1%4

YCO Ora _ MURahwastment Management

A Feasibility Report for theAsian Development

Bank

TA ` 87~

1 August, 1988

AN o

ESTABLISHING A MUTUALFUND COMPANY IN THE

PHILIPPINES

A Feasibility Report for theAsian Development Bank

This report has been prepared by Jardine Fleming Holdings Ltd and Russell &Co. Inc. solely for the use of the As ian Development Bank. It may not be disclosedor copied in whole or in part to any other person without the prior written consent of theAsian Development Bank.

The information, opinions, and recommendations contained herein are based oninterviews, research, and analyses carried out by Jardine Fleming Holdings Ltdand Russell & Co. Inc. and to be best of their knowledge and belief the informationcontained in this report is correct at the date hereof.

Jardine Fleming Holdings Ltd and Russell & Co. Inc. accept no liability forany errors or omissions of fact or opinion expressed or implied herein.

IX. SCOPE OF THE FUND MANAGEMENT COMPANY 40Retail Savings 41Institutional Savings 42Closed-End Equity Fund 42Venture Capital Fund 43Fixed-Incernne Fund 44Retail Fund 44

X. CRITERIA FOR FOREIGN FUND MANAGER 47XL ACTION PROGRAMME FOR THE ASIAN DEVELOPMENT BANK 48

Fund Management Company 48Securities Trading Systems 49Securities and Exchange Commission 49Issuance of Equity 50Concluding Remarks 51

All queries on this document should be directed to:

TABLE OF CONTENTS

IL PRINCIPAL ABBREVIATIONS 2III EXECUTIVE SUMMARY 3

Approach ToThe Assignmenc 3Key Reoanmardations 4

A. Establish a Fund Management Company 5B. Improve the Trading Systems of The Securities Exchanges 7C. Upgrade the Securities and Exchange Cammimion 8D. A

on S to Encourage The Issuance of More 9E. Agree on an Action Programme for Implementation of Key Recommendations 1 0

Criteria For Foreign Fund Manages »...»»...._»..» » » »»-.»- » » » 10Concluding Canments 11

IV. PAST OPERATIONS OF MUTUAL FUNDS .................................................................................................................................................... 12V. REASONS FOR THE THINNESS OF THE STOCK MARKETS 15

Strict listing Requirements 16Ifigh Issue Costa 16Limited Availability of Informatiot 17Need for Public Incentives 18Unattractiveness of the Equity Markets As an Investment Alteaiative 19Inadequate Regulaticns 19Shortfall in the Supply of Stacks.» 19

VL OVERVIEW OF THE STOCK MARKET TRADING SYSTEMS 22Stock Clearing Procedures 22Domestic Transactions 22Cornptteasatim 24Unification of Stock Exchanges 24

VU. STATUS OF THE SEC 26Existing Structure and Responsibilities 27Recommendations 27

Existing Organisation and Structure 28Systems 28Financial Resources 28Human Resources 28Current and Future Rolea 29

VIIL REVIEW OF RELEVANT SECURITIES REGULATIONS 31

John R. StyleRegional Corporate DevelopmentJardine Fleming Holdings LimitedConnaught Centre47th FloorHong Kong

Richard E. RadezPresidentRussell & Company Incorporated30 Rockefeller PlazaSuite 1936New York, New York 10112

Telephone: (852) 5-843-8888 Telephone: (212) 245-4640Telex: 75608 FLEDGFacsimile: (852) 5-810-1694

Telex: 271259 RUSL URFacsimile: (212) 262-4093

Mutual Fund Regulations 31Establishment Procedure 31Capital Structure 32Management Company 32Investment Advises 33Custodian, 33Operation 33Investment Activities 33Conflict of Interest 34Reports and Disclosure 34Stock Exchange ListingTaxation 35

Common Trust Regulations 36General Provisions and Financial Requirements 36The Trust Plan 37

II. PRINCIPAL ABBREVIATIONS

Throughout this Feasibility report, the following abbreviations shall, unless otherwiseindicated, have the meanings set opposite them:

ADB

- the Asian Development Bank

ICA

- Investment Companies Act 1960

PLDT

- Philippine Long Distance Telephone Company

RSA

- Revised Securities Act 1982

SEC

- Securities and Exchange Commission

"U.S. $" and "$" - the United States dollar.

Throughout this document, unless otherwise stated, the following exchange rate shallapply:

U.S. $100 = P 20.85.

The Philippine peso is not a freely convertible currency.

page 2

II. PRINCIPAL ABBREVIATIONS

Throughout this Feasibility report, the following abbreviations shall, unless otherwiseindicated, have the meanings set opposite them:

ADB

- the Asian Development Bank

ICA

- Investment Companies Act 1960

PLDT

- Philippine Long Distance Telephone Company

RSA

- Revised Securities Act 1982

SEC

- Securities and Exchange Commission

"U.S. $" and "$" - the United States dollar.

Throughout this document, unless otherwise stated, the following exchange rate shallapply:

U.S. $100 = P 20.85.

The Philippine peso is not a freely convertible currency.

page 2

III. EXECUTIVE SUMMARY

This report responds to contract CAS/S/87-229 dated 11 November 1987 to examinethe feasibility of establishing a viable mutual fund in the Philippines (see AppendixXII-A for a request for proposal). As discussed in greater detail in this report, werecommend the establishment of a fund management company. Ultimately, thiscompany will manage a group of mutual funds rather than a single mutual fund.

The viability of the fund management company and its group of funds will be verydependent upon the actions of the Asian Development Bank (ADB) and theGovernment of the Philippines to give substance to our other three recommendations.These deal with the upgrading of the Securities and Exchange Commission (SEC), thestrengthening of the underlying stock exchange systems to trade stocks and theenactment of certain measures to encourage companies to issue more equity.

Approach To The Assignment

The assignment was jointly undertaken by Jardine Fleming Holdings Limited of HongKong and Russell & Company Incorporated of New York.

Jardine Fleming, established in 1970, was the first merchant bank in Hong Kong andnow provides a complete range of investment banking services in the Far East,including investment management, corporate finance, banking, broking and foreignexchange. Jardine Fleming has total funds under management of U.S. $4.9 billion.One of these funds is the JF Philippine Trust which was launched in 1974.

Russell & Company provides advisory, research and finance services to a limitednumber of private firms and financial institutions wishing to do business in Asia.Russell & Company clients include:

•

CP Ventures - a leading Australian venture capital firm

•

Rockefeller & Co., Inc. - the Rockefeller Family's investmentmanagement firm

•

Asian Development Bank

•

Royal Trust Asia Ltd. - the Hong Kong arm of the Royal Trust Group.

To undertake this assignment, Jardine Fleming and Russell & Company fielded a teamof experts to cover:

•

Securities Regulation

•

Group of Funds Management

•

Public Fund Management

•

Securities Administration

•

Philippine Corporate Finance

•

Securities Market Development

page 3

Exhibit I

Organizations Interviewed in Manila

Type of Organization Names

Securities Industry Anscor Hagedorn SecuritiesBarcelon, Roxas SecuritiesBelson SecuritiesFirst Pacific SecuritiesInvestment Underwriting ServicesMakati Stock ExchangeManila International Futures ExchangeManila Stock Exchange

Financial Community Barclays BankCityTrustDevelopment Bank of the PhilippinesFar East Bank and Trust CompanyHambrecht & QuistThe Hongkong and Shanghai Banking CorporationLand Bank of the PhilippinesLincoln Philippine Life Insurance Co.The Philippine American Life Insurance Co.Philippine National BankPrivate Development Corporation of the Philippines

Business Community C. Virata & AssociatesCentre for Research and CommunicationsJardine DaviesMMA ConsultantsMondragon International PhilippinesMurray Fisher GroupSKR Managers & AdvisersSyCip, Gorres, Velayo & Co. (SGV)

Legal Community Angara, Abello, Concepcion, Regala & CruzSan Jose, Enriquez, Lacas, Santos & BorgeSyCip, Salazar, Hernandez & Gatmaitan

Government Organizations Armed Forces Retirement SystemAsset Privatization TrustCentral Bank of the PhilippinesDepartment of FinanceOffice of the PresidentSecurities and Exchange CommissionSocial Security System

International Organizations Asian Development BankBritish EmbassyInternational Finance CorporationThe World Bank

• Private Equity Investment•

Mutual Fund Marketing

•

Unit Trust Administration

•

Securities Computer Operations.

This team has spent in excess of six man-months on the assignment. It has conductedmore than sixty interviews of executives of the organisations shown in Exhibit I onthe facing page. A detailed summary of individuals interviewed in Manila formsAppendix XII-B.

During the assignment, each expert reviewed a wide number of written documents onthe Philippine securities markets, the most important of which include:

•

A CAPITAL MARKET STUDY OF THE PHILIPPINES by NomuraResearch Institute dated 22 February 1985.

• DEVELOPING THE CAPITAL MARKETS OF THE PHILIPPINES byTerrence Reilly of Curtis, Mallet - Prevost, Colt & Mosle dated 14 March1987.

• TOWARDS A DEVELOPMENT OF THE PHILIPPINES CAPITALMARKETS by University of the Philippines Business ResearchFoundation dated 2 October 1986.

• REPUBLIC OF THE PHILIPPINES REVISED SECURITIES ACT OF1982, INVESTMENT COMPANIES ACT 1960, and the associatedPhilippine securities regulations.

These interviews, research and analyses form the basis for our key recommendations.

We wish to emphasise that whenever references are made in this report toshortcomings and deficiencies in various governmental departments and agencies, itmust always be borne in mind that the problems identified are not attributable to theexisting management and staff. In fact, it is to their credit that these governmentaldepartments and agencies, in particular the Securities and Exchange Commission,have not broken down totally, given that they have been deprived of adequateresources over many years.

Key RecommendationsWe have four key recommendations:

• Establish a fund management company to set up and manage a group offunds, the first being a closed-end fund that will invest primarily inequities.

•

Improve the underlying trading systems of the securities exchanges so thatsecurities can be easily and confidently traded.

•

Upgrade the SEC so it can play a major proactive role in securitiesregulation and development of the capital market.

•

Agree steps to be undertaken by the Government of the Philippines toencourage companies to issue more equity via public offerings.

page 4

All four of these key recommendations should be implemented via an actionprogramme that will be agreed after appropriate policy dialogues, between the ADBand relevant departments and agencies of the Government of the Philippines. TheADB should be prepared to support this action programme with technical assistancegrants. Depending upon the dimensions of the programme, it may also be appropriateto involve other international aid organisations, such as the World Bank, in itsimplementation.

Each recommendation and the action plan are addressed separately.

A. Establish a Fund Management Company

We recommend that a fund management company be incorporated to manage a groupor "family" of funds, each of which will be tailored to the specific needs or prioritiesof differing types of investors and managed by fund managers with relevantexperience in each particular field.

To ensure that the investing public has confidence in the fund management companyand its products, the financial standing and integrity of the shareholders should beunimpeachable. To this end, we recommend that the fund management company bestructured as a joint venture with the following possible shareholdings:

• An international fund management company will contribute the proveninvestment skills and expertise required to ensure the long term viabilityof mutual funds.

• The Asian Development Bank's involvement will contribute significantlyto investor confidence and provide on-going support to the developmentof the capital markets.

• A quasi-government banking, institution will provide a link betweengovernment policy makers controlling the privatisation programme andthe private sector capital markets.

• Major Filipino financial institutions will have the required levels ofintegrity and financial standing in addition to providing a nationwidenetwork of offices.

The foreign fund manager, in addition to taking equity, will manage the mutual fundsfloated by the fund management company on a remuneration/incentive commissionbasis. This will ensure professional management of the fund management company.The association of quasi-governmental organisations such as the Development Bankof the Philippines and major Filipino financial institutions will give the fundmanagement company added image and credibility, and greater access not only to theauthorities - indispensable at this stage of Philippine capital market development -

page 5

Shareholder$ Eauity

Foreign Fund Manager 40.00%Asian Development Bank 5.00%Quasi-government Bank 5.00%Major Filipino Financial Institutions 50.00%

100.00%

Our reasoning for recommending such a shareholder structure is that:

FUND MANAGEMENT COMPANY: Establish a fund managementcompany to set up and manage a group of funds, the first beinga closed end fund that will invest mainly in equities.

Commence

g new >mutna(consultant working with SEC).

•

Review fiscal policy and its impact on mutual funds andinvestors (consultant working with SEC).

Publish new mutual fund rules and regulations.

fund rules and gu ati

Exhqhst II

Timing of ActionProgramme

•

Commence drafting a unified mutual fund/unit trust code(consultant working with SEC).

Agree on structure (spon egal framework, capitalisation,management etc...) and timing oflaunch of first "authorised"fund managementcompany (SEC working with ADB and firstsponsor).

SECURITIES AND EXCHANGE COMMISSION: Upgrade the SEC sothat it can play a major proactive role in securities and devel-opment of the capital market.

Study SEC organisation,'structure, computer systems. finan-cial and human resources, in order that they may be upgradedto fulfill adequately its current and future roles(' ultanworking with SEC' and ADB).

•

Second SEC staff members to regional financial institution fortraining in administration of mutual funds (SEC and ADB).

Formulate a transaction levy to increase financial resourcesavailable to SEC (SEC and ADB)_

•

Implement programme to upgrade quality of existing staff/recruit new staff with specialist skills.

SECURITIES TRADING SYSTEMS: Improve underlying tradingsystems of securities exchanges so that securities can be easilyand confidently traded.

Develop plan to computerise a unified stock exchange (SEC,'stock exchanges. ADB>au dce sultant) ,>

•

Develop computer systems for stock clearing and settlements(stock exchanges and systems consultants)

Agree on timetable fist a erger;cf. tarsi a anexchanges (SEC and stock;cxchanges .

•

Computerise STD systems at Central Bank to expedite repa-triation of forex (CB and systems analysts).

Makai: ' tack

I SSUANCE OF EQUITY: Agree on steps to be undertaken byGovernment of the Philippines to encourage companies toissue more equity via public offerings.

Developand comment i reposing "Oh, dent" lending tint itsoncommercial banks (SEC and Central Bank)

•

Initiate public offerings as part of privatisation programme.

Agree on Debt/Equity ratios to be met by companies raisinginternational debt under Government guarantees (ADB, IFC,:SEC and Central Bank).

• Review conditions under which Philippine subsidiaries ofmultinational corporations might raise equity in the local stockmarkets (consultant working with ADB).

0 - COMMENCE•

- COMPLETEA -IMPLEMENT

19883rd Qtr

1988

19894th Qtr 1st Qtr

19892nd Qtr

19893rd Qtr 1

but also to the stocks of enterprises such as the Manila Hotel which the Governmentof the Philippines wants to privatise.

We further recommend that the ADB work with the relevant Filipino authorities toincorporate and authorise the fund management company as soon as possible. Thesubsequent development and performance of the fund management company can beclosely monitored over the next three years and be used as a model when formulatingupgraded legislation to regulate the mutual fund industry. Further fund managementcompanies can be authorised by the SEC when market conditions are consideredsuitable. A suggested timetable for the preliminary stages of the recommended actionplan is set out in Exhibit II on the facing page. Provided the timetable is adhered to,the SEC, with technical assistance from the ADB, should be able to commencesimultaneously : -

•

the upgrading of rules and regulations governing the mutual fund industryand the protection of investors

•

the upgrading of its existing organisational structure and resources

•

the incorporation of the recommended fund management company

There are several key factors that will determine the types of funds that the proposedfund management company should launch and the timing of the launches:

• There simply are not enough. equities available in the Philippine stockmarkets to make a traditional mutual fund viable. There are only about10 stocks of investment grade with adequate liquidity. Consequently, thefirst priority is to help develop a greater supply of publicly availableequities in future years.

• It will take 18 months at least, probably longer, to put in place at the SECthe bare minimum of resources and expertise needed to regulate mutualfunds offered to the public.

