Magoosh GRE

The Asian Financial Crisis

| November 16, 2012


1. Background    

In recent years, the Asian Financial Crisis in 1997, and the two largest bankruptcies in the U. S. history- Enron in December 2001 and WorldCom in July 2002, have all served to highlight the importance of corporate governance (CG). Inadequate CG system and heavily concentrated ownership of most Asian companies have been considered the major two reasons suffering the serious consequences on the Asian financial crises.  Governments worldwide have been placing great emphasis on addressing the problems on this issue and drawing on all their resources to implement improvements.  This paper, therefore, aims to evaluate the development and trends of CG in Taiwan, including the study of an example of Taiwan Semiconductor Manufacturing Company (TSMC) that follows excellent CG.  Towards the end, some possible methods or procedures to improve the current CG in Taiwan are illustrated.

This paper focuses on the case study of CG in Taiwan.  Taiwan’s capital markets collapsed when the Asian Financial Crisis hit Taiwan in 1997.  After that, a “domestic” financial crisis or scandal occurred between July of 1998 and December of 1999, where 28 fraudulently listed companies failed overnight, causing investors to suffer tremendous losses.  These companies are now mostly “retired” from the Taiwan Stock Exchange, and some of these companies’ leaders have been prosecuted.  The main reason for this collapse was that the leaders were using companies’ stocks as collateral to leverage their personal needs or switch-out investments, creating a hidden financial risk in a number of companies.  Initially these companies’ leaders bought significant portions of stock from a variety of listed companies, financing the purchase of these stocks with local banks.  After capital markets collapsed, the companies’ leaders, who had bought stocks and financed it, were required by the banks to pay the difference between the collateral value and the market value of the stocks.  Not being able to generate enough cash to maintain companies’ stock prices, these companies went bankrupt.  The worst thing was that the leaders or managers misappropriated funds from their companies and transferred funds to their affiliated companies or personal accounts.

To protect investors from suffering extreme losses again, the immediate task is to deal with and prevent any possible crises by undertaking integrated restructuring of the assets and liabilities of highly indebted firms, external debt restructuring, and financial sector reform. Integrated restructuring of both corporate assets and liabilities is required if competitive enterprise and financial sectors are to be developed, the risk of crises recurring to be reduced, and the costs to taxpayers of accomplishing these goals are to be minimized.

On the other hand, changing or improving current CG of Taiwanese companies is also an essential task.  From a legal perspective, lack of an effective, strong supervision framework, and regulations of CG are major problems.  The Securities and Futures Commission (SFC) (證期會), which has become Securities and Futures Bureau (SFB) (證期局) in Taiwan has the responsibility to build up a legal framework and develop guidelines and standards for CG.  The highest priority for the SFB in Taiwan should be to establish a healthy and comprehensive internal control system, with effective mechanisms to control and maintain the “integrity” of companies.  Other necessary steps should include broadening the ownership of corporations by liberalizing foreign entry and expanding the role of capital markets.

2. Agency Theory and Agency Costs

Since Jensen and Meckling (1976) proposed a theory of the firm (Agency Theory) based upon conflicts of interest between various contracting parties – shareholders, company managers and debt holders – a vast literature has been developed in explaining both aspects of these conflicts.  Jensen and Meckling (1976) further specified the existence of “agency costs” which arise owing to the conflicts either between managers and shareholders (agency costs of equity) or between shareholders and debtholders (agency costs of debt).  Financial markets capture these agency costs as a value loss to shareholders.

Jensen and Meckling (1976) defined the agency relationship as a contract under which one party (the principal) engages another party (the agent) to perform some service on their behalf.  As part of this arrangement, the principal will delegate some or all of the decision-making authority to the agent. In practice, shareholders from most corporations delegate the decision-making authority to the board of directors (BOD). In turn, the BOD delegates power to the chief executive officers (CEO).  The agency problems arise because of the impossibility of perfectly contracting for every possible action of an agent whose decisions affect both his own welfare and the welfare of the principal.

The agency theory argues that an agency relationship exists when shareholders (principals) hire managers (agents) as the decision makers of the corporations. The agency problems arise because managers will not solely act to maximize the shareholders’ wealth; they may protect their own interests or seek the goal of maximizing companies’ growth instead of earnings while making decisions. Jensen and Meckling (1976) suggested that the inefficiency may be reduced as managerial incentives to take value maximizing decisions increased.  Agency costs are arising from divergence of interests between shareholders and company managers. “Agency costs” are defined by Jensen and Meckling as the sum of monitoring costs, bonding costs and residual loss.

(1) Monitoring Costs

Monitoring costs are expenditures paid by the principal to measure, observe and control an agent’s behavior. The economic impact of asymmetric information also results in various corporate agency problems. Firm managers (insiders) know more about their firm than shareholders and debt financiers (outsiders). When outsiders are unable to judge over the firm’s performance, they tend to qualify a firm’s performance as moderate. A result of this asymmetric information is that shares of a firm with a great performance are undervalued and vice versa. More specifically, information asymmetries between shareholders or bondholders and corporate executive management creates the necessity of monitoring (costs) and complications for the structuring of financial contracts.  They may include the costs of preparing reliable accounting information and audits, writing executive compensation contracts and even ultimately the cost of replacing managers.

Denis, Denis, and Sarin (1997) contended that effective monitoring is restricted to certain groups or individuals. Such monitors must have the necessary expertise and incentives to fully monitor manager. In addition, such monitors must provide a credible threat to management’s control of the company.

(2) Bonding Costs

To minimize monitoring costs, managers tend to set up the principles or structures and try to act in shareholder’s best interests. The costs of establishing and adhering to these systems are known as bonding costs. They may include the costs of additional information disclosures to shareholders, but management will obviously also have the benefit of preparing these themselves. Agents will stop incurring bonding costs when the marginal reduction in monitoring equals the marginal increase in bonding costs.

