A Review of Corporate Governance in Malaysia with Special Reference to Shareholder and Creditor Rights
Thillainathan, R
1. Introduction
Where a firm relies only on internal finance, there is no separation between management and financing or between ownership and control. Corporate governance is not an issue as control and cash-flow rights are perfectly matched.
Designing an appropriate corporate governance system becomes a problem where the firm places reliance on external finance. This will make for a separation between management and financing thus giving rise to an agency problem. This will also lead to a mismatch between control and cash-flow rights with the mismatch being greater the more dispersed the shareholding or the more marked the separation between ownership and control. The manager or controlling shareholder, dubbed the insider in the literature, may end up having an enormous discretion about what is done with the funds, often to the point of being able to expropriate much of it. “….. the principal practical question in designing a corporate governance system is ……. how to introduce significant legal protection of at least some investors so that mechanisms of extensive outside financing can develop.” (Schleifer and Vishny 1997: 4)
There is a view that we should not worry about governance, since in the long run, product market competition would force firms to minimise costs, and as part of this cost minimisation to adopt rules, including corporate governance mechanisms, enabling them to raise external capital at the lowest cost. While agreeing that product market competition is probably the most powerful force toward economic efficiency in the world, Schleifer and Vishny (1997: 3) are sceptical that it alone can solve the problem of corporate governance.
“One could imagine a scenario in which entrepreneurs rent labour and capital on the spot market every minute at a competitive price, and hence have no resource left over to divert to their own use. But in actual practice, production capital is highly specific and sunk, and entrepreneurs cannot rent it every minute. As a result, the people who sink the capital need to be assured that they get back the return on this capital. The corporate governance mechanisms provide this assurance. Product market competition may reduce the returns on capital and hence cut the amount that managers can possibly expropriate, but it does not prevent the managers from expropriating the competitive return after the capital is sunk. Solving that problem requires something more than competition.”
The corporate governance mechanism should be designed primarily to protect shareholders and creditors and not employees or community members. The investments by shareholders, for instance, are largely sunk, and further investment in the firm is generally not needed from them. This is much less the case with employees or community members. “The employees, for example, get paid almost immediately for their efforts, and are generally in a much better position to hold up the firm by threatening to quit than the shareholders are. Because their investment is sunk, shareholders have fewer protections from expropriation than the other stakeholders do.” (Schleifer and Vishny 1997: 13). To induce them to invest in the first place, they need stronger protection in the form of shareholder voting rights supplemented by an affirmative duty of loyalty of the managers to shareholders. Managers have a duty to act in shareholders’ interest and the courts in the developed countries have generally accepted the idea of a manager’s duty of loyalty to shareholders.
There is a possibility for raising finance without governance, that is, without giving suppliers of capital any control rights in return for their funds. Then financing will be based on reputations of managers or on excessively optimistic expectation of investors about the likelihood of getting their money back. The sizeable equity financing in the rapidly growing East Asian economies may be based in part on investor optimism about near-term appreciation. In part investors may be counting on reputation in the short run and legal protection in the longer run when the firm’s needs for continued access to capital markets can be relied on to sustain its good behaviour until the requisite institutions and legal protection are put in place. Financing without governance, however, cannot be sustained in the long run.
There are two basic approaches to financing with governance. The first approach, based on dispersed ownership, is to give investors power through legal protection from expropriation by managers. Protection of minority rights and legal prohibitions against managerial self-dealing are examples of such mechanisms. The second approach, based on concentrated ownership (or ownership by large investors), is to match significant control rights with significant cash-flow rights. With concentrated ownership – through large share holdings, take-overs and large bank finance – corporate governance is typically exercised by the large investors. These large investors still rely on the legal system but they do not need as many rights as the small investors to protect their interests. They have both the interests in getting their money back and the power to demand it. Although large investors are very effective in solving the agency problem, they have the potential to expropriate other investors and stakeholders in the firm. But large investors are not diversified and hence bear excessive risk. Where a large investor is family-based, management may not be professional. This is more likely to be a problem when family fortunes pass on to the descendants of the founder-entrepreneurs.
2. Corporate Governance Issues with Reference to Control and Cash-flow Rights
To examine the strengths and weaknesses of corporate governance in Malaysia, it is useful to categorise the companies listed on the Kuala Lumpur Stock Exchange (KLSE) into four groups based on the relationship between the control and cash-flow rights of the parties who control the companies as follows.
Group A: Management-controlled companies with dispersed shareholding where the managers have control rights with little or no cash-flow rights.
Group B : Shareholder-controlled companies where the controlling shareholder has a direct majority stake with control rights more closely aligned with cash-flow rights. As many decisions only require a majority vote, the controlling shareholder may end up in practice exercising outright control.
Group C: Shareholder-controlled companies where the controlling shareholder has a direct but substantial minority stake with his control rights aligned with his cash-flow rights (probably to a lesser degree than for Group B companies).
Group D: Shareholder-controlled companies where the controlling shareholder has only an indirect stake, either through a pyramid-structure or a cross-holding, as a result of which the control rights of the indirect owner is well in excess of its cash-flow rights.
In Malaysia, there are few companies on the KLSE which fall into Group A, that is, companies which are characterised by dispersed ownership with the manager exercising control rights and having little or no cash-flow rights. On the other hand, there are many companies that fall into Groups B and C. These are companies with large shareholders who exercise both control as well as cash-flow rights. These large shareholders are typically families or government-owned or promoted institutions. No banks have emerged as large shareholders in keeping with the Anglo-Saxon model of banking practised in Malaysia. There are also many publicly quoted companies that fall into Group D, which are companies where the controlling interest is indirect and where the control rights far exceed the cash-flow rights of the controlling shareholder. Group D companies include public quoted companies which are subsidiaries or associates of other listed companies, which in turn are controlled by a controlling shareholder. In Malaysia, as elsewhere in Asia, minority shareholders in Group D companies run the highest risk of being expropriated. Unfortunately, the Group D form of companies is not uncommon.
There are many public-quoted companies in Malaysia and elsewhere in Asia which are family-dominated. In meeting the interests of the small or outside shareholders they have been viewed unfavourably in relation to the management-controlled companies of many countries in the OECD world. Large shareholders are certainly in a position to expropriate the small shareholders given their control rights. But the managers in companies with dispersed shareholding also have similar powers given the effective control rights they exercise. Whether expropriation or squandering of a company’s resources will take place will depend on shareholder rights including the rights of large shareholders vis-a-vis small shareholders and how these rights are enforced in practice.
Before we examine how Malaysia fares in this regard, we first explore the incentive for the maximisation of shareholder value in a company which is controlled by a large shareholder (that is, a Group B or C company) compared to one which is controlled by a manager with dispersed shareholding. In a company with concentrated ownership, as there is a better matching of the control rights of the dominant shareholder with its cash-flow rights, there will be a greater incentive for that control to be exercised in maximising shareholder value. Therefore, the incentive of the controlling shareholder is more likely to be aligned to the interest of other shareholders. On the other hand, as a manager has control rights with little or no cash-flow rights, he has less incentive to maximise shareholder value. It is to deal with this problem that a manager is given an incentive contract in the form of share ownership or a stock option to align his interests with those of investors. Even with such incentive contracts, the mismatch between control and cash-flow rights will still be large in a management-controlled company1. Therefore, a company with concentrated ownership, where the mismatch between control and cash-flow rights are much less, is likely to promote shareholder value much more than a management-controlled company. In this context, it is useful to note that the use of incentive contracts has been limited by difficulties in the optimal design of incentives, by fear of self-dealing or by distributive politics.