• Presently, the investment appetite of the Filipino public is largely limitedto short-term, money-market instruments. With the exception of a verysmall segment of wealthy individuals, most Filipinos have not seen theirsavings recover from the economic downturn of the mid-1980's.Consequently, people do not want to risk whatever small savings theyhave been able to accumulate by investing in equities.

Given these constraints, we recommend that the first fund offered by the new fundmanagement company be a closed-end fund that will invest primarily in:

•

Convertibles, warrants and/or preferred stock of publicly quotedcompanies

•

Initial public offerings of equities

•

Secondary equity offerings by publicly quoted companies

•

Significant minority positions in private companies that will ultimately gopublic

•

Leveraged buyouts, management buyouts and company reconstructionsthat will also go public in due course.

page 6

This fund will increase the investment appetite for equities by acting as aninstitutional investor that is willing to purchase a broader and more sophisticatedrange of securities. These investments will be warehoused in the fund until such timeas it is profitable to sell them off on the secondary market. In turn, this will increasethe supply of investment grade stocks available to public investors, both institutionaland retail.

The initial size of this fund should be between U.S. $25 million and U.S. $50 millionif it is to have any significant impact on broadening and deepening the Philippineequity markets.

The second fund should be a small venture capital fund of about U.S. $10 million.We are confident that there is a pool of capable management available to identify andmanage these new venture companies. This fund will also contribute to thebroadening of the equity market by developing companies that will be ready to gopublic in three to six years time.

The third fund should be a fixed-income fund targeted at small to medium-sizedfinancial institutions. Because of their size, these institutions cannot afford in-houseprofessionals to invest their liquidity. This fixed-income fund might be a:

• Money market fund targeted at smaller banks and "thrifts". Historically,these institutions have had to place their liquidity with larger banks at arate disadvantage.

• Medium-term bond fund targeted at smaller life insurance companies.These institutions are unlikely to have the investment evaluation skillsneeded to analyse higher yielding but potentially riskier bonds issued byprivate companies.

The fourth fund might be an equity or fixed-income fund for small retail investors.However, it is our strong belief that the launch of an equity mutual fund targeted atsmall retail investors should be delayed until such time as the stockmarket has been"broadened and deepened." A mutual fund, launched prematurely, will face problemsidentical to those encountered in the 1960's and 1970's (see Section IV) and will run ahigh risk of failure, the consequence of which will be the retardation of the mutualfund industry by another fifteen years. The timing of the launch of a fixed incomefund will be determined by the continuing recovery of personal income and savings.

B. Improve the Trading Systems of The Securities Exchanges

Considerable work needs to be done to improve the underlying trading systems of thesecurities exchanges if securities are to be easily and confidently traded. At present,the systems and procedures of the Manila and Makati Stock Exchanges are totallyinadequate to handle a high volume of stock trading, much less to ensure that therights of investors are protected adequately.

It takes, on average, approximately fifty days to clear a domestic stock trade on theseexchanges (i.e. the time taken from the date of trade to the date of receipt of physicalcertificates by a custodian bank). While the time required for each step in the clearingprocess is documented in greater detail in Section VI, there is a major bottleneck inthe transfer agent's capability to process and release new stock certificates to the stockclearing house.

Stock clearing takes even longer for a foreign investor. In average trading volumes, itnormally takes, at best, fifteen and on average, thirty days for foreigners to obtainapproval from the Central Bank to repatriate their foreign currency. In addition, it is

page 7

not uncommon for up to eight letters of assignment to be outstanding for a singlecertificate. Further, there is no central depository system to hold the shares after theyhave been cleared.

In terms of the efficiency of the stock exchanges and the brokerage houses, there is ageneral lack of computerisation. Furthermore, there is no automated reporting systemto disseminate price information from the floor of the exchanges to the brokeragecommunity, both domestic and foreign.

The ADB should take a major role in assisting the stock exchanges to computerise andmodernise their trading and price reporting systems. This will involve undoubtedlythe review of trading systems employed by other securities exchanges in the Pacificregion, particularly those in Taiwan, Hong Kong and, perhaps, New Zealand. Specificimplementation projects will then flow from this review.

C. Upgrade the Securities and Exchange Commission

One of the contributory factors to past problems within the securities markets,including the past failures of the Filipino mutual fund industry, was the lack ofspecialist expertise of those involved in monitoring and regulating the market. Inparticular, if the SEC is to fulfill its fundamental role in the securities market, it isessential that its staff not only has a full knowledge of the relevant laws, rules andregulations but also has sufficient experience and perspective of its particular fields ofresponsibility to be able to implement them. Professionalism of the SEC is the key tothe development of the securities industry as a whole.

Again, we wish to emphasise that wherever references are made to the SEC'sshortcomings it must always be borne in mind that the shortcomings identified are notattributable to the existing SEC management or its staff. In fact, it is to its credit thatthe SEC, deprived of adequate resources over many years, has not broken downtotally.

Our review indicates that there is insufficient staff within the SEC to cope with thecurrent demands imposed upon it and certainly there is a very significant lack of depthof specialist knowledge in various fields. The current legislation and regulations havebeen established by Government (presumably having taken advice from specificoutside professional advisers and practitioners). If the development of the mutualfund industry is to be encouraged even on the basis of the existing regulatorystructure, it will be essential for specialist expertise in the following areas: -

•

data collection, statistics compilation, information distribution and storage(including computerisation)

•

establishment of detailed regulations for registration and approval of thosewithin the industry and monitoring due compliance on an on-going basis.

19

reviewing local and foreign regulations and policies as they affect thechanging requirements of the securities industry.

•

production of detailed financial and market analysis reports.

Experience in these fields will involve legal, accounting, computer, legal drafting,statistical and administrative skills.

At the present time, mutual fund activity is very limited and accordingly theopportunity (and indeed the necessity) within the Philippines to gain the necessaryexperience is equally limited. It is our view that there is a significant shortage of

page 8

Exhibit III

DEBT-EQUITY RATIOS OF TOP 1000 COMPANIES

Type of Company 1981 1982 1983 1984 1985 1986

Agriculture, fishing

Construction

Electricity, gas, andwater

Manufacturing

Mining and quarrying

Services

Transportation,communication

Wholesale and retailTrade

Financing, real estate

Total

Total (excludingfinancing)

2.40

3.49

1.32

2.17

2.09

1.67

3.16

3.92

5.75

4.64

2.40

2.15

4.15

1.42

2.13

3.47

1.78

3.69

3.97

9.86

4.66

2.33

4.18

2.40

1.97

2.43

4.26

1.12

6.50

3.79

10.36

5.03

2.71

3.73

2.86

2.47

2.81

4.53

1.61

3.38

3.73

10.28

5.38

2.87

5.81

2.83

1.70

2.13

5.70

1.40

1.04

2.47

12.33

1.68

2.29

4.32

2.97

1.27

2.20

12.49

0.75

1.19

2.64

8.28

3.96

2.39

Sources: Business Day, Top 1,000 Corporations in the PhilippinesBest 1,000 Corporation - Mahal Kong Philipinas Foundation

personnel with the necessary experience and expertise both generally within theindustry and particularly within the SEC.

The development of the industry and the regulations relating thereto, as recommendedin this report, will make the requirement for experienced and expert skills moreessential.The recommendations made elsewhere in this report cannot be fully effectiveunless and until the SEC has upgraded the quality of existing staff and has recruitednew officers with specialist skills and experience.

As an initial step in this process, we recommend that the ADB work with the SEC todevelop plans for updating the existing Philippine regulatory framework, initiate astaff training programme and formulate a programme to increase the budgetaryallocation available to the SEC from sources such as a transaction levy. Thepreparation of these plans probably should include visits to regulatory bodies in theUnited States, the United Kingdom, Hong Kong and perhaps Australia.

Once these plans have been formulated, the ADB should assist the SEC to increase theexperience and expertise of its staff. This exercise should have two dimensions.

The first is to recruit regulatory personnel from other countries to Manila on shortterm contracts to work as consultants with relevant departments within the SEC. Suchindividuals might still be with a regulatory body such as the Securities and ExchangeCommission in the United States or they might be retired personnel from either publicor private sectors elsewhere with relevant securities regulatory experience.

The second is to assist the SEC to develop to the point where it can implementindependently its full responsibilities, including the upgrading of its monitoring andenforcement duties. This, in turn, will have a side benefit of requiring the Philippinesecurities industry as a whole to raise its own standards in order to comply withupgraded rules and regulations. Strong and effective regulation by the SEC will be amajor step in improving confidence in the Philippine securities market.

D. Agree on Steps to Encourage The Issuance of More Equity

A key element in ensuring the viability of the first three recommendations is for theADB and the Government of the Philippines to agree on steps to encourage companiesto issue more equity via public offerings on the Philippine stock market.

There is universal agreement that the private sector would be strengthened if Filipinocompanies issued more equity and thereby built stronger financial foundations. TheTop 1,000 Companies are thought to be substantially overleveraged (see Exhibit IIIon the facing page). The SEC, however, does not yet have the institutional resourcesnecessary to take the initiative to encourage the issue of more equity or to monitor thedevelopment of the capital market. The same holds true with certain Governmentorganisations which are involved with its privatisation policies.

To this end, we recommend that the ADB and the Government of the Philippinesagree on action necessary to encourage companies to issue more equity. Such actioncould include, inter alia:

• The imposition on commercial banks of "prudent" ratios to limit theamounts they can lend to overleveraged companies. The ultimateobjective of these controls is to ensure that companies broaden theirequity bases. The "prudent" limits should be introduced over a two tothree year period, be closely monitored and strictly enforced.

page 9

Exhibit IV

Elements in Action Programme

AreaFund Management

CompanySecurities Trading

SystemsSecurities &

ExchangeCommission

Issuance ofEquity

KeyRecommendation

Establish a fundmanagement company toset up and manage agroup of funds, the firstbeing a closed-end fundthat will invest primarilyi n equities.

I mprove the underlyingtrading systems of thesecurities exchanges sothat securities can beeasily and confidentlytraded.

Upgrade the SEC so itcan play a majorproactive role insecurities regulation anddevelopment of thecapital market

Agree on steps to beundertaken by theGovernment of thePhilippines to encouragecompanies to issue moreequity via publicofferings

Key Elements in •

Publish a new mutual •

Agree on a timetable •

Study the SEC's •

Develop and imposeAction fund code for the Manila and organization and "prudent" lendingProgramme Makati Stock structure, its limits on commercial

•

Establish rulesrelating to the

Exchanges to merge computer systems,financial and human

banks

operation of mutualfund managementcompanies

•

Review fiscal policy

•

Develop Computersystems for stockclearing andsettlement

resources so they canbe upgraded to meeti ts current and futureroles

•

Agree ondebt-to-equity ratiosto be met byPhilippine companiesraising international

as it impacts mutualfunds and theiri nvestors

•

Agree on structure(sponsors, legal

•

Computerise thefunds transfersystem at the CentralBank for repatriationof foreign exchange

•

Recruit experiencedregulatory staff fromother countries tospend 12 to 24months at the SEC toassist in staff

debt under aGovernmentguarantee

•

I nitiate publicofferings as part of

framework,capitalization, and

•

Develop a plan tocomputerise the

training t he privatisationprogramme

management) andtiming of thel aunching of the first

unified stockexchange

•

Set in motion aprogramme toupgrade the quality

fund management of existing staff andcompany to be to recruit new staffli censed with specialist skills

•

Analyse conditions •

Formulate aunder which transaction levy toPhilippine i ncrease financialsubsidiaries of resources availablemultinational to the SECcorporations mightraise equity in thel ocal stock markets

• Any company seeking international debt finance that would be guaranteedby the Philippine Government and/or extended by the World Bank, theInternational Finance Corporation or the ADB should also be required tomeet a designated debt-to-equity ratio. If the loan proposed will result inthe designated debt-to-equity ratio being exceeded, then the companyconcerned should be required to offer "compensating equity" to the publicvia the Philippine stock markets. An example that immediately comes tomind is the recent International Finance Corporation loan extended to thePhilippine Long Distance Telephone Company. There was universalagreement among senior Philippine Government officials that the PLDTshould increase its equity base but there was no institutional mechanismfor addressing this issue.

• Public offerings should be considered as part of the privatisationprogramme. Initially, these public offerings should start with smallerentities such as the Manila Hotel. There is no reason why the ManilaHotel could not be a publicly owned company. The Singapore StockExchange, for example, has several publicly owned hotels quoted on it. Asmaller initial public offering of this sort can also serve as a useful "dressrehearsal" for the larger public offerings that will be associated with theprivatisation of companies such as Philippine Airlines and the PhilippineNational Oil Company.

E. Agree on an Action Programme for Implementation of Key Recommendations

A critical element in ensuring the viability of our four key recommendations is for theADB and relevant departments and agencies of the Philippine Government to agree anaction programme to implement these recommendations. Exhibit IV on the facingpage summarises the specific elements that might be contained in such an actionprogramme. These elements are discussed in different sections of this report and theyare discussed in greater detail in Section X'I.

After appropriate policy dialogues with the Government of the Philippines, the ADBshould be able to identify priorities for the elements in the action programme, lay outa timetable for its implementation and designate Philippine governmental agenciesthat will be responsible for implementing specific elements of the programme. TheADB should be prepared to support this action programme with technical assistancegrants. Depending upon the ultimate dimensions of this action programme, it mayalso be appropriate to involve other international aid organisations, such as the WorldBank, in its implementation.

Criteria For Foreign Fund ManagerWe believe that there are five key criteria for the ultimate selection of a foreignmanager for the proposed fund management company:

•

Established corporate finance skills that can be applied in themanagement of the closed-end equity and venture capital funds.

• Management experience in operating and administering a retail financialservices organisation that specialises in personalised marketing to retailcustomers and the subsequent investment management of their funds.

• A major presence in Asia to ensure that personnel with the requisiteexpertise and experience is readily available for secondment to the fundmanagement company.

page 10

• A proven track record in the management of mutual funds in theAsia/Pacific region.

•

A depth of knowledge of and experience in the Philippines.

In considering any candidates, the ADB will also have to discuss them with theGovernment of the Philippines. For instance, the Government may feel that certaincandidates might have conflicts of interest vis-a-vis the ongoing reschedulings of theiroutstanding loans to the Philippines.

Concluding CommentsViewed realistically, our report indicates that the evolution of a broadly based capitalmarket in the Philippines will take at least five to ten years. To ensure success, it isessential that the development process is carefully monitored and, if necessary,guided. We believe that there is a very real risk of failure unless there is constantsupervision.

Ultimately, such supervision and direction will come from a domestic PhilippineGovernment agency such as the SEC and from an integrated stock market. However,we cannot envisage the SEC being professionally equipped to fulfill this roleindependently for at least three to five years. Consequently, it will be necessary forthe ADB to take the lead by assisting with supervision and direction in the near term.

If the market conditions and regulatory framework currently prevailing remainunaltered, we do not believe that the fund management company and the associatedgroup of funds recommended in this report will be viable. Even if a minimum of theinfrastructure requirements are met, we still are doubtful that the fund managementcompany will be viable. In our opinion, there is no alternative other than for thePhilippine Government, assisted by the ADB, to embark upon a broadly based capitalmarket development programme that may take anywhere from five to ten years toreach fruition, given relative political stability.

page 1 1

ExhibitV

Philippine Mutual Funds

Source: Jardine Fleming/RusseIl interviews and research

OriginalName

DateCreated Type

ManagementCompany

T. A./Custodian.

Date ofChange

NewName

NowManagement

CompanyT. A./

Custodian

CurrentPortfolio

Value

Remarkson

CurrentStatus

AyalaFund Inc.

17/7/74 Close AyalaI nvestment

Management.I nc.

Bank of thePhilippine

I slands

November 1986(thru series of

purchases at thestock exchangeApril-July 1986)

SMFund

I nc.

Far East Bank(partly) andHenry Sy

together withofficers of SM

Fund, Inc.

Treasurer ofSM Fund,

I nc.