As suggested by the agency theory, the optimal bonding contract should aim to entice managers into making all decisions that are in the shareholder’s best interests.  However, since managers cannot be made to do everything that shareholders would wish, bonding provides a means of making managers do some of the things that shareholders would like by writing a less than perfect contract.

(3) Residual Loss

Despite monitoring and bonding, the interest of managers and shareholders are still unlikely to be fully aligned.  Therefore, there are still agency losses arising from conflicts of interest.  These are known as residual loss, which represent a trade-off between overly constraining management and enforcing contractual mechanisms designed to reduce agency problems.

There are some other types of agency costs as following:

(4) Agency Costs of Debt

There are three groups of participants in a firm, suppliers of equity, debt suppliers and firm managers.  It is logical that they would try to achieve their goals with different measures. Suppliers of equity, or shareholders, are interested in high dividend ratio’s and high share prices. Debt suppliers, on the other hand, are interested in interest and debt repayments, whereas firm managers would be focused on their financial remuneration. These conflicts of interest give rise to opportunity costs (whereby best strategies are often not adopted) and real costs (e.g., inspection costs). These costs decrease the market value of a firm.

Kim and Sorensen (1986) investigated the presence of agency costs and their relation to debt policies of corporations. It is found that firms with higher insiders (managers) ownership have greater debt ratios than firms with lower insider ownership, which may be explained by the agency costs of debt or the agency costs of equity.

(5) Agency Costs of Free Cash Flow

The free cash flow theory presumes that there are enormous conflicts of interest between shareholders and stakeholders. This implies that managers’ decisions do not always maximize the value of a firm (Jensen, 1986).

Jensen (1986) also emphasized the continuous agency conflicts between top managers and shareholders. These conflicts are especially severe in firms with “large” free cash flows. A free cash flow is the balance of money a company is left with when all projects are financed. If top managers hold more cash than profitable investment opportunities, they may overspend money on organization inefficiencies or invest it in projects with net present value (NPV) less than zero. The logic has it that higher debt levels reduces free cash flows and consequently increases the value of the company.

3. Corporate Governance

Finance theories have been developed both theoretically and empirically to allow a full investigation of the problems caused by divergences of interest between (1) shareholders and corporate managers and (2) shareholders and debtholders.  This paper firstly attempts to summarize major research on key topics that have emerged in terms of the agency theory and CG.

Based on the agency theory, managers will not act to maximize the returns to shareholders unless appropriate governance structures are implemented to safeguard the interests of shareholders, especially in large corporations.

The relationship between managerial discretion and corporate performance has been studied enormously in the literature.  “Managerial discretion,” defined as managers’ decision-making latitude, allows managers to serve their own rather than shareholders’ objectives, and therefore is likely to be associated negatively with corporate performance (Jensen and Meckling 1976, Fama 1980, Fama and Jensen 1983a, Fama and Jensen 1983b, and Jensen and Ruback 1983).  CG then serves to motivate managers to maximize firm value instead of pursuing personal objectives.

“Corporate Governance” may have different meanings to different people depending on their perspectives.  This study is inclined to take the financial perspective of Shleifer and Vishny (1997) that considered CG dealing with the ways in which suppliers of finance (i.e. shareholders and debt holders) to corporations assure themselves of getting a return on their investment.

The need for the existence of CG is also because of the agency problems incurred by the separation of the capital providers (shareholders) and managers.  When it fails to enforce the contract between capital providers and managers, there has to be other mechanisms to ensure the efficiency of capital allocation in the economy.  The review that follows will be focused on this perspective.

The remainder of this paper is organized as follows: Section II deals with various designs of efficient governance mechanisms as means of reducing agency conflicts or costs; Section III presents the research method; Section IV presents the general view of CG in Taiwan, and an example of Taiwan Semiconductor Manufacturing Company (TSMC) that shows excellent CG, Section V illustrates some methods or procedures for improving current CG in Taiwan and provides a conclusion.

II Governance Mechanisms

1. Executive Compensation Contracts

Compensation contracts (financial rewards or incentive plans) are designed to align the executive’s and shareholders’ financial interests. In a company, managers are the ones to make the actual decisions; however, managerial discretion may have negative impact on the firm performance or value.  The structure of executive compensation contracts can have a significant influence on the alignment of the interest between shareholders and management.  Compensation contracts represent a financial incentive for management to increase company value.  Higher levels of such incentives should ultimately lead to higher company performance (Jensen and Meckling, 1976).

Compensation generally includes four components: salary, accounting-based performance bonuses, stock option schemes and long-term incentive plans. Murphy (1985) found that executive compensation is strongly and positively related to shareholder returns. Coughlan and Schmidt (1985) also found that salary and bonus changes are significantly related to shareholder returns. Baker, Jensen and Murphy (1988) further illustrated that the level of pay determines where managers should work, but the structure of the compensation contract determines how hard they work.  Effective compensation contracts should provide management with sufficient incentive to make value-maximizing decisions at the lowest possible costs to shareholders.  Gerhart and Milkovich (1990) show that future profitability is positively related to the level of incentives in the compensation mix.

The use of stock options in executive compensation plans is generally one of the most effective means of tying the interests of managers and shareholders as they are seen as an increase of managerial ownership.  Such options give management the right to buy company stock at a fixed price in the future.  The higher the value of the firm, the higher the value of the options and profit managers can make upon exercising them.  Additionally, Fenn and Liang (2000) also found that higher levels of managerial stock options lead to higher levels of share repurchases.  Grinstein and Hribar (2004) investigated CEO compensation for completing M&A deals.  They found that CEOs who have more power to influence board decisions receive significantly larger bonuses. CEOs with more power also tend to engage in larger deals relative to the size of their own firms, and the market responds more negatively to their acquisition announcements. This evidence is consistent with the argument that managerial power is the primary driver of M&A bonuses.

