THE EFFECTS OF ECONOMIC AND POLITICAL SHOCKS ON CORPORATE GOVERNANCE SYSTEMS IN CHILE

THE EFFECTS OF ECONOMIC AND POLITICAL SHOCKS 183Revista ABANTE, Vol. 2, Nº 2, pp. 183-206 (octubre/abril 2000)

THE EFFECTS OF ECONOMIC AND POLITICAL SHOCKSON CORPORATE GOVERNANCE SYSTEMS IN CHILE

FERNANDO LEFORT*EDUARDO WALKER*

ABSTRACT

We present a synthesis of the major political and economic events thathave influenced the development of laws and capital markets in Chile,and their impact on the evolution of Chilean conglomerates throughtime. We find that laws and regulations in Chile have been extremely«path dependent», corresponding in most cases to reactions to crises ormajor events, and argue that these events have persistently shapedcorporate governance systems in Chile. We identify the episodes offinancial repression and credit rationing, the privatization rounds, thedebt crisis of the eighties and the pension fund reform, as the mostimportant events conditioning the development of corporate governancesystems in Chile. Since most of these phenomena have also occurred inother countries in the region, this study provides some lessons of gene-ral interest.

Key words: Shocks, Regulation, Corporate Governance, EmergingMarkets, ChileJEL Classification: G38, N26

RESUMEN

Este artículo presenta una síntesis de los principales eventos políticos yeconómicos que han influido en el desarrollo del mercado de capitaleschileno y en su legislación, y que han afectado el la evolución de losgrupos económicos chilenos. Se encuentra que las leyes y regulacionesen Chile dependen fuertemente de la historia. Generalmente han apa-recido en reacción a crisis y otros eventos. Estos sucesos han determi-nado en gran parte el sistema de gobierno corporativo actual en Chile.Se identifica como principales hechos a la represión financiera, lasprivatizaciones, la crisis de la deuda y la reforma al sistema de pensio-nes. Como la mayoría de estos fenómenos son comunes para muchospaíses de la región, este estudio provee de algunas lecciones generales.

* Escuela de Administración, Pontificia Universidad Católica de Chile

184 REVISTA ABANTE, VOL. 2, Nº 2

In this paper, we present a synthesis of the major political and economicevents that have influenced the development of laws and capital marketsin Chile, and their impact on the evolution of Chilean conglomeratesthrough time. We show that ownership concentration and the fear to ithave always existed in Chile, even though there has been significant groupmobility.

The fact that groups, regulations and institutions last much longer thanthe events that motivated them in the first place may cast doubts on thehypothesis that corporate governance mechanisms around the world con-verge toward a certain optimum.1 Accordingly, we discuss salient aspectsof Chilean capital markets and laws, and find that laws and regulations inChile have been extremely "path dependent", corresponding in most casesto reactions to crises or major events. We therefore argue that these eventshave persistently shaped corporate governance systems in Chile.

A few major events can be highlighted. First, financial repression andcredit rationing made convenient to organize bank-based groups until midseventies. Second, a first round of privatization at relatively attractiveprices, in the context of a recently liberalized economy, a naive legalenvironment and primitive capital markets, gave incentives to the creationof significantly indebted groups. Third, the 1982 debt crisis meant theend of several bank-based conglomerates, and triggered the implementationof strict bank regulations. Among other things, banks were no longerallowed to invest in equity, tough restrictions applied to related party loans,and cross-holdings were forbidden. As a consequence, banks could nolonger be at the core of groups. Fourth, the second privatization roundinduced some degree of development of equity markets, fueled by localpension funds and foreign investment funds. In addition, the accumulationof significant pension funds has meant that authorities have frequentlyhad to modernize the existing regulations and institutions, trying to improveminority shareholder protection among other issues. The second round ofprivatization also produced a significant boost to the upsurge of new andmore active groups.

During the last 15 years, capital markets have boomed in Chile inresponse to the natural process of capital accumulation experienced by theChilean economy as a consequence of privatization, the implementation

1 See Johnson and Shleifer (1999) for a discussion on the Coasian view of corporate governance.

THE EFFECTS OF ECONOMIC AND POLITICAL SHOCKS 185

of structural reforms, and the decrease of discount rates.2 The process ofcapital market development was, of course, shaped by major economicand political events. In this paper we also present a description of thedevelopment of the banking sector and capital market, and its relationshipto events and new regulations.

Our revision of the historical evidence regarding corporate governancestructures and their evolution over time for the particular case of Chileprovides some lessons for other countries in the region. Since many ofthe developments considered have also occurred in other countries, someof the conclusions may not only be applicable to Chile. For example,financial repression and credit rationing; the privatization rounds; the deepeffects of the debt crisis in the 1980s; and the accumulation of significantpension funds, are all elements that one way or another are present inmost Latin American countries.

II. IMPORTANT EVENTS AND THE EVOLUTION OF GROUPS

History matters. Important economic and political events shape busi-ness practices, corporate structure, and capital market laws and regulations.The recent economic and political history of Chile has almost certainlyaffected the ways in which corporate governance is exercised. This sectionof the paper intends to provide a brief description of the most significantevents associated to major changes in economic policy that might havehad some effect on corporate governance practices in Chile.