P115.42MNAV per

unit atP1.490 as

at30/10/87

Capitalstock

i ncreasedfrom P75Mto P200M.Listing of

additionalshares on

6/1/88

PacificFund

June1969

Open Pacific FundFund

ManagementCo. (dissolvedi n early 1984)

Great Pacific Life(controller's

office)

RizalCommercial

BankingCorporation

P10.1 M(P6.6Msecs.,P3.5M

fixed-in-come)P27.66

per unit asat

06/01/88

Notavailable for

newsubscriptionbut existing

planholdersmay

i ncreasetheir

holdings

TrinityShares

I nc.

22/8/69 Open Trin-InvestManagementServices, Inc.(subsidiary of

PDCP)

PhilippineBanking Corp.

PDCP subsidiarysince 1979

Land Bankof the

Philippinesfrom 10/87

Peso 3.8M AwaitingSEC

guidelinesto

reactivatemarketing

effortPhilippine

I nvest-ment Co.

31/4/74 Close BANPEBMgmt. Corp.(joint venture

of BancomDevpt. Corp.,

FEBTC,Anselmo

Trinidad & Co.

Cres-cent Int'l

Fund(Luxem-bourg)

Far EastBank &

TrustCompany

Liquidatedi n 1983

FilipinasMutualFund

6/12/57 Open I nvestmentPlanning Corp.

of thePhilippines

Far East,Philbanking

30/6/62converted into a

financial co.(NAV of the fund

was P8.5Mwhen it wasconverted)

I n 1976,the

companywas

convertedinto a

develop-ment

corporation

IV. PAST OPERATIONS OF MUTUAL FUNDS

The concept of mutual funds was introduced to the Philippines from the United Statesin the late 1950's when the Filipinas Mutual Fund (FMF) was launched on December6, 1957. Three other mutual funds followed suit twelve years later, namely the PacificFund, Trinity Shares and Crescent International Fund. The last mutual fund, theAyala Fund, was created in 1974. Exhibit V on the facing page shows thebackground details of each of these funds. Ultimately, each of these mutual funds wasunsuccessful.

FMF was launched in the middle of a bull market, its promotional and marketingefforts attracting considerable public interest. With a nationwide sales force rangingbetween 8,000 to 10,000 agents selling its shares, either by outright purchase orthrough a monthly instalment scheme marketed as a private investment plan, FMF atits height had some 70,000 investors and a net asset value of approximately Pesos 14million in 1960.

Having grown rapidly in a rising market, FMF encountered serious problems wheninvestors, concerned about the volatility of the stock market and the value of theirinvestments, attempted to redeem their holdings. In effect, there was a run by FMFinvestors similar to a run on a bank. FMF was unable to liquidate its stock marketholdings rapidly enough to meet the redemption requirements of its investors.Consequently, its share price collapsed.

A combination of factors led to the failure of FMF. The most important of these were:

• Cost to investor. For those who acquired shares through outrightpurchase, a front-end load or commission of 8% was deducted from thevalue of their investment. In addition, annual management fees in theregion of 1.5% per annum were also charged by the fund managers.

Investors acquiring FMF shares through monthly installments under theprivate investment plan suffered considerable dilution of the actualinvestment value of their contributions. As much as 50% was lost in thefirst year through deductions by fund managers for selling commissionsand associated costs.

As the initial euphoria created by a rising stock market and high-profilemarketing subsided, investors began to realise that the cost of entry intothe stock market through FMF was inordinately high.

• High administrative costs. FMFs administrative costs became excessivebecause the majority of its 70,000 investors were usually paying only 10to 15 Pesos per month (equivalent to about Pesos 100 per month now).

• Absence of regulatory control. Lack of legislation, codes of conduct orguidelines issued by the Philippine Government to control the marketingand administration of mutual funds resulted in many abuses

Many unsophisticated retail investors were lured into purchasing FMFshares by extravagant promises made by, at best, hastily and partiallytrained salesmen whose sole motivation was to obtain their salescommissions. Although FMF did set up a training programme, it wasnever able to educate fully the 8,000 to 10,000 agents who, at one stage,were selling FMF shares. The professionalism of the sales force was

page 12

further suspect because people sensed that each salesman really only hada small group of family and friends to sell to. Once this limited markethad been saturated, the sales agents had neither the skills nor theexperience required to develop new clients on a "cold calling" basis.

• Volatility of the stock market. Investor confidence was seriouslyundermined by dramatic fluctuations in the stock markets. Any adversemovement in stock prices in the Philippines usually triggers a rush toliquidate, resulting in further sharp price declines. A mutual fund, inparticular, would be unlikely to liquidate its own holdings fast enough tomeet the subsequent surge of redemptions. In the case of FMF, very fewinvestors were sufficiently wealthy to be able to sustain losses withouthardship. For those who had. transferred the bulk of their savings intoFMF shares, any downward movement in share values precipitated panicselling.

• Narrow character of the stock market. The paucity of investmentgrade stocks inevitably resulted in the prices of these securities beingdriven even higher by the inflow of funds seeking quality investments.As these stocks became "overbought", buying attention switched tosecond and third liners and, in some cases, to more speculative issues.When selling pressure replaced active buying and FMF sought to raisecash to meet redemptions, the market for lower-grade stocks evaporated,leaving FMF with no choice but to liquidate its holdings of blue chips andmarketable second liners. Consequently, the residual portfolio wasreduced to unmarketable low-grade stocks with the result that theremaining investors became "locked in".

Faced with an inability to remain a viable open-ended mutual fund, FMF wasconverted into a finance company, Filipinas Mutual Finance, in June 1962.Eventually, FMF became a development corporation in 1976.

By 1969, interest in mutual funds was again rekindled and three new funds werelaunched: Pacific, Trinity and Crescent International. The Crescent InternationalFund was registered in Luxembourg and sold to international investors.

The three funds enjoyed the boom in the Philippine stock markets but became, likeFMF, victims of the market's volatility. They encountered a bear market, the fall ofwhich was too fast for them to meet redemptions. In the process, many smallerinvestors were again seriously "burned" and effectively lost the value of theirinvestments. With the exception of the Trinity Mutual Fund, which today comprises amere 900 investors and a net asset value of Pesos 3.8 million, the other funds wereclosed.

The last Filipino mutual fund was launched in July 1974 when the Ayala Groupintroduced the closed-end "Ayala Fund". This was well managed and properlystructured. However, even the Ayala Fund suffered from the same extremely limitedrange of investment grade quoted issues and fell prey to the same problems that othermutual funds had encountered in a bear market.

Rather than close the fund, Ayala decided to withdraw. The fund management andeffective ownership was transferred to the Shoemart Group and the name changed to"SM Fund". The SM Fund is quoted an both the Manila and the Makati StockExchanges and has recently increased its capital stock from Pesos 75 million to 200million. However, the SM Fund can no longer be considered a mutual fund in thegenerally accepted sense. Its composition and control are now closely linked to thecorporate interests of the Shoemart Group and Sy family, the controlling stockholdersof Shoemart.

page 1 3

When reviewing the performance of mutual funds in the Philippines over the pastthirty years, it is clearly evident that the majority of the retail investors who investedin them had little or no basic understanding of the workings of capital markets.Essentially, they are people in the middle or lower-middle income categories whoseinvestment/savings strategy is historically inclined to short-term deposits with localbanking or savings institutions.

Their only exposure to "longer term" investment is almost exclusively limited to pre-need schemes such as memorial or education plans and life insurance. Their lack ofinvestment acumen makes them particularly vulnerable to plausible and wellpresented sales pitches by, at best, over enthusiastic and, at worst, unscrupuloussalesmen. These unsophisticated investors invariably purchase mutual fund sharesafter the market has risen and then get caught when the market declines. Fallsexperienced in a bear market in the Philippines are, more often than not, too fast tomeet redemptions.

The consequence of the failure of these five mutual funds is that today they have avery speculative image with virtually all Filipinos. This "casino" image, coupled withthe lack of investors' sophistication, a volatile and narrowly based stock market,escalating administrative costs, insufficient regulatory control and a strong biastoward short-term money market instruments, remains a major obstacle to thesuccessful re-introduction of equity-oriented mutual funds sold to retail investors.

page 14

Exhibit VI

Manila Stock Exchange Composite Index(Year-End)

1980 1981 1982

Source: Manila Stock Exchange

1983 1984 1985 1986 1987

V. REASONS FOR THE THINNESS OF THE STOCK MARKETSEven though the Philippine stock markets have risen eightfold since their low point in1984 (see Exhibit VI on the facing page), they still remain thin equity markets. Outof a total of 129 companies listed on the Manila Stock Exchange, there are only 13actively traded. These are:

Exhibit VIIActively Traded Philippine Stocks

* - Atlas and Lepanto are designated as second liners in that Atlas is currently overgeared and both Atlas andLepanto have passed dividends in recent years.

As Exhibit VIII on the next facing page illustrates, the remaining volume isconcentrated on third liners on the "Big Board" and speculative stocks on the "SmallBoard".Even within the most heavily traded shares, only a small portion of the total shares isactually available for the investing public to buy. San Miguel Corporation has 31% ofits shares that are freely available for purchase. Ayala Corporation has 11%. Theremaining shares are "locked up" in the hands of the founding family or in the handsof friends (see Appendix XIID).

The ADB asked us to examine certain areas to assess whether they were reasonscontributing to the thinness of the stock markets. These areas and our assessment ofthem are:

Discriminatory Fiscal Treatment of Capital Market AssetsWe do not believe that the fiscal treatment of capital market assets vis-a-vis bankdeposits and the lack of fiscal and other incentives for companies to go public is soserious as to be a major impediment to the development of the securities markets. Infact, there are two major fiscal incentives that should make it attractive for companiesto go public:

a. Inheritance Tax is higher on equity holdings in private companies.

page 15

Major Blue Chip Good Second LinersCommercial/Industrial San Miguel Sime Darby

P.L.D.T. Soriano Corp.Globe-Mackay Ayala Corp.

Mining Philex ApexBenguetAtlas*Lepanto*

Oil Exploration Oriental Petroleum & MineralsPhil. Overseas Drilling

2.07

Volume of 10 most actively traded listed companies

Volume of second-line companies and speculative issues

0.72

1982

0.65

1984

1.56

8.36

19.3

70%

70%

Source: Manila Stock Exchange

ExhibitVIll

Manila Stock Exchange(shares traded in billion pesos)

21%

53%

4596

53%

75%

1986San Miguel 1,089,004Philex 999,871PLDT 511,828Lepanto 354,869Globe Macka 203,162Atlas 199,804Benguet 143,300A. Soriano 111,129Sime Darby 107,197Oriental Pet. 70,400

3,790,562Tot turnover P8,362.2 B

1985Philex 131,118San Miguel 44,491Phil Cocoa 36,739Globe Macka • 32,572PLDT 22,179Lepanto 19,508Atlas 17,619Benguet 10,255Oriental Pet. 8,307I nsular Bank 6,409

329,197Tot turnover P1,557.2 B

1984Philex 161,725Atlas 91,888PLDT 51,517San Miguel 38,178Fil. Synth 26,000Benguet 23,707Lepanto 21,660Prec. Elec. 16,398Globe Macka • 13,265Oriental Pet. 11,868

456,225Tot turnover P0.649 B

1987Philex 2,712,748Lepanto 2,634,921San Miguel 2,137,253Atlas 1,508,423Apex 1,180,448Phil O'seas 1,108,346Oriental Pet. 1,107,545PLOT 867,969Trans-Asia 737,524A. Soriano 559,571

14,554,748Tot turnover P19,265.713

1980Atlas 446,397Philex 199,441San Miguel 143,731Lepanto 141,228Oriental Pet. 139,999Apex 118,691I nterport 101,558Benguet 61,406Phil O'seas 61,1711st Phil Hldg 44,723

1,458,345Tot turnover P2.07 B

1981Philex 73,731Atlas 59,167Oriental Pet. 54,105Lepanto 43,162Apex 41,428San Miguel 35,526PLOT 26,857Trans-Asia 22,343Stanford 22,0901st Phil Hldg 18,757

408,166Tot turnover P0.614 B

1982Semirara Coa 124,581Banco Filipino 84,476Atlas 67,460Oriental Pet. 60,532Philex 56,386San Miguel 46,630Phil O'seas 31,168Lepanto 28,324Metropolis De 27,500Trans-Asia 24,550

1,804,989Tot turnover P0.724 8

1983Philex 626,925San Miguel 508,559Atlas 223,035Precision 119,939Lepanto 119,902PLOT 111,976Benguet 36,947Oriental Pet. 21,383Phil O'seas 20,142BF Homes 16,182

1,804,989Tot turnover P3.4 B

b. Capital Gains Tax is minimal con the disposal of shares in publicly quotedcompanies.

Strict Listing RequirementsWe do not consider that existing formalities, in themselves, constitute an obstructionto the listing of securities. Neither the disclosure conditions nor the documentaryrequirements are unduly onerous. The published form of Listing Agreement sets outongoing obligations of a listed company, the requirements of which are straight-forward. We did note, however, that the exchanges may require additionalinformation from companies in support of listing applications. The exchanges alsoreserve the right, at their discretion, to suspend dealings of listed securities. Anunreasonable exercise of these rights would naturally act as a strong deterrent to anycompany seeking a listing. Nevertheless, any less detailed disclosure requirementswould be detrimental to the development of a more sophisticated securities market.

There is, however, an additional safeguard for investors. Before any securities can belisted on the exchanges, they must first be registered with and receive the approval ofthe SEC before their listing and sale to the public. In its application to the SEC, eachcompany must provide extensive, detailed information which includes all theinformation required by a Listing Agreement. Approval by the SEC is a preconditionto an application to the exchanges for a listing and, although the exchanges reviewapplications independently of the SEC (and may require such additional informationas they think fit), they are able to rely on the details filed in the company'sRegistration Statement as approved by the SEC.

High Issue CostsAs discussed in the paragraphs above, the listing requirements and procedures of theexchanges are not unduly cumbersome. There are, however, areas for improvement.

Provided a company has completed the application correctly (together with allnecessary supporting documentation) and is able to satisfy any additional enquiries,we estimate that the exchanges, acting through the Joint Listing Committee, would beable to approve the listing within four to six weeks. As mentioned above, the relativelack of detailed information required by the exchanges is balanced by the moreextensive details to be filed with the SEC under the provisions of the RSA.

The SEC has the power to require any additional information or documentation as itdeems necessary in the public interest and in order to protect the interests of investors.For the same reasons, the SEC may either reject applications or impose suchconditions on registration as it thinks fit. It is estimated that the registration ofsecurities and the approval for sale to the public would take sixty to ninety daysprovided the papers were in order. While we would not favour any reduction in theinformation required by the SEC, we would recommend a review of SEC internalprocedures in order to reduce the time taken for the determination of an application.

The fees charged by the exchanges for the initial listing (max. Pesos 42,000 -including both exchanges) and the annual fee (Pesos 10,000 per exchange) arereasonable. There is a maximum fee of 0.10% payable to the SEC on initial filingbased on the maximum aggregate price at which the securities are to be offered. Inaddition, there are the inevitable printing costs and fees of lawyers, accountants andother professional advisers. The fees to be paid to the underwriters are conventionallylimited to a maximum of 5%. However, the current trend is for a listing to besponsored by selected groups of brokers from each exchange who negotiate their feesindependently with the issuing company. The SEC, in giving its approval to the sale

page 1 b

of the securities, may impose the maximum amount of remuneration or commissionto be paid in connection with the sale (or offer for sale) of the securities. Providedthe SEC imposes reasonable limits and ensures compliance, the costs of newissues are not unduly high when compared with the costs of an issue on anexchange in another jurisdiction. The costs may, however, be significantly higherthan those for raising capital through banking institutions.

Limited Availability of InformationTheoretically, any member of the public may have access to the audited annual andunaudited semi-annual accounts of companies whose shares are registered withthe SEC under the RSA. The SEC will not release to the public the annualaccounts of other corporations unless there are exceptional circumstances.