In respect of a company where the controlling interest is indirect (that is, a Group D company) there will be a mismatch between the control and cash-flow rights of the controlling shareholder. Therefore, the incentive of this controlling shareholder with an indirect stake will be less aligned with the interest of the other shareholders. Even then, other things remaining equal, there is likely to be a greater coincidence of interest between the incentive of such a controlling shareholder and his fellow shareholders than between the incentive of the manager and his shareholders (in a management-controlled company).
3. Insider Control and the Risks and Rewards of External Financing: Some Preliminary Findings
To identify the nature and level of insider control, as well as the scope and extent of interlocking ownership and implicit guarantees between financial intermediaries and firms (and between firms and other firms such as those belonging to a conglomerate), we have examined the situation with respect to 50 out of the 383 (or 13.1 per cent) of the public listed companies (PLCs) in the non-financial sector on the Main Board of the KLSE and 9 out of the 66 (or 13.6 per cent) of the Main Board PLCs in the financial sector. The PLCs examined are the larger or more reputable ones accounting for 50.73 per cent and 53.10 per cent of the market capitalisation of the two sectors, respectively, in 1996 and 62.11 per cent and 45.86 per cent in 1997.
Out of the fifty non-financial enterprises, 13 were foreign-controlled with a share in market capitalisation of 7.67 per cent (1996: 4.71 per cent) and five were public sector controlled with a share in market capitalisation of 29.41 per cent (1996: 21.59 per cent). Of the nine financial enterprises, one was public sector controlled with a share in market capitalisation of 25.17 per cent (1996: 24.04 per cent) and another was foreign-controlled but with a share in market capitalisation of only 0.66 per cent (1996: 0.65 per cent).
In the sample of 59 companies we examined, there were six companies where the largest shareholder had a shareholding of 25 per cent or below. In fact, the shareholding of the largest shareholder in two was around 15 per cent, in one it was 20 per cent, in another two it was 23.5 per cent and in the sixth it was 25 per cent. These PLCs can be deemed to have more dispersed shareholding compared to the rest and therefore came closest to being considered as management-controlled. And yet all of them had substantial foreign shareholding. The largest shareholder in three of the six was foreign. Excluding the shareholding of the largest shareholder (where it was foreign), the shareholding of the foreign institutional shareholders in these companies ranged between 28.6 per cent and 52.6 per cent in 1996. In four out of the six companies including Renong Berhad, the foreign shareholding increased in 1997, in one, it registered a marginal decline whereas in the other, namely KFC Holdings, there was a substantial decline from 34.3 per cent to 15.0 per cent (the latter because of a questionable transaction). The interesting question is not why there was a decline in, but rather what explains the spread in and the size of the foreign shareholdings. Is it that minority shareholder rights are well protected in Malaysia, that the investors were over-optimistic about prospects or that the shareholders could count on the managers to be concerned about reputation and could therefore expect the managers to work in the larger interest of all shareholders? Or is it that the large foreign shareholdings were held by one or two large investors who worked in concert with the largest shareholder in each company?
Reputation will count if the managers need to go back to the shareholders for additional capital. Over the last four years, the only company from this set which went back to the shareholders was Renong. Therefore, it is not clear if reputation would have been a sufficiently strong consideration for shareholders to place their trust in management. Over-optimism could have played a role but this implies minority shareholders are prepared to part with their money without an assurance that their rights are protected.
In the six companies examined, the equity stake of the largest foreign shareholder2 was 10 per cent or less. Even if one assumes that this shareholder was working in concert with a company’s largest shareholder, the share of foreign shareholding of the institutional variety was still large. In Carlsberg, the second largest shareholder was a local group and together with, the largest shareholder, the two had a 50 per cent stake in the company. But this may point to concentrated holdings if the two or three largest shareholders are deemed to be working jointly. The incidence of substantial minority shareholding in the face of concentrated shareholding in the hands of the controlling party or parties is a phenomena that requires explanation and this is attempted in the next section.
In another 45 of the companies in the sample, where the largest shareholder exercised control either directly or through a PLC it controlled, the controlling stake was significantly higher. In 28 of the companies, the controlling shareholding exceed 50 per cent, in nine it was between 40 and 50 per cent and in eight it was between 30 and 40 per cent (of which for four it was 39 per cent). Where the controlling shareholder exercised control in a PLC through its control of another PLC, its effective interest was significantly lower thus causing a big divergence between its control and cash-flow rights. For instance, Tan Sri Halim Saad was the controlling shareholder of Renong Berhad with a direct stake of 23.5 per cent, which in turn controlled UEM Berhad with an interest of 37.1 per cent. Therefore, Tan Sri Halim Saad’s effective interest in UEM Berhad was only 8.6 per cent, but he exercised control over it.
Unlike the two subsets of companies considered above, one which is characterised by more dispersed shareholdings and the other which has more concentrated shareholdings, the third subset of companies in the sample (but numbering only eight) entails ownership and control that is exercised through a chain listing or a pyramid-structure and through cross-holdings. For instance, the Estate of Tan Sri Yahya owned 65.3 per cent in Gadek Malaysia through a cross-holding which in turn controlled Hicom and Proton, the latter through Hicom. The Yahya Group’s effective interest in Proton was only 4.6 per cent. Cross-holdings (but not an extended chain listing) is also evident in the William Cheng and Kuok Group of companies.
Based on our sample, the incidence of inter-locking ownership is almost mild compared to Japan or Korea. Pyramid structures are not pronounced. Where the manager or the major shareholder exercises control over a PLC through a pyramid structure or cross-holding, and where there is a significant divergence between control and cash-flow rights, the risk is higher of the insider engaging in activities which maximise his private benefits of control or which expropriate minority shareholders.
Given the risks indicated above, let us examine to what extent minority shareholders, and specifically foreign institutional shareholders, took such risks into account in their equity investment decisions. It is interesting to note that in the operating subsidiaries of the Yahya Group, namely Proton and EON, in which the effective interest of the controlling shareholder was almost negligible and therefore in which companies the risks were correspondingly higher, foreign shareholding was not only substantial but also increased from 28.2 per cent in 1996 to 34.6 per cent in 1997 in respect of Proton and from 22.0 per cent to 34.3 per cent in EON. On the other hand, in respect of the two holding companies where the risks were lower, the foreign shareholdings which were significantly lower declined from 25.7 per cent to 21.4 per cent in Gadek but increased marginally from 11.2 percent to 12.5 per cent in DRB. Another interesting case was the Halim Saad Group. We had noted that the foreign shareholdings in Renong had in fact increased from 14.3 per cent to 22.1 per cent. In the case of UEM, where foreign shareholdings stood at the incredible level of 54.2 per cent in 1996, declining to 35.1 per cent in 1997, it is not clear whether this was due entirely to the unexpected announcement that the then cash-rich UEM had acquired a 33 per cent stake in Renong without proper disclosures or even approvals.
In spite of the obvious risks, it is useful to enquire what factors encouraged even sophisticated investors such as foreign fund managers to invest substantially in companies such as EON, Proton and UEM. To what extent this was encouraged by the legal protection of minority shareholders vis-a-vis the controlling shareholder is examined in the next section. A large investor may be rich enough that he prefers to maximise his private benefits of control (including investments in unrelated activities, whether for diversification or for the purpose of empire building), rather than maximise his wealth. Unless he owns the entire firm, the large investor will not internalise the cost of these control benefits to the other investors. This will then be reflected in the failure of large investors to force their managers or companies to maximise profits and pay out the profits in the form of dividends.
An examination of 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 reinvesting the profits in diversified or empirebuilding activities). Such high dividend pay-out ratios may have been facilitated by the healthy relationship between the control rights of the majority shareholder and its cash-flow rights.