The section also describes the evolution of a particular form of busi-ness unit: the “economic group”. For more than 40 years, economic groupshave been a characteristic form of business organization in Chile. OurSecurities Law defines what an economic group is and tries to rule theirbusiness practices. Here we provide a succinct description of the evolutionof this form of business organization, because economic groups exercisecontrol over a large fraction of Chilean corporations.3

2 See Superintendencia de Valores y Seguros (1996) and Eyzaguirre and Lefort (1999).3 See Lefort and Walker (2000).


A. Local events that have shaped Corporate Governance in Chile

It is important to analyze the extent to which specific Corporate Gov-ernance arrangements have appeared as a consequence of a country’s eco-nomic history. The fact that these institutions last much longer than theevents that motivated them in the first place may cast doubts on the hy-pothesis that corporate governance mechanisms around the world convergetoward a certain optimum. In this sense, if a certain kind of “crisis” hasnever taken place in a given country, some institutions, laws or arrange-ments are likely to never exist.

Some of the events that presumably have had a significant impact onthe way that corporate governance has evolved in Chile during the lastfifty years follow in chronological order.

A.1. Financial Repression (1940-1973)

Valdés (1988, 1992) identifies the period 1940-1970 as one of increas-ing financial repression. It is also recognized, as one in which there is asecular trend towards a centrally planned, state-based economic system.Indeed, during this period a multiplicity of restrictions was common.

For example, until 1958 there were quantitative and qualitative restric-tions to the uses of bank credit as well as ceilings on the nominal interestrate that could be charged. In this period, inflation rates were very highand volatile, and real interest rates negative, naturally leading to creditrationing.4 Direct access to bond markets by firms did not seem possibleeither, partly because of the upper limits on interest rates and the prohi-bition of indexation that existed until 1958. Instead, large and well con-nected firms had access to cheap financing by related banks. Finally, hightaxes on dividends (in addition to other major problems) made equity in-vestment unattractive.

During the late 50s and early 60s indexation was allowed. However,ceilings on nominal interest rates were kept. In parallel to the bankingsystem, a heavily regulated national system of savings and loans (SINAP)was created, allowing an expansion of the capital market at some extent.However, the SINAP was mainly oriented to provide funds to individualsand housing.4 The annual inflation rates ranged between 20 and 80 percent during that period.


Chilean capital markets were further repressed during the socialist pe-riod (1970-73).5 In the first three months of the new government 50 percent of the banking system was nationalized. While in 1970 the Statecontrolled 26 firms, as of September 1973 this figure reached 517 (Hachetteand Lüders, 1992). GDP per capita grew 7 per cent in 1971 due to asignificant fiscal expansion, but in the following two years it fell a cumu-lative 10 per cent.6 In summary, because of redirection of bank credittoward arbitrary targets, across-the-board price controls and unclear prop-erty rights, the capital market nearly disappeared except for the SINAPand direct credit by government institutions.

For many years high inflation levels, capital controls, selective creditand indexation benefits, high taxes and ceilings on nominal and interestrates altogether implied a financially repressed and almost non-existentcapital market in Chile. In this context, the problem of corporate gover-nance as defined by Shleifer and Vishny (1997) simply did not exist,because there were hardly any external providers of funds to firms.

A.2. The initial experiences with privatization and liberalization of con-trols (1973-1981)

This period can be broadly interpreted as a reaction to the socialistexperience of 1970-1973. In 1975 GDP per capita fell near 15 per cent.The recession of 1972-75 was the second deepest in the history of Chile,after the great depression (Díaz et al., 1998): GDP per capital fell bymore than 20 per cent. Later, from 1976 until 1981, the economy grewsteadily, mainly fueled by foreign capital flows, mostly in the form ofdebt. During this period, previously nationalized firms were privatized,and most of them returned to their original owners (this became known asthe “first round” of privatization). A relatively small number of conglom-erates quickly grew, organizing themselves around the recently privatizedbanks.

Regarding capital markets, the reforms for this period included (seeValdés, 1988):

5 See Valdés (1992) and Larraín and Meller (1990).6 See Díaz, Lüders and Wagner (1998).


− Market forces could freely determine interest rates.− Administrative controls to credit would be abandoned and reserve

requirements for banks reduced.− Indexation could be used in all kinds of financial instruments.− A tax reform would be implemented such that taxes would be paid

only on “real” gains.− Long-term loans could be contracted for any purposes (not just hous-

ing).− The economic authorities would not judge the risk of financial secu-

rities but would increase the information requirements for issuing them.

These reforms were implemented before 1981. Some of the major eventsthat can be identified follow.

In 1975, a state agency began the successful privatization process ofbanks. In most cases, a fraction of total shares large enough to allowcontrol was auctioned. However, there were tight limits on ownershipconcentration. Despite these restrictions, some economic groups managedto by-pass these limits obtaining control of banks. Finally, in 1978 therequirement regarding ownership dispersion was abandoned.

Also in 1975, the SINAP went bankrupt. Among the reasons for thisbankruptcy we highlight that reserve requirements had been significantlyreduced, and at the same time, a significant mismatching between assetsand liabilities had been allowed: while loans were long-term, deposits wereshort-term. A rise in interest rates and a shortage of funds triggered bank-ruptcy. During the period 1975-1977 several other financial institutions,including a bank, cooperatives and informal credit unions, also becamebankrupt. However, there were no additional bankruptcy cases until 1980.