Our research reveals that even for the former category neither the SEC nor theexchanges have taken steps to ensure that these companies produce accountswith sufficient data to enable others to measure their true trading performance or toassess, with any confidence, the strength of their balance sheets.

It is our experience that Filipino companies, be they privately or publicly owned,are extremely reluctant to publish or even discuss details of their current andprospective activities with anyone unconnected with the company. It is, therefore,highly improbable that they will create pressure themselves for stricter disclosurerequirements. It is a fundamental criterion for the development of the securitiesmarket, however, that companies disclose sufficient information in their accountsfor investors to assess realistically their true financial condition. The currentsituation will only be improved by a strong lead from the SEC.

Neither the brokers nor other institutions involved in the securities markets havedeveloped research facilities capable of producing and disseminating detailedcompany analyses. It is unclear if this is a direct result of the lack of sufficientfinancial information or their perception that research material is neither necessarynor required. If the former, they should be encouraged to voice their opinions insupport of the changes necessary to provide fuller disclosure by companies. If thelatter, they should be persuaded to the view that a more active securities marketwill be to their obvious benefit and that this can be assisted substantially by thepublication of up-to-date detailed research material.

As stated above, the information required to be contained in published accounts isinsufficient and, in the absence of effective compliance controls from the SEC, thereis the possibility that a failure by a company to file its accounts might goundetected. Not only is a strong lead required from the SEC but also we wouldrecommend that the Accounting Standards Council be consulted in thedevelopment of improved disclosure requirements for published accounts.

Existing financial reporting requirements are inadequate. Insufficient information isavailable for analysts to assess with any degree of confidence the past andprojected trading performance of individual corporations or the strength of theirbalance sheets.

The accounting profession must be encouraged to adopt and comply with stricteraccounting standards.

page 17

Unattractiveness of the Equity Markets As an Investment AlternativeUltimately, investors, both retail and institutional, buy equities because they believethey offer superior returns (in the form of capital appreciation and dividend yields)over other investment alternatives. Exhibit IX on the facing page shows the post-taxreturns of alternative investments in the financial markets in the Philippines since1983. Equities have not been attractive investments when compared to otheralternatives.

The outstanding feature of the Philippine financial markets during this period has beenthe very high level of interest rates. There was a strongly inverted yield curve during1983 and 1984. At present, the cost of 30-day money has dropped to approximately14%. However, the Government deficit is expected to increase during 1988, therebyincreasing pressure on interest rates. In such an investment climate, the only sensiblething for the smaller investor to do is to invest his money in short-term, fixed-incomeinstruments. We believe that this is the major reason why investors have not foundthe equity market to be an attractive investment alternative.

If accepted, this reasoning has important consequences for certain Government actionsthat have been proposed. Specifically, while the strong bias remains towards debtrather than equity finance, there is little point in the Government offering tax or fiscalincentives to try to attract capital to the stock market. Such incentives might makestocks marginally more attractive, but the benefits of these incentives will be morethan offset by the attraction of high interest rates. Until the yield curve movessubstantially downward, Philippine investors will be reluctant to convert their excessliquidity into capital market investments, be they equities, fixed interest notes orbonds.

Inadequate RegulationsAs Robert Fell, Chief Executive of the Stock Exchange of Hong Kong, recentlypointed out, "supervision of securities listings plays a key role in maintaining theintegrity of a stock market. The settlement system and the surveillance of exchangemembers' conduct also contributes to an equity market in which people feel safe toinvest." Put another way, if investors perceive an equity market as being unsafe (i.e.,controlled by insider trading and speculative stock manipulation), they simply will notinvest their money in equities.

Unfortunately, the regulation of both Filipino stock exchanges has not been as strongand as effective as it should have been. There was a general consensus among thosewe interviewed that the local stock exchanges were unsafe markets in which to investone's accumulated capital.

We believe that the fundamental reason for this attitude is that the regulatoryapparatus, primarily the SEC, has inadequate resources to fulfill effectively its role ofsupervision and regulation. Until this state of affairs is remedied, investors willremain reluctant to put their capital at risk in the Philippine Stock markets. This iswhy one of our key recommendations focuses upon the strengthening of the SEC.This topic is discussed in greater detail in Section VII.

Shortfall in the Supply of Stocks

Owners of private companies and the management of public companies sell equitiesvia the stock markets for one fundamental reason: they believe they are getting anattractive price for their equity. If the owner of equity can obtain a price multiple of

page 19

ExhibitX

DEBT-EQUITY RATIOS OF TOP 1000 COMPANIES

Type of Company 1981 1982 1983 1984 1985 1986

Agriculture, fishing

Construction

Electricity, gas, andwater

Manufacturing

Mining and quarrying

Services

Transportation,communication

Wholesale and retailTrade

Financing, real estate

Total

Total (excludingfinancing)

2.40

3.49

1.32

2.17

2.09

1.67

3.16

3.92

5.75

4.64

2.40

2.15

4.15

1.42

2.13

3.47

1.78

3.69

3.97

9.86

4.66

2.33

4.18

2.40

1.97

2.43

4.26

1.12

6.50

3.79

10.36

5.03

2.71

3.73

2.86

2.47

2.81

4.53

1.61

3.38

3.73

10.28

5.38

2.87

5.81

2.83

1.70

2.13

5.70

1.40

1.04

2.47

12.33

1.68

2.29

4.32

2.97

1.27

2.20

12.49

0.75

1.19

2.64

8.28

3.96

2.39

Sources: Business Day, Top 1,000 Corporations in the PhilippinesBest 1,000 Corporation - Mahal Kong Philipinas Foundation

Need for Public IncentivesAgain, we see no need, at present, for incentives for the public to invest in securities.The fundamental problem is that a substantial majority of the Philippine public doesnot have sufficient disposable income to engage in any sort of savings activity at all.In one interview, an interviewee estimated that 98% of the Philippine public is unableto participate in a meaningful savings programme.

Tax cuts or other fiscal incentives will not, in themselves, correct this situation. Astronger domestic economy, more widespread employment and sustainable economicgrowth are the fundamental factors that will increase the savings available for more ofthe public to be able to invest in securities.

Generally, the small minority of Filipinos who have savings available to invest insecurities have found post-tax returns of alternative investments to be more attractive.When there is an inverted yield curve with short-term interest rates reaching 40% perannum at one point, rational investors would never invest in securities. Instead, theywould do what people have done: purchase short-term money market instruments andstay liquid.

During our interviews, executives gave us many other reasons for the thinness of thestock markets. The most frequently mentioned reasons included:

•

The founding family does not want to lose control (even though thecompany may already be publicly listed).

•

They do not want outsiders prying into their business affairs.

•

Filipinos want to keep a good thing "in the family".

• Public companies have to answer to more people and to disclose morefinancial information to the public, particularly the Bureau of InlandRevenue.

•

The board of a public company becomes more conservative.

•

Public companies lose the entrepreneurial spirit that built them in the firstinstance.

A further reason, mentioned only once, concerned the insider trading case associatedwith Lepanto mining. This case has lingered, unresolved, with the SEC for over tenyears. One interviewee thought this unresolved case may have had a chilling effectupon the appetite of private companies to go public.

While all these reasons have some degree of validity, they and others like them havenot prevented private companies in other Asian countries from going public during thepast fifteen years. In fact, virtually all of the initial public offerings in Hong Kongduring the past fifteen years have been those of previously privately owned, family-controlled companies.

Instead, we believe that the reasons for the thinness of the Manila stock markets aremore complex. Basically, we have divided these reasons into three categories:

•

Unattractiveness of the equity markets as an investment alternative

•

Regulatory shortcomings

•

Shortage of stocks.

page 1 8

Exhibit IX

Post-Tax Returns of Alternative Investments

Source: Jardine Fleming/Russell research and analysis

1983 1984 1985 1986Pre-TaxReturn

Post-TaxReturn

Pre-TaxReturn

Post-TaxReturn

Pre-TaxReturn

Post-TaxReturn

Pre-TaxReturn

Post-TaxReturn

1. Money Market Paper 16.90 14.37 27.20 23.12 20.98 17.83 13.58 11.20

2. Gov't Securities 14.54 12.36 37.90 32.33 27.05 22.99 16.04 13.23

3. Stocksa. Commercial 15.60 13.27 11.52 9.79 9.06 7.70 3.57 3.21

b. Mining 5.48 4.66 6.41 5.45 9.51 8.08 4.45 4.01

4. Savings Deposits 9.70 8.25 9.85 8.37 10.84 9.21 8.62 7.11

5. Time Deposits 15.30 13.00 24.16 20.53 21.83 18.56 14.77 12.19

Source:

Annual Reports of Makati and Manila Stock Exchanges, Central Bank Annual Reports, Top 1,000Companies

Note:

Witholding Tax: 1985 - 15%; 1985 - 17.5%Dividend Tax: 10%Stock returns based on selected C-I and Mining Issues.

five or six times earnings (or even higher), then there is a strong financial incentive forhim to raise capital by selling equity on the stock market. By the same token, if he islikely to receive only one or two times earnings, there is virtually no incentive for himto come to the market.

Unfortunately, the investment climate in the Philippines during the past ten years hasbeen very unattractive. It is really only in the past eighteen months that the stockexchange has become an interesting market for selling equities. If the equity marketscontinue to remain strong or rise to higher levels, then they will become a moreattractive alternative for owners of equities. In fact, it is probably critical to thesuccess of the privatisation programme initiated by the Philippine Government thatequity markets continue to stay strong.

The Government has announced its intention to privatise several publicly ownedcorporation and to dispose of shares sequestered by the Presidential Commission onGood Government of certain major Filipino corporations. Included in the original listare: -

•

Philippine National Oil Corporation

•

Philippine Air Lines

•

National Steel Corporation

•

Manila Electric Corporation

•

Philippine Communications Satellite Corporation (Philcomsat).

If the Government were to implement its privation policy, it has been estimated thatsome Pesos 10 billion (US$500 million) of new stocks could become available duringthe next two years. A securities broker felt that it would be virtually impossible to sellPesos 5 billion (US$250 million) of new equity during 1988. This would imply thatthe privatisation programme will either be severely curtailed or that new sources ofequity investment will have to be developed (i. e. foreign investors).

A further problem associated with the supply of stocks is the pricing of new issues.On the one hand, securities professionals invest in equities rather than in bankdeposits. On the other hand, the listing committees of the stock exchanges have astrong say about what they consider to be a fair price for the investing public.Unfortunately, this can result in substantial underpricing of initial public offerings.There is, therefore, a very understandable reluctance on the pan of private companiesto go public.

There is general agreement that the balance sheets of Filipino companies should havestronger equity bases. The top 1,000 companies are thought to be substantiallyoverleveraged (see Exhibit X on the facing page). The SEC, however, does not yethave the institutional resources necessary to take the initiative to ensure thatcompanies increase their equity bases, let alone to monitor the implementation of suchinitiatives.

To this end, we recommend that the ADB and the Government of the Philippinesagree steps to encourage companies to issue more equity. Such steps could include,inter alia:

• The imposition on commercial banks of "prudent" ratios to limit theamounts they can lend to overleveraged companies. The ultimateobjective of these controls is to ensure that companies broaden their

page 20

equity bases. The "prudent" limits should be introduced over a two tofour year period, be closely monitored and strictly enforced.

• Any domestic listed or unlisted company seeking international debt to beguaranteed by the Philippine Government and/or extended by The WorldBank or the ADB should also be required to meet a designated debt-to-equity ratio. If the loan proposed will result in the designated debt-equityratio being exceeded, the domestic company should be required to offercompensating equity to the public via the Philippine stock markets. Anexample that comes immediately to mind is the recent InternationalFinance Corporation loan extended to the Philippine Long DistanceTelephone Company. There was universal agreement among seniorPhilippine Government officials that PLDT should increase its equitybase, but there was no institutional mechanism for addressing this issue.

• Public offerings should be considered as part of the privatisationprogramme. Initially, these public offerings should start with smallerentities such as the Manila Hotel. There is no reason why the ManilaHotel could not be a publicly owned company. The Singapore StockExchange, for example, has several publicly owned hotels quoted on it. Asmaller initial public offering such as this can also serve as a useful dressrehearsal for the larger public offerings that will be associated with theprivatisation of companies such as Philippine Airlines and the NationalOil Company.

These steps will be a key element of the preliminary action needed to commence thedevelopment of the broadly based capital market necessary for the fund managementcompany to be viable.

Viewed realistically, the process of "broadening and deepening" the Philippine stockmarkets will be a five to ten year exercise of continual capital market development.Unless there is a sustained effort to guide and monitor this process, there will be avery real risk that the growth rate of the Philippine economy will fall even furtherbehind those of its ASEAN neighbours.

Ultimately, such supervision and direction will come from a domestic Philippinegovernment agency such as the SEC and from the stock markets themselves.However, we cannot envisage the SEC being professionally equipped to fulfill thisrole independently for at least three to five years. Consequently, it will be necessaryfor the ADB to assist the SEC in providing supervision and direction in the near term.

page 2 1

TRANSFERAGENT

EfFJCJENT?•

AVERAGE

INEFR1ENTI

MAWLM7E

DaAlF Y6FS7Vrx

BWM C* '

TRrWSFM

CLEARING

~ • I CUSTODIAN

BROKER AGENT i i momi

9ROKER ~IVDUAL~ •

$TEP 1 SIEA2

Exhibit XI

DOMESTIC TRANSACTION

STEP'S

STEP 4

VMS

i

i

I

TOTAL

26

47

96+

TARE MEN

LOW Pa"WEAVERAGE kt L1lEA M VOLUME

SEUM8RAKER

Exhibit XII

SALE OF STOCK & REPATRIATION OF FOREX

SEU ORMmADELG4TE

cwr" BAAarSE PI ES nUASAC1kWMaw

00

VI. OVERVIEW OF THE STOCK MARKET TRADINGSYSTEMS

Considerable work needs to be done to improve the underlying trading systems of theexchanges, if securities are to be easily and confidently traded. At present, the systemsand procedures of the Manila and Makati stock exchanges are totally inadequate tohandle high volumes of stock trading, much less to ensure that the rights of investorsare adequately protected.

Stock Clearing Procedures

It takes, on average, approximately fifty days to clear a domestic stock trade from theseexchanges (i.e., the time taken from the date of trade to the date of receipt of physicalcertificates by a custodian bank). While the time required for each step in the clearingprocess is documented in greater detail in the subsections below, there is a majorbottleneck in the transfer agent's capability to process and release new stock certificatesto the stock clearinghouse.

Stock clearing takes even longer for a foreign investor. In average trading volumes, itnormally takes at least twenty and, on average, thirty days for foreigners to obtainapproval from the Central Bank to repatriate their foreign currency. Interviews withofficials at the Central Bank highlighted the shortage of staff to process promptlyapplications to repatriate foreign currency.

If the delays and backlogs experienced by overseas investors are to be avoided,computerised systems should replace the laborious manual systems currently in use. Inperiods of high trading volumes, average delays at the Central Bank SecuritiesTransaction Division are, at best, forty six days, at worst, in excess of ninety days.

So far as domestic clearing is concerned, it is not uncommon for up to eight letters ofassignment to be in circulation for a single certificate. Furthermore, there is no centraldepository system to hold shares after they have been cleared.

These topics are discussed in greater detail in the subsections below.

Domestic Transactions

Exhibit XI on the facing page outlines each stage of a domestic transaction. Wehave analysed the average time taken to complete a transaction under three scenarios -where the Transfer Agent is, by Filipino standards, "efficient", "average" and"inefficient".

• Buying Broker to Clearinghouse to Transfer Agent (Steps I and 2). Theaverage time taken between the trade date and the delivery of documentationby the clearinghouse to a Transfer Agent is seven working days, sometimeseight when trading volumes are high. By any standards, this isunacceptably slow. An immediate objective should be 48 hours, whichshould be reduced to 24 hours within a year.