2. Transparent and Reliable Financial Accounting Information

The issue of “transparency” can be explained from the viewpoint of Economics, by focusing on the concept of “information asymmetry.” A situation in which information asymmetry exists can be described as a “lack of transparency”.  In other words, the improvement of transparency means a mitigation of information asymmetry or uneven distribution of information. Well performing companies can reduce this information problem by providing reliable information signals.  Objective, verifiable accounting information facilitates shareholder monitoring and the effective exercise of shareholder rights under existing securities laws; it also enables directors to enhance shareholder value by advising, ratifying and policing managerial decisions and activities.

Bushman and Smith (2001) defined the governance role of financial accounting information as the use of externally reported financial accounting data in control mechanisms that promote the efficient governance of corporations. Ball (2001) argued that timely incorporation of economic losses in the published financial statements (that is, conservatism) though increases company’s costs but enhances the effectiveness of CG.  Bushman and Smith (2003) further emphasized greater transparency as CG is needed for companies to control risks. However, developing and maintaining a sophisticated financial disclosure is expensive.  Jensen and Meckling (1995) observed that where there are high knowledge transfer costs, decentralization is necessary; where decentralization occurs, there is a control problem, which can be addressed by providing a control system. Hay (2003) examined the circumstances in which financial reporting exists, and predicted that where there are high knowledge transfer costs, there will be a control system; if the control system uses financial reports, these will occur for activities with high knowledge transfer costs.

Varying public securities markets rely on complex systems of supporting institutions that promote the governance of publicly traded companies. Institutions promoting the governance of firms include reputational intermediaries such as investment banks and audit firms, securities laws and regulators such as the Securities and Exchange Commission (SEC) in the U. S., and disclosure regimes that produce credible firm-specific information about publicly traded firms.

There are other mechanisms of controls such as the legal protection, ownership structure (large shareholders and creditors), the use of leverage, role of Board and dividend policy.

3. Legal Protections

In the U.S., corporate governance has been of interest for a number of years, but it was not until Congress passed the Sarbanes-Oxley Act of 2002 that it became critical. CEOs must now certify that their financial statements are faithful representations of the financial position and results of operations of their companies and rely more heavily on internal controls to detect any misstatement that would otherwise be contained in these financials. This law instructed companies and stock exchanges that corporate governance had to be taken seriously or there would be serious repercussions.  As a result, the Securities and Exchange Commission (SEC) and many exchanges, such as the New York Stock Exchange, created a set of rules for companies to follow.  The Sarbanes-Oxley Act has created a new age of accountability requiring even greater corporate transparency. Before that, the Foreign Corrupt Practices Act of 1977 required that all U. S. corporations under the jurisdiction of the Securities and Exchange Commission maintain an adequate system of internal control. Companies that are subject to, but fail to comply with the rules may be subject to fines and officer imprisonment.

In U.S., “Forensic Accounting” is the fastest growing area of Accounting today, particularly with the passage of the Sarbanes-Oxley act.  Forensic accounting is the practice of utilizing accounting, auditing, and investigative skills to assist in legal matters. Accountants and specialists in this field are engaged in the public practice of forensic examination; others work in private industry for such entities as banks and insurance companies or governmental entities such as sheriff and police departments, the Federal Bureau of Investigation (FBI), and the Internal Revenue Service (IRS).

The most important legal right shareholders have is the right to vote and elect the boards. Like shareholders, creditors also have legal protections. These may include the right to possess collaterals, the right to liquidate assets, the right to reorganization, and, in some cases, the right to remove managers.  It is common that external financing has legal protection -companies who provide the financing may have the protection. If managers violate the contract, then the shareholders or creditors have the right to seek damages from the court. However, these legal protections may not be effective in some circumstances; therefore, there has to be other mechanisms to ensure a high standard of corporate governance.

4. Ownership Structure

The advantage of concentrated structure is having a strong leadership and cohesive management team formed by the family-owned or controlled members. However, the problem is: companies, if dominated by one family, tend to grant the right of governance over the company for the benefit of their own interests and sacrificing the benefits of minority shareholders.  From the literature, several findings indicated that “large” shareholders structure may play an active or effective role in corporate governance.  In Germany, for example, Franks and Mayer (1994) found that large shareholders are associated with higher turnover of directors.  Gorton and Schmid (1996) documented that block holdings by banks improve companies’ performance.  In Japan, Kaplan and Minton (1994) found that companies with large shareholders are more likely to replace managers in response to poor performance than firms without them.

Jensen and Meckling (1976) proposed that as managerial ownership increases the owner-manager’s interest converges with shareholders.  Therefore, there is an increasing incentive for the owner-manager to maximize the value of the firms as managerial ownership increases. It may be effective to control the manager incentives by being large. In the U.S., Morck, Shleifer, and Vishny (1988) proposed a non-linear model in which increased ownership by CEO leads to entrenchment, where the manager will indulge in non-value-maximizing behavior; however it was also found that there is a non-linear relationship (inverted “U”) between management ownership and companies’ performance, as measured by their Tobin’s q[1].  Griffith,  Fogelberg and Weeks (2002) examined the relation between CEO ownership and bank performance. It has found that the relation between ownership and the performance of commercial banks is nonlinear. Additionally, in contrast to previous studies, it was found out whether or not the CEO also holds the title of chairman of the board was realized to have little impact on bank performance. It was concluded that in commercial banks, management entrenchment may offset the effects predicted by Jensen and Meckling’s (1976) convergence-of-interest hypothesis.

5. The Use of Leverage

Over borrowing may lead to financial distress and even bankruptcy. In financial stress short of bankruptcy, conflicts of interest between bondholders and stockholders may lead to poor operation of business and investment decisions. There is always a risk that a company may not be able to pay interest on loans or the loans themselves.  However, this risk helps managers lead and organize a firm more efficiently.  Adequate use of financing policy increases the firm value due to the reason of borrowing saves a firm’s money on its corporate taxes.  Debt also reduces the agency costs of free cash flow by reducing the cash flow available for spending at the discretion of managers (Jensen, 1986).  By using debt, managers bond their promise to distribute future cash flows.