In the case of locally controlled companies, the control rights were usually well in excess of the cash-flow rights of the controlling shareholder, usually because of the pyramid structure of companies in the same group. This could explain their much lower dividend pay-out ratios and their greater propensity to reinvest their profits even in unrelated activities, at least in part to maximise the insider’s private benefits of control.
An examination of the financials of EON and Proton vis-a-vis Gadek and DRB show that the operating entities of the Yahya Group had better dividend pay-out ratios. This was, however, not the case with respect to UEM.
The higher dividend pay-out ratios of the Yahya Group should not come in as a surprise. In the operating entities we are reviewing, the Yahya Group was in joint venture with either a foreign party or a local party or both. These joint venture partners could have acted as checks and balances. In UEM, there were only institutional investors and no joint venture partners.
Under the Malaysian law, a corporate cannot lend to or issue a guarantee on behalf of a director-related entity, unless that entity is a subsidiary. Therefore, the issue of guarantees between firms and other firms (such as those belonging to a conglomerate) is not a serious problem in Malaysia. A recent study (Susela Devi 1998) based on the year 1996 found that the total contingent liabilities reported by the listed companies on the Main Board (including corporate guarantees given to banks on behalf of subsidiaries credit facilities) amounted to RM 15.9 billion versus their debt of RM168.1 billion. The corresponding numbers for Second Board companies were RM2.5 billion and RM11.4 billion3. The highest amount of contingent liabilities was reported by the industrial and trading sectors which also had a higher ratio of short-term bank borrowings.
4. Shareholder Rights in Malaysia: A Review and Suggested Reforms
From the preceding discussion it is clear that both the manager as well as the controlling shareholder are in a position to expropriate the small or minority shareholders unless these shareholders’ rights are protected by law. In this section, we briefly review these, and indicate how they are enforced in Malaysia compared to other developed and developing countries4.
4.1. Rights of shareholders
The adequacy of investor protection in Malaysia can be examined in relation to the rights of shareholders, the protection that shareholders enjoy against abuses and expropriation by insiders as well as the quality of law enforcement. The principal rights that shareholders have is the right to vote on the election of directors, on amendments to the corporate charter (which will include any changes in the nature of business of the company, a transfer to another jurisdiction, or a change in the nature of its shares) as well as on key corporate matters such as the sale of all or a substantial part of the company’s assets, mergers and liquidations thus limiting the discretion of insiders on these key matters.
In determining how well Malaysia fares as regards this principal right of shareholders, we have to examine the voting rights attached to shares as well as the rights that support the voting mechanism against interference by the insiders (dubbed anti-director rights by La Porta et al. (1996) in their cross-country study on law and finance in 49 countries).
The one-share-one-vote rule with dividend rights linked directly to voting rights is taken as a basic right in corporate governance. This rule obtains when the law prohibits the existence of both multiple-voting and non-voting 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. In the La Porta et al. (1996) study, Malaysia was found to be one of only 11 countries out of the 49 which impose a genuine one-share-one-vote rule.
La Porta et al. (1996) identify five anti-director rights which essentially describe how easy it is for shareholders to exercise their voting rights. These rights and the findings are set out in Table 1. In respect of these anti-director rights, the United States was the only country to record a perfect score of 5 whereas Malaysia registered a score of 3(5). The average score for the sample as a whole was 2.44 whereas it was 3.39 for the English common law countries, 1.76 for the French civil law countries, 2.0 for the German civil law countries and 2.5 for the Scandinavian civil law countries. The score was 4 each for Australia, Hong Kong, New Zealand and the UK and 3 for Singapore. The score was 3 for Thailand, 2 for Indonesia but 4 for Philippines.
The La Porta et al. (1996) study did not examine the laws in place for the protection of minority shareholders against insider expropriation or abuses. But this has been attempted in a recent joint study of the Asian Development Bank and the World Bank for certain selected Asian countries (Asian Development Bank & World Bank 1998). Table 2 sets out the findings of the study.
From a review of the table, one can infer that Malaysia and Thailand stand out on the positive side in respect of safeguards against insider abuses. Shareholder approval of major as well as interested transactions is mandatory. Reporting by large shareholders and connected interests is also mandatory. Loans to directors or shareholders are prohibited. Pre-emptive rights of shareholders to new stock issues, stiff penalties against insider trading, provisions on take-overs and a mandatory independent audit committee minimises abuses by insiders and protects minority interests. Weaknesses in existing provisions or legislation are dealt with later.
In Malaysia, as in many other common law countries, shareholder voting rights are supplemented by an affirmative duty of loyalty of managers to shareholders that is, managers have a duty to act in shareholders’ interest. The most commonly accepted element of the duty of loyalty is the legal restrictions on managerial self-dealing, such as outright theft from the firm, excessive compensation or issues of additional securities (such as equity) to the management and its relatives. The courts would interfere in cases of management theft and asset diversion, and they would surely interfere if managers diluted existing shareholders through an issue of equity to themselves. However, courts are less likely to interfere in cases of excessive pay and in line with the business judgement rule (that keeps the courts out of corporate decisions) are very unlikely to second guess managers’ business decisions, including the decisions that hurt shareholders (e.g. empire-building). Shareholders in Malaysia, as in the United States, have the right to sue the corporation using class action suits that get around the free rider problem, if they believe that the managers have violated the duty of loyalty. However, civil procedure in Malaysia is less facilitative of class actions and contingent fees are prohibited6.
4.2. Enforcement
In addition to measures of investors’ legal rights, La Porta et al. (1996) also examined the measures or proxies for the quality of enforcement of these rights, namely estimates of ‘law and order’ in different countries compiled by credit risk agencies. Of the five measures studied, namely efficiency of the judicial system, rule of law, corruption, risk of expropriation and likelihood of contract repudiation, the authors noted that only the first two pertain to law enforcement proper and the last three deal more generally with the government’s stance toward business. The study also emphasised the role accounting plays in corporate governance7. Accordingly, in addition to the rule of law variables, the study used an estimate of the quality of a country’s accounting standards. Like the rule of law measures, the study used a privately constructed index based on examination of company reports from different countries as a measure of accounting standards.
The specification in the study of the indices for the two law enforcement variables and for accounting standards are set out in Table 3. For the variable “efficiency of judicial system”, Malaysia was scored at 9 (which is surprisingly high). The average score for countries with a legal system of English origin was 8.15, of French origin 6.56, of German origin 8.54 and Scandinavian origin 10:00. Australia, Hong Kong, New Zealand, Singapore, UK and US, which are all common law countries, registered a perfect score of 10 each whereas Thailand was scored at 3.25, Indonesia at 2.50 and Philippines at 4.75.
With respect to the “rule of law” variable, Malaysia was scored at 6.78 as against an average of 6.46 for countries with a legal system of English origin, 6.05 for French origin, 8.68 for German origin and 10, for Scandinavian origin. Australia, New Zealand and the US had a perfect score of 10 with the scores for Hong Kong at 8.22, Singapore at 8.57 and UK at 8.57. The scores for Thailand, Indonesia and Philippines were 6.25, 3.98 and 2.73 respectively.
For the rating on accounting standards, Malaysia was scored at 76, compared to the average of 70 for countries of English origin, 51 for countries of French origin, 63 for countries of German origin and 74 for countries of Scandinavian origin. Malaysia was behind Singapore and UK, which had a score of 78, whereas it was ahead of Australia at 75, Hong Kong at 69, New Zealand at 70 and the US at 71. Malaysia was also way ahead of Thailand’s 64 and Philippines’ 65. Indonesia was not scored.
From the above review, it is clear that Malaysia was one of the few countries studied that impose a genuine one-share-one-vote rule. However, in respect of the exercise and enforcement of these voting rights, there is still a significant room for improvement in Malaysia. The authorities should actively consider allowing proxy voting by mail and cumulative voting for directors to strengthen the position of retail investors vis-a-vis the controlling shareholders.