• Transfer Agent (Step 3). Transfer Agents create a very serious bottleneckin the clearing system. In average: trading volumes, an "efficient" TransferAgent will, at best, take fourteen working days to process a transaction andto issue a new certificate. A "reasonably efficient" Transfer Agent will

page 22

take, on average, thirty five days and inefficient Transfer Agents (themajority) will not take less than eighty days.

We strongly recommend that a detailed review of the role of TransferAgents be undertaken by the SEC as a matter of urgency. We believe thatthere are too many Transfer Agents and that the majority are unqualified tofulfill their role in a professional manner. We were informed by the SECthat every Transfer Agent, some fifty in all, was required to register withthe SEC by 1st January, 1988. Now that the SEC has a Register ofTransfer Agents, it should undertake a thorough review of their role in theclearing system.

• Transfer Agent to Clearinghouse to Buying Broker to Custodian (Steps 4and 5). Again, the average time taken is, at five days, unacceptably slow.We cannot see any reason why the time taken to complete Steps 4 and 5should not be reduced immediately to 48 hours and further reduced to 24hours within six months.

• Letters of Assignment. As a direct result of the inefficiency of TransferAgents in delivering certificates promptly, securities may have been tradedseveral times during the clearing process (Steps 1 to 4). To overcome theproblem of the lack of physical stock certificates, letters of assignment areused to transfer title. One interviewee said that it was not unusual for eightletters of assignment to be in circulation for a single certificate.

• Repatriation of Foreign Exchange. A major obstacle to the restoration ofinternational confidence in the Philippine stock markets was created by thevirtual inability of foreigners to get money out of the Philippines in 1984 -at least across the official exchanges. In theory, repatriation was permittedbut, in practice, the Central Bank was not processing any applications. It isestimated that at the end of 1984 some Pesos 110 million of frozen foreignfunds were sitting in Manila (mainly in the custody of the Hongkong andShanghai Banking Corporation) and not earning interest.

The position has improved subsequently but we have found that there are still lengthydelays. Exhibit XII on the facing page analyses the procedures involved betweenthe date of trade and the eventual repatriation of foreign currency. Three scenarios aredepicted. The time taken between the trade date and the remittance of foreign currencyin low trading volumes is, on average, a tolerable eight days. However, if tradingvolumes increase, as they have done over the past two years, the delay in receivingCentral Bank approval increases dramatically.

The principal reasons for the lengthy delays can be summarised as:

•

Scarcity of foreign exchange at the Central Bank

•

Inefficient manual systems in the Securities Transaction Division

•

The Securities Transaction Division is understaffed.

Unless the Central Bank improves its systems, the scepticism of internationalinstitutional investors regarding their technically unfettered right to repatriate foreignexchange will act as a major deterrent to the inflow of foreign investment sought by thePhilippine Government.

We recommend that the systems employed at the Central Bank be computerised. Tothis end, the SEC and both exchanges should open a dialogue with the Central Bank toexamine how best this can be achieved.

page 23

There is a clear and urgent need for a critical review of the trade execution, clearing andsettlement systems of both exchanges. This problem area is one where the ADB canprovide valuable technical assistance to the SEC. Existing procedures need to bereplaced by modern computerised systems. Our comments and recommendationsregarding computerisation are set out below.

Computerisation

In terms of stock exchanges and the brokerage houses, there is a general lack ofcomputerisation. Furthermore, there is no automated reporting system to disseminateprice information from the floor of the exchanges to the brokerage community, bothdomestic and foreign. In addition, there is no computerised central depository systemto hold the shares after they have been cleared.

In all modern stock exchanges, the major functional components are handled bycomputer systems. These include:

• An order execution system that transmits buy and sell orders from memberfirms to the floor of the exchange, executes the order and then retransmits theorder execution information back to the member firm.

• A consolidated price reporting system that transmits prices of executed tradesto all member firms, both domestic and foreign and to other interested membersof the financial community, as well as the general public.

•

An automated interface to the clearing and settlement systems, both of whichare also usually automated.

These systems are normally run on nonstop computers and are supported by majorstaffs of computer executives both at the stock exchange and at member firms.

In addition to the computer automation systems associated with the stock exchange,there can also be computer-based links to associated futures and options exchanges andto the financial community. The links to the financial community are particularlyimportant to support the movement of funds associated with securities trading andfinancing of the brokerage community.

Because virtually all of these computer systems are absent from the Manila and theMakati stock exchanges and the associated Philippine brokerage community, thePhilippines has a unique opportunity to learn from the experience of other stockexchanges as it begins to install its own systems. In effect, the Philippines canincorporate the best features of systems installed in foreign stock exchanges whendesigning its own integrated system.

Unification of Stock Exchanges

A significant body of opinion is in favour of the unification of the stock exchanges.There are many compelling reasons for unification, not least of which is that financialresources in the Philippines are, at the best of times, scarce and it would be a perversedecision of both Manila-based stock exchanges to duplicate the costly computer systemsnecessary to upgrade trade executions, clearing and settlements. Given the evidentinability of both exchanges to agree on the terms of a merger, there is a strongpossibility that two incompatible and inferior systems may be developedsimultaneously, at considerable expense.

page 24

The ADB could enhance the prospects of a unified stock exchange by offering aTechnical Assistance grant for a detailed analysis of computer systems suitable for amerged exchange.

This assistance probably will involve a review of the relative strengths and weaknessesof trading systems employed by other securities exchanges in the Pacific region,particularly those in Hong Kong, Taiwan and New Zealand. Each of these stockexchanges has implemented recently a major computerisation programme.

Other stock exchanges recommended for review are the Toronto Stock Exchange andthe Midwest Stock Exchange in Chicago. These exchanges have devoted substantialresources, both financial and managerial, over the past ten years to computerising theirsecurities trading systems. Moreover, because these are medium-sized, they havetended to learn from the experience of the larger exchanges. While the Philippines maywant to review briefly the computerisation systems at the London and New York stockexchanges, it should be noted that these are handling vastly different volumes oftrading. We believe that a medium-sized stock exchange, such as the Midwest StockExchange or the Toronto Stock Exchange, will be a more valuable model for thePhilippines. Specific implementation projects will flow from a review of these andother regional stock exchange trading systems. The ADB should be prepared tosupport these with appropriate technical assistance grants.

page 25

VII. STATUS OF THE SECMr. Robert Fell, Chief Executive of the Stock Exchange of Hong Kong, recentlystressed the vital role played by the Securities Commission of Hong Kong in thesupervision of, inter alia, new listings, the settlement system and surveillance ofexchange members' conduct.

We believe that an efficient, professionally staffed and adequately funded SEC is thevery cornerstone on which the development of the Philippine capital markets, thesecurities industry and the protection of investors will depend.

One of the contributory factors to past problems within the securities market, includingthe past failures of the Filipino mutual fund industry, was the lack of specialist expertiseof those involved in monitoring and regulating the markets. In particular, if the SEC isto fulfill its fundamental role in the securities market, it is essential that its staff not onlyhas a full knowledge of the relevant laws, rules and regulations but also has sufficientexperience and perspective of its particular fields of responsibility to be able toimplement them. Professionalism of the SEC is the key to the development of thesecurities industry as a whole.

The current legislation and regulations have been established by Government(presumably having taken advice from specific outside professional advisers andpractitioners). If the development of the mutual fund industry is to be encouraged, evenon the basis of the existing regulatory structure, it will be essential for enhancedspecialist expertise in the following areas:

•

data collection, statistics compilation, information distribution and storage(including computerisation)

• establishment of detailed regulations for the registration and approval ofthose working within the industry and monitoring due compliance on anon-going basis.

•

reviewing local and foreign regulations and policies as they affect thechanging requirements of the securities industry.

•

production of detailed financial and market analysis reports.

Experience in these fields will involve legal, accounting, computer, legal drafting,statistical and administrative skills.

At the present time, mutual fund activity is very limited and accordingly the opportunity(and indeed the necessity) within the Philippines to gain the necessary experience isequally limited. It is our view that there is a significant shortage of personnel with thenecessary experience and expertise both generally within the industry and particularlywithin the SEC.

The development of the industry and the regulations relating thereto, as recommendedin this report, will make the requirement for experienced and expert skills moreessential.

We wish to emphasise that whenever references are made to the SEC's shortcomings itmust always be borne in mind that the shortcomings identified are not attributable toeither the existing SEC management or its staff. In fact, it is to their credit that theSEC, deprived of adequate resources over many years, has not broken down totally.

page 26

PolicyandReview

Assistant CommissionerPolicy Development

Legal

I

UnitTrusts

Protec-tion ofInves-tors

Commissioner

Deputy Commissioner

Assistant CommissionerCorporate Finance

Corpo-rateTake-overs

FinanceandMergers

Exhibit XIII

HONG KONG COMMISSION FOR SECURITIES AND COMMODITIES TRADING

Disclo-sure

MarketSur-veil-lance

MarketSur-veil-lance &Regis-try

Assistant CommissionerOperations

AuditRegis-try

Audit

DealersAccountRegis-t ry

DealersRegis-trationRegis-try

Regis-trationICL Ac-counts

Inter-preta-tion &Trans-lation

Confi-dentialRegis-try

Manage-mentService

I

GeneralRegis-try

Throughout the duration of this study, we have received the full cooperation of theSEC.

Existing Structure and ResponsibilitiesThe SEC comprises ten departments employing a total staff of 572. Each department iscontrolled by a Director reporting to a board of four Associate Commissioners and aChairman. The Associate Commissioners are rotated annually between departmentson a roster system. The responsibilities of the SEC are much wider than itscounterparts in other countries. The SEC acts as the Companies Registry for allFilipino corporations as well as being the regulatory body responsible for the securitiesmarkets and their constituent members. The SEC also has quasi-judicial powers andfunctions. The department responsible for the supervision and regulation of andcompliance by the securities industry has a total staff of 70, less than 8 percent of thetotal SEC workforce.

Our research and interviews confirmed that the SEC is, at present, dangerouslyunderequipped to fulfill its existing responsibilities, let alone to undertake any enhancedroles. There are serious backlogs and lengthy delays of routine applications.

The underlying reasons for the SEC's existing plight can be attributed to:

•

A lack of understanding by the Government of the importance of the SEC'sproper role

•

Inadequate Government funding over many years

•

Government bias, in previous years, toward debt financing rather than thedevelopment of the domestic capital market.

Exhibit XIII on the facing page illustrates the structure of the Securities Commissionof Hong Kong. The Philippine SEC, as presently constituted, has neither themanpower, professional skills or resources to create a similar structure nor thecomputer or software systems essential to carry out adequately its critical regulatoryrole.

RecommendationsThe upgrading of the SEC will be a major undertaking requiring the support andcommitment of the Philippine Government and international aid organisations such asthe ADB. The development of the SEC into a professional, proactive and independentbody will be a lengthy process, lasting up to five years. As stated elsewhere in thisreport, the SEC is underfunded and will need Technical Assistance grants from theADB to enable it to upgrade its professionalism.

Our prime recommendation is that the ADB give top priority to the allocation ofTechnical Assistance grants for a detailed study of the SEC, its organisation andstructure, its systems, its resources (both financial and human) and its current andfuture roles.

There are many areas requiring immediate review, the most important of which can besummarised as:

page 27

• Existing Organisation and Structure:

- The Companies Registry function should be separated entirely from thatof the SEC.

- The annual rotation of Commissioners between departments should bereviewed. The existing roster system results in a lack of momentum andcontinuity.

- The Constitution of the SEC should be amended so as to enable the SECto recruit professional staff other than CPAs and lawyers. The SECcurrently employs 120 CPAs and lawyers but does not have anyprofessional securities market specialists on its payroll.

- The existing structure of the SEC should be the subject of a major review.ADB's support through Technical Assistance grants, will be essential if theSEC is to be reorganised along; lines similar to the Securities Commissionsregulating other Asia Pacific stock markets.

• Systems. The SEC lacks telex facilities let alone computerised systems.A separate systems study will be needed before any detailedrecommendations can be made.

• Financial Resources. The upgrading of the SEC will require asubstantial increase in its annual budget. Until a more detailed study iscarried out, it will not be possible to estimate accurately how muchadditional funding will be required. However, so far as the sources offunding are concerned, we would recommend that consideration be givento increasing company registration fees and the implementation of atransaction levy similar to that charged in Hong Kong. The additionalincome generated, if supplemented by Government and international aidorganisation grants during the earlier stages of the SEC's development,should eventually make the SEC self-funding. Furthermore, a broaderbased and more active stock market will lead, in due course, to anincreasing flow of income generated by the transaction levy.

We believe that additional funding of the SEC is essential not only for itsdevelopment but also to ensure its future independence.

• Human Resources. It is evident that one of the contributory factors topast problems within the securities market was the lack of specialistexpertise of those involved in monitoring or operating the securities market.

In particular, if the SEC is to fulfill its fundamental role in the securitiesmarket, it is essential that its staff not only has a full knowledge of therelevant laws, rules and regulations but also has sufficient experience andperspective of its particular fields of responsibility to be able to implementthem. Our review indicates that there is insufficient staffing within the SECto cope with the current demands imposed upon it and certainly there is avery significant lack of depth of specialist knowledge in various fields.Areas of major weakness are identified earlier in this Section. Therecommendations made elsewhere in this report cannot be fully effectiveunless and until the SEC has upgraded the quality of existing staff and hasrecruited new officers with specialist skills and experience.

We recommend that experienced regulatory staff are recruited from othercountries to spend between twelve and twenty-four months working asconsultants with relevant departments within the SEC. These individuals

page 28

might still be with a regulatory body such as the SEC in the United Statesor they might be retired personnel from either public or private sectorselsewhere, with relevant securities regulatory experience. Domesticstandards will inevitably be raised by the experience imported by suchindividuals.

So far as local recruitment is concerned, we consider it essential that theSEC is seen to be offering attractive career opportunities with competitivescales of remuneration. Without these ingredients, the SEC will be atsignificant disadvantage when recruiting or retaining skilled andexperienced personnel.

• Current and Future Roles. As the cornerstone of the securitiesindustry, the SEC's responsibilities are far reaching and onerous. Otherparts of this report have discussed in some detail the many problemsconfronting the SEC. The most critical areas can be summarised as:

- The Regulatory Framework. We recommend that a detailed review beundertaken to update and consolidate provisions relating to securitiescontained in the Revised Securities Act 1982, the Investment CompaniesAct 1960, The Corporation Code and the General Banking Act 1948(insofar as it concerns Common Trust Funds offered for sale to the public).The principal objective should. be to create a single unified code covering allaspects of the public sale or offer for sale of securities. Without animproved and unified Code, there will be a very real risk that differentregulatory standards will create confusion in the minds of investors.

- The Stock Exchange. We recommend that the SEC, with TechnicalAssistance support, initiate a detailed review of the existing stockexchanges. Key areas for review will include:

Management of the exchanges

Unification of the exchanges

Computerised systems for order execution, price reporting, clearingand settlements

Listing procedures and requirements

reports and investor information

Compliance

Disclosure (including related party transactions)

Conduct and solvency of exchange members.

The need to review existing trading, clearing and settlement procedures hasbeen discussed in Section VL

- Public Relations. As stated elsewhere in this report, the public'sperception of the equity markets is that they are highly risky and open tomanipulation and insider dealing. The word "casino" was mentionedregularly during interviews. The reputation of mutual funds is equally poor(see Section IV).

page 29

Although there is universal agreement that a sustained public relations programmeshould be undertaken in order to educate the general public about the role of the capitalmarkets, the exchanges and the SEC itself, there is an apparent reluctance by thoseinterviewed to suggest how this will be funded and who will be responsible for itsimplementation.

We recommend that the SEC and both stock exchanges reach a consensus on the typeof promotional activity required to alter the public's perception of the equity marketsand to agree on budgets for future years. It will take several years to alter publicperception of the equity markets and stock exchanges. One means of tackling theproblem might be for the SEC and stock exchanges to issue regular press releasesreporting the steps being taken to improve the regulatory framework of the capitalmarkets and, in particular, the strengthening of regulations concerning investorprotection.

