Bank Mandiri - quickedit3 - Global Clearinghouse Services Ltd

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Executive Summary PT. Bank Mandiri's overall score of CGS-5.4 reflects the numerous positive steps taken by its management and Board members to improve governance policies and practices, the challenges posed by its government ownership, and the uncertainties relating to its upcoming initial public offering ("IPO") that is now scheduled for early 2003. Privatization can significantly change Bank Mandiri's corporate governance profile over time as the government's ownership stake decreases. However, the implications of such changes are difficult to predict and evaluate today. This analysis of Bank Mandiri focuses on the current state of affairs but also takes a forward-looking approach, where appropriate, to analyzing governance related issues from the standpoint of existing as well as prospective financial stakeholders in a post-IPO environment. The transparency of Bank Mandiri's ownership structure is not currently a concern given the 100% government ownership. In the future, whether the structure remains transparent will depend on the pace and direction of the privatization, and Bank Mandiri's ability to closely track and disclose its shareholders. Of greater concern is the government's ongoing influence over the bank that derives from its controlling ownership stake, a "golden share" that grants it certain additional powers, and its broader economic stake that relates to the government bailout of the banking system generally and Bank Mandiri specifically. Whether or not the government acts as a positive force for good corporate governance is beyond the control of Bank Mandiri's Board of Directors ("BOD"), Board of Commissioners ("BOC"), or future minority shareholders. The government will need to appropriately balance its public policy and commercial interests so that this inherent conflict of priorities does not adversely impact minority shareholders. Certain past instances where the government has involved itself in the bank's affairs underscore the difficulty of achieving this balance, particularly given Indonesia's uncertain economic and political situation. Existing voting and meeting procedures are clearly articulated and are generally fair to shareholders. However, some of the notification and briefing practices and voting procedures must be ! " ! # $ % & ’’ () ’ " ! # $ % ! * + , # )- - . ! / $ + , # )- - . ! For important information on Corporate Governance Scores, please see the last page of this report. ! " # $ % % & ’ ( ) * + ( , ( , -. / ) 0) ) ( , -! % ( ) * + 0 1 2 + ! + . + ! 3 4 + 5 6 ! # 2 2 3 4 + 5 6 ! ! % . ! + ) 3 4 + 5 $ + ! + ! 3 4 + 5

Transcript of Bank Mandiri - quickedit3 - Global Clearinghouse Services Ltd

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Executive SummaryPT. Bank Mandiri's overall score of CGS-5.4 reflects the numerous positive steps taken by its management and Board members to improve governance policies and practices, the challenges posed by its government ownership, and the uncertainties relating to its upcoming initial public offering ("IPO") that is now scheduled for early 2003. Privatization can significantly change Bank Mandiri's corporate governance profile over time as the government's ownership stake decreases. However, the implications of such changes are difficult to predict and evaluate today. This analysis of Bank Mandiri focuses on the current state of affairs but also takes a forward-looking approach, where appropriate, to analyzing governance related issues from the standpoint of existing as well as prospective financial stakeholders in a post-IPO environment.

The transparency of Bank Mandiri's ownership structure is not currently a concern given the 100% government ownership. In the future, whether the structure remains transparent will depend on the pace and direction of the privatization, and Bank Mandiri's ability to closely track and disclose its shareholders. Of greater concern is the government's ongoing influence over the bank that derives from its controlling ownership stake, a "golden share" that grants it certain additional powers, and its broader economic stake that relates to the government bailout of the banking system generally and Bank Mandiri specifically. Whether or not the government acts as a positive force for good corporate governance is beyond the control of Bank Mandiri's Board of Directors ("BOD"), Board of Commissioners ("BOC"), or future minority shareholders. The government will need to appropriately balance its public policy and commercial interests so that this inherent conflict of priorities does not adversely impact minority shareholders. Certain past instances where the government has involved itself in the bank's affairs underscore the difficulty of achieving this balance, particularly given Indonesia's uncertain economic and political situation.