Several legal reforms were implemented as a consequence of the ob-served bankruptcies:

i. Regarding banking regulation the following amendments were intro-duced:

− New attributions were given to the superintendence of banks, in-cluding the discretion to write-off certain loans.

− Fraud was better typified, giving explicit legal responsibilities tobank managers.


− Higher fines were imposed on banks that violated the requireddebt-equity ratio.

− Limits to related lending were established.7

ii. New pension fund, securities, insurance and corporation laws wereimplemented in 1980-1981.8 In broad terms, these are the laws cur-rently in place. Among other things, these new regulations included:− Cross-holdings were forbidden, and a mandatory requirement to

inform the public of any “related party” transactions was put inplace. This requirement allowed a better understanding of the com-plicated group relationships.9

− A public record of issuers of commercial paper became manda-tory, with certain minimum equity and information disclosure re-quirements.

− Security issuers were required to present their financial statementsin standardized formats (FECU) in a relatively detailed way.

This period ended with the intervention of eight financial institutionsby the Superintendence. The arguments given for such intervention in-cluded “mismanagement”, fraud and excessive loans to related parties.

A.3. The debt crisis (1982-1983)

The debt crisis of (1982-1983) was the fourth largest recession ofChilean economic history.10 GDP per capita fell 19 percent and unem-ployment reached 22 percent in 1983. This recession is usually attributedto excessive foreign indebtedness,11 in the context of an extremely over-valued currency (due to a pegged exchange rate) and high internationalinterest rates, and was triggered when the debt crises of Mexico, Braziland Argentina implied a sudden halt in foreign capital flows into Chile.7 For example, Valdés (1988) reports that in the Banco de Santiago case, the third largest, 45%

of loans were made to related parties.8 For a different version of the “convergence hypothesis” for corporate governance, it is important

to keep in mind that the IFC of the World Bank helped in the process of creating these newlaws.

9 See section Lefort and Walker (1999b).10 According to Díaz et al. (1998).11 Indeed, foreign debt increased from US$9.4 billion in 1980 to US$14.8 billion in 1983 and

US$17.7 billion in 1984.


In January 1983, the authorities intervened eight banks. Three of themwere liquidated right away. Given the high debt levels of productive firms,12

intervention of banks implied that most of them fell in the hands of thestate. That same year a new bankruptcy law was passed. Its main objec-tive was to privatize bankruptcy costs.

A.4. The 1984-1998 period

This period is one of steady and very significant economic growth,during which per capita GDP more than doubled.

In 1985 the government engaged in debt-equity swaps in order to re-duce foreign debt. At the same time, in the second round of privatizationbanks and productive firms were re-privatized through cheap loans givento individuals in order to purchase these stocks. Tax incentives were alsoprovided. From 1985 on pension funds were allowed to invest in stocks.All this generated a relatively wide base of small investors in the priva-tized firms, including foreign investment funds, individuals and local pen-sion funds.

The principal legal reforms of this period are:− A new tax law, in 1984, which at the margin provides incentives to

the use of equity.13

− Also in 1984, a mandatory risk-rating requirement for firms that getinvestments from pension funds.

− In 1986, a new bank law required significant diversification and closerasset-liability matching. It does not allow banks to be the “core” ofgroups, since they cannot hold equity permanently.

− In 1994 took place a significant “Capital Market Reform”,14 whoseprincipal objective was to give investment flexibility to the significantresources accumulated by pension funds and life insurance compa-nies.

12 See Hernández and Walker (1993).13 See Hernández and Walker op.cit.14 The IFC of the World Bank also had some participation in the discussion of these laws.


A.5. Summary

There have been a few major events that have necessarily shaped theway that Chilean conglomerates have evolved through time. These eventsare, successively:

a) Financial repression and credit rationing until 1973, which made itconvenient to organize bank-based groups.

b) In the mid-seventies, the first round of privatization at relatively at-tractive prices, in the context of a recently liberalized economy, anaive legal environment and primitive capital markets. This gave in-centives to the creation of significantly indebted groups.

c) The 1982 crisis is perhaps one of the most important determinants ofthe way in which Chilean corporations are currently organized. Onthe one hand, the crisis meant the end of several bank-based conglom-erates. On the other hand, several important regulations were set inplace as a consequence of the crisis. For example, banks were nolonger allowed to invest in equity and thus could not be at the core ofgroups. Bank loans had to be diversified and additional restrictionsapplied to related party loans. In all the relevant laws, related-partytransactions had to be informed and cross-holdings were forbidden.

d) The 1984 tax law provided incentives to issue equity, partly in prepa-ration for the second round of privatization, but presumably also toreduce the level of domestic debt. This law also reduced the incen-tives to use bank debt. Indeed, Hernández and Walker (1993) showthat after the debt crisis there was a significant reduction in the over-all use of debt by firms, and a shift in its composition against bankdebt.

e) The second privatization round meant some degree of development ofequity markets, fueled by local pension funds and foreign investmentfunds.