4.3. The need for reform
Given the concentration in ownership in Malaysia, not unlike elsewhere in Asia (see Table 4), these improvements in voting rights will nevertheless not be adequate to protect the interests of minority shareholders, and hence, the increasing reliance on external finance from these shareholders. For instance, the three largest shareholders owned some 54 per cent of the shares of the ten largest non-financial private firms and 46 per cent of the shares of the ten largest firms in Malaysia, whereas the average for the Asian countries listed in Table 4 (excluding Korea) was 50 per cent and 46 per cent respectively. Given the high ownership concentration, the large shareholders are in a position to expropriate minority shareholders, for instance, by selling to a connected party the output or an asset of the company at below market price, or by buying from a connected party an input or an asset at above market price.
There are, however, laws or rules in Malaysia on related party transactions to protect the interests of minority shareholders from expropriation or abuses by an insider, including the controlling shareholder. Shareholders appear to have more powers to limit the discretion of insiders in key corporate matters in Malaysia than elsewhere. In most jurisdictions, the ultimate power of control by shareholders is retained only in two instances, namely the power to remove the directors (which power may be wielded too late to unravel a transaction) and the power to alter the corporate constitution.
In Malaysia, notwithstanding any provisions to the contrary in a company’s constitution, there have been legislative measures to increase matters that require the general meeting’s approval:
* The approval for the acquisition or disposal by directors of an undertaking or property of a substantial value (Section 132C of the Companies Act).
* The approval for issue of shares by directors (Section 132D).
Further, there are legal provisions to prevent abusive behaviour by interested, related or connected parties:
* Loans to directors or director-related parties are prohibited (Sections 133 and 133A read with 122A) unless they are subsidiaries.
* Acquisition of shares or assets in a shareholder or director-related company is also prohibited8 (Section 132G read with 122A).
* Substantial transactions in any non-cash assets involving directors or persons connected with directors require disclosure and the prior approval of shareholders (Section 132E read with Section 132F and 122A).
* Substantial shareholding and changes in substantial shareholding is required to be disclosed both to the company and the exchange (Sections 69E and 691).
There are also legal provisions to prevent abusive behaviour by insiders:
* There are stiff penalties against insider trading.
* There is a take-over code to protect against violation of minority shareholders rights.
* Shareholders are entitled to full pre-emptive rights on new stock issues, unless they have voted to do so otherwise.9
From the preceding tabulation it is clear that minority shareholders do enjoy some protection from abuses of insiders from existing laws and regulations. This may account for the large size of the public equity markets in Malaysia despite widespread ownership concentration. However, there is still significant room for improvements of investor protection. Firstly, on efficiency grounds, a strong case can be made for the removal of existing prohibitions on certain related party transactions. Instead such transactions should be made subject to shareholder approval with the interested parties required to abstain from voting.10
Secondly, section 132E as presently drafted, only embraces transactions with directors or persons connected with directors. It does not embrace transactions between a company and a substantial shareholder or persons connected with a substantial shareholder. Only section 132G recognises the concept of a substantial shareholder in related party transactions. Therefore, the ambit of the section should be extended to cover substantial shareholders and persons connected to substantial shareholders.
Thirdly, section 132E only requires the related party transactions to be disclosed and approved by shareholders but it does not prohibit the related party from exercising its voting rights on such transactions. Amendments should be considered to require the related parties (and in particular when the ambit of the section is expanded to cover substantial shareholders) to abstain from voting on interested party transactions.
Fourthly, there are also weaknesses in existing legal provisions with respect to a substantial acquisition or disposal which requires shareholders approval”. The KLSE Rule on a substantial transaction, and in particular, the new rule which came into force from July 1998, is more clearly defined. It makes sense for the relevant provisions in the Companies Act to be redefined in a similar manner with respect to such tests as the assets test, profits test, consideration test, consideration to market capitalisation test and the equity or capital outlay test.
And finally, the provisions on an interested party transaction in the Companies Act only capture an acquisition or disposal of an asset from or to a related party. It does not capture the acquisition of an interest in or sale from an entity connected with a related party. This appears to be a serious omission, but from a first reading of even the old KLSE Rules, there does not appear to be such an omission in these rules.
Notwithstanding the above, the listing rules of the KLSE normally require that a circular be sent to shareholders on all related party transactions affecting a director or a substantial shareholder, that their prior approval of the transaction be sought at a general meeting, and further may require that the interested party abstain from voting (and that a statement that it will not vote be included in the circular)12. These provisions in the KLSE listing requirements, however, will not suffice unless very high fines are imposed to deter such violations and the resulting proceeds are distributed to the injured shareholders. Delisting is not a practical alternative as it will end up hurting the injured parties further.
The purchases by UEM, a blue chip company with a strong balance sheet, of a one-third interest in a related company but with a weaker balance sheet, namely Renong Berhad, without prior shareholder approval (in spite of this requirement), and KLSE’s inadequate or inappropriate response to the violation of its Rule, as well as controversy over the waiver granted to UEM from making a mandatory general offer under the take-over code, led to a further battering of the Malaysian stock market in late 1997 and early 1998 (which had already succumbed to the regional financial crisis from mid 1997). The UEM-Renong deal has raised some fundamental questions about the state of corporate governance in Malaysia and elsewhere in Asia.
There were also some gaping weaknesses in insider trading rules in Malaysia. With the recent amendments to the Securities Industry Act, which came into effect this year, the law against insider trading has been greatly improved. Insiders are no longer defined as persons with fiduciary duty or duty of confidentiality namely directors, managers, advisors and agents but include all persons who have in their possession material non-public information. Any person who has received a tip and who uses such information will also fall into this group. The law which only provided for criminal action has now been expanded to enable the regulator or any person who has suffered loss or damage from insider trading (or market manipulation) to institute civil action against the offenders, thus heralding a new era in Malaysian securities industry regulation. Penalties for insider trading have also been increased to include civil penalties with provision for the regulator to recover three times the insider’s gain or loss avoided. The new civil penalties also allow investors to seek full compensation for loss or damages from the offenders.
Another gaping weakness in corporate governance is in respect of the take-over code that is administered by the Securities Commission (SC). Parties who are involved in an acquisition or a take-over are allowed to apply to the Foreign Investment Committee (FIC) of the Economic Planning Unit for a waiver from making a general offer on ‘national interest’ grounds or to the Securities Commission if it meets its criteria with respect to the restructuring of a group of companies. Since August 29, 1997, the FIC has invoked Rule 34.2 of the Malaysian Code on Take-Overs and Mergers (the Code) in granting exemptions to several trust agencies, majority shareholders, individuals and public companies from the obligation to extend a mandatory general offer (MGO) pursuant to Rule 34.1 of the Code, so as to facilitate the acquisition of shares in certain identified companies in order for them to stabilise share prices.
The exemptions granted were subject to the conditions that any intended increase in shareholdings should be done through open market purchases only, and was limited to a holding of not more than 50 per cent equity interest in the relevant identified companies. The exemption granted did not extend to any increase in shareholdings by the relevant parties through private treaties or through any corporate proposals whether announced or to be implemented in future. UEM was one of the companies that had been exempted from making a MGO on ‘national interest’ grounds for the remaining shares of Renong after its acquisition of a 33 per cent that we had referred to earlier.
If the take-over code requires a full bid beyond the threshold level and does not entertain partial bids as in the US, then a very strong case can be made for no exceptions to be made to a general offer on ‘national interest’ grounds. The case is even stronger if such waivers are in fact serving private rather than national interest as appeared to be the case in such deals as the UEM-Renong transaction. Furthermore, the power to grant all such waivers should be left to the SC rather than the FIC to minimise unnecessary division of responsibilities between different governmental agencies.
