is a strong negative correlation between ownership concentration and the quality of investor protection mechanisms. Ownership concentration substitutes for poor investor protection by reducing the agency problem in corporations, but also has costs that are discussed further below. In another paper, La Porta et al. (1997) suggest that poor protection mechanisms will limit the availability of external finance for firms, as well as raise the cost of funds to compensate for increased risk of expropriation. Based on a sample of 49 developing and industrial countries, they show that countries with poor investor protection tend to have smaller and narrower debt and equity markets, which is consistent with this hypothesis. The quality of protection mechanisms depends on a wide variety of factors such as the treatment of investor rights in company, bankruptcy and securities legislation, the efficacy of legal enforcement, and the content and enforcement of capital market regulations, including listing rules and disclosure. On the equity side, these protection mechanisms include provisions regarding the duties of insiders (directors and corporate officers), the rights and remedies of shareholders, disclosure and use of information by insiders, and takeovers and new issues (La Porta et al., 1998; Asian Development Bank and World Bank, 1998).9 For creditors, the most basic are rights to 9 These mechanisms are directed at achieving the following objectives: (1) directly prevent abusive behavior by insiders (e.g., prohibition of loans to directors, rules regarding insider trading); (2) limit the discretion of insiders in key corporate matters (e.g., mandatory shareholder approval of fundamental decisions); (3) ensure adequate disclosure and transmission of information (e.g., mandatory disclosure of connected interests of board members); (4) facilitate shareholder control and monitoring (e.g., permitting proxy voting, including by mail); and (5) options for "oppressed" minority shareholders, such as judicial remedies to a broad class of persons regarding corporate decisions that are unfairly prejudicial, or that unfairly disregard the interests of shareholders, and the entitlement for dissenting shareholders to be bought out of the company at a fair appraised value. 9 repossess collateral and to participate in key decisions such as filing for creditor protection and management during reorganization (Baird, 1993). Strong disclosure and accounting standards and practices are essential for both equity and debt investors to monitor corporate performance. Legal and regulatory enforcement is also essential, of course, for these rules to have real content. International experience suggests, however, that countries do not compensate weak investor protection legislation by improving the quality of legal enforcement. Indeed, countries with weak investor protection rules also tend to be those with weak enforcement (La Porta et al., 1998), other factors remaining equal.'0 Overall, the most important determinant of the quality of legal enforcement is the amount of resources allocated to the judiciary, including for creating legal infrastructure such as land and securities' registries (e.g., Posner, 1998). Concentrated Ownership The fundamental benefit of concentrated ownership is that it solves the agency problem since large shareholders are able to more easily assert control over a firm and limit management inefficiency and abuse. Indeed, except for certain industrial countries, high ownership concentration, including controlling ownership, is common. For example, the share of the three largest shareholders in the 10 largest publicly traded private companies averaged 46% in a sarnple of 45 developed and developing countries (La Porta et al., 1998). Table 2 shows ownership concentration in several Asian and Latin American countries. Shleifer and Vishny (1997) discuss several examples of the benefits for corporate governance of concentrated ownership in industrial countries. In particular, large shareholders have been associated with high turnover of directors and managers, and with the increased likelihood of takeovers, which in turn has enhanced firms' efficiency of operations and investment. Regarding the pursuit of non-profit maximizing objectives, Morck, Shleifer and Vishny (1988) and other authors find evidence of an inverted "U" shape relationship between the degree of ownership concentration and profitability. Intuitively, as ownership concentration rises, agency costs decrease and hence profitability rises in the upward sloping part of the curve; but as owners gain control and wealth, they pursue empire building strategies and other private benefits of control. Controlling ownership may also lead to increased risk taking behavior since other stakeholders such as creditors and employees share in the downside risks but not to the same degree in the benefits. The potential for this type of behavior is greater if there are ownership and/or family inter-relationships between banks and corporations, bank incentives are skewed towards risk taking, and bank supervision is inadequate. Several studies in the empirical literature on corporate governance make the point of possible negative effects of the dominance of family control. Johnson et al. (1985), for example, study the effect on share prices of sudden deaths of executives-in plane crashes or from heart attacks-and associated transfer of control to other managers. They find increasing prices following the death announcement, particularly for large conglomerates whose founders built diversified businesses. The authors interpret the evidence to suggest that changes in management can be useful as they can serve to induce more efficient management. The evidence also shows that family control can lead to loss of value. ID East Asia, including Thailand, appears to be an outlier in this respect as is further analyzed below. 