Existing voting and meeting procedures are clearly articulated and are generally fair to shareholders. However, some of the notification and briefing practices and voting procedures must be

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For important information on Corporate Governance Scores, please see the last page of this report.

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enhanced in order to facilitate the participation of future international shareholders. Shareholders should be able to vote on an appropriate range of issues and enjoy certain protection such as pre-emptive rights. Security of ownership and transferability is not a major concern when the government is the sole shareholder. Post IPO, Bank Mandiri will need to utilize Indonesia's independent registry and book-entry clearance system in order to ensure a secure and independent process for share registration and transfer of ownership. With the notable exception of the government's golden share, the current single class share structure conveys equality of ownership. Structural takeover defenses are not a concern, although from a practical standpoint, the government must approve any eventual transfer of control.

Bank Mandiri's quality, timing, and accessibility of public disclosure, particularly its financial reporting is generally good and meets the needs of international debt holders. Meeting the needs of international equity holders will pose some challenges, particularly with respect to non-financial information. The bank's bilingual website can fill some of the void over time, but its existing content is very limited. The integrity and independence of Bank Mandiri's audit process is its major governance strength. The Audit Committee oversees a robust internal audit process and actively manages the relationship with external audit firm Ernst & Young. The latter's independence is enhanced by the absence of non-audit assignments and Bank Indonesia's requirement for auditor rotation after five years.

Bank Mandiri's two-tier Board structure – with a separate Board of Directors ("BOD") and Board of Commissioners ("BOC") – provides a good balance of executive (BOD) and non-executive (BOC) members, with appropriate representation of management and shareholder interests given the current government ownership. The key concern is how the BOC can provide fair representation of minority shareholder interests post IPO, particularly given that the government can control all future appointments. The lack of fully functioning Nomination and Remuneration committees underscores the fact that the government controls the nomination, appointment, removal, remuneration, and evaluation processes for all BOD/BOC members. The key to the Board's effectiveness at present is that the BOC is highly engaged and actively involved in the bank's business – both operations and strategy. The amount of time spent on the job by BOC members is high by both local and global standards, although their direct involvement in operations is limited to large loan approvals. However, the BOC's deep involvement may in the future create complications due to some overlap and ambiguity regarding the BOD's and BOC's respective roles and responsibilities. Furthermore, while the BOC's current level of involvement makes sense given the bank's recent history and management's need for strong oversight and advice, it is not optimal over the long term. Although the two Boards and the senior management work in an open and collaborative manner, the BOC's lack of formal authority over the BOD may eventually become problematic post IPO. If the government does not delegate some of these specific responsibilities to the BOC, the balance of power may shift more toward management and the BOD. Without an empowered BOC, minority shareholders will lack a strong voice at the Board level that can counterbalance management. Additional concerns relate to executive and BOD/BOC remuneration, evaluation, and succession policies. The existing remuneration packages generally will not align the interests of executives and Board members with those of non-government shareholders. Processes relating to BOD/BOC personnel matters have been controlled by the government (rather than the BOC) and are not transparent. This will become a more serious governance concern to the extent that minority shareholders lack the formal channels through which they can express their views on such matters and realistically impact the outcomes. BOC succession planning is now an immediate issue given the upcoming expiration of all BOD/BOC terms and the advanced ages of three out of the four BOC members.

Bank Mandiri – Company Profile Bank Mandiri is Indonesia's largest bank in terms of total assets, loans, and deposits, and is wholly owned by the Republic of Indonesia through the Ministry of State-Owned Enterprises. A full-service "universal" bank is making a major push into consumer banking to complement its traditional focus on corporate and government clients. It was established in October 1998 upon the legal merger of four legacy State-owned banks. The four banks – Bank Bumi Daya, Bank Dagang Negara, Bank Exim, and Bapindo – were also wholly owned by the State and were technically insolvent at the time. Bank Mandiri and these four banks officially merged on July 31, 1999 and commenced commercial operations as of August 1999. As part of a massive restructuring and recapitalization of the banking system following the Asian financial crisis, the banks transferred non-performing loans to the Indonesian Bank Restructuring Agency ("IBRA"), and the government injected cash into the bank, which was simultaneously used to purchase government recapitalization bonds ("recap bonds")