In this context, it is heartening to note that the SC announced in a press statement on December 5, 1998 that the FIC will cease to consider any further applications for exemptions from the MGO. And with the amendment to the Securities Commission Act, which came into force with effect from January 1999, the SC is now the sole authority to grant exemptions from provisions of the Take-over Code.
Apart from the quality of legal protection, the quality of law enforcement also matters for a system of good corporate governance. The La Porta et al. (1996) study adopted the rule of law variable as a proxy for the quality of law enforcement. Going by this measure, Malaysia only ranked 9th amongst the 17 common law countries which were covered by the study. Of the 11 German and Scandinavian civil law countries, only South Korea registered a lower score than Malaysia for this variable. Even amongst the French civil law countries, there were 7 countries that had a better quality of law enforcement than Malaysia. In the light of the UEM-Renong debacle, Malaysia’s record on the quality of enforcement may in fact be worse than what is suggested in the study. Therefore, it is clear that there is considerable room for Malaysia to improve its record in matters related to law enforcement.
Another yardstick for judging the quality of a country’s system of corporate governance is by reference to the criteria laid down by the Cadbury Committee, that is, whether a company has independent board committees to deal with audit and remuneration matters and whether the chairman of the board of directors is a full-time executive. The KLSE was quick to amend its listing rules to provide for an independent board audit committee but no requirements have been stipulated with respect to the board remuneration committee or the status of the chairman. As has been suggested by certain authorities, if corporate boards even in the US (which have a good tradition of strong outside directors) have been captured by management, then it is not clear if the adoption of the Cadbury proposals alone can make for good governance. This is especially so since in Malaysia and elsewhere in Asia, unlike in the Anglo-Saxon world, ownership concentration is more pronounced and the dominant shareholder is in a position to make the key corporate decisions.
The Cadbury proposals are necessary to achieve good corporate governance but certainly they are not sufficient. And given the ownership concentration, allowing proxy voting by mail and cumulative voting for directors, are the minimum rule changes required to increase the possibilities for the election of more independent directors, at least in companies where the controlling shareholder only has a substantial but a minority stake. The case for these changes is even stronger when it is recognised that the widespread incidence of a pyramid structures in Asia, where the controlling shareholder may only have an indirect stake and where its control rights therefore far exceed its cash-flow rights, increases the incentive of the controlling shareholder to maximise its private benefits of control13.
The under-development of institutional investors and fund managers in Malaysia has resulted in the shareholders in a listed company to be made up largely of retail investors. One key reason for this under-development is due to the capture by the Employees Provident Fund (EPF) of a sizeable portion of national savings through its forced-savings scheme for employees and the centralised investment of these savings by the EPF. Only 20 per cent of its funds are invested in equities. The under-investment in equities, and that on a portfolio basis without concerning itself with who gets elected as independent directors, has led even the independent directors to be the nominees, for all intents and purposes, of the principal shareholders. Either EPF should take a more active role in such matters, or otherwise it should parcel out its funds for external management by fund managers (which may be the preferred alternative for several reasons), who may then be able to play a meaningful role by demanding better disclosure and corporate governance practices from corporations.
5. Corporate Governance, Transparency and the Exit Route
An investor in a publicly quoted company always has the option to quit by selling his shares. Given the availability of this exit route, the business judgement rule that governs the attitude of courts on the separation of management and financing (and hence towards the agency problem), is to keep the courts out of corporate decisions except on matters of executive pay, self-dealing and protection of shareholders against expropriation by an insider14. If equity markets are active and liquid, then a shareholder can rely on the exit route to protect himself against managerial inefficiencies or abuses which are not kept down by the courts. These abuses include the consumption by managers of perquisites, such as plush carpets and company aeroplanes, as well as managers expanding the firm beyond what is rational (where they are engaging in empire-building or pursuing pet projects). For a shareholder to rely on the exit route to protect himself and to recover his investments, the regulatory regime must ensure that all material information that investors need to make decisions are disclosed on a full and timely basis, that there are safeguards against anti-competitive behaviour and other forms of abusive behaviour by market participants (who may play a key role in regulation and enforcement), that investors are protected from the insolvency of financial intermediaries and that there are adequate controls for systemic risk.
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 interests of minority shareholders15. From 1995, a disclosure-based regulatory regime is being implemented on a phased basis. This will require firms to disclose all material information at the time of new listings, as well as on a periodic or continuing basis thereafter, depending on the nature of the information to be disclosed. In countries with more developed capital markets, firms rely on market practice and due diligence obligations to ensure the disclosure of all material information. In Malaysia, as the markets are less developed, the regulators are playing a more active role in recent years in defining and enforcing specific accounting, financial reporting and disclosure standards. To reinforce market incentives, the regulators are strengthening due diligence and fiduciary obligations of both financial intermediaries as well as of directors, managers, accountants and auditors16.
5.1. Accounting standards
A vital and integral part of any disclosure system is the accounting and financial reporting standards and practices. To encourage overseas investments in the equity markets, Malaysia has been adopting, starting from the 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 25 of the 31 extant IAS standards.17 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, Bank Negara Malaysia ( BNM), the central bank, has drawn up its own standard format of financial reports. The sixth is on disclosure and presentation of financial instruments for which the standard came into force 1 January, 1999. Schedule 1 in the Appendix enumerates the IASs which have been adopted for application in Malaysia. Schedule 2 sets out the various Malaysian Accounting Standards.
The Malaysian GAAP is inferior to the best practices recommended by IAS Committee to the extent that Malaysia has been a little slow in adopting the revised IASs. Comfort can be drawn from a review of Schedule 1. It shows that for financial year commencing from 1 January, 1998 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.
Malaysia has not only been adopting good standards but has also been trying to strengthen actual accounting and auditing practices. The professional accounting bodies in the country review published financial statements annually on a random basis to ensure compliance by their members with the accounting standards and statutory disclosure requirements.
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 recognised, 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 January , 1998 the adoption of 24 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 that have 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 reporting requirements, and to evaluate the practical aspects relating to the application of the accounting standards.
Since its commencement, the MASB has established 43 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 of developing a framework to set out the accounting concepts based on Syariah principles. As shown in Schedules 1 and 2, by 31 January 1999, MASB had issued twelve exposure drafts which are expected to become Standards on July 1, 1999, as well as one foreword, one discussion paper on statement of principles, 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 2 and 3.
5.2. Auditing standards
The Council of the 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.
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 that 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 4. The International Auditing Guidelines (IAGs) which were replaced by the IASs in mid-1998 are set out in the same Schedule.
MSAs are produced and issued by the MIA as part of its efforts to define standards of auditing and harmonise auditing practices in Malaysia. MSAs are issued to augment ISAs approved by the MIA. MSAs are intended to cover topics not dealt with in an ISA or topics where particular circumstances of the Malaysian environment warrant a domestic standard written specifically to address those circumstances. When necessary, further guidance will be issued to members. Presently there is only one MSA in force, namely AMI entitled, ‘Auditor’s Reports: Forms and Qualifications’.
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. An audit report has to contain a positive statement to the effect that the audit has been conducted in accordance with Approved Standards on Auditing issued by the Malaysian Institute of Accountants.
The Council has determined that the principles and spirit of the standards must be observed and the application of the standards in totality is recommended. The Council reserves the right to inquire into apparent failures by members and those persons under their supervision to observe approved Standards on Auditing and generally accepted auditing principles. Any failure to observe approved Standards on Auditing could be regarded as conduct discreditable to the profession of an accountant and might lead to disciplinary action being taken against the member or members concerned. To date the accounting profession has not directed as much attention to strengthening auditing practices, as it has devoted to strengthening accounting practices. Members have also been advised that a court of law may, when considering the adequacy of the work of an auditor, take into account any pronouncements or publications that it thinks may be indicative of good auditing practice. Approved Standards on Auditing are likely to be so regarded.