Leland and Toft (1996) pointed out that the use of long-term debt financing, though generates more tax benefits, may increases the likelihood of bankruptcy and agency costs for a company.  They argued that using short-term debt reduces agency conflicts, thus reducing the associated level of risk. Stulz (1988) and Harris and Raviv (1988) examined the relationship between leverage and managerial voting right control. They suggested that management can change the fraction of the votes it controls through capital structure (leverage) changes.

6. Role of Board

In theory, the board of directors is directly elected by shareholders at the company’s annual general meeting.  Fama and Jensen (1983) suggested that effective company boards would be composed largely of outside independent directors.  They argued that effective boards have to separate the functions of decision management and decision control.  If the CEO was able to dominate the board, separation of these functions would be difficult, and shareholders would

suffer as a result.  Outside directors, they contended, are able to separate these functions and exercise sound decision control.

The role of the Board is significant in designing efficient corporate monitoring and ratification mechanisms.  With respect to reducing agency costs at the Board level, Boards of directors have three key decision rights: (1) Monitoring (2) Ratification (3)Reward and punishment rights  They may even remove top managers from their positions and sanction them for their decisions.

The monitoring role of the boards has been examined in several academic studies.  For example, the relationship between corporate performance and outside directorships was examined by Kaplan and Reishus (1990).  Brickley et al. (1994), Bryd and Hickman (1992), Cotter, Shivadasani, and Zenner (1997) studied the role of directors in takeover control of firms.  Vafeas (1999) conducted an interesting study on the frequency of board meeting and firm performance. It was documented that board meeting frequency is related to corporate governance and ownership characteristics in a manner that is consistent with the agency theory. The meeting is inversely related to firm value: boards increase their meeting in bad times. In addition, it was found that the operating performance of firms in the sample improved following years of abnormal board activity.

Recently, Denis and Sarin (1999) examined the ownership structure and board composition using a time-series analysis over a 10-year period 1983-1992. The results suggested that firms experience substantial changes in ownership and board structure. These changes are correlated with one another: changes in ownership and board structure are strongly related to top executive turnovers, prior stock price performance and corporate control threats. Ryan, Jr. and Wiggins, III (2004) adopted a bargaining framework to empirically examine the relations between director compensation and board-of-director independence. Their evidence showed that independent directors have a bargaining advantage over the CEO that results in compensation more closely aligned with shareholders’ objectives.

7. Dividend Policy

Dividend policy is important for several reasons.  First, researchers have found that a firm uses dividends as a mechanism for financial signaling to the outsiders regarding the stability and growth prospects of the firm. Second, dividends play an important role in a firm’s financial decisions.

Much can be manipulated in the assessment of companies – whether it is audited financial statements or earnings figures.  However, in the world of finance there is one “hard” number – cash dividends paid out to shareholders.  If this number is continually rising, then companies are clearly doing more for their shareholders.  Woolridge and Ghosh (1988 and 1991) suggested that firms usually do not like to reduce or eliminate dividend payments; therefore they make announcements of dividend initiation or increases to indicate good performance.  Schooley and Barney (1994) examined dividend policy and chief executive officer (CEO) stock ownership as interrelated mechanisms that may be used to reduce agency costs. Borokhovich, Brunarski, Harman, and Kehr (2005) reported new evidence on the hypothesis that dividends reduce agency costs, finding that, on average, firms with a majority of strict outside directors on their boards experience significantly lower mean abnormal returns around the announcements of sizeable dividend increases.

III Case Study Methodology

1.     Research Assumptions

Firstly, the basic assumption of this paper is based on the agency theory as mentioned in introduction section, that is: managers will not act to maximize the returns to shareholders unless appropriate governance structures are implemented to safeguard the interests of shareholders. Secondly, good CG mechanisms lead to good corporate performance.

2.     Research Method and Steps

In general, there are three different kinds of case study based on different research objectives ( Eckstein, 1992): (1) A theoretical/configurative idiographic case studies(純描述性的專題研究)– these studies have a role as good descriptions that might be used in subsequent studies for theory building, but by themselves, such case studies do not cumulate or contribute directly to theory. (2) Disciplined configurative case studies(解釋性個案研究) use established theories to explain a case. The emphasis may be on explaining a historically important case, or a study may use a case to exemplify or strengthen a theory. A disciplined configurative case can contribute to theory testing because it can “impugn established theories if the theories ought to fit it but do not,” and it can also serve heuristic purposes by highlighting the need for new theory or concept in neglected areas. (3) Heuristic purposes case studies(啟發性個案研究) inductively identify new variables, hypotheses, causal mechanisms, and causal paths. “Deviant” or “outlier” cases may be particularly useful for heuristic purposes, as by definition their outcomes are not what traditional theories expect them to be.

The disciplined configurative case study is applied as the research method of this paper.  This particular case study method analyzes special cases considering agency theory and concept of CG, which has comparative merit than traditional configurative idiographic study.  Many well-known case study researchers such as Stake (1995) and Yin (1993, 1994) have written about case study. According to their suggestions, there are four steps for organizing and conducting this research as following:

(1) Determine the research questions

This research basically aims to answer two questions: (a) “Do we have good CG in Taiwan that is consistent with the current trend of CG than before? (b) Is there a typical example or case in Taiwan that may be represented to prove the agency theory or the concept that good CG leads to good corporate performance?

(2) Select the cases and determine data gathering and analysis techniques

     A good example that shows good CG should be supported by its sound CG environment. Therefore firstly I analyze and evaluate the CG in Taiwan as a case study in a specified country. Then I choose the case of TSMC which is unique and typical in some way to represent the good example inside a country.

A key strength of the case study method involves using multiple sources and techniques in the data gathering process. Data gathered is largely qualitative, but also some quantitative including documents of facts or evidences and statistical data. Techniques involve comprehensive analysis and comparing the data from multiple sources.