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totaling about Rp. 175,000 billion. These recap bonds comprised almost 60% of Bank Mandiri's total assets as of March 31, 2002, and interest earned on these bonds accounted for 68% of total interest income in first-quarter 2002. The government is in the midst of a major privatization initiative for its State-Owned Enterprises ("SOE") and has announced its intention of having Bank Mandiri to be the first of the state-owned banks to launch an IPO after the national banking recapitalization program. The IPO has already been postponed from the first quarter of 2002, in part due to unfavorable market conditions, but is still scheduled to launch during first-quarter 2003.

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Transparency of ownership is currently a non-issue because the Republic of Indonesia wholly owns Bank Mandiri. It is not possible to predict what the ownership structure will look like post IPO. We also cannot predict at this time the extent to which management will be able to track and fully disclose details about the ownership structure as the privatization process evolves and public shares trade. To the extent domestic investors hold shares through nominee accounts, transparency of ownership will become a concern because under Indonesian law, custodians need not identify the beneficial owners behind nominee accounts.

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Prior to 2001, the Ministry of Finance held Bank Mandiri's shares on behalf of the Republic of Indonesia; commencing in 2001, the shares were transferred to the Ministry of State-Owned Enterprises. While transparency of ownership is currently not an issue, we expect that once the IPO is completed, it will be difficult for Bank Mandiri to track and fully disclose details about the ownership structure going forward. While it is not possible to predict what the likely mix of public investors will look like, the IPO is expected to target both retail and institutional domestic investors, while the overseas offering will target institutional investors. Given the government's stated intention to sell no more than a 30% stake to the public and thereafter reduce its remaining holdings gradually, it is unlikely that another blockholder can emerge in the near future with the voting power to counter the government's influence.

The Capital Market Law (Disclosure of Interests) requires the disclosure of substantial share ownership holdings (5% or more) in listed companies and disclosure of all associated companies. How transparent the ownership structure (particularly those with ownership of less than 5%) will be post IPO will depend largely on Bank Mandiri's ability to track its shareholders both internally and by using outside specialist firms. One concern for prospective investors is that so long as the government maintains control of the company, there may not be a strong incentive on its part to track the minority shareholdings. Additionally, under Indonesian law, it will be difficult if not impossible for the bank to identify, or force custodians to identify, the beneficial owners of shares held in nominee accounts. Post IPO and as the privatization process evolves, it will also become important to track whether or not shares are purchased by entities that are directly or indirectly controlled by the government, Bank Mandiri, or its employees, Directors and Commissioners. Holdings of this nature could potentially obscure the company's true ownership structure and the extent of ownership concentration.

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Post IPO, the government intends to retain an ownership stake of about 70% and then reduce its holdings gradually. The government also intends to retain its "golden share"(still under discussion), as it has done with other SOE's that have recently privatized. While the government has not overtly or forcefully attempted to influence Bank Mandiri's management on operational or commercial matters, the potential for such actions remain, particularly given Bank Mandiri's strategic importance to the state and Indonesia's uncertain economic and political landscape. This risk is somewhat mitigated given that the BOD and BOC have demonstrated a commitment to managing the bank's business on strict commercial terms.

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The current ownership structure assures that the government maintains ultimate control over Bank Mandiri, and this reality will not change over the near to medium term. The government's stated intention is to initially sell only up to 30% of the bank to the public. Given the existing voting thresholds as stated in the Articles of Association, public ownership would have to rise above 33% before the government would lose absolute power to approve most resolutions brought to a vote at shareholder meetings. Furthermore, the government maintains the previously noted "golden share" that grants its final approval authority over proposed amendments to the Articles relating to key areas including Board appointments, and certain amendments to the Articles of Association. While market participants and outside advisors have urged the government to relinquish its golden share for Bank Mandiri and other SOEs, the issue remains unresolved even though it is a moot point as long as the government still holds at least a two-thirds ownership stake. Some market participants believe that the government in fact would relinquish its golden share in any SOE once its ownership stake falls below two-thirds.