6. Governance by Large Creditors and Creditor Rights18
As in Germany and Japan, banks in Malaysia play a dominant role in lending. But the Malaysian banks do not play a role in governance (with respect to the appointment of managers or directors or the choice of investments), because they do not control or vote significant block of shares or sit on boards of directors. As a rule, they vote the equity of other investors, namely of their clients, but only under their express instruction.
The banks in the country, however, do play a major governance role in 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 insolvency19. Banks thus do not play a role in governance save in bankruptcies.
There are some experts who favour promoting in Malaysia, governance based on banks or even state enterprises as large shareholders, as an alternative to current arrangements. This recommendation is not likely to be successful. Banks in Malaysia 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. Empirical findings in Japan and Germany attest to this and are highlighted by Shleifer and Vishny ( 1997) in their survey article. Where a state enterprise, through its shareholdings in a listed company, plays a role in governance, here too the incentive is likely to be distorted because of the complete divergence between the control and cash-flow rights of state enterprise managers. This point is also made very strongly by Shleifer and Vishny (1997).
Malaysia has five options for dealing with financial distress in the corporate sector ranging from outright liquidation to debt restructuring and reorganisation of the company as an ongoing concern. Two of the options have always existed in the Companies Act but the other three options have emerged only this year.
6.1. 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, and 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.
6.2. 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 so long as a majority in number representing three-fourths in value of the creditors or class of creditors 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 [10] is to permit the preservation of the company as an ongoing concern while enabling creditors to recover monies under compromise and reorganisation 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 Malay sian company law is based, such as the UK, Australia and Singapore, in Malaysia there are no specific provisions or guidelines. The process is cumbersome and the courts have limited experience in supervising reorganisation plans. Some experts have made a case for Malaysia to adopt 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 misused the provisions of section 176 to seek from the Courts temporary relief from creditors20 for periods of up to nine months on a unilateral basis without the company being 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 introduced a Bill requiring that a company needs the consent of creditors representing at least 50 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 bank guarantees21. This can seriously undermine the credibility of bond markets and undermine its development.
6.3. The corporate debt restructuring committee
Repossessing assets in bankruptcy is often very hard even for the secured creditors. With multiple, diverse creditors who have conflicting interests, the difficulties of collecting are even greater, and bankruptcy proceedings often take years to complete. Because bankruptcy procedures are so complicated, creditors often renegotiate outside of formal bankruptcy proceedings both in the US and in Europe. The situation is worse in developing countries, where courts are less reliable and bankruptcy laws are less complete.
The Corporate Debt Restructuring Committee (CDRC) was established mid-August 1998 under the aegis, and with the secretarial support, of BNM, to provide a framework to enable creditors and debtors to arrive at schemes of compromise and reorganisation on a voluntary basis without resorting to legal processes. The aim of this scheme, based on the “London Approach”, is to tackle complex cases of indebtedness, with outstanding debts of at least RM50 million and with more than three creditors.
The key features of the CDRC framework have been worked out but guidelines which are viewed as credible, transparent and consistent have yet to be developed to encourage the use of the voluntary process. To assist in this process, and in the absence of a long tradition of co-operation 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 for the even 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 60 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 is, what majority rule would be used to reach an agreement over the restructuring plan and who would be eligible to vote? Further, the restructuring process may entail a change in the capital structure (for example a debt-equity conversion), a change in ownership and control (such as a removal of existing directors, injection of outside equity and management), a
change in activities or may involve a merger. A number of laws will thus have a bearing on the restructuring process. To prevent the problem of overlapping and multiple jurisdictions and to prevent a restructuring from being incompatible under a particular law, the Government must undertake a review of the various rules and regulations or be prepared to remove any inconsistencies.
6.4. The Asset Management Company or Danaharta
Danaharta was 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 Act22. The goal is to expedite and shorten the legal procedures and to bring to bear professional expertise in design and implementation of reorganisation plans. The operations of Danaharta are covered under a special act that confers on it broad ranging powers to acquire and manage assets.
6.5. 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 to enable these borrowers to continue to receive financial support while restructuring their operations. In addition, these borrowers can also use the Danaharta route.
6.6. Creditor rights reviewed
We conclude this section by examining creditor rights in Malaysia based on the La Porta et al. (1996) study. Like shareholders, creditors have a variety of legal protections, which also vary across countries. These may include, in line with the analysis of Shleifer & Vishny (1997), the right to grab assets that serve as collateral for the loans, the right to liquidate the company when it does not pay its debts, the right to vote in the decision to reorganise the company and the right to remove managers in reorganisation.
The variables used to measure creditor rights in the La Porta et al. (1996) study are shown in Table 5. La Porta et al. (1996) found that the protection of creditor rights is generally more common than the protection of shareholder rights. Here, we state the position of Malaysia only in relation to the common law countries sampled in the study. Common law countries offer creditors better legal protections against managers. They most frequently (71 per cent of the sample countries including Malaysia and this due to the introduction of the recent bill) preclude managers from unilaterally seeking court protection from creditors; they have the lowest (29 per cent) incidence of allowing automatic stay on assets (Malaysia too does not allow an automatic stay on assets; with one exception (and that exception is New Zealand and not Malaysia) they guarantee that secured creditors are paid first; and they have far and away the lowest (24 per cent) incidence of managers staying on the job in reorganisation proceedings. In Malaysia as well, management is replaced by a party appointed by the court or the creditors. According to La Porta et al. (1996), the US is actually one of the most anticreditor common law countries. It allows unimpeded petition for reorganisation, permits automatic stay on assets and lets managers keep their job in reorganisation.
7. Conclusions and Recommendations
1. In Asia (not including Japan) dispersed shareholding and management-control is uncommon. Ownership concentration is the order of the day. Both approaches to governance are exposed to the same problem. The manager and the controlling shareholder are in a position to expropriate the minority shareholders unless their rights are protected by law.
2. The concentration of shareholding in Malaysia imposes a severe constraint on the market for corporate control. Thus there is little or no role for hostile take-overs to play a disciplinary role on insiders who are not working towards the maximisation of shareholder value. However, share price movements exercised through the exit route or a sell-down of shares, do provide an avenue for disenchanted or aggrieved shareholders to discipline errant insiders23.
3. The advantage of ownership concentration as an approach to governance is that there is a better matching of the control rights of the dominant shareholder with its cash-flow rights. Thus there will be a great incentive for that control to be exercised in maximising shareholder value. Therefore, the incentive of the controlling shareholder is more likely to be aligned to the interest of other shareholders. On the other hand, the advantage of dispersed shareholding as an approach to governance is that it enables large wealth holders to minimise risk through diversification. It also makes for more efficiency through the hiring of the best manager. The fact that both approaches to governance is thriving in the developed world suggest that choosing between the two alternatives can be a difficult task.
4. 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 cash-flow rights of insiders. Therefore, the incentive is for insiders to maximise 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.
5. The managers or controlling shareholders in a company are in a position to expropriate minority shareholders:
a. by selling to a connected party the output or an asset of the company at below market price,
b. by buying from a connected party an input or an asset at above market price, and
c. by acquiring an interest in a company connected with a related party at above market price.
6. 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 capitalisation) 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 cash-flow rights of the controlling shareholder.
7. A large investor may be rich enough that he prefers to maximise his private benefits of control (including investments in unrelated activities, whether for diversification or for the purpose of empire building), rather than maximise his wealth. Unless he owns the entire firm, the large investor will not internalise 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 maximise profits and pay out the profits in the form of dividends.