Virtually no effort has been made to increase public awareness of the role of capitalmarkets or the exchanges themselves. We were informed that the combined promotionalexpenses of both Stock Exchanges in 1986 was Pesos 10,000 (US$500).

page 30

VIII. REVIEW OF RELEVANT SECURITIES REGULATIONS

The principle features of the regulatory framework governing mutual funds are theInvestment Companies Act 1960 (ICA), the Revised Securities Act 1982 (RSA) andthe various rules, regulations and guidelines issued by the SEC.

Because of the similarity of common truss: funds promoted by banking institutions andregulated by the Central Bank, we have allso reviewed the General Banking Act 1948,the Manual for Regulation of Banks and Financial Institutions and other Central Bankrules and guidelines. Our comments on these are set out in this section following ourcomments on mutual fund regulations.

Mutual Fund RegulationsThe ICA was passed specifically to regulate mutual fund activities through the SEC.As the creation of a mutual fund involves the sale or the offer for sale of securities tothe public, it is also necessary for the shares of the mutual fund to be registered underthe RSA. These statutes together with various rules, regulations and guidelines issuedby the SEC constitute the principle regulatory framework governing mutual fundactivities.

We have identified various components of the regulatory framework governingmutual funds that should be subject to review. The principal areas identified forreview can be summarised as follows.

Establishment Procedure

A mutual fund company must first be incorporated under the Corporation Code.

Both the ICA and the RSA set out detailed but separate requirements for the filingwith the SEC of a registration statement as part of the procedures for registrationunder each statute. After consultation between the SEC and legal representatives of aproposed mutual fund, a unified statement has been designed to standardiserequirements and to avoid duplication of information and documentation. Theregistration statement must set out in detail all relevant facts relating to the structure ofthe mutual fund and its proposed activities including: a) its capital structure,b) thenames and relevant experience of its directors and officers, c) its commitment, if any,to any one or more brokers and the agreed fees and d) its investment guidelines andpolicy. The text of any proposed prospectus or other marketing documentation inconnection with the issue must also be filed for approval by the SEC.

The SEC has power to require such additional information and documentation to beprovided, as it deems necessary, in the: public interest or for the protection ofinvestors. It also has power to limit the registration of mutual funds depending on thecurrent investment opportunities or prevailing market conditions.

We recommend that the information required for inclusion in the registrationstatement be reviewed to ensure full and detailed disclosure of all material factssufficient for the SEC to be able to monitor and regulate due compliance after themutual fund has commenced operations. [n addition to details relating to the mutualfund company itself, there should also be full and detailed disclosure of the particularsof the proposed management company, the investment management company (ifseparate) and the custodian.

page 3 1

In approving the registration, the SEC' sets out specific conditions, rules andregulations concerning the operation and activities of the individual fund, compliancewith which is a requirement for continued registration. The SEC has power topromulgate detailed rules and regulations generally concerning all mutual funds but asyet their power has not been exercised fully. In their absence, the rules andregulations imposed as a condition of registration comprise that mutual fund'sindividual code.

After approval by the SEC, the registration statement must be published in the OfficialGazette for two consecutive weeks and inn two daily newspapers for two consecutivedays.

It is our recommendation that a full mutual fund code should be published by theSEC. This will avoid the necessity of detailed individual codes although the SECshould still retain the discretion to impose additional conditions where thecircumstances of a specific application so warrant. The publication of the detailedcode will provide assistance for those advising on the establishment and operation ofmutual funds and will also enable investors to have a better understanding of theinvestment and regulatory controls provided by the SEC.

Capital Structure

The registration statement must contain details of the proposed capital structure of themutual fund and of the composition of its board of directors.

The ICA currently requires a minimum capital of Pesos 500,000 and the CorporationCode also establishes minimum subscribed and paid-up capital requirements. Theserequirements should be reviewed, particularly in the case of an open-end fund, toensure that they are appropriate and practical. We understand that the SEC isconsidering increasing the minimum capital requirement to Pesos 10,000,000. Webelieve that the size of the increase is secondary to the importance of ensuring thatthere is an effective and experienced board of directors and that there is a detailedoperating policy set out in the registration statement.

The provisions relating to the constitution of the board of directors are restrictive (e.g.,all directors must be Filipino citizens; not more than 50% of the board can be officersof the mutual fund). It is of paramount importance that the SEC ensures that there issufficient expertise and experience on the board and that this will be a condition ofinitial and continued registration. The current provisions should be reviewed toremove restrictions which are not conducive to the establishment of an appropriateboard.

Management Company

We envisage, in the majority of cases, that the mutual fund company will beestablished by a separate existing or newly-established management company withspecific responsibility for the operation and administration of the mutual fundactivities. At present, there are no specific rules and regulations relating to suchmanagement companies, (other than those general corporate provisions set out in theCorporation Code and those applying by virtue of other activities, if any, of thecompany). We understand that the SEC is considering the establishment of aminimum capital requirement for management companies in the region of Pesos20,000,000, although this may be reduced in individual cases depending on the qualityand experience of the officers and shareholders of the company.

page 32

We recommend that the SEC establishes detailed rules and regulations relating to theconstitution, operation and administration. of management companies.

Investment Adviser

The ICA provides that if a separate investment adviser is appointed, it will be subjectto annual reappointment by the directors or shareholders of the mutual fund after aninitial period of two years and that its remuneration and termination conditions mustalso be similarly approved. We recommend that these provisions are reviewed andcontrol of the investment adviser be regulated by way of registration with the SECunder provisions similar to those applying to the registration of brokers, dealers andsalesmen under the RSA.

Custodian

Section 16(f) of the ICA provides that custody of the assets of the mutual fund mustbe placed with 1) a local commercial batik of good repute or 2) a member of one ofthe stock exchanges, subject to such rules and regulations as the SEC may determineor 3) the mutual fund company itself, subject again to such rules and regulations as theSEC may determine, including a requirement that the relevant officers of the mutualfund company be bonded in such sums as the SEC may determine. This latterprovision itself implies concern as to the suitability of the appointment of the mutualfund as its own custodian.

It is our firm recommendation that responsibility for custodianship of the assets(including cash) of the mutual fund company be given to an independent bank withspecialist custodian capabilities.

Operation

The existing statutory provisions do not contain guidelines for the detailed operationof the mutual fund and its relationship and communications with existing andprospective investors. We consider it essential that the SEC should issue rules andguidelines relating to all aspects of the procedures for sale, issue and redemption ofshares and related charges. Similarly, guidelines should be issued for the valuation ofinvestments and the calculation of the net asset value including a statement ofpermitted deductions or charges allowed when calculating the prices available forinvestors. The adoption of these rules and guidelines as a minimum standard wouldbe a condition of registration for each fund.

Investment Activities

The ICA contains provisions restricting certain investment related activities (e.g.borrowing, short selling, buying on margin) which can only be effected in accordancewith rules and regulations of the SEC. The provisions are not extensive and inthemselves do not provide a satisfactory guideline for mutual funds or for investors. Itis accepted that a wider range of restrictions is taken into account at the time ofapproval of the registration statement. However, we recommend that the SEC shouldpublish a standard form of detailed minimum investment restrictions and prohibitionswhich must be adopted as a condition of registration.

page 33

Conflict of Interest

The ICA contains provisions to establish a separation of responsibilities withprohibitions of common connected persons between the separate entities in order toprevent potential conflicts of interest. Whilst we strongly support the principle ofensuring that the interests of investors are not prejudiced by abuses of conflict ofinterest situations, we consider that the specific provisions are unclear and in need ofreview. For example, Section 9(b)(1) of the ICA provides that a mutual fund cannotemploy as a regular broker any director, officer or employee of the mutual fund or anyone who is affiliated to such a person. However, Section 16(e)(2) provides that anaffiliated person of the mutual fund may act as a broker provided its commissions orfees are within specified reasonable limits.

In the review and promulgation of the rules and regulations referred to in this section,we recommend that there should be no requirement imposed for non-affiliation orindependence of the directors, officers or shareholders of the mutual fund company,management company or investment management company. We do not consider thata complete separation of responsibilities is necessary in all cases, provided always thata full disclosure of common interests is made available to investors.

In addition, the SEC has the general power to monitor and supervise the activities ofthose involved in mutual fund activities under the provisions of the RSA and ICA. Afull exercise of this power will serve to prevent abuses arising from conflict of interestsituations and thereby protect the interests of investors.

Reports and Disclosure

It is obviously in the best interests of the public that they have access to sufficientinformation concerning the mutual fund company, its operations and policies in orderto be able fully to understand the nature and risk of a prospective investment. The fullregistration statement is available for inspection at the SEC, but this is clearlyimpractical for all applicants for shares. We recommend that all applicants are given acopy of the registration statement or, preferably, a summary of the relevant partsthereof as approved by the SEC, at the time of an application for shares.

It is also essential for investors to be informed of the status of the mutual fund on aregular basis. The ICA currently provides for audited annual and unaudited semi-annual reports to be distributed to shareholders. The ICA sets out certain minimumrequirements to be included in these reports and these should be reviewed to ensurethat there is a full disclosure of all relevant information for investors. We alsorecommend that there should be a specific requirement for the bid/offer prices to bepublished daily in a relevant newspaper.

The SEC itself requires reports on a quarterly basis and also has wide powers to callfor further information from mutual funds in order for it to be able fully to effectregulatory control. The SEC should consider requiring monthly reports from mutualfunds for a period of twelve months from the initial launch of a new mutual fund.

It is important to ensure that the public has access only to such information as isnecessary for the protection of the interests of investors.

Stock Exchange Listing

It is clearly appropriate for a closed-end fund to seek a listing on the exchanges inorder to establish a trading forum for its shares. The SM Fund is currently listed on

page 34

the exchanges. This is not as necessary for an open-end fund where shares are issuedand redeemed directly through the administration and operating structure of themutual fund. However, both exchanges have indicated that they are supportive of theconcept of listing the shares of an open-end mutual fund, although it would only bepossible on the assumption that an accommodation will be reached regardingcompliance with certain of the current listing requirements.

It would not be relevant for an open-end mutual fund to undertake the procedures andexpense necessary to achieve a listing in order only to create an additional tradingcapability. However, as we mention below, there are currently certain taximplications in not being listed.

If the development of mutual fund activities gave rise to a requirement for more funds,whether closed-end or open-end, to be listed we would recommend that the listingrules be reviewed and a separate category of listing rules for mutual funds beestablished.

Taxation

We have not undertaken an extensive study of all aspects of the taxation provisionsrelating to mutual funds and their activities. However during the course of our review,we have identified two matters which require consideration by the relevant authorities.

A mutual fund company as a matter of course would be involved in activitiesclassified as dealing in securities. Under existing tax rules all income derived fromthese activities (including realised gains on investments) would be subject to acorporate income tax of 35% charged on net income. This represents a very severepenalty on the value of the assets of the investors. We consider that the investmentsare, in reality, the assets of the investors and not the mutual fund and accordingly themutual fund should be treated as transparent for this taxation liability.

From an investor's taxation standpoint there is a distinction between the tax treatmenton gains on disposal of shares in a mutual fund depending on whether or not the gainarises from the disposition of a listed or unlisted investment. Listed investments arecharged at 0.25% of gross selling price as a final tax. However, gains on thedisposition of an unlisted security are charged at 10% on the first Pesos 100,000 andthereafter at 20%. This creates an artificial inducement for an open-end mutual fundto seek a listing on an exchange. As we have stated earlier, it is not necessary for anopen-end fund to require an additional trading forum through an exchange listing as italready provides an accessible trading environment for the public through its ownstructure. The taxation provisions should be amended, as appropriate, to the effectthat dispositions of shares by investors in a registered open-end mutual fund should beeither exempted from capital gains tax or subject to the 0.25% final tax.

We recommend a review of all aspects of the taxation provisions as they affect mutualfunds to ensure a uniform and reasonable tax treatment for both the mutual fund andits investors.

There is an urgent requirement for a revision of the existing rules and regulations andfor the establishment of a detailed mutual fund code to be administered by the SEC.The need for review is illustrated by the following specific problems:

page 35

a) inadequate requirements for detailed information on establishment of amutual fund;

b) failure to promulgate detailed rules and regulations relating to theoperation and administration of a mutual fund;

c) inappropriate capital and board structure requirements for the mutual fundcompany;

d) absence of rules and regulations relating to management companies;

e) inappropriate custodian requirements;

f) inadequate and inappropriate regulations for the operation andadministration of mutual funds;

g) insufficient investment guidelines and restrictions;

h) inadequate reporting and disclosure requirements.

In addition, taxation provisions, insofar as they relate to mutual funds, should berevised to ensure the establishment of a fair and reasonable tax environment formutual funds and investors.

It is fundamental to the development of the mutual fund industry for the SEC itself tobe upgraded to enable it to fulfil the role necessary for the successful implementationand operation of the new code and of the revised mutual fund regulations.

Common Trust RegulationsThe General Banking Act of 1984 defines a trust company as a corporation formed ororganised for the purpose of acting as a trustee or administering any trust or holdingproperty on trust for the use and benefit of others. It further provides that any trustcompany or any bank authorised by the Central Bank to engage in the business of atrust company will be subject to the control of the Central Bank. In addition to thespecific provisions of the General Banking Act, the Central Bank has issuedregulations governing the trust operations of trust companies, banks and investmenthouses (for the purposes of this review, we refer to these collectively in the term "trustcompany").

There are regulations which relate generally to the carrying on of a trust business andalso specific provisions which relate to the establishment of a common trust fund.This is defined as a fund maintained exclusively for collective investment andreinvestment of certain moneys received in the capacity of trustee. It is thedevelopment of the activities of the common trust funds that is of concern in thereview of the mutual fund industry.

General Provisions and Financial Requirements

The trust company must be permitted by its articles and by application to the CentralBank to carry on trust business. Once so authorised a trust company may establish,administer and maintain one or more common trust funds (a "CIF").

A trust company must maintain a minimum deposit of Pesos 250,000 with the CentralBank. This deposit is adjusted monthly depending on the size of trust assets on a scaleof Pesos 250,000 for every Pesos 35.5 million assets. An additional deposit of 10%

page 36

of the trust assets themselves must also be maintained at the Central Bank (althoughCTFs have preferred claims to this deposit). Government securities and othersecurities approved by the Central Bank may be used for these deposits. Althoughbanks and investment houses must comply with separate minimum capitalrequirements (Pesos 100 million ) and also comply with other financial criteria inrespect of their wider activities, these do not apply to trust companies. Werecommend that the capital requirements for trust companies be increased to at leastthe level recommended for mutual fund management companies and that the depositrequirements are generally reviewed to ensure that they represent adequate protectionfor investors in a CI'F.

A trust company may carry out other activities but the regulations provide for aseparation of the trust activities from the other activities of the company. They alsorequire the specific duties and responsibilities of those officers involved in the trustactivities to be set out in by-laws or in board resolutions.

The board of directors of the trust company have authority and responsibility for theadministration of the trust business although they may delegate their duties andresponsibilities to a committee or other officers. Officers dealing with trust operationsmust not only meet the qualifying standards for bank officers but also have suitableexpertise. The separation of duties referred to in the previous paragraph is reinforcedby a requirement that officers in charge of trust operations should not carry out anyother banking duties and members of a committee in charge of trust operationspreferably should not.

It is essential that the quality and experience of those responsible for theadministration of a CTF should be subject to regulatory approval and the currentprovisions clearly are not sufficient in this respect. Further, it is noted that theregulations concerning the establishment of the Trust Plan for a CTF (referred tobelow) do not require disclosure of details concerning those responsible foradministration of the CTF.

The regulations require trust operations to maintain separate books and accounts andfor trust assets to be kept separate from all other assets. They also provide that thetrust should not transact directly with other departments or with directors or officers ofthe trust company nor deal in assets owned or controlled by the trust company. Theregulations are not specific in relation to the assets of one CTF being kept separatefrom those of another CTF administered by the same trust company nor do they makeclear whether or not the trust assets, although accounted and maintained separately,would be unaffected by adverse financial situations in the trust company generally.These points are fundamental and adequate provisions safeguarding the CTF's assetsmust be adopted.