A key concern for financial stakeholders post IPO is the potential conflict between the government's public policy interests at the national level and its commercial interests as an investor in a publicly traded private sector enterprise. The government has already demonstrated a tendency to take an active oversight role, as evidenced by the high turnover rate at the President Director (CEO) position. President Director Neloe is the third person to hold this position since 1998, and the government reportedly had forced the departures of his predecessors with very little public explanation for its actions. Some market sources cite politics rather than performance and commercial considerations as the main reasons behind the government's actions. While it is difficult to judge the merits of these actions, the manner in which they were carried out raises concerns about how the government will use its influence over the bank in the future.

On the other hand, there is no evidence to date that the government has abused its power to the detriment of minority shareholders at other SOEs that have been privatized recently, through either its majority shareholding or the golden share. Indeed, the government has a strong vested in interest in achieving a successful privatization of Bank Mandiri and the other SOEs given the enormous costs that it incurred to bail out and restructure the banking system following the Asian financial crisis. Furthermore, continued International Monetary Fund (IMF) support for Indonesia is predicated in large part upon successful execution of the privatization initiatives. Our discussions with the government and other market players confirm that the government is well aware of and is sensitive to the need to reconcile these competing interests. On the other hand, given the dire state of the economy and the possibility of future political instability, there can be no assurance that the government will be willing and able to manage successfully the privatization in a manner consistent with good corporate

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governance. The depressed global equity markets, the negative ramifications of the recent Bali terrorist act from both an economic and political standpoint, and the continued decline in foreign investment all present challenges that will stretch the government to the limit. This in turn could lead the government, under certain circumstances, to place the national interest above that of minority shareholders and thus undermine corporate governance at the company level.

Certain representations made by Bank Mandiri in key public documents also underscore the potential conflict between the government's public policy and commercial interests. For example, Article 3 of the Articles of Association states that "the purposes and objectives of the Company are: to participate in development programs of the Government by taking part in and supporting the implementation of the policies and programs of Government in the field of economy and national development in general, especially in the field of banking." Additionally, Bank Mandiri's disclosure in the risk factors section of the Offering Circular for its subordinated note issue dated July 26, 2002 notes that "the Government has historically influenced, and is likely to continue to influence, the Bank's strategy and operations. The Government also has the ability to influence and control other Government-related entities, some of which are our competitors, and to direct opportunities to our competitors or favor their interests over ours." The disclosure also cites a specific example where the government, in late 2001, tried to persuade Bank Mandiri to merge with a troubled domestic bank – Bank Internasional Indonesia (BII). However, Bank Mandiri's management, with the support of the BOD and BOC, decided not to pursue the merger because they determined that it would not make commercial sense.

While Bank Mandiri's BOD and BOC have demonstrated a determination to manage the business on strict commercial terms, this will be a challenging ideal to maintain given Indonesia's challenging economic and political situation and the bank's strategic importance to Indonesia. Specific areas where this inherent conflict may manifest itself, aside from mergers and acquisitions, include the pricing and credit policies related to lending to strategic sectors (e.g. state owned enterprises, public sector, certain industries, small and medium sized enterprises), the purchase of non-performing loans from IBRA, the provisioning policies in respect of non-performing loans, ongoing negotiations with the government concerning terms of the bailout, which may result in Bank Mandiri returning excess capital to the government, and "re-profiling" (rescheduling) of the recap bonds. The latter point relates to the fact that the government can change the terms of the recap bonds at its discretion, with or without the bank's consent, which in turn can lead to an adverse impact on the bonds' market value as well as interest income. The government is currently looking to lengthen some of the bonds' final maturities in order to avoid upcoming principal repayments that would further stretch the government's already strained finances. In November 2002, the government and Bank Mandiri reached an agreement to re-profile Rp. 104.3 trillion of bonds (67.1% of the bank's total government bond portfolio). The re-profiling involved extending the maturities on the bonds from 2004-2009 out to 2010-2020. The bank's press release noted that the bank will be compensated with a yield pickup of about 1% on the re-profiled fixed-rate bonds, or about Rp. 300 billion per annum. While the higher bond yield is a positive outcome for shareholders generally, non-government shareholders may have limited influence in determining the outcome of any future re-profiling.