An examination of the foreign controlled companies, especially those with 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 reinvesting the profits in diversified or empire-building activities). Such high dividend pay-out ratios may have been facilitated by the more healthy relationship between the control rights of the majority shareholder with its cash-flow rights.
In the case of locally controlled companies, the control rights were usually well in excess of the cash-flow rights of the controlling shareholder, usually because of the pyramid structure of companies in the same group. This could explain their much lower dividend pay-out ratios and their greater propensity to reinvest their profits even in unrelated activities, at least in part to maximise the insider’s private benefits of control.
8. 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 that must be addressed as expeditiously as possible to reduce ownership concentration and increase the reliance of companies on external finance.
9. There are weaknesses in existing legal provisions with respect to a substantial acquisition or disposal, which requires shareholders approval. The KLSE Rule on a substantial transaction, and in particular, the new rule which came into force from July 1998, is more clearly defined. It makes sense for the relevant provisions in the Companies Act to be redefined in a similar manner with respect to such tests as the assets test, profits test, consideration test, consideration to market capitalisation test, and the equity or capital outlay test.
10. 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 KLSE Rules, in particular the new Rules, do not suffer from the same deficiency. Reliance on the KLSE Rules, however, is not satisfactory as the KLSE may have powers only to penalise or punish the listed companies and not the insiders committing the offence. In fact, where the companies are punished through suspension or delisting, we may end up compounding the losses of the injured parties, namely the minority shareholders. Therefore, the Companies Act should be amended to require the interested parties to abstain from voting on a connected party transaction. In this regard, it is interesting to note that the powers of the Exchanges have been substantially embellished by the very recent amendments to the securities Industry Act which strengthens the ability of the Exchanges to take action against directors and anybody to whom the listing rules of the Exchanges are directed at, where it was previously confined to the listed entity24.
11. A substantial or interested party transaction should have the prior approval of shareholders. It is not advisable to let a company enter into a transaction on a conditional basis where approval of shareholders is obtained subsequent to the event. This is because, in the fast-moving or more volatile market environment of today, undoing a transaction (if prior approval is not obtained) may be impossible or may encounter considerable difficulties.
12. 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. The existing penalties against breaches of the KLSE Rules on substantial and connected transactions (where breaches are easier to determine given the greater clarity of the KLSE Rules) do not act as a sufficient deterrent to the offenders. Reliance on some of these penalties may have the unintended consequence of compounding the losses of the injured parties.
13. On efficiency grounds, a strong case can also be made for the removal of existing prohibitions on certain related party transactions, (e.g. 132G). Instead such transactions should be made subject to the prior approval of shareholders with the interested parties required to abstain from voting.
14. As the take-over code requires a full bid beyond the threshold level and does not entertain partial bids as in the US, a very strong case can be made for no exceptions to be made to a general offer on “national interest” grounds. The case is even stronger if such waivers are in fact serving private rather than national interest. Furthermore, the power to grant all such waivers should be left to the SC rather than the FIC to minimise the unnecessary division of responsibilities between different Government agencies. The amendment to the securities Commission Act providing for this from January 1999 is therefore most welcome.
15. The Cadbury proposals for the establishment of independent board audit and remuneration committees are necessary to achieve good corporate governance but certainly they are not sufficient. And given the ownership concentration, allowing proxy voting by mail and cumulative voting for directors are the minimum rule changes required to increase the possibilities for the election of more independent directors, at least in a company where the controlling shareholder only has a substantial but a minority stake. The case for these changes is even stronger when it is recognised that the widespread incidence of pyramid structures or cross holdings in Asia, where the controlling shareholder may only have an indirect stake and where its control rights therefore far exceed its cashflow rights, increases the incentive of the controlling shareholder to maximise its private benefits of control.
16. The capture by EPF of a sizeable portion of national savings, its centralised investment and under-investment in equities, have led to the under-development of institutional investors and fund managers in Malaysia. EPF’s decision to invest its funds on a portfolio basis without seeking any board positions cannot be faulted. Nonetheless, it has to be vigilant against abuses of minority shareholder rights by the insiders. Although it held 10 per cent of the shares in UEM and 14 per cent in KFC, it failed to initiate any actions against the insiders in these companies whose apparent disregard of minority interests led to a steep fall in the shareholder value of these companies. A case can be made for the setting up of a Minority Shareholder Watchdog Group to monitor and combat abuses by insiders against minority shareholders. Initially EPF as the major institutional investor can take the initiative to set up and organise such a Watchdog Group with the technical assistance of the World Bank or the ADB. Representatives from the Malay sian Institute of Corporate Governance, the Malaysian Association of Investors and the Malaysian Association of Asset Managers should be invited to participate in the Group. As the growth of the fund management industry in Malaysia gathers momentum through a decentralisation of EPF’s investment activities, funds managers can then play a more active role in this Watchdog Group.
17. The accounting, auditing, financial reporting and disclosure standards have witnessed significant improvements in Malaysia in recent years. By adopting good standards, strengthening actual accounting practices and enforcing due diligence and fiduciary obligations of both financial intermediaries as well as of directors, managers, accountants and auditors, market incentives can be reinforced. Investors can then increase their reliance on markets and on the exit route to protect themselves against the inefficiencies or abuses of controlling shareholders and other insiders that are not kept down by the courts. These abuses include the consumption by managers of prequisites, (such as plush carpets and company aeroplanes) as well as managers expanding the firm beyond what is rational (where they are engaging in empire-building or pursuing pet projects). If the financial markets are to play a more effective role as a signalling and monitoring device in Malaysia to allocate capital and monitor corporate insiders, there is a need for more timely and continuous disclosure of information, including information about asset-liability mismatches, credit risk, liquidity risk and market risk. Given the ownership concentration in Malaysia, a strong case can in fact be made for a quarterly reporting of financial results and for companies to issue warnings whenever earnings, debt or risk profiles are likely to differ significantly from analysts’ expectations or the companies own forecasts. This is to ensure that the investing public do not trade under false expectations and that the insiders do not have too much time to trade on price-sensitive information that the market does not have. Surprise news on debt levels, risk profiles or prospective earnings in the 1997 Annual Reports of blue chips companies such as Magnum and Kulim released during the course of this year have battered their share prices. Investors should not be forced to wait for the reporting season to learn about such surprises. It is preferable to issue wanings about such surprises on a timely basis in order not to disadvantage the ordinary investors vis-à-vis the insiders. Many listed companies are not complying with the KLSE ruling with respect to the filing of annual accounts and reports within the stipulated period. This warrants close scrutiny by regulators.
18. Banks in Malaysia do not play a role in governance save in bankruptcies. But there are some experts who are in favour of promoting governance based on banks. However, as argued earlier, 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.
1 In this regard, it is interesting to note that “legal protection of creditors is … more effective than that of the shareholders since default is a reasonably straightforward violation of a debt contract that a court can verify” (Schleifer and Vishny 1997: 13).. On the other hand, to make incentive contracts for managers feasible, “some measure of performance that is highly correlated with the quality of the manager’s decision must be verifiable in court.” (Schleifer and Vishny 1997: 7).
2 Or second largest, if the largest shareholder was also a foreign shareholder.
3 The database used to compute these numbers did not capture some information on contingent liabilities for all companies in the sample. The study does not attempt to quantify the extent of the omission.
4 The comments of Shanti Kandiah of the Securities Commission have been extremely valuable in correcting errors and tightening the arguments in this discussion.
5 The index aggregating shareholder rights was formed by adding 1 when (1) the country allows shareholders to mail their proxy vote; (2) shareholders are not required to deposit their shares prior to the general shareholders’ meeting; (3) cumulative voting is allowed; (4) an oppressed minorities mechanism is in place; or (5) when the minimum percentage of share capital that entitles a shareholder to call for an Extraordinary shareholders’ meeting is less than or equal to 10 per cent (the sample median). The index ranges from O to 5. [La Porta et al. 1996: Table 1].