10 Table 2: Ownership Concentration in the Ten Largest Firms (1) All Firms (2) Private (3) All Firms (2) Private (3) Asia Latin America India 38% 40% Argentina 50% 53% idonesia 53% 58% Brazil 31% 57% Korea 23% 20% Chile 41% 45% Malaysia 46% 20% Colombia 63% 63% Pakistan 26% 54% Mexico 64% 64% Philippines 56% 37% Venezuela N/A. 51% SriLanka 60% 60% Thailand 44% 47% (1) The average percentage of common shares owned by the three largest shareholders in the ten largest non-financial firms. The percentages are not corrected for shareholder affiliation and cross- shareholding between firms. (2) Excluding the public share. (3) Largest 10 firms with no public ownership. Source: La Porta et al. (1998). Both the benefits and costs of ownership concentration are exacerbated in developing countries. Stylized facts regarding the legal and institutional frameworks in developing countries-- for example, weaker disclosure and property rights and underdeveloped legal enforcement--suggest that the potential for abuse by managers is higher than in industrial countries. Indeed, as noted above, high agency costs are an important explanatory factor of concentrated ownership. At the same time, however, these same institutional weaknesses also facilitate the abuse of minority shareholders. Similarly, financial systems are more likely to be weak and inadequately supervised, and relationships between corporates and banks more common."1 Concentrated ownership is, hence, likely to lead to increased risk taking behavior in developing countries. Finally, in developing countries, high ownership concentration also reflects the fact that most businesses are relatively young, and still managed by their founders or their direct descendants. While family management may be appropriate during the earlier stages of development, more professional management may be better suited as the economy and firms mature. Presumably, this process of professionalization should be faster in the larger and more complex businesses. In sum, high ownership concentration is typically both a symptom and a cause of weak corporate governance. Ownership concentration is symptomatic of weak corporate governance because it is a means for investors to monitor and control management when protection systems are weak. It is a cause because it may lead to more risk-taking behavior and to the abuse of minority investors. In addition, controlling shareholders are a potential source of pressure to delay improvements in disclosure and governance, as these improvements may erode their corporate control and insider benefits. 11 For example, it is more likely that governments in developing countries offer guarantees to financial institutions and that banks are undercapitalized. 11 In the next section, we discuss some issues related to the specificity of corporate governance in Thailand. 4. CORPORATE GOVERNANCE IN THAILAND While Thailand made rapid and substantial progress in developing its capital--and especially equity--markets during the 1990s, both corporate governance and disclosure systems were still weak and capital markets played a limited role in the governance of firms. Perverse connections between lenders and borrowers were not uncommon and facilitated excessive expansion and diversification of firms, financing of prestige projects and other "white elephants." There have been five interrelated problems: concentrated ownership; high level of diversification; weak incentives; poor protection of minority shareholders; and weak information standards. But most of these problems were not more severe in Thailand than in the rest of East Asia and indeed in many developing countries. Concentrated Ownership The organizational chart in Figure I can describe the salient features of large corporates in Thailand. Compared to the typical organization in developed countries, corporates in Thailand have two distinct features. First, the most influential organizational form in Thailand is the diversified conglomerate that is controlled by large corporations and, most importantly, family. Second, those conglomerates have large debt, much of which is from local financial institutions. Before the 1997 crisis, these large conglomerates used debt financing to expand aggressively- through mergers and acquisitions, direct investment and project finance-while undertaking little hedging against foreign exchange and interest rate changes. One of the most important features of the corporate sector in Thailand is the dominance of family control over business operations. Thai firms are generally closely held and managed by majority - often family - interests. As shown in Table 2, the three largest shareholders own between 44%-46% of the shares of the ten largest non-financial private firms. These numbers do not take into account shareholder affiliation and cross-shareholding between firms, and the former is believed to be particularly important in Thailand. Many shares are held in nominee accounts, which make it difficult to determine shareholder affiliation. However, based on Siam Business Information (1995), a relatively limited number of families controls many of the corporates listed on the SET. 12 Figure 1: The Organizational Chart of a Typical Thai Conglomerate Sgomest Govenment Market Market Hedging Frex Hedg ng Itrest Rate /Cntact Debtholders Zep Debt Finacn | Small Equity| I I~~ O"ers Owners Over-expandinu bG Debt Financing This.characteristicae \Comsnfgome r outof 's orporate7s The Domestnc y hnt one Domestic 4 t0tu