f) The accumulation of significant pension funds has meant that the le-gal authorities have frequently had to modernize the existing regula-tions and institutions, trying to improve minority shareholders protec-tion among other issues.15

15 See Walker and Lefort (2000).


B. A brief history of the evolution of Chilean conglomerates

Economic groups have been a traditional business structure in Chilefor a long time. Their origins and evolution are closely related to thepolitical and economic events described in the previous section.16

During the first half of the 20th century a number of large state com-panies were created in the context of a national plan of industrializationunder the supervision of a public entity (CORFO). Those companies wereprivatized later on and gave origin to several of today’s conglomerates.During the fifties several groups were created around a bank, probably inresponse to the financial repression. Lagos (1961) identifies eleven largegroups, all related to banks in 1958. For 1966, Garretón and Cisternas(1970) identify 19 additional groups, most of them presumably small fam-ily groups.

The socialist period of 1970-73 imposed severe conditions to the de-velopment and continuity of groups. However, Dahse (1979) and González(1978) identify for 1978 more or less the same groups as previous studies,although some important changes in property and new associations hadtaken place.

The first round of privatization during the late seventies provided anew push to the creation of economic groups.17 Most of these groupswere developed around a bank. The most important groups that appearedin that period were Cruzat-Larraín, BHC, and Claro. However, the 1982-83 bank crises implied a large quake for groups. Bank failures and stateintervention caused the disappearance of several groups like Vial and BHC,and the reduction of others like Cruzat-Larraín. New laws and regula-tions, put in place in response to the debt crisis, were going to greatlyreduce the importance of banks for future groups.

The second round of privatization that took place during the secondhalf of the eighties produced a significant boost to the upsurge of new andmore active groups. Because of the privatization strategy described in theprevious section, this process tended to disperse firm ownership. How-ever, economic groups rapidly took control over most newly privatizedfirms. The large size of the firms being privatized implied the need for

16 Paredes and Sánchez (1994) summarize several studies regarding the evolution of groups overthe years.

17 See Hachette and Lüders (1992).


Chilean groups to be associated with foreign companies like Carter-Holtin the case of the Angelini group. For 1993, Paredes and Sánchez (1994)identify seventeen major groups, 10 of which are new and related with thesecond round of privatization. The groups that have been present since thesixties are just three: Matte, Angellini and Luksic, although today theyappear “consolidated” and quite large. Paredes and Sánchez (op.cit.) in-terpret this evidence as significant mobility and no barriers to entry orexit of groups.

The Superintendencia de Valores y Seguros (SVS) (Article 96 of theLaw Nº18.045) defines an “economic group” as

“... the collection of entities that present links in their prop-erty, administration or responsibility with creditors, in sucha way that it can be presumed that the economic and finan-cial actions of their members are guided by the commoninterests of the group, or subordinated to it, or that there arecommon financial risks in the loans that they get or in thesecurities that they issue”.18

In practice, if a group of shareholders controls directly or indirectly 50percent or more of a given firm, or if they control the majority of theboard of directors, the firm is considered to be part of the group. Thefollowing table shows the recent evolution of the number of groups, asdefined by the SVS.

TABLE 1

NUMBER OF GROUPS ACCORDING TO THE SVS

18 Free translation.

“Circular” Nº Date Number of Groups766 Jan 15, 1988 12921 Jan. 23, 1990 261030 Aug. 26, 1991 291112 Feb. 11, 1993 471162 June 27, 1994 581216 May 11, 1995 601282 May 16, 1996 711361 Sept. 30, 1997 711399 July 31, 1998 71


Eleven of the twelve groups that were present in 1988 are still presentin 1998. This is just an indication that this period of high economic growthhas encouraged the appearance of new groups. The stability in their num-ber from 1996 on, jointly with the recession of 1999 and the wave ofacquisitions suggest that the number of groups will probably decrease.

II. LEGAL FRAMEWORK, THE DEVELOPMENT OFFINANCIAL MARKETS AND CORPORATE

GOVERNANCE PRACTICES IN CHILE

Corporate structure is not only affected by important political and eco-nomic events but also by laws and regulations. Of course, in many cases,financial regulation arises in response to specific events and in order toshape corporate structures. The purpose of this section of the paper is toprovide a description of the main aspects of the financial legal frameworkin Chile, and to discuss their main implications in relation to corporategovernance mechanisms and the development of capital markets in Chile.19

Financial activity in Chile is regulated through a set of different lawsand supervisory institutions. Among the former, the most relevant are theBanking Law, the Security Markets law and the Corporations Law. Inaddition, a series of other laws and regulations specify the rules of thegame for institutional investors such as pension funds, mutual funds andforeign capital investment funds, and rule bankruptcy procedures amongother things. Three main supervisory entities overlook different aspectsof financial markets in Chile. The “Superintendencia de Valores y Seguros”(SVS) is in charge of supervising capital markets functioning and publiccompany information disclosure practices. The “Superintendencia deBancos e Instituciones Financieras” (SBIF) supervises the compliance ofbanking regulations. Finally, the “Superintendencia de Administradoresde Fondos de Pensiones” (SAFP) overlooks pension fund manager activi-ties. The Central Bank also participates actively in the financial systemregulatory and supervisory process, specially in issues regarding interna-tional transactions and foreign market participants.