6 Civil procedure in the United States is much more facilitative of class actions. 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 damages recovered in the action. In Malaysia, on the other hand, once a plaintiff in his representative capacity has established his claim to the damages, each member of the class has to bring his own action to establish damage suffered by him within the limitation period.
7 “For investors to know anything about the companies they invest in, some basic accounting standards are needed to render company disclosures interpretable. Even more important, contracts between managers and investors typically rely on some measures of firms’ income or assets being verifiable in court. If a bond covenant stipulates immediate repayment when income falls below a certain level, this level of income must be verifiable for the bond contract to be, even in principle, enforceable in court. Accounting standards might then be necessary for financial contracting, especially if investor rights are weak.” (La Porta et al. 1996: 28).
8 Unless the said company is a wholly-owned subsidiary or parent or unless the transaction was entered into three years after the said company became shareholder or director-related.
9 The Directors may make a special issue of shares of up to 10 per cent of a company’s paid-up capital to the general public or to any class of investors if they have obtained the general authority of the shareholders to do the same at a general meeting.
10 Many observers would agree that the outright prohibition in 132G should be revised but not sections 133 and 133A, which deal with loans to directors or persons connected with directors. There is a fairly widely-held view that the section should be widened to embrace quasi-loans or other financial benefits or arrangements, gifts or quasi-gifts received or receivable. Also outright prohibitions against loans to directors are not uncommon (unlike the prohibition in 132G which is peculiar to Malaysia) and may be found both in UK and Australia. Notwithstanding what has been said in this footnote, a case can still be made for a review of 133 A. As presently drafted, it prohibits a company from granting a loan to a director-related company even where the director does not have a material interest in the company and even where it makes commercial sense. I believe that a company should be permitted to make a loan to a director or shareholder-related company provided it is subject to prior shareholder approval with the interested parties abstaining from voting. Even a loan from a parent company to a subsidiary which is not wholly-owned should be subject to approval of minority shareholders.
11 See Koh (1997) who contends that 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. It can be debated in anyone case whether the transaction is adverse to company performance or financial position.
12 The old rule 118 only covered transactions involving the interests of directors and substantial shareholders, direct or indirect. The new rule also covers transactions involving the interest, direct or indirect, of persons connected with directors or substantial shareholders. A connected person is (a) a family member (spouse, parent, child (adopted or step-child), brother, sister, spouse of the child, brother or sister, (b) a body corporate associated with the person, (c) his partner or a partner of person connected with that person, (d) for example, if the company wishes to purchase a piece of land belonging to a director’s step-child, the transaction is considered a related-party transaction and subject to the rule of the KLSE.
13 Those who are sympathetic to the Cadbury approach, which is essentially a self-regulatory approach, agree that it may not be enough to counter the abuses related to ownership concentration. However, they view the Cadbury approach as a form of modified self-regulation, modified to the extent of compliance with the Code. They contend that this will make board processes and internal workings of companies more transparent thereby enhancing the quality of market discipline. They further contend that this will then nicely tie back to the point made in the paper about the need for institutional investors to play a more meaningful role in corporate governance.
14 Given that this exit option is not available to minority shareholders of private companies, the burden placed on the courts to protect the interests of such shareholders, will be much greater. If the courts are not able to meet this demand, then there will be few or no such minority shareholders.
15 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.
16 Under KLSE regulations, listed companies are required to make timely disclosure of material financial and corporate information. From 1 January, 1998 to 18 February, 1999, based on data supplied by the KLSE:
* sanctions ranging from a private reprimand to a fine of RM100,000 were imposed on 7 public listed companies for breaches of the Listing Requirements relating to non-disclosure of material transactions, and
* sanctions ranging from a private reprimand to a fine of RM100,000 were imposed in 27 instances on public listed companies for the failure to submit financial statements within the periods prescribed in the Listing Requirements.
17 One of the IAS standards, that is, IAS3, had been superseded by two other standards (namely by IAS27 & IAS28) and another that is, IAS6 had been withdrawn. By mid-1998, the revised IAS1 will replace the original IASl as well as IAS5 & IAS13. The Malaysian Accounting Standards Board’s exposure draft for the revised IASl will come into force for financial year commencing from 1.1.1999.
18 I wish to acknowledge my debt of gratitude to Mr Arun Gupta of the World Bank for educating me on the basics of corporate debt restructuring and reorganisation.
19 The banks as large creditors combine substantial cash-flow rights with the ability to interfere in the major decisions of the firm. This is because of a variety of control rights they receive when firms default or violate debt covenants and in part because they typically lend short term, so borrowers have to come back at regular, short intervals for more funds.
20 By August 1998, 32 companies had sought and received summary relief from creditor actions. During the 1986 economic, corporate and banking crisis, the number of companies accorded unilateral temporary relief was in the single digit.
21 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% 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 13 outstanding issues totalling RM1.48 billion by 12 different issuers under section 176 protection. Of these, 10 were bank guaranteed, two were corporate guaranteed and one was 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 ‘Section 176: An Impact Analysis’, RAM Focus, Issue No. 9, September 1998.
22 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 12 months (can be extended if necessary) will take effect over winding-up petitions, enforcement of judgements, proceedings against guarantors, repossession of assets, applications under section 176 of the Companies Act. During this period the SA will prepare a plan for disposal of assets. The plan would be presented to Danaharta who would seek the opinion of an independent advisor as regards the reasonableness of the proposal and the manner in which the proposal safeguards the interest of creditors. Once the approval of the corporation has been received, the SA would convene a secured creditors meeting, seek a majority approval vote and then implement the plan. Plan options could range from restructuring of debts and reorganisation of the borrower as an ongoing concern to disposal of assets through liquidation.
23 This is evident from an examination of foreign shareholding in and share price movements of UEM and KFC, companies which had been viewed by the market as blue chip companies before the announcement of the major breakdown in their corporate governance practices in 1997. The foreign shareholding in UEM (represented by some of the top names from the world of institutional investors) amounted to 54.2 per cent at year end 1996 versus Renong’s shareholding (which was the controlling shareholder) of 32.6 per cent. The announcement of the corporate governance irregularities in November 1997 led to a 48.2 per cent decline in the UEM share price (versus a decline in the Kuala Lumpur Composite Index of 14.5 per cent over the corresponding period) and foreign shareholding in UEM contracted to 35.1 per cent by year end 1997. The disclosure of the corporate governance irregularity by KFC in June 1998 also led to a sharp fall in its share price of 47.6 per cent (versus a decline in the KLCI index of 6.1 percent). Foreign shareholding had fallen from 34.3 percent to 15 percent between 1996 and 1997 and the corresponding number for 1998 is still not available. It is not clear what caused the sharp fall even before the public disclosure of the irregularity – the perceived problem of insiders or under performance. For a sample of 75 public listed companies (see Section IV), the weighted average of foreign shareholding had in fact increased marginally from 24 per cent to 24.2 per cent over the 1996-1997 period.
24 However, it is also important to note that the KLSE does not have the enforcement infrastructure available to a statutory regulator, which would include for example the statutory right to require information as well as rights of search and seizure that would make its enforcement exercise more effective.
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R. Thillainathan*
Genting Berhad
* E-mail: rtn@genting.po.my
The views expressed do not in any way reflect the view of the institutions with which the writer is associated with. They reflect the situation prior to the imposition of capital controls and the change in the accounting, financial reporting, and disclosure standards of the banking industry announced by the Government in September 1998.
Copyright Malaysian Economic Association Jun-Dec 1998
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