The Trust Plan

Every C:IF is established in accordance with a specific declaration of trust (the Plan)which must be approved by the directors and submitted to the Central Bank thirtydays prior to its implementation. The declaration of trust is executed as trustee by aspecific trust company or by directors or officers of the trust company and the trusteehas exclusive management control of CTF. The Plan is available for public inspectionduring regular business hours. The rules require the Plan to make provision forvarious basic operating features (e.g. admission and withdrawal of funds, investmentpowers, auditing requirements, valuation basis, operations procedures). They do not,however, provide details for these features.

The rules are not specific as to whether or not the Central Bank has power to approveor reject the Plan and if so on what grounds. It is provided that the Plan may be

page 37

amended by resolution of the directors of the trustee and the amendments submitted tothe Central Bank for notation, but there are no provisions for prior approval by eitherthe Central Bank or investors.

The Plan is the central feature of the establishment of a L I E The requirement for thepromulgation of detailed rules and regulations is as essential for the CTF as it is forthe mutual fund. The inadequacy of the existing regulations is illustrated in thefollowing instances:

a) There is a specific investment limitation restricting investments in any onecompany to a maximum of 15% of the trust assets (unless the security isissued or guaranteed by the government) but there are no other detailedspecific investment guidelines or restrictions.

b) There are provisions which require accounts and reports to be issued tothe Central Bank and investors but without specifying in detail thefrequency or content of the reports.

c) The trustee is entitled to charge a management fee out of the fund butthere are no provisions setting out details of the manner of calculation orpayment of the fee.

In addition, we recommend that the contents of the Plan and changes to the contentsshould be subject to approval of the Central Bank as the current regulatory authority.We also recommend that changes to the Plan should be subject to the approval of theinvestors. At present the only remedy available to an investor is to withdraw hisinvestment in the event of changes being made with which he disagrees.

It would appear that the concept of a CTF has developed from a desire by the banks tointroduce specialist savings accounts for their clients and the rules issued by theCentral Bank have evolved as an adjunct to the regulatory control already exercisedover the bank by virtue of its other banking businesses.

The provisions attempt to provide a complete separation of the trust functions fromthe banking operations whilst at the same time maintaining Central Bank control bypreventing any delegation outside the trust company.

There are however no restrictions on the development of CTF into a fully fledgedequity orientated mutual fund established by a bank or investment house or, moresignificantly, a trust company established specifically for that purpose. The currentCentral Bank rules and regulations clearly do not provide the necessary frameworkappropriate in such circumstances.

The current regulations are inadequate as an effective code of rules for a mutual fundindustry. The following headings illustrate certain fundamental problem areas:

1. Inadequate capital requirements for the trust company.

2. Lack of regulatory supervision of the suitability of those responsible forimplementation and operation of a Cl'1P.

3. No independent custodian.

4. Lack of regulatory control on establishment of the Plan and changesthereto.

5. Very limited rights of the investor.

page 3 8

6. Lack of detailed operating guidelines.

7. Inadequate investment guidelines or restrictions.

8. Inadequate disclosure, reporting and accounting requirements.

9. Inadequate fee and commission controls.

If mutual funds are to develop through the expansion of Ci l- activities it is essentialthat a full detailed code of rules and regulations is promulgated.

The same basic principles of regulatory control and supervision and investorprotection apply equally to a CTF and a mutual fund established under the ICA. Therevised codes for both should therefore be consolidated or, at the very least, beidentical in all material details.

page 39

IX. SCOPE OF THE FUND MANAGEMENT COMPANY

We recommend that a fund management company be incorporated to manage a groupor "family" of funds, each of which will be tailored to the specific needs or prioritiesof differing types of investors and managed by fund managers with relevantexperience in each particular field.

To ensure that the investing public has confidence in the fund management companyand its products, the financial standing and integrity of the shareholders should beunimpeachable. To this end, we recommend that the fund management company bestructured as a joint venture with the following possible shareholdings:

Our reasoning for recommending such a shareholder structure is that:

• An international fund management company will contribute the proveninvestment skills and expertise required to ensure the long term viabilityof mutual funds.

• The Asian Development Bank's involvement will contribute significantlyto investor confidence and provide on-going support to the developmentof the capital markets.

• A quasi-government banking institution will provide a link betweengovernment policy makers controlling the privatisation programme andthe private sector capital markets.

• Major Filipino financial institutions will have the required levels ofintegrity and financial standing in addition to providing a nationwidenetwork of offices.

The foreign fund manager, in addition to taking equity, will manage the mutual fundsfloated by the fund management company on a remuneration/incentive commissionbasis. This will ensure professional management of the fund management company.The association of quasi-governmental organisations such as the Development Bankof the Philippines and major Filipino financial institutions will give the fundmanagement company added image and credibility and greater access not only to theauthorities - indispensable at this stage of Philippine capital market development -but also to the stocks of enterprises such as the Manila Hotel which the Governmentof the Philippines wants to privatise.

We further recommend that the ADB works with the relevant Filipino authorities toincorporate and authorise the fund management company as soon as possible. Thesubsequent development and performance of the fund management company can beclosely monitored over the next three years and be used as a model when formulating

page 40

,Shareholders Equity

Foreign Fund Manager 40.00%Asian Development Bank 5.00%Quasi-government Bank 5.00%Major Filipino Financial Institutions 50.00%

100.00%

FUND MANAGEMENT COMPANY : Establish a fund managementcompany to set up and manage a group of funds, the first beinga closed end fund that will invest mainly in equities.

Fxhibit XIV,

Timing of ActionProgramme

Commence, drafting new mutual fund rules

egusultant working with SEC).

•

Review fiscal policy an its impact on mutual funds ani nvestors (consultant working with SEC).

•

Publish new mutual fund rules andregula ns.

•

Commence drafting a unified mutual fund/unit trust code(consultant working with SEC).

• Agree on structure (sponsmlegal framework, capitalisation,managementetc-.) and timing of launch offirst"authorised"fund managementcompany (SEC workingwith ADD and firstsponsor).

SECURITIES AND EXCHANGE COMMISSION: Upgrade the SEC sothat it can play a major proactive role in securities and devel-opment of the capital market.

Study SEC organtsar on, structure, computer systems. finan-cial and human resources, in order that they may be upgradedto fulfill adequately its current and;fusum roles . (consultantworking with SEC and ADD):

•

Second SEC staff members to regional financial institution fortraining in administration of mutual funds (SEC and ADS).

Formulate a transaction levy to increase financial resoavailable to SEC (SEC and ADD).

•

Implement programme to upgrade quality of existing staff/recruit new staff with specialist skills.

SECURITIES TRADING SYSTEMS: Improve underlying tradingsystems of securities exchanges so that securities can be easilyand confidently traded.

Develop plan' to computerise a unified stock exchange SECStock ex es, ADS and consul

Develop computer systems for stock clearing and settlements(stock exchanges and systems consultants)

gree o

nexchanges (SEC

lanes)

•

Computerise STD systems at Central Bank to expedite repa-triation of forex (CB and systems analysts).

ISSUANCE OF EQUITY: Agree on steps to be undertaken byGovernment of the Philippines to encourage companies toissue more equity via public offerings.

Develop andcommence impos t g;

units oncommercial banks (SEC and Central Bank

•

Initiate public offerings as part of privatisation p

gree an Debt/Equityratios to be met by companies raisinnternational debt under Government guarantees (ADD, IFC,

SEC and Central Bank).

• Review conditions under which Philippine subsidiaries ofmultinational corporations mightraise equity in the local stockmarkets (consultant working with ADB).

19883rd qtr

O - COMMENCE

•

- COMPLETE

AL-IMPLEMENT

O

1988 + 1989~

1989

1989

4th Qtr 1st Qtr 2nd Qtr ( 3rd Qtr

ON 3OING RE0

fEW

upgraded legislation to regulate a mutual fund industry. Additional fund managementcompanies can be authorised by the SEC when market conditions are consideredsuitable.

A suggested timetable for the preliminary stages of the recommended action plan isset out in Exhibit XIV on the facing page. Provided the timetable is adhered to, theSEC, with technical assistance from the ADB, should be able to commencesimultaneously : -

•

the upgrading of rules and regulations governing the mutual fund industryand the protection of investors

•

the upgrading of its existing organisational structure and resources

•

the incorporation of the recommended fund management company

Our recommendations about the scope of the fund management company and thesequence in which its mutual funds are offered are driven by our understanding ofwhere savings are being accumulated in the Philippine economy.

Retail Savings

Interviewees estimated that some 2% of the population (approximately one millionpeople) control anywhere between 60% and 80% of the country's wealth. A further10% of the population controls perhaps an additional 15%. It is this 12% of thepopulation that has the financial capability to save. Of these, only about 20% (i.e., 2%of the total population) have sufficient savings to contemplate an investment in thestock market. Essentially, these are the only Filipinos who have the ability to absorbthe risk should the prices of stocks decline, rather than rise.

Another method of quantifying the number of Filipinos who can save is to identify thenumber of life insurance policies in existence throughout the country. There arebetween two million and three million current life policies, including associatedprepaid policies for other future liabilities such as burial or college expenses. Eventhese life policy premium flows are, by arty standards, modest. Philippine AmericanLife Insurance Company (Philamlife), the largest life insurance firm in thePhilippines, accepts an average monthly premium as small as Pesos 75 (U.S. $3.75)from a school teacher. Philam Life's total monthly premium inflow from schoolteachers throughout the entire country amounts to Pesos 29 million (U.S. $1.5million).

Of the Filipinos who have the ability to save, more than 50% live in the Metro Manilaarea. The majority of the balance is split more or less evenly between Cebu andDavao, two major urban centres in the outlying provinces. The remainder of thePhilippine population is living at or close: to the margin and simply has no ability tosave capital. The extended family is their survival net, not accumulated savings.

During our interviews, there was general agreement that more funds will be cominginto the financial system from smaller savers in the rural areas. International pricesfor primary commodities have risen significantly, in particular for coconut products.Eighteen million people are dependent upon the coconut industry compared to twomillion dependent on sugar. The Philippine National Bank, for instance, is nowreceiving more deposits from the provinces than from Metro Manila. These smallsavers lack any alternative form of investment. An issue to be addressed by ourrecommended mutual fund management company will therefore be: "What sort ofdistribution system can be used to reach these savers in a cost-effective manner?" As

page 4 1

discussed later, we believe that such a distribution system might have to be part of acountrywide life insurance sales force.

Institutional SavingsIn the institutional area, the great majority of savings are concentrated in a fewinstitutions. The Armed Forces Retirement System, SSS, GSIS and PCIC controlpension fund savings. One life insurance company, the Philippine American LifeInsurance Company, controls about 40% of the life insurance industry's assets. Thetop three banks control the majority of the trust funds.

Institutional savings, moreover, are predominantly placed in fixed income securitieswith a significant proportion in the short end of the yield curve. This is, to a largedegree, the result of the high interest rates currently on offer in the Philippines, butcan, in part, also be attributed to the lack of suitable equity investment opportunities.

These key considerations on the magnitude and distribution of savings in thePhilippines lead us to recommend that the family of funds be offered in the followingsequence:

•

A closed-end fund that will invest primarily in special equity situations.This fund will total between U.S. $25 million and U.S. $50 million.

•

A small venture capital fund of about U.S. $10 million to developcompanies that will be ready to go public in 3 to 6 years' time.

•

A fixed-income fund targeted at small and medium-sized financialinstitutions.

•

An equity and/or fixed-income fund for small retail investors.

Each of these funds is discussed in turn.

Closed-End Equity FundGiven the constraints discussed in the beginning of this appendix, we recommend thatthe first fund offered by this new fund management company be a closed-end fundwhich will invest primarily in these sorts of equities:

•

Convertibles, warrants and/or preferred stock of publicly quotedcompanies

•

Initial public offerings

•

Secondary offerings by publicly quoted companies

•

Significant minority positions in private companies that will ultimately gopublic

•

Leveraged buyouts, management buyouts and company reconstructionsthat will also go public in due course.

page 42

This fund will increase the investment appetite for equities by acting as aninstitutional investor that is willing to purchase a broader and more sophisticatedrange of securities than the institutions presently active in the Philippines today.These investments will be warehoused in the fund until such time as it is profitable tosell them off in the secondary market. This in turn will increase the supply ininvestment grade stocks available to public investors, both institutional and retail.

The initial size of this fund should be between U.S. $25 million and U.S. $50 millionif it is to have any significant impact on broadening and deepening the Philippineequity markets. While some of the capital in this fund may come from institutionalinvestors in the Philippines, we believe that a significant proportion of the capital willhave to come from foreign sources. In fact, it may be necessary for the ADB, theWorld Bank and other international governmental agencies to provide the majority ofthis fund.

We believe that there will be adequate investment opportunities for this fund. Certainof our interviewees mentioned significant private companies that are considering apublic offering provided the economic recovery is maintained and the stock marketstays healthy. Moreover, there are sizable publicly quoted companies that may beforced to seek capital from the public equity markets. For instance, the San MiguelCorporation is at or close to the "single borrower limit" of most of its banks. Thereare a number of attractive subsidiaries within the San Miguel Corporation such as theCoca-Cola Bottling and the Magnolia Foods operations that would be ideal candidatesfor a public offering. In addition, there is a significant number of foreign companiesthat have substantial investments in their Philippine operations.

Appendix XII-C lists 237 foreign companies that are active in the Philippines. Webelieve that certain of these local subsidiaries might be willing to go public if some orall the proceeds can be repatriated into foreign currencies by their parent companies.It would be an attractive feature of this fund if the capital raised internationally couldbe kept in foreign currencies and used to purchase an equity interest in the Philippineoperations of a multinational corporation. This is a matter, however, that willultimately have to be negotiated with the Philippine Government financial authorities.

Venture Capital Fund

The second fund should be a small venture capital fund of about U.S. $10 million.We are confident that there is a sufficient pool of capable management available toidentify and manage these new venture companies.

In one of our interviews, we encountered a private venture capital group that hasalready assembled a small grouping of three companies:

•

One specialising in hand-sewn toys for export

•

A second manufacturing office furniture, principally for export

•

And a third engaged in prawn farming.

They have also identified a dress accessory factory and a household goods manu-facturer, both of which will be acquired in 1988.

This group has been able to purchase these companies at net asset value or lessbecause the previous owners could not raise sufficient additional working capitalneeded to keep them viable. Banks had been unwilling to provide additional workingcapital finance because companies such as these do not usually have the real estateassets required by banks to serve as collateral for loans. This private venture group

page 43

has found that there is a significant number of similar companies available forpurchase. Their only limiting factor at the moment is the lack of executive timeavailable from the partners in the venture group to pursue other investmentopportunities.

A second interview was with the Philippine director of Hambrecht & Quist (H&Q), aleading American venture capital firm based in San Francisco. H&Q are planning toput in place a U.S. $10 million venture capital fund and also to manage the investmentof U.S. $50 million from a major American commercial bank. They are planning tofocus on:

•

Contract manufacturing and offshore production for Silicon Valley firms

•

A well-defined group of agriculture-based businesses

•

Labour-intensive/export-oriented domestic manufacturing operations

•

Turnarounds.

They view these venture capital opportunities as having moderate risk, yet offeringgood returns over a five to ten year time frame.

The H&Q venture capital fund will, in due course, help broaden the equity market bydeveloping companies that will be ready to go public in the medium term, i.e., withinthe next, say, three to six years.

Fixed-Income FundThe third fund offered should be a fixed-income fund targeted at small and medium-sized financial institutions. There is a proliferation of smaller financial institutions inthe Philippines. One of our corporate interviewees, for example, has a small savingsand loan association that serves its employees. Being small, institutions such as thesecannot normally afford a team of professionals to invest their liquidity. Consequently,they tend to invest their cash in treasury bills or commercial paper.