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The Articles of Incorporation clearly articulate the shareholder notification, voting and meeting procedures. Most procedures are sufficient given the current ownership structure. However, certain procedures should be enhanced to accommodate the needs of a broader shareholder base.

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The Articles of Incorporation provide sufficient general guidance on how shareholders are to be notified of shareholder meetings. While these guidelines may not be followed in practice because the government is the sole shareholder, additional considerations will be necessary in order to accommodate international shareholders post IPO. The articles require that notices of the annual General Meeting of Shareholders ("AGM") be sent by registered mail at least 14 days prior to such meeting to all shareholders of record per the Shareholder Register. The notice must also be advertised in two daily Indonesian language newspapers. The notice specifies the day, date, time, and place of the meeting and a brief description of the business on the agenda and provides information on when detailed information on AGM agenda items will be made available for review by shareholders at the company. While these requirements may be sufficient for future domestic shareholders, they would not provide for timely and complete notice to shareholders outside of Indonesia. The company website is not currently used to convey details of upcoming AGMs. Post IPO, these latter two points will become more relevant.

The Articles also provide for specific voting procedures at shareholder meetings that appear to be fair to all shareholders. However, more formalized procedures may be needed to insure the integrity of the process once the government is no longer the sole shareholder. Shareholders representing more than half of the total voting shares constitute a quorum for an AGM or EGM to proceed. Voting on resolutions concerning persons (e.g. election of BOD/BOC members) is done by unsigned folded ballot papers, while voting concerning other matters is done orally unless otherwise determined by the Chairman provided there is no objection from any shareholders present at the meeting. While the Articles have no provisions for tallying votes by poll or for independent verification of voting results, in practice, an independent notary has been present at these meetings and presumably can fill this role. A simple majority vote decides all resolutions except for certain specific issues that require a super majority such as amendments to the Articles and a consolidation, merger, or acquisition of the company. Shareholders may be represented by another person at a meeting via power of attorney and can vote by proxy.

The Articles note that shareholders at the AGM will vote to approve the company's annual report, annual accounts, and dividend payment and ratify the company's work schedule and budget. The shareholders also nominate, appoint or re-appoint, and remove members of the BOC and BOD. Article 11 notes that shareholders must also approve "major" or "related" transactions that involve the transfer, disposition, or encumbrance of all or a substantial part of the company's assets, although the Articles do not provide guidance as to what defines "substantial." Such approval requires an affirmative vote by at least three-fourths of the total shares having voting rights. This specific

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provision is positive for minority shareholder rights to the extent that the IPO results in the sale of 30% of the company, since it gives the new shareholders some ability to block an attempt by the government to force through a transaction of this nature.

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Security of ownership interests and transferability is not a concern under the current ownership structure. Post IPO, Bank Mandiri will need to utilize Indonesia's independent registry and book-entry clearance system to ensure a secure and independent process for share registration and transfer of ownership. The existing share class structure provides for one-share one-vote. The Articles articulate a broad dividend policy, and the bank has paid a dividend in each of the past three years.

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While security of ownership and transferability is not a major concern because the government is currently the sole shareholder, the existing system lacks the independence and transparency that will be needed once there are public shareholders. Share registration requirements are guided by the requirements of Bank Indonesia and Indonesia's Companies (Amendment) Ordinance 1995, which in turn are reflected in Bank Mandiri's Articles. The company maintains the shareholder register at its head office and must maintain specific information on their shareholders including names and addresses along with share-specific details such as the number, serial number and date of acquisition of the shares owned. The BOD is vested with the responsibility of keeping and maintaining the shareholder register and the "special" register that records the specifics of shareholdings by BOD and BOC members and their families. There is no independent registrar for Bank Mandiri's shares, which is understandable for a company with a single shareholder.

