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Business & Economics Review Vol. 10 No. 1 1998-1999 Corporate Governance, Philippine Style: WHO CONTROLS THE BALL? Michael John Sullivan & Angelo Unite INTRODUCTION Corporate governance can be viewed as the relationship between corporate stakeholders and managers and how these participants determine the direction and of the corporation. How corporate governance is manifested varies among performance economies, depending on how the role and importance of corporate participants are affected by the type of corporate governance system in place and by the evolution and maturity of the system. Influential corporate participants typically include shareholders of directors, and in some cases may include of common stock, managers, and the board creditors, the government, employees, suppliers, and customers. Three models of corporate governance are discussed in the literature: (1) the capital market model, (2) the industrial group model, and (3) the entrepreneurial corporate model (Prowse 1992, Garvey and Swan 1994, Megginson 1997). In discussing the effectiveness of these alternative forms of corporate governance it is important to answer the basic question of how suppliers of capital are able to assure themselves of receiving a return on their investment; or more importantly, how common stockholders, who are the legal owners of the corporation, are able to assure themselves that the corporation is managed with their interests in mind. The intent of this research is to investigate and analyze the corporate governance system of an emerging market economy and determine whether the Anglo-ll.merican or Japanese-German form, or some alternative form has evolved. The particular country analyzed is the Philippines. The Philippines has many similarities with its emerging Southeast Asian neighbors due to proximity, and some differences, as well, due to its unique history and culture. First, we describe each of these corporate governance models (see Megginson 1997 for a detailed description). Then we discuss which of these alternative models best describes the Philippine economy. We conclude by discussing the strengths and weaknesses of the Philippine system of corporate governance. MODELS OF CORPORATE GOVERNANCE Tile Capital Market Model Economies based on the capital market model rely on the marketplace to allocate resources and to determine asset values. These economies are characterized by having a large number of independent, publicly traded companies where freely transferable 32 CORPORATE GOVERNANCE, PHILIPPINE STYLE ownership rights are traded in liquid markets. Corporations in these markets rely on public markets for external financing and use professional managers to make important corporate decisions. Since ownership is characteristically highly diffuse, managers run the company and often exert significant influence on the board of directors. Therefore, as a method of preventing managers from acting disproportionately in their own interests, laws and regulations are developed to protect small investors and mandate reliable information disclosure. Vast amounts of corporate information are available and corporate activities and corporate financial positions are transparent to market participants. There are two primary methods of assuring that managers perform with stakeholders' interests in mind. First, managerial compensation packages are designed to motivate managers to act in a manner that will maximize shareholder wealth. Second, an active market for corporate control acts as the ultimate means of disciplining managers who act contrary to interests of shareholders. This corporate governance model is found in the United States, the United Kingdom, and Canada. The capital market model has many advantages in this modern world of international markets. Corporations in these economies are able to raise large sums of money, comparatively quickly, and at minimal costs (typically the costs of gathering information, monitoring, and trading are lower). The strong enforcement of regulations which requires that information be made public, promotes transparency and allows investors to make informed decisions. This transparency also promotes the creation of risk-tolerant markets that promote growth firms and venture funds, and together with market liquidity gives rise to the increased development of large public and private pension funds. In addition, the presence of professional managers and a relatively large market of managerial talent, together with an active takeover market, allow for the efficient allocation of management talent. One weakness of this system is the disproportionate concentration on short- term goals by management in order to satisfy investors' short-term interests. Also. the presence of agency problems created by the separation in goals between professional managers and owners, and the high costs of disciplining these managers, allow managers some latitude to act in their own interests and contrary to the goals of owners. Finally, the mandatory information disclosure to financial markets results in the greater difficulty of protecting proprietary information. The Industrial Group Model The industrial group model is a system where a country's economy is dominated by industrial groups. These large industrial groups are composed of a close alliance of large manufacturing, marketing, and banking companies, and are typically headed by a large commercial bank. Company groups control all aspects of product flow, from acquisition of raw materials to production, marketing, and distribution. These groups are held together by a combination of interlocking directorships, cross-shareholding, joint ventures, and product development agreements. As a result, the domestic economy is dominated by a small number of immensely large and economically powerful corporate groups that also act as the country's leading exporters. Consequently, equity markets are underdeveloped and small shareholders have no avenue in which to exert their ownership rights since legal protections are inadequate and the takeover market is virtually nonexistent. The primary advantage of this system, as present in Japan and South Korea, is that it has acted as the vehicle for rapid economic development without reliance on foreign markets.' Product development and export growth have been fueled by MICHAEL JOHN SULLIVAN & ANGELO UNITE 33 competition between groups. Centralized control of decisions emanating from the main bank promotes monitoring and information transfer, and allows for rapid dissemination of corporate decisions. This focus permits these groups to concentrate on long-term decisions when appropriate, allowing focused growth and development. One weakness of this system is the necessity for groups to be competitive and to grow at similar rates. Otherwise, a few groups