(3) Collect data in the field

     Exemplary case studies use databases to categorize and reference data so that it is readily available for subsequent reinterpretation. For instance, I have collected “Cash dividends payout analysis of Taiwanese listed companies for Past 10 years”; “Shareholding Ratio of Directors & Supervisors of TSE Listed Firms” in three different years to illustrate the trend of becoming more de-centralized ownership structure of Taiwan’s listed companies.

(4)   Evaluate and analyze the data

     There is a trait in this research that using the quantitative data that has been collected to corroborate and support the qualitative data for understanding the rationale or theory underlying relationships (i.e. the TSMC case study in next section).  Another technique, the cross-case search for patterns, is also applied such as “Cash dividends payout analysis of Taiwanese listed companies” and “Free Cash flow Analysis of Taiwan Top 50 Non-Financial Listed Companies”.  In addition, a comparative analysis between the financial figure and ratios of TSMC and those of the average of all electronic listed firms is illustrated in the next section.


IV Trends and Development of CG in Taiwan

1. Overview

In Taiwan, the basic CG organizational model is a two-tier structure that consists of a Board of Directors and Supervisors, both of whom are elected by shareholders. Generally, the Board of Directors is responsible for ensuring compliance with laws and regulations, avoiding conflicts of interest and for overall management of a company’s business. Supervisors are responsible for the effective monitoring of a company’s board and management, and generally function in a capacity equivalent to the Audit Committee in the U.S.

The legal basis of CG in Taiwan primarily arises from the application of the Company Law, Securities and Exchange Law and their related rules and regulations. The Securities and Exchange Law enhances the regulation of disclosure and transparency toward listed companies. The Company Law particularly binds rules to protect present and future shareholders and creditors.

Under the Corporate Law and Securities and Exchange Law in Taiwan, companies are not currently required to have Audit and Compensation committees as they are required in the U. S.  Listed company has been required to elect at least two independent directors for listing in Taiwan Stock Exchange (TSE) or computerized over-the-counter market (known as GreTai Securities Market, GTSM).  However, there is no clear definition in TSE/GTSM Listing Rules for “independence”. It only regulates the situations of constituting lack of independence.  In February 2002, the company applying for listing should have at least one independent supervisor.  In addition, at least one of the elected independent supervisors should be a professional in accounting or finance.  Before the 2001 amendment to the Company Law, supervisor was elected from the shareholders.  The amendment in 2001 has abolished the limitation.

Most companies in Taiwan used to be closely related to family conglomerates. More than 80% of Taiwanese companies are small and medium-sized enterprises (SMEs). The shares of these companies are concentrated in the hands of a few shareholders. Therefore, the power to run these firms belongs to the founders or controlling owners.  Most other shareholders do not have substantial influence in the operations of these firms.  This is totally different from the market-based system of corporate governance in which board of directors (or supervisory board) represents a greatly dispersed group of shareholders like U.S. and U.K. systems, which are good examples of this system of corporate governance.

Most of Taiwan’s banks are also lack of the principles of CG. State-owned banks are managed by those who are selected by political connection rather than by professional or independent consideration.  On the other side, private banks are mostly owned by family business groups that dominate the ownership and management.  Under these circumstances, the rights of minority shareholders at most private banks are totally ignored.

Till recently, Taiwan’s companies and banks have started to learn the concept of CG.  There used to be no clear distinctions among management, the board of directors and the board of supervisors. In most firms, board members are also managers or closely related to management. Virtually most businesses are governed by a small group of controlling owners, which may include the founder, and such businesses still can grow to substantial size.  The ownership of most companies is heavily concentrated.  There are no “real” independent directors.  Managers of companies can easily borrow funds from banks because board of directors does not scrutinize the actions of management. Thus, there is a greater likelihood of these companies getting into trouble or financial distress.

The Asian financial crises provide lessons for Taiwan to esteem the importance of CG.  Knowing that inadequate CG is the key factor that Asian corporations could not compete with the corporations in global financial markets, Taiwan securities regulator (Financial Supervisory Commission, or FSC) has tried its best to advocate CG to publicly held companies since 1998.  Securities and Futures Institute (SFI, 證券基金會), founded as a quasi-public organization for research, training and protecting investors, together with Taiwan Stock Exchange, over-the-counter market, and Corporate Governance Association(CGA), introduced the system of independent directors and independent supervisors.  They also have established and promoted “Corporate Governance Code” in Taiwan.  In the future, all mentioned organizations will continue to make efforts in helping corporations by adopting best practice as to keep up with the current trends.

Since SMEs are the major corporation style in Taiwan, the board members in SMEs tend to be family-related, which means most companies in Taiwan do not have significant numbers of outside influential shareholders. Even when the company is growing bigger and goes public, family-control is still a dominant characteristic in many large corporations.  Mostly, the shareholding of listed companies is still under control of the family-related board members or a small group of controlling owners. The major problem is that companies, dominated by one family, tend to grant the right of governance over the company for the benefits of their own interests and neglecting the benefits of minority shareholders.

As the transformation from traditional labor-intensive industries to high-tech companies since early 1980s, Taiwan has revealed a highly demand for separation of ownership and control. High-tech companies need to share ownership with scientists, engineers and managers so as to stay competitive.  At present Taiwan stock market, electronics and high-tech companies represent one-third to half of the trading or market capitalization. Table 1 shows the trend of becoming more de-centralized ownership structure of Taiwan’s listed companies. Director and Supervisor’s shareholding which is less than 10% has increased a lot from 2.68in 1985 to 18.28in 1999 and 15.67in 2003; while the shareholding of them between 50% to 60% has decreased from 10.71in 1985 to only 3.08in 1999 and 3.29in 2003.


Source: Corporate Governance, Securities & Futures Institute(證券基金會)

On July 2002, Congress had promulgated “Securities Investor and Futures Trader Protection Act”, and was effective since January 1, 2003.  According to the Act, the authority established “Securities and Futures Investors Protection Center” and protection foundation to provide complaint filing, mediation, class-action lawsuit, and arbitration services for investors.