The provisions in Bank Mandiri's Articles of Association relating to transfer of shares do not appear to contemplate open trading of shares on a stock exchange. Article 9 stipulates that any transfer of shares requires the filing of a deed of transfer, written notice to the BOD, and a written offer to other shareholders specifying an offer price and conditions of sale (best practice). The other shareholders are then entitled to purchase the offered shares within a 30-day period from the date of offer. Article 9 also prohibits any transfer of shares commencing from the date of notice of an AGM or EGM until the day of such meeting. Such restrictions clearly place limitations on free trading and liquidity that are not compatible with a public listing. However, the bank intends to address these issues in a revised Articles of Incorporation to be completed prior to the IPO.

A local listing of Bank Mandiri's shares will require the usage of Indonesia's central registration and clearing system. This would provide a secure and independent process for owning and trading its shares post IPO. Specifically, the KSEI's C-BEST system was created in December 1997 to become the central depositary and book-entry settlement system for all participating securities companies that handle stock transactions in Indonesia. While there is no one central share depository, most share certificates are held by 18 custodians. Transactions between C-BEST participants are by electronic book entry and are settled on the third trading day following the transaction.

There is currently only a single class of shares, with each share conferring the right to cast one vote. While this creates equality of ownership in concept, the likely post-IPO ownership structure will still allow the government total control of Bank Mandiri through its super-majority stake and golden share. The government also reserves the right to amend the Articles of Association to create new classes of shares or other mechanisms that could give it control over the company that is further disproportionate with its ownership stake. Furthermore, minority shareholders' ability to exercise their right to elect BOD/BOC members will be substantially curtailed because Directors and Commissioners serve long

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(five year) terms relative to global norms (three years or less). While shareholders can call an EGM to remove a Board member at any time, this would be difficult to do in practice given the government's controlling interest.

Shareholders representing at least 10% of the total voting shares can either call an Extraordinary General Meeting ("EGM") or add an agenda item to the AGM. Shareholders must approve any new share issuance. Shareholders are protected from dilution risk through their pre-emptive rights to subscribe for new share issuances, in proportion to the number of shares they own, within a 14-day period commencing from the date of offer.

Bank Mandiri's Articles articulate a broad dividend policy, and the bank has paid a dividend in each of the past three years. On the other hand, we would expect the bank to make regular dividend payments so long as it turns in a profit. The government, given its fiscal challenges, is expected to support dividend payments from all bank SOEs that the government had recapitalized to the extent such banks are profitable and generating cash.

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While there are no explicit anti-takeover defenses in place, the government has effective veto power over any takeover attempt under the existing and likely near term ownership structure. Privatization of Indonesia's banking sector may continue to proceed more slowly than other sectors given its strategic nature.

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Bank Mandiri's Articles of Association do not contain any explicit anti-takeover defenses. Directors and Commissioners serve concurrent five-year terms, which is common for Indonesia's SOEs as compared with the three-year terms that are typical for private sector companies. The length of the terms can make it more difficult for an acquirer to gain control of the board, although shareholders can remove them by simple majority vote at an AGM or EGM. As cited earlier, however, this would be difficult to achieve in practice.

Bank Mandiri's Articles stipulate that a resolution for a consolidation, merger or acquisition of the bank requires approval at a General Meeting of Shareholders from shareholders representing at least three-fourths of the total legal voting rights issued as well as at least three-fourths of the total votes legally cast at the meeting (in person or by proxy). Given the current plan of selling only up to 30% of Bank Mandiri through the IPO, the government will retain final say over any such transaction for the near future. There is also the additional requirement that Bank Indonesia must approve any purchase of shares for 25% or more of the bank's issued shares or such lower proportion that results in a transfer of control of the bank.

While the market for corporate control in Indonesia is starting to open up with SOE privatization being high on the government's agenda, we expect that the government's divestiture of Bank Mandiri will proceed slower compared with that of other SOEs given the strategic importance of banks and Bank Mandiri's special status as Indonesia's largest bank. Any privatization of a SOE still requires approval from Indonesia's Parliament, which can be a lengthy and tedious process that by its nature can also be highly politicized. Another possible deterrent to any prospective acquirer is the presence of the recap bonds, which make up the bulk of the bank's assets. Given the limited liquidity of these obligations and the government's ongoing ability to re-negotiate their terms, the acquirer would need to negotiate with the government to resolve the uncertainties related to these bonds. However, the recent re-profiling of these bonds partly mitigates this concern.

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Bank Mandiri provides good financial and non-financial disclosure in the annual report and the offering circulars for its recent debt issues. The audited accounts are prepared only under Indonesian GAAP, which varies in certain significant respects from International Accounting Standards ("IAS").

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� � � �9 7 / �� � � � � � � � � � � % �� � � � � � � = �� 2 + 2 �� 2 � % �� � � % �� � �! � � � � � � �� � � � . � ! � � � �� � � � � ! � � ��

" � � � � � � �

Bank Mandiri provides good financial disclosure in its annual report and the offering circulars for offshore debt issues. Of particular relevance to Bank Mandiri are the details provided on the accounting treatment of the merger of the four legacy banks, the related recapitalization of the bank by the government, related party transactions (particularly with government related entities), and accounting for non-performing loans.

Management's discussion of the bank's financial results, operations, strategy, business environment, and special risks is extensive, particularly in the debt offering circulars. Of particular note is the management's straightforward discussion of the risk factors related to the government's ownership of and influence over Bank Mandiri. The annual report also includes a brief section on corporate governance and compliance.

The audited accounts are prepared only under Indonesian GAAP. However, the management has already announced its plans to provide a reconciliation of the financial results under Indonesian GAAP with IAS in preparation for the IPO (subject to further IAS development and guidance for first-time application), and our discussions with the external auditor Ernst & Young confirm that this work is near completion. The debt offering circular does contain an explanation of the principal differences between Indonesian GAAP and U.S. GAAP. On the other hand, Ernst & Young noted that while Indonesian GAAP and IAS are generally similar, they vary in certain significant respects. The significant differences pertinent to the Bank relate to the provisioning for possible losses on earning assets, recognition of provision for employee entitlements, and determination of fair value of derivative instruments.

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Timeliness and accessibility of financial information is good and meets the needs of international debt holders. Meeting the needs of international shareholders will pose additional challenges, particularly with respect to non-financial and third party information. The company website falls short of meeting such needs.

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Bank Mandiri provides timely financial reporting through its annual report and interim releases, including monthly financial reports posted on Bank Indonesia's website and quarterly reports published in the

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domestic newspapers. The bank also holds quarterly press briefings on its results and overseas road shows for investors. Having issued international debt twice in the past year, the bank has made a strong effort to improve the content and accessibility of its information reporting.

Accessibility of non-financial information such as Articles of Association, records of shareholder meetings, AGM voting rules, AGM notices and agendas, however, is much more limited. While some of this information is available upon request from the company or third parties, it is not centrally available in electronic or print media. These types of information are more critical to international shareholders than to debt holders. The company website, which can fill some of this void over time, is currently underutilized. The bilingual website provides very limited English language content and lacks a specific investor relations section. At present, the website contains the last two annual reports, the most recent quarterly financial statements, and the accompanying press releases. Noticeably absent are debt offering circulars, analyst reports, management presentations, links to government agency filings, and detailed general press releases.

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The external auditor is a reputable international firm with extensive experience in Indonesia. Both the auditor and Bank Mandiri have adopted practices and policies to maintain auditor independence. The Audit Committee actively oversees the audit process and the relationship with the external auditor. The Internal Audit Group's direct reporting line to the BOD rather than the BOC and the Audit Committee may be a cause