will dominate the economy resulting in diminished competition, and therefore, greater economic inefficiency. There is little market of available reliable information. In addition, the reliance on discipline because of lack company groups imposes high costs on domestic consumers, since the industrial groups focus on remaining competitive in export markets. The Entrepreneurial Corporate Model Entrepreneurial corporate systems are found in Western Europe, East Asia, and generally in most of the developing world. These systems vary greatly among countries an earlier, less-developed version of the capital and in many ways resemble being either market or industrial group systems. A common feature is that corporations are controlled by their founding families, where ownership is extremely concentrated, and in the rare case where the firm is publicly-traded, many shares are closely-held and rarely traded. Consequently, capital markets are mostly undeveloped and companies rely on internally generated funds or bank financing to fund operations and growth. Due to having underdeveloped stock and bond markets, a small number of very large, strong commercial banks with inordinate power in lending and underwriting typically emerge. With top management positions, there is minimal reliance on professional managers. In addition, the use of stock-based compensation is rare; there is very little mandated information disclosure; and the market for corporate control is inactive, except in extreme cases. The strength of this entrepreneurial corporate system depends on the strength and functioning of the country's intermediaries, most importantly the large commercial banks. In this system intermediaries act as the source of the majority of corporate funds, and are therefore, in a natural position to act as corporate monitor. This role means intermediaries raise and allocate resources. Also, intermediaries can better build long- term relationships and are in better position to assist firms in financial distress. The inherent problem with this system lies in the conflict-of-interest arising from the intermediaries' role as the primary creditor to the country's largest firms and the ownership position these same firms often have in the lending intermediaries. This creates an atmosphere of self-dealing, with little information transparency on which regulators can rely to assure the safety of the banking system. In addition, high levels of sell-dealing diminishes efficiency in the banking system, which in turn results in higher transaction costs lor banking customers. SYSTEM FOR THE PHILIPPINES The system currently in place in the Philippines most closely resembles the entrepreneurial corporate model.ln the Philippines the economy is dominated by large family groups through their holding companies [e.g. Sy Group with SM Investments Corporation, the Gokongwei Group with JG Summit Holdings, Inc., and the Lopez Group with Benpres Holdings Corporation], many of which have significant holdings in large commercial banks [e.g. the Gokongwei Group with 28% and the Lopez Group with 26% of Philippine Commercial International Bank (PCIB), and the Ayala Group with 46% of 34 CORPORATE GOVERNANCE, PHILIPPINE STYLE the Bank of Philippine Islands (BPI)] (Philippine Stock Exchange 1997). This association between large firm groups and banks allows lor the rapid growth of group companies and the increasing concentration of economic wealth on these groups. How effociently the purchased assets are employed depends on how well these family-dominated groups are managed by the founders or their offspring. To determine how well this Filipino system of corporate governance functions, it is essential to evaluate the regulatory environment, the monitoring system, and the presence of moral hazard. Regulation An important feature of the Philippine regulatory environment affecting the corporate governance system lies in the enforcement of government regulations that are meant to promote the transparency of information and create a sound banking system. Adequate regulation and its enforcement can take the place of markets, in the case of the capital market system, and main banks, in the industrial group system, to ensure the adequate monitoring of corporate activity and to reduce moral hazard problems. The Philippine system of corporate governance can be broken down in three areas, namely, (1) monitoring bank lending, (2) financial reporting, and (3) assuring fairness for investors trading in public equity markets. Monitoring Bank Lending In the Philippines, one way in which bank lending practices are monitored through government regulation is via Republic Act 337, Chapter IX, Section 83. This statute regulates loans and other credit accommodations to Directors, Officers, Stockholders, and their Related Interests, otherwise known as DOSRI rules. The general policy states that "Dealings of a bank with any of its directors, officers or stockholders and their related interests should be in the regular course of business and upon terms not less favorable to the bank than those offered to others".2 DOSRIIoan limits are defined in general terms as (a) the individual limit to an amount not to exceed their outstanding deposits and book value of their paid-in capital contributions in the lending bank (provided that unsecured credit does not exceed 30% to any DOSRI), and being constrained to (b) an overall limit of loans to all DOSRI of 15% of the total loan portfolio or 100% of combined capital accounts net of deferred income tax and other capital adjustments as may be required by the Bangko Sentral ng Pilipinas (BSP). The central question is how well these regulations are enforced. Many argue that commercial banks associated with firm groups often lend to group companies at favored terms, regardless of risk and without proper disclosure to regulators (Prowse 1992, Krugman 1998). Oftentimes a major purpose of a group bank is to act as a conduit transferring savers funds to group companies for the purpose of supporting company growth. An example that puts the enforcement of DOSRI regulations into question is the case of the failure of Orient Bank in early 1998. Orient Bank seriously viofated DOSRI rules, but these violations only became known after the bank failed as a result of liquidity problems. Before its failure in 1998, Orient Bank was controlled by the Go family. The amount of loans made by Orient Bank to other Go Family companies was in violation of DOSRI limits. At the time of failure it was discovered that of the bank's 6.1 billion peso loan portfolio, 5.8 billion pesos in loans (95.1%} were to DOSRI parties, which were well in excess of the limits (Business World, March 9, 1998). At the time of bank failure, Orient Bank had only reported DOSRIIoans of 365 million pesos (less than 6.0%). This
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