A fixed-income fund that offered higher yields than those available to smallerdepositors should be attractive to smaller financial institutions. This fund might be a:

• Money market fund targeted at small banks and "thrifts". Usually, theseinstitutions are at a substantial rate disadvantage when they place theirliquidity with the larger banks.

• Medium-term bond fund targeted at smaller life insurance companies.These institutions may not have the investment evaluation skills needed toanalyse higher yielding, (but potentially riskier) bonds issued by privatefirms.

Retail FundThe fourth fund offered by the fund management company might be an equity or fixedincome fund for smaller retail investors. The timing of the launch of this fund,however, will be determined by four key factors:

•

The continuing recovery of personal income and savings

•

The establishment of the proper regulatory apparatus to ensure thatsmaller investors are protected

page 44

• A more broadly based stock market•

A substantial investment in sales staff and operational equipment to allowthe fund management company to penetrate the retail market.

We feel that the most propitious timing for the launch of a money market fund will beat least two years hence, possibly longer. I n part, our estimation of timing is driven byour assessment of how long it will take to install the proper regulatory apparatus at theSEC. Another factor we have taken into consideration is the experience of CityTrustwith their Star Fund.

The Star Fund is a different legal entity, a unit trust, but essentially it is a moneymarket mutual fund offered to retail investors. CityTrust is offering the Star Fund toits wealthier retail customers through their private banking sales forces in the 39branches throughout Manila and the Philippines.

After its launch in October 1987, the Star Fund has grown to a size of Pesos 150million (U.S. $7.5 million). There is a Pesos 100,000 minimum subscription leveland a penalty of one-quarter percent if the subscriber redeems his shares before thirtydays.

To date, CityTrust's experience with the Star Fund has been mixed. Most investorsonly remain in the fund for forty to forty five days before redeeming their shares. Thesize of the fund has stabilised at Pesos 150 million and has not grown further. Ineffect, net redemptions are roughly equal to net new subscriptions. CityTrust iscarrying out market research to identify the reasons why this fund has not grown morestrongly.

Our own view is that the Star Fund is probably positioned in the wrong segment of theretail market. People with Pesos 100,000 to place on deposit can go to a bank andreceive rates similar to those they receive through the Star Fund. Moreover, they willnot have their money tied up for the minimum thirty-day redemption period.

Our initial conclusion is that the money market fund will have to be aimed at a lowersegment of the retail market. Moreover, in order for this fund to be marketed cost-effectively, it probably will have to be sold by a financial institution that already hasan established sales force and distribution system. A good example would be ThePhilippine American Life Insurance Company which has a countrywide sales force ofmore than 8,000 agents managed through a network of 104 branch offices. Such asales force might be capable of selling a money market fund to its client base as anadditional financial product.

?s& ft, ?s.

We also want to comment upon tax implications, restrictions on remittances abroadand estimates of the yields the investors can expect from their investments in theclosed-end equity fund and the venture capital fund.

We believe that a substantial number of potential investors in these funds will comefrom international investment institutions. When the ultimate legal and investmentcriteria affecting these funds are negotiated with the appropriate PhilippineGovernment authorities, we strongly recommend that potential investors are not facedwith a penal tax differential when the attraction of these funds is compared with other"competing" regional funds.

page 45

The Philippine Government should also give serious consideration to reducing, if noteliminating, the problems of repatriation by overseas investors of their investments inthe Philippines. If, as the current Government has avowed, the Philippines isencouraging the injection of "new" capital, investors will need reassurance that theease with which the Philippines accepts foreign investment will be reciprocated whenthe time comes for investors to realise some or all of their investments.

With respect to the estimates of the yields the investors can expect from theirinvestments in these funds, we consider the most appropriate benchmark to be theyield an investor can expect from an investment in a similar fund in Thailand. TheStock Exchange of Thailand has been attracting considerable interest frominternational investors through the flotation of new on-shore and off-shore Thai funds.

Over the past five years, an investor in the Thai stock market would have realised anannualised rate of return of over 20%. Given that the proposed closed-end equity fundand venture capital funds are much more illiquid investments than publicly tradedequities, we consider that similar funds in Thailand would have had to achieve a yieldof at least 30% in order to be attractive to the international investment community.We believe, therefore, that the two funds proposed for the Philippines will have toyield a similar rate of return in order to be attractive to the international investmentcommunity.

page 46

X. CRITERIA FOR FOREIGN FUND MANAGERWe have selected five key criteria for the ultimate selection of a foreign manager forthe proposed fund management company:

•

Established corporate finance skills that can be applied in themanagement of the closed-end equity and venture capital funds.

• Management experience in operating and administering a retail financialservices organisation that specialises in personalised marketing to retailcustomers and the subsequent investment management of their funds.

• A major presence in Asia to ensure that personnel with the requisiteexpertise and experience are readily available for secondment to the fundmanagement company.

•

A proven track record in the management of Mutual Funds in the AsiaPacific region.

•

A depth of knowledge of and experience in the Philippines.

In considering any candidates, the ADB. will also have to discuss them with theGovernment of the Philippines. For instance, the Government may feel that certaincandidates might have conflicts of interest vis-a-vis the ongoing reschedulings oftheir outstanding loans to the Philippines.

page 47

Exhibit XV

Elements in Action Programme

AreaFund Management

CompanySecurities Trading

SystemsSecurities &

ExchangeCommission

Issuance ofEquity

KeyRecommendation

Establish a fundmanagement company toset up and manage agroup of funds, the firstbeing a closed-end fundthat will invest primarilyi n equities.

I mprove the underlyingtrading systems of thesecurities exchanges sothat securities can beeasily and confidentlytraded.

Upgrade the SEC so itcan playa majorproactive role insecurities regulation anddevelopment of thecapital market

Agree on steps to beundertaken by theGovernment of thePhilippines to encouragecompanies to issue moreequity via publicofferings

Key Elements in •

Publish a new mutual •

Agree on a timetable •

Study the SEC's •

Develop and imposeAction fund code for the Manila and organization and "prudent' lendingProgramme Makati Stock structure, its li mits on commercial

•

Establish rulesrelating to the

Exchanges to merge computer systems,financial and human

banks

operation of mutualfund managementcompanies

•

Review fiscal policy

•

Develop Computersystems for stockclearing andsettlement

resources so they canbe upgraded to meeti ts current and futureroles

•

Agree ondebt-to-equity ratiosto be met byPhilippine companiesraising international

as it impacts mutualfunds and theiri nvestors

•

Agree on structure(sponsors, legal

•

Computerise thefunds transfersystem at the CentralBank for repatriationof foreign exchange

•

Recruit experiencedregulatory staff fromother countries tospend 12 to 24months at the SEC toassist in staff

debt under aGovernmentguarantee

•

I nitiate publicofferings as part of

framework,capitalization, and

•

Develop a plan tocomputerise the

training t he privatisationprogramme

management) andtiming of thel aunching of the first

unified stockexchange

•

Set in motion aprogramme toupgrade the quality

fund management of existing staff andcompany to be to recruit new stafflicensed with specialist skills

•

Analyse conditions •

Formulate aunder which transaction levy toPhilippine i ncrease financialsubsidiaries of resources availablemultinational to the SECcorporations mightraise equity in thel ocal stock markets

XI. ACTION PROGRAMME FOR THEASIAN DEVELOPMENT BANK

We have four key recommendations for the establishment of a mutual fundmanagement company in the Philippines:

• Establish a mutual fund management company to set up and manage agroup of funds, the first being a closed-end fund that will invest primarilyin equities.

•

Improve the underlying trading systems of the securities exchanges so thatsecurities can be easily and confidently traded.

•

Upgrade the SEC so it can play a major proactive role in securitiesregulation and development of the capital market.

•

Agree steps to be undertaken by the Government of the Philippines toencourage companies to issue more equity via public offerings.

A critical element in ensuring the viability of our four key recommendations is for theADB and relevant departments and agencies of the Philippine Government to agree anaction programme to implement these recommendations. Exhibit XV on the facingpage summarises the specific elements that might be contained in such an actionprogramme. These elements are elaborated upon:

Fund Management CompanyThe key elements involved in establishing a fund management company to set up andmanage a group of mutual funds are:

• Publish a new mutual fund code. This code should be written andpublished by the SEC. Furthermore, the code should cover common trustfunds as operated by bank trust departments. This new mutual fund codeshould incorporate upgraded controls that have been implemented in othersecurities markets such as the United States, the United Kingdom andHong Kong.

• Establish rules relating to the operation of mutual fund managementcompanies. Again, the SEC should take the initiative in establishingrules and regulations relating to the constitution, the operation and theadministration of mutual fund management companies.

• Review fiscal policy as it impacts mutual funds and their investors.We have identified two areas where existing fiscal policy adverselyaffects mutual funds - taxes on mutual funds and taxes on investors inmutual funds. There should be a review of all aspects of the taxationprovisions as they affect mutual funds to ensure uniform and reasonabletreatment for both a mutual fund and its investors.

• Agree on the structure for the fund management company. Thisstructure should include sponsors for the fund management company, itslegal framework, its capitalisation and its management. In addition, thisagreement should include the timing of the launching of the first mutualfund management company to be authorised.

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• Analyse the conditions under which Philippine subsidiaries ofmultinational corporations might raise equity in the local stockmarkets. The ADB should analyse the conditions under which suchpublic offerings could be arranged to the mutual benefit of themultinationals operating in the Philippines and the development of thePhilippine capital markets. Given that a decision of this importance isusually made by the senior financial executives in the home office of amultinational corporation, the ADB will have to interview these seniorexecutives, many of whom will be located in North America and Europe.

Securities Trading SystemsThe elements in the action programme should be oriented toward improving theunderlying trading systems of the securities exchanges so that securities can be easilyand confidently traded. These elements should include:

• Development of computer systems for stock clearing and settlement.These functions presently are very labour-intensive and very lengthy.Until these functions are computerised, it will not be possible toconfidently trade equities on the stock exchanges and the growth ofsecondary market trading will be severely hampered.

• Encourage the stock exchanges to merge. We cannot see any strongcommercial reason for having two different stock exchanges trading in anarrowly based market with a very limited free float. The cost ofcomputerisation of price reporting, trading, clearing and settlementsystems will be considerable. Consequently, if both exchanges embark onseparate computerisation programmes, there will be a duplication of thiscost and a real risk that two incompatible and inferior systems will bedeveloped. The ADB could enhance the prospects of a unified stockexchange by offering Technical Assistance grants for a detailed analysisof computer systems suitable for a merged exchange. This assistanceundoubtedly will involve a review of trading systems used by othersecurities exchanges in the region, particularly those in Taiwan, HongKong, and New Zealand. Each of these stock exchanges has undergonerecently a major computerisation programme. Further specificimplementation projects will then flow from this review.

• Computerisation of the funds transfer system at the Central Bank forrepatriation of foreign exchange. Until the Central Bank improves itssystems, international institutional investors will be sceptical of theirability to repatriate foreign exchange. Consequently, this will act as amajor deterrent to the inflow of foreign investment sought by thePhilippine Government.

Securities and Exchange CommissionThe elements in this section of the action programme should be oriented to upgradingthe SEC so it can play a major proactive role in securities regulation and developmentof the Philippine capital markets. These elements include:

• A study of the SEC's organisation and structure, its computer systems andits financial and human resources in order that they can be upgraded tomeet its current and future roles. This is primarily a managerial andadministrative study, as opposed to the legal studies recommended vis-a-vis the rules and regulations for mutual funds. This study will serve as the

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foundation for all further action in developing the resources of the SEC toregulate the Philippine securities markets.

• The recruitment of experienced regulatory staff from other countries onshort-term contracts to assist the SEC in staff training. Bringingexperienced regulatory staff to the Philippines will be one way to broadenthe experience and skills of the Philippine staff at the SEC. Sendingindividual SEC staff members overseas for training may be necessary incertain instances but as a matter of policy it will be too expensive to senda large number of SEC staff members overseas for up to twelve or twentyfour months.

• The implementation of a programme to upgrade the quality of existingstaff and to recruit new staff with specialist skills. Again, the SEC needsto broaden the scope of experience and expertise of its in-house staff.

• The introduction of a transaction levy to increase the financial resourcesavailable to the SEC. Given that budgetary resources available to theSEC from the Government of the Philippines are likely to remain limitedin the immediate future, a transaction levy should be imposed to generatethe additional financial resources needed to upgrade the SEC. The ADBmay wish to review a similar transaction levy that has been imposed onthe Hong Kong securities industry.

Issuance of Equity

This area of the action programme involves the agreement of steps to be undertakenby the Government of the Philippines to encourage companies to issue more equityvia public offerings. These elements include:

• The imposition on commercial banks of "prudent" ratios to limit theamounts they can lend to overleveraged companies. The ultimateobjective of these controls is to ensure that companies broaden theirequity bases. The "prudent" limits should be introduced over a two tofour year period, be closely monitored and strictly enforced.

• Any company seeking international debt finance that would be guaranteedby the Philippine Government and/or extended by the World Bank, theInternational Finance Corporation or the ADB should also be required tomeet a designated debt-to-equity ratio. If the loan proposed will result inthe designated debt-to-equity ratio being exceeded, then the companyconcerned should be required to offer "compensating equity" to the publicvia the Philippine stock markets. An example that immediately comes tomind is the recent International Finance Corporation loan extended to thePhilippine Long Distance Telephone Company. There was universalagreement among senior Philippine Government officials that the PLDTshould increase its equity base but there was no institutional mechanismfor addressing this issue.

• Public offerings should be considered as part of the privatisationprogramme. Initially, these public offerings should start with smallerentities such as the Manila Hotel. There is no reason why the ManilaHotel could not be a publicly owned company. The Singapore StockExchange, for example, has several publicly owned hotels quoted on it. Asmaller initial public offering of this sort can also serve as a useful "dressrehearsal" for the larger public offerings that will be associated with the

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privatisation of companies such as Philippine Airlines and the PhilippineNational Oil Company.

All of the above elements in the action programme can be promoted through separatetechnical assistance grants. Alternatively, the ADB may want to subdivide them intosmaller, more focused studies.

In addition to these technical assistance grants, the ADB should be prepared to be anequity investor in the fund management company and in the funds themselves. In ouropinion, it is essential for the future success of the fund management company and itsfunds for the international aid organisations to be seen to be providing their completesupport. Above all else, this support will be perceived as an overall indicator of the"integrity" of the funds and its managers by local and international investors alike.

Concluding RemarksViewed realistically, our report indicates that the evolution of a broadly based capitalmarket in the Philippines will take at least five to ten years. To ensure success, it isessential that the development process is carefully monitored and, if necessary,guided. We believe that there is a very real risk of failure unless there is constantsupervision.

Ultimately, such supervision and direction will come solely from a domesticPhilippine Government agency such as the SEC and from an integrated stock market.However, we cannot envisage the SEC being professionally equipped to fulfill thisrole independently for at least three to five years. Consequently, it will be necessaryfor the ADB to offer assistance in providing this supervision-and direction in the nearterm.

If the market conditions and regulatory framework, currently prevailing, remainunaltered, we do not believe that the fund management company and the associatedgroup of funds recommended in this report will be viable. Even if a minimum of theinfrastructure requirements are met, we still are doubtful that the fund managementcompany will be viable. In our opinion, there is no alternative other than for thePhilippine Government, assisted by the ADB, to embark upon a broadly based capitalmarket development programme that may take anywhere from five to ten years toreach fruition, given relative political stability.

If it is willing to assist with a broadly based capital market development programme,we recommend that the ADB encourages the relevant Filipino authorities toincorporate and authorise the proposed fund management company as soon aspossible. The subsequent development and performance of the fund managementcompany can be closely monitored over the next three to five years and be used as amodel when formulating upgraded legislation to regulate a mutual fund industry.Additional fund management companies can be authorised by the SEC as and whenmarket conditions are considered suitable..

In this manner, it will be possible to quickly re-establish mutual funds in thePhilippines within a controlled environment and simultaneously commence theupgrading of both the SEC and the regulatory framework which will be required tosafeguard the interests of future mutual fund investors.

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