Recently, there has been an significant improvement in the overall regulatory structure in Taiwan: the government has created a new regulatory body in Taiwan and began operating on July 1, 2004 –Financial Supervisory Board, Executive Yuan” ( FSB or Authority 行政院金融監督管理委員會,金管會)[1]– which

incorporates the Securities and Futures Commission, the Bureau of Monetary Affairs (財政部金融局) and the regulatory functions of the Central Bank (央行).  The head (chairman) of the FSB reports directly to the Premier and has been given the authority of both policy-making and execution. However, when there is a disagreement on financial policy and taxation (fiscal) policy, a conflict between the finance minister and the supervisory board chairman may likely to occur.  Such a design may result in administrative enforcement which is still slow and inefficient.

In order to reform Taiwan’s CG system through integrated planning and gradual movement, the SFC (which has become Securities and Futures Bureau, SFB,[1] 證券期貨局since July 1, 2004) has launched “The Project for Planning, Promotion, and Implementation of Corporate Governance System in Taiwan” In July 2003.  “The Group for Implementing Corporate Governance”, comprising of representatives from Taiwan Securities Exchange Corporation (TSEC), GreTai Securities Market (GTSM), Securities & Futures Institute (SFI), other competent authorities, industries concerned, and the academic institutions, were organized to meet on a monthly basis to propose various plans aiming at establishing a corporate governance system consistent with the international trends and unique domestic needs.

Before SFI established an “Information Transparency and Disclosure Rankings System (ITDRS)” in 2003, Taiwan have not identified evaluation criteria of corporate information transparency and disclosure, like the information transparency measurement model of Standard & Poors’ 2002.  The “ITDRS” was designed to evaluate the level of transparency for all listed companies in Taiwan since 2003.  For the second time, the 2004 full-year ranking results were released on May 17, 2005.[2]  The IDTRS gauged the level of corporate transparency by searching annual report, regulatory filling via inter net, and company websites. In order to access the transparency and disclosure practices of listed companies, IDTRS identified 88 disclosure items as evaluation criteria grouped into the following five categories:


  • Compliance with the mandatory disclosures
  • Timeliness of reporting
  • Disclosure of annual report
  • Disclosure of Financial forecast
  • Corporate website disclosure
A similar conclusion can be reached for overall CG in Taiwan – there has been certain progress so far but it is still not extensive and can be stretched into the distance.  However, there indeed has been a significant improvement in dividend payout ratio over the latest five years. Table 2 shows data for all listed companies on the TSE for the year of 1995 to 2004.  For all listed companies, total cash dividends to be paid in year 2004 will be US$12.54bn, up 59% from US$7.88bn in 2003, which was up 52% from US$5.19bn in 2002.  Cash dividends are best assessed as a percentage of the profits of profit making companies (loss makers do not pay dividends) and we can see that this number has risen from a low of 6.8% in 1997 to 45% for accounting year 2003 (paid in 2004).  It also can be seen clearly from the table that the cash dividend payout ratio in Taiwan has a continuously tremendous increase from 22.4% in 2000, 34.3 (2001), 42.0 (2002) to 45% in 2003. Taiwanese companies are apparently doing more for their shareholders.
Taiwanese companies pay bonuses to staffs in the form of both cash and shares which are expensed in the reserves rather than the profit and loss statement.  In terms of market value over 95% of bonuses are in the form of shares.  In the table above we can see that the market value of employee bonus shares (Market value stock) has been in decline: from a high of US$4.16bn in 1999, the absolute number has nearly fallen by half compared with firms proposing to give theiremployees bonus shares with a current market value of US$2.61bn in 2004.  These figures show evidence of improvement in companies’ dividend policy when assessing corporate governance in Taiwan.  This also implies that free cash flow has improved and overinvestment by top managers become much less of a problem than before.
Table 3 shows data for the 50 largest non-financial companies listed in Taiwan as of the end of each calendar year for 1994 to 2003.  The group of companies changes each year but is highly representative of the index.  The ratios derived from this data show the transformation in the market’s financial performance over that period.  The most important change is in the ratio of free cash flow to profit over the period of this economic recovery.  Previously Taiwanese companies would reinvest all their cash flow back into the business.  However, the period from 2001 to 2003 shows a dramatic improvement in free cash flow.  The ratios for capital expenditure/ depreciation and capital expenditure /fixed assets show the 1995 to 2000 period to be one of overinvestment while 2001 to 2003 look much better.
2. The Case of Taiwan Semiconductor Manufacturing Company (TSMC)

As stated above, firms even with overwhelming market capitalization may be controlled by a small group of owners.  Since large institutional investors distrust controlling owners, many firms pay a premium for the capital they raise in public and, therefore, failing to reach their full potential, – to become large scale or size because of their poor governance structure. The following is a case of excellent CG, which attracts many institutional investors to make investments.

Taiwan Semiconductor Manufacturing Company (TSMC, 台積電), the world’s largest contract chipmaker, is also the number one technology company in Taiwan with a global leading position in its sector. It also has a record of strong revenue and earnings growth over the cycle and usually received the highest CG score in the tech sector by many institutions including Standard & Poors.  TSMC has developed a CG practice that involves six major components: Integrity, Board Independence, Shareholder Value, Structure Simplicity/Financial Transparency, Low Financial Leverage and Dividend Policy.


(1)   Integrity: The number one rule in TSMC’s employee code of conduct, it is also the basis for all their relationships, including those with customers, vendors, shareholders, employees, and TSMC’s relationship with society as a whole.  The Chairman – Dr. Morris Chang has pointed out “Good ethics leads to good business”. Integrity is especially critical in customer relationships, as customers entrust TSMC with design secrets. TSMC must be made accountable for confidentiality in the face of today’s competitive market.  Additionally, a high standard of integrity also applies to the company’s relationship with shareholders, and that is evidenced by Asia Money Magazine voting TSMC as the best company in Taiwan for the treatment of minority shareholders.

(2) Board Independence: TSMC’s Board of Directors consists of nine members. Their careers span a wide range of technology, businesses and management experience. Three of the nine board members are independent directors. The TSMC’s board members are independent from the management. TSMC’s management is legally responsible for, among other things, day-to-day business operations, preparing of financial statements, fund raising, and investments. The activities of the Board do not supersede or alter those responsibilities. The Board’s primary duty is to fulfill its oversight responsibilities for the overall business affairs of TSMC. The Board monitors regulatory activities, such as amendments to Taiwan’s laws, amendments to the U.S. SEC Rules and Regulations, and changes to the Taiwan Stock Exchange and New York Stock Exchange listing requirements.

TSMC’s Board of Directors established an Audit Committee in 2002 and a Compensation Committee in 2003. The Audit Committee assists the Board in fulfilling its financial oversight responsibilities, which include reviewing the Company’s financial reports, the Company’s auditing and accounting policies and procedures, and the Company’s systems of internal control. TSMC’s Audit Committee is empowered by its Charter to conduct any study or investigation it deems appropriate to discharge its responsibilities. It has direct access to TSMC’s internal auditors, the Company’s outside independent auditors, and any employees of the Company.  On the other hand, the Compensation Committee assists the Board in discharging its responsibilities related to compensation and benefit policies, and TSMC’s compensation plans and programs. It also evaluates the compensation of TSMC’s executives, directors and supervisors.[1]

(3) Shareholder Value: TSMC has not grown into a conglomerate that engages in cross-financial dealings but has chosen to remain as one company.  Consequently, all profits the company generates go directly to the shareholders.  There is no preferential treatment between shareholders and no single shareholder benefits more than others from any of the company’s operations.

(4) Financial Transparency: Structure simplicity helps TSMC achieve financial transparency. TSMC was the first company in Taiwan to release their company earnings on a quarterly basis and the first Taiwanese company to list on the New York Stock Exchange (NYSE).  Due to their listing on the NYSE, TSMC reports their financial results under both Republic of China (ROC) GAAP and US GAAP. The company reports their financials to all relevant regulatory agencies in Taiwan and in the U.S.  They will incorporate both sets of financial results in the publication of their annual report.

(5) Low Financial Leverage: TSMC maintains a very low financial leverage profile. They maintain a strong balance sheet and keep high cash reserve, and this helps preserve shareholders wealth by reducing share price volatility.  Table 3 and 4 shows some of the significant financial figures and ratios of TSMC and the average of all electronic listed firms for the past 10 years respectively.  As is seen in Table 4, leverage (debt/assets) ratio dropped from over 30% in the former years to less than 20% in the latest years.  Extremely higher cash flow ratios (cash flows from operation activities/ current liabilities) of TSMC for the past ten years are also indicated in comparison with those of the average of all electronic listed firms in Table 5.

Table 5 Financial Figures and Ratios of Electronic Listed Firms Average

– Past 10 years


Source: Taiwan Economic Journal (TEJ) Data Bank

Good CG increases shareowner returns significantly. The evidences from Table 3 show that TSMC has continuous higher corporate equity returns (ROE) and higher earnings (EPS), in contrast with the ratios of the average of all electronic listed firms. In addition, better CG is supposed to lead to better corporate performance by preventing the expropriation of controlling shareholders and ensuring better operational efficiency.  Table 4 shows the evidence that of TSMC has kept higher ROA for the past 10 years, comparing with the data of the average of all electronic listed firms, especially in the year of 2004: ROA of TSMC reached to 21.16%, at the same time the average ROA of all electronic listed firms was only 8.8%.

In expectation of such improvements, the stock price of TSMC is supposed to respond instantaneously to the news indicating better CG..  Therefore TSMC is supposed to have high price to earnings (P/E) and price to book (P/B) ratios and ought to consistently outperform their number one competitor and other Taiwan high-tech blue chip companies.  It shows the evidences from Table 3 that generally TSMC has higher P/E and P/B ratios, comparing with the average of those ratios of the average of all electronic listed firms for the past ten years.

As a result of these and other practices, TSMC was recognized by Finance Asia and The Asset Magazine in 2003 as having the best CG of all Taiwan Corporations. The company was also recommended by Asia Money Magazine for having the best CG of all semiconductor companies in Asia. Corporate Governance Association in Taiwan (TCGA) has evaluated TSMC as an excellent example of CG of all Taiwanese listed companies.


(6) Dividend Policy Change

On Dec. 21, 2004, TSMC passed a major change in its dividend policy amid efforts by the nation’s financial regulator to improve dividend distribution practices. Distribution of profits is now made preferably by way of cash dividends. Under new policy, the ratio for stock dividends should not exceed 50% of the total distribution. It is a current trend for all electronic companies that distributing more cash instead of stock dividend from profit than before.  In the past, profit distribution was generally accomplished by the way of stock dividend. This is because Taiwan’s electronics manufacturers, chipmakers in particular, have tended to give stock dividends to engineers as incentives to secure top talent. As a result, the total number of shares of local high-tech companies could balloon by up to about 5 percent annually due to hefty stock dividends to shareholders and employees. The expansion has resulted in a serious erosion of shareholders’ earnings.  The new policy of TSMC was designed to prevent the company’s total number of shares issued from swelling too fast.


V Conclusion and Recommendations

In 1999, the Organization for Economic Cooperation and Development (“OECD”) put forward the Principles of Corporate Governance which have become the basis of corporate governance reform for every country.  The principles of corporate governance focused on (1) the right of shareholders, (2) the equitable treatment of shareholders, (3) the role of shareholders, (4) disclosure and transparency, and (5) the responsibilities of the board of directors[1]. Accordingly to these five principles, there are some applicable methods or procedures to present for improving CG in Taiwan:

  • Shareholders’ Rights

The most important legal right shareholders have is the right to vote and elect the boards. The typical framework of CG views shareholders as principal; and the objective of the management of a corporation is to maximize the interests of the shareholders. Even though shareholders entrust the board of directors to guide and monitor the management, they have to be given rights and opportunities to participate directly in monitoring their firms. Their basic rights should include obtaining relevant company information on a timely and regular basis, participating in and voting at general shareholders’ meetings, and electing board members. The management of a company has the obligations to the shareholders such as compliance with the mandatory disclosure requirements, disclosure of annual report and financial forecast and “website” disclosure.

  • Equitable Treatment of Shareholders and the Role of Shareholders

In family or major shareholders-controlled enterprises, corporate management tends to consist of controlling owners or people related to them, who might try to maximize their own interests, often at the expense of minority shareholders. Nevertheless, because of the free-rider problem, minority shareholders have little incentive to monitor their firms, thus making them all the more vulnerable to expropriation by the controlling owners. Therefore, providing minority shareholders with effective mechanisms to protect their interests from abuses is important. Companies with large shareholders or de-centralization of ownership structure may solve this problem, since shareholders have been given the same right to obtain relevant company information, to participate in and vote at general shareholders’ meetings and elect board members. Even if shareholders cannot physically attend the meetings, they should be able to participate in decision-making through such means as designating proxies or voting by mail. Institutional investors and minority shareholder protection groups should be allowed to play an active role in the voting process.

  • Disclosure of Information and Transparency

CG structures should ensure that minority shareholders receive “transparent” and reliable information about the value of the company; and that the company’s managers and large shareholders do not cheat them out of the value of their investments. Developing and maintaining a sophisticated financial disclosure to keep up with the international standards is necessary; and to boost confidence of investors as well as further increase attractiveness to invite foreign direct investments.

Transparent disclosure requires the provision of “material” information.  It is information the omission or misstatement of which could influence the economic decisions made by the users of information. Applying the concept of materiality in developing disclosure requirements helps companies and regulators to decide what information is truly relevant.  There are some disclosure shortcomings should be avoided: (1) insufficient disclosure of related-party transactions; (2) hiding of large enterprise debts through related-party transactions and off-balance sheet financing, such as cross-guarantees within corporate groups; (3) insufficient reporting of contingent liabilities, particularly loan guarantees granted to related and unrelated parties; (4) insufficient segment information that would have revealed the risks related to specific sectors such as real estate. Additionally, regulators, chambers of commerce, business groups, institutes of directors, and self-regulatory, academic and professional organizations must take part in this effort to raise the awareness of shareholders’ and the public’s right to corporate transparency.

Additionally, the highest priority for the SFB in Taiwan should be able to establish a healthy and comprehensive internal control system, with effective mechanisms to control and maintain the “integrity” of the companies.  Forensic accounting has been only a concept and still not prevailing in today’s society in Taiwan. Publicly held companies should consider the necessity for forensic accounting as a part of a strong internal control effort to comply with governmental and market demands for accurate reporting. Opportunities should be open for qualified forensic accounting professionals in public or private companies to help prevent and detect misuse of company resources.

  • Responsibilities of the Board of Directors

Establishing a sound and effective Board of Directors is the hub of successful CG. Firstly, board size and composition are important determinants of board effectiveness. The size should be large enough to secure sufficient expertise on the board, but not too large to have productive discussions or for free-riding among directors to be prevalent.  A board should have a mix of inside/executive and outside/independent directors with a variety of experience and core competence if it is to be effective in judging the management’s performance objectively.  The Company Law has been revised in Taiwan, but it has not completely addressed the issue of an outside board of directors or an independent board of directors.

Secondly, Board members should be independent from the management.  The Board’s compensation should remain tied to the company’s performance.  Major shareholders should have limited power at the board level and enjoy no special privileges.  As the case of ENRON clearly demonstrates, a board of independent directors does not guarantee of good corporate performance. However, large institutional investors still prefer to invest in companies like TSMC which is controlled by highly professional independent directors.  The evidence of TSMC indicates that good governance leads to little expropriation of corporate resources by managers or controlling shareholders, which fact contributes to better allocation of resources and better corporate performance. As investors and lenders will be more willing to put their money in firms with good governance, they will face lower costs of capital, another source of better firm performance. Other stakeholders, including employees and suppliers, will also want to be associated with and enter into business relationships with such firms, as the relationships are likely to be more prosperous, fairer, and longer lasting than those with firms with less effective governance.

Furthermore, boards must have regular meetings without top managers present; and all executive stock option plans must be approved by shareholders. Other priorities include selecting more better qualified, truly independent directors, carrying out formal evaluations of the board and directors, providing education to directors; and adopting codes of conduct for directors.

Whether the founder, the majority shareholder, or the manager, their common objective is to maximize the company’s profits and welfare.  Maintaining a respectable company image and ensuring the valuation of the shares are of same importance to a company. This is another dimension to explain the demand of complete and sound CG, especially when a company seeks outside investment.  Regardless of where a company raises its capital, whether through the capital markets or a specific institutional investor, the company must pay attention to the investors’ standard of sound CG.  A company must prove that it is managed by the investors’ standards before being granted capital.

Finally, CG has become much more important in today’s competitive environment.  If we look from the implications of CG towards the economy as a whole, are also obvious.  Economic growth will be more sustainable, because the economy is less vulnerable to a systemic risk.  With better protection of investors at the firm level, the capital market will also be boosted and become more developed, which is essential for sustained economic growth. At the same time, good corporate governance is critical for building a just and corruption-free society.  Less expropriation of controlled shareholders and fewer corruptive links between big businesses and political power may result in a more favorable business environment for smaller enterprises and more equitable income distribution.  It is the responsibility of the government to keep abreast of international trends, setting up clear-cut CG rules and regulations that should be made mandatory for listed joint stock companies.  Furthermore, compliance with these rules of CG and their proper implementation need to be strictly enforced.



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