19 Up to April of 2000, a new set of laws and some modifications to the existing ones were atdiscussion in Congress. The aim of this amendment is to improve the mechanics of CorporateGovernance in Chilean capital markets. See Lefort and Walker (2000ª) for a discussion.


A. Banking Sector

The 1982-83 collapse of the financial system importantly shaped theevolution of the banking sector. As a consequence of the crisis a numberof bailout measures were launched. They included subsidies to debtorsthat entailed longer maturities, soft interest rates and a reduced price ofthe foreign exchange for external debts, and the purchase of delinquentloans made by commercial banks by the Central Bank.

After the crisis a comprehensive new banking law was dictated in 1986.The regulatory and supervisory framework implemented since 1986 hasbeen mainly responsible for the moderate credit growth in Chile. Anothercandidate is the tough and preemptive stance of monetary policy that theCentral Bank has been continuously pursuing and, to some extent, theregulation of capital inflows.

In general terms, the new law included a partial deposit insurancescheme, and requirements that financial investments to be valued at mar-ket prices. Credit portfolio risk provisions were established. In addition,the law imposed restrictions designed to limit exchange rate, interest rateand credit risk, in the form of ceilings on maturity mismatching, and in-dicating that differences in assets and liabilities in foreign currency cannotexceed 20 per cent of bank’s capital and reserves.

Most importantly, regarding corporate governance systems the law in-troduced strict limitations on related lending. In the case of one person orone company, the maximum amount of loans is 5 percent of the bank’scapital and reserves. The ceiling is raised to 25 percent if the credit hascollateral. Loans to other financial institutions cannot exceed a ceiling of30 per cent of bank’s capital and reserves. Loans to persons or compa-nies owner- or management-related cannot be given under better condi-tions of maturity, interest rate and collateral, than those given to otherclients in similar transactions. It is forbidden to lend to members of thebank directory, their companies and their direct relatives.20 Finally, banksare not allowed to keep shares in their portfolios, with a few minor excep-tions.

The 1986 Banking Law is, therefore, responsible for the reduced im-portance of banks for corporate governance in Chile. Bank credit wassubstituted off from corporation source of funds and replaced mostly by20 See Eyzaguirre and Lefort (2000).


equity issues and to a lesser extent by corporate debt. Also, banks stoppedbeing a central unit of economic groups, at least in organizational terms.All these regulations have notably diminished the importance of banks forconglomerates. On the one hand, the restrictions imposed to related lend-ing make less attractive for groups to own banks and used them as theydid before the 1982-83 debt crisis. On the other hand, since banks cannotown shares from corporations, conglomerates’ parent companies are nolonger banks but rather investment firms. Table 2 shows that while stockshave gone from 44 percent of total assets in 1980 to 53 percent during thenineties, the importance of the banking sector measured as M7 has fallenfrom 48 percent to 22 percent of total assets.

At the end of 1997 new amendments were introduced to the 1986 Bank-ing Law. The most important changes are the following:

- Procedures for new bank licenses were established.- The Basle recommendations on capital requirement were adopted.- Regulations on new domestic branches were simplified.- International branches and operations are more easily allowed.- Banks are allowed to hold shares of companies in related business

such as stock brokers, investment and mutual fund managers, fac-toring and others.

TABLE 2FINANCIAL DEEPENING IN CHILE

Market Value in Millions of Dollars, Dec. 1996

* Includes both Public and Private Stocks, excludes Mutual Fund Shares.** Includes Corporate Bonds,Commercial Papers, Financial Sector and Mortgages.*** Includes Corporate Bonds, Banks, Mortgages, Treasury Securities and Central Bank Securities.(2) Source: PIMA.

DATE TOTALValue % of total Value % of total Value % of total Value % of total

1980 10,287 44.5 282 1.2 1,501 6.5 11,069 47.8 23,1391990 20,520 38.4 4,341 8.1 12,131 22.7 16,379 30.7 53,3711996 66,215 50.6 10,455 8.0 23,292 17.8 30,814 23.6 130,776

Average ́ 90s 52,719 52.7 6,948 6.9 18,441 18.4 21,979 22.0 100,088

1980 30.1 0.8 4.4 32.4 67.81990 45.6 9.6 27.0 36.4 118.61996 94.4 14.9 33.2 43.9 186.4

Average ́ 90s 89.4 11.9 32.0 37.9 171.2

(percentage of GDP)

M7 (less public bonds)Equity* Private Bonds** Government Bonds***


The new bank law has given banks much more flexibility and has wid-ened their business scope. We therefore can guess that banks may be-come more important actors for corporate governance in Chile in the fu-ture.

B. Capital Markets

The actual institutional arrangements of the Chilean capital market de-veloped starting in 1980 with the creation of the main supervisory entity,the “Superintendencia de Valores y Seguros”. This entity together withtheir homologue for pension funds and banks and other financial institu-tions have been in charge since their creation of supervising the compli-ance of the law by all market participants.

The functioning of the Chilean capital market is framed in a body oflaws and regulations comprised by two main laws: the Securities MarketLaw and the Corporations Law. In response to the changing environmentas a consequence of the increasing financial integration and sophisticationof Chilean capital markets, both laws had a major amendment in 1994.The modifications consisted mainly in broadening the investment alterna-tives to institutional investors, and improving the regulation in matterssuch as conflict of interests and risk rating systems.

Formally, the aim of this legal framework is to support an adequatedevelopment of the market; to establish internationally recognized disclo-sure practices; to provide clear and non-discriminatory rules; to ensurethat securities intermediation is carried by authorized entities; and to pro-vide the environment for an efficient market where price determinationand trading are carried out in an efficient and fair way.21

The appendix provides a list of the main articles regarding corporategovernance mechanisms in Chile. Panel A presents the articles in theCorporations Law, especially those that aim to give some degree of pro-tection to minority shareholders. First, the Chilean law allows preferredshares, as long as the terms of preference are clearly stated in the com-pany statutes and the duration of privileges is specified. Therefore, thelaw allows the existence of series with different voting powers. Although,universal one share-one vote structure is viewed as the best practice fromthe minority shareholder rights perspective, avoiding series with different

21 See Superintendencia de Valores y Seguros (1999).


voting powers might exacerbate the use of pyramiding in order to achievecontrol without increasing ownership.22

Regarding the administration of corporations, the Chilean law specifiesthat the board of directors exercises the administration of the company.The members of the board are elected by the shareholders, and must rep-resent each and every shareholder and not only to those that voted forthem. The law also specifies that business between the corporation andentities related to board members or officers must be conducted understrict market conditions.

Most important company decisions are, however, made at shareholdermeetings. There are two classes of shareholder meetings: ordinary andextraordinary. Ordinary meetings are held once a year. In them, share-holders are informed about important company matters, board membersare elected, and dividend payments are determined. The election of boardmembers is performed under the cumulative voting procedure.

Extraordinary meetings are called every time that is required, and when10 percent of shareholders or the SVS decide to call a meeting. Extraor-dinary meetings consider especial issues such as: company dissolution;approving of a major transformation, merge or status reform; a sale of amajor amount of assets; capital reductions; and changes in board attributes.All of these matters require a 2/3 voting approval, allowing minority share-holders to block important company decisions with only a third of thevoting power. Moreover, in most of these decisions dissident sharehold-ers have the right to step out of the corporation. The company must buyup their shares at market value.

Regarding bankruptcy procedures, in 1986 Chilean authorities intro-duced important modifications to the Bank and Bankruptcy Laws thattended to privatize the liquidation procedures. The Corporations Law, onthe other hand, specifies that company’s termination can occur when allshares end up in a single hand, or if decided in a shareholder meeting.Bankruptcy can be called when the company defaults an obligation, andin those cases loans received from shareholders (usually as part of a capi-tal reduction) are junior to all other creditors.

Panel B of the appendix presents the main articles in the SecuritiesLaw regarding corporate governance. A first body of rules specifies therequirements on information disclosure. In particular, takeover intentions

22 See Laporta, Lopez-de-Silanes, Shleifer and Vishny (1996).


must be informed at least five days in advance of the actual transaction.23

The same information is required when any shareholder holding more than15 percent of shares intends to buy 3 percent of more of the samecompany’s shares. In both cases, board members are required to preparea report indicating the potential effects of the takeover on shareholderwealth and their relationship with the bidder.24

It is worth noticing that the main body of both the Corporations Lawand the Securities Law was written in 1981. They were both amended in1989 and more deeply in 1994. During those episodes the Chilean au-thorities were advised by IFC members developing at the end a legislationthat, in principle, tries to mimic the one in the U.S.. Of course, the Chileanlegal system is French in origin while the United States' comes fromCommon Law and, therefore, we should expect important differences inthe interpretation and enforcement of the law when comparing both coun-tries.25 In any case, the analysis of the Chilean legislation regarding capi-tal markets indicates that, in principle, legal protection to minority share-holders seems to be adequate, and not very different to the one in moredeveloped, common law countries, like the US and United Kingdom. Thisanalysis may indicate that the sharp differences in ownership concentra-tion and market liquidity between Chile and the US could be attributableto other factors besides legal framework. In addition to enforcement, someof these factors might be more related to Chilean past economic historyand specifically to the events described in the previous section of thispaper.

However, as we mentioned before, another possibility is that we willhave to wait many decades to see the effects of legal reforms on capitalmarkets. At the end, the final outcome could be independent of the spe-cific history of a country, and all governance systems could be converg-ing to the same optimal pattern.

In any case, the evolution of capital markets can not be taken as inde-pendent of the above considerations. Chilean capital markets have, in-deed boomed in the last fifteen to twenty years. As Table 2 shows, whiletotal financial assets were 67 percent of GDP in 1980, they reached al-

23 These requirements are increased under the new proposed law.24 Two other sets of amendments have been recently proposed regarding tender offer procedures.

See Lefort and Walker (1999ª).25 See Laporta, Lopez-de-Silanes, Shleifer and Vishny (1996).


most 190 percent of GDP in 1996. This impressive development is ex-plained by the natural process of capital accumulation experienced by theChilean economy since the late seventies in its transition to a new steady-state level of capital originated by privatization, the implementation ofstructural reforms, and the decrease of discount rates. The process ofcapital accumulation was, of course, shaped by the events and regulationsdiscussed in the preceding section of this paper.

The development of the Chilean capital market has not been uniform.It has involved important changes in the composition of financial instru-ments, the relative importance of different security issuers and investors,the development of new regulatory institutions, and the mechanics of thetrading process itself. In fact, like all ongoing development processes, theevolution of the Chilean capital market has been characterized by a learn-ing process, in which new institutions, rules and practices have been in-corporated as needed, sometimes in response to economic events.

In particular, three main events help to explain the change in the com-position of financial assets presented in Table 3.26 First, the 1982 debtcrisis explains the jump in government debt to around 15 percent of GDP,as the Treasury and later the Central Bank assumed responsibility for thebad loans made by the banking sector. The crises also explains the fallin market value of stocks, bonds and financial assets, reduction in newissues and decrease in transactions as a result of the lack of new profit-able investment projects and the wave of firm bankruptcies. Only after1985 capital markets started to show some sign of recovery. However, aswe discussed above, the very strict regulation applied to the banking sys-tem after the debt crises has meant a reduction in its relative importanceas financial intermediary.

Secondly, the internationalization of the Chilean economy and the in-creasing globalization of the world economy starting in the late eightiesare the main reason for the explosion in the market value of stocks andprivate bonds in the last 9 or 10 years. It also explains the increase inCentral Bank debt as a consequence of the sterilization of the monetaryeffects of international reserve accumulation. Finally, the presence ofinstitutional investors has contributed to the development of markets fi-nancial and to the general improvement in efficiency and control in capi-26 See Eyzaguirre and Lefort (1999).27 See Walker and Lefort (2000) for an analysis of the effects of pension fund reform in capital

market development.


tal markets.27

These three events have implications from the point of view of corpo-rate governance. First, we have already mentioned that the legislationfollowing the debt crises importantly reduced the importance of banks inChilean corporate governance. Second, financial integration poses somechallenges to emerging economies. The entrance of large foreign inves-tors increases competition and demands more sophisticated financial mar-kets. Competition has taken the form of ADR’s. Almost 60 per cent offirms included in the selective index IPSA are cross-listed as ADR in theUS. Table 3 shows that while by 1996 ADRs in the US reached morethan 7 billion dollars, foreign capital investment funds accounted only for1.3 billion dollars. These figures indicate that foreign investors seem toprefer American depository receipts. Among the possible reasons for thispreference we highlight better information and disclosure practices, andmore liquidity in the US than in Chile.28 Firms cross-listing in the UShave to go through the standard American process of creating a prospect,standardizing accounting practices and disclosing all relevant informationto investors. As long as the disclosing practices are more demanding inthe US than in Chile, American investors will find it easier to invest inADRs. Disclosure practices not only are important from a foreign inves-tor point of view, but also from local investors. Other disadvantages ofChilean capital markets are capital gains tax and capital controls: the oneyear minimun requirement and the tax on capital inflows.29

TABLE 3FINANCIAL ASSETS: INVESTORS

(Millions of Dollars, Dec. 1996)

28 Saens (1999) finds 5% and 9% cumulative average-abnormal returns for firms announcingADR issues in windows of 3 and 21 days respectively.

29 See Eyzaguirre and Lefort (1999) for a discussion of the macroeconomic implications of capi-tal controls in Chile.

* Difference between Total Issues less Total Investors.

F O R E I G NP O R T F O L I O

I N V E S T M E N TD A T E P e n s i o n s

F u n d sI n s u r a n c e

C o m p a n i e sM u t u a lF u n d s

F o r e i g n C a p i t a lI n v e s t m e n t

F u n d s

I n v e s t me n t

F u n d s

A D R ´ s B o n d s B a n k s , H o u s e h o l d s a n dO t h e r s *

1 9 8 0 0 6 7 7 7 9 3 0 0 - 8 5 2 1 , 5 8 41 9 8 1 3 0 6 7 3 4 6 8 6 0 0 - 1 3 9 1 8 , 2 7 31 9 8 2 9 5 2 8 3 6 6 7 0 0 0 - 1 5 6 1 5 , 0 7 71 9 8 3 1 , 7 2 2 8 9 1 1 4 7 0 0 - 1 3 8 1 3 , 8 7 01 9 8 4 2 , 2 7 6 1 , 1 0 2 1 4 9 0 0 - 1 4 9 1 4 , 0 7 41 9 8 5 3 , 1 3 7 1 , 3 3 4 2 2 3 0 0 - 1 4 1 5 , 1 9 91 9 8 6 4 , 1 0 2 1 , 6 1 1 3 9 2 0 0 - 0 1 9 , 3 5 31 9 8 7 5 , 0 2 6 1 , 5 2 8 5 0 8 0 0 - - 1 4 2 2 , 7 8 8

1 9 8 8 6 , 1 5 5 1 , 8 2 0 6 3 7 0 0 - - 2 6 2 7 , 4 3 31 9 8 9 7 , 5 8 8 2 , 2 1 1 5 5 6 1 9 5 0 0 - 3 7 3 4 , 4 8 01 9 9 0 1 0 , 0 5 0 2 , 8 3 5 6 5 5 6 8 4 0 1 5 5 1 8 4 3 8 , 8 0 91 9 9 1 1 4 , 2 1 4 3 , 5 8 0 1 , 1 9 6 1 , 3 4 4 3 2 2 5 7 3 4 7 5 5 , 6 3 21 9 9 2 1 5 , 8 3 8 4 , 2 6 2 1 , 2 0 4 1 , 3 9 2 7 7 9 0 0 3 7 0 5 5 , 5 9 81 9 9 3 2 0 , 3 5 5 5 , 2 9 5 1 , 5 8 0 1 , 9 9 2 1 3 6 1 , 9 6 9 3 9 5 7 1 , 9 8 51 9 9 4 2 4 , 5 6 6 6 , 5 0 5 2 , 3 0 9 2 , 3 0 6 3 3 4 4 , 2 9 1 7 2 0 8 4 , 6 5 31 9 9 5 2 6 , 1 1 3 7 , 3 1 0 2 , 6 1 7 2 , 0 0 1 9 2 5 5 , 9 7 6 1 , 3 1 7 8 4 , 5 7 31 9 9 6 2 7 , 6 7 2 8 , 5 3 9 2 , 8 2 5 1 , 4 1 6 1 , 0 7 8 7 , 1 6 5 1 , 4 0 9 8 1 , 1 2 7


Finally, we must consider the role of institutional investors. As Table3 indicates, the main institutional investors in the Chilean capital marketare pension fund managers, with over 30 billion dollars in assets. Insur-ance companies manage almost 9 billion dollars in assets; mutual funds 3billion dollars; FICE (Foreign investment funds) 1.3 billion dollars; andlocal investment fund managers 0.3 billion. The market value of pensionfunds increased from less than 1 per cent of GDP in 1981 to more than45 percent in 1996. Although, pension funds were allowed to invest incommon shares of stock only after 1985, by 1996 the value of their stockholdings represented more than a 30 per cent of the total market value ofpension funds.

From the point of view of this paper, the increasingly important pres-ence of institutional investors has decisively influenced the mechanics ofcorporate governance in Chile, through more disclosure requirements andtheir important role as minority shareholders.30 For this reason, new capi-tal market regulations have been pursuing the development of an adequateframework where pension funds may efficiently channel retirement sav-ings, and the government has developed appropriate supervisory institu-tions that control the compliance of the new regulatory framework. Ob-viously, the beneficial effects of this process permeate to all areas of capitalmarket development.

In particular, limits on types of securities and issuers were imposedbased on risk ratings, portfolio diversification, ownership concentration,and other specific criteria. Regulations considered such important aspectsas the commitment of corporations to achieve a desirable level of de-concentration in order to allow pension funds to invest in their securities.This procedure was crucial in order to allow pension funds to participateactively in the domestic stock market. Through this mechanism, pensionfund reform has had an important effect on corporate governance prac-tices in Chile. Pension funds usually contribute to the board of largecorporations with at least one board member that tends to represent theminority interest.31 Also, because of the limits imposed on ownershipconcentration of the target firms, pension fund capital should tend to dis-criminate in favor of less concentrated corporations. Finally, another

30 See Iglesias (2000).31 See Iglesias op.cit.


important aspect in pension fund regulation has to do with fund manag-ers’ conflict of interests. The “Superintendencia” supervises the adequatebehavior of fund managers in those matters in which conflict might arise.

III. SUMMARY AND CONCLUSIONS

We have argued that groups or conglomerates have been the predomi-nant form of business organization in Chile since the 1950s. These groupsthat are diverse in nature have been shaped by some major economic andpolitical events both directly through new business opportunities, and in-directly through new laws and regulations. Since conglomerates are themost common form of business organization in emerging economies, ana-lyzing corporate governance in these countries is essentially equivalent toanalyzing the relationship between fund providers and groups, givenShleifer and Vishny’s (1997) definition of corporate governance. Thisrelationship is affected by major economic shocks. We identified in thecase of Chile the financial repression, the privatization process, the 1982debt crisis, and the pension fund reform, as the most influential of theseshocks. They probably have been also crucial in determining the devel-opment process of capital markets in other countries of the region.

In the Chilean case, it is worth noticing that during the preparation ofthe main body of both the Corporations Law and the Securities Law, andin their subsequent amendments, Chilean authorities were advised by theIFC, developing at the end a legislation that, in principle, tries to mimicthe one in the US. The Chilean legal system is French in origin and theUnited States' comes from Common Law, we thus expect important dif-ferences in the interpretation and enforcement of the law when comparingboth countries. In any case, the analysis of the Chilean legislation regard-ing capital markets indicates that, in principle, legal protection to minorityshareholders seems to be adequate, and not very different to the one inmore developed, common law countries, like the US and United King-dom. This analysis may indicate that the sharp differences found in theliterature, regarding ownership concentration and market liquidity betweenChile and the US could be attributable to other factors besides the legalframework. In addition to differences in law enforcement, some of thesefactors may be more related to Chilean past economic history and specifi-cally to the events described in the previous section of this paper.


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THE EFFECTS OF ECONOMIC AND POLITICAL SHOCKS ON CORPORATE GOVERNANCE SYSTEMS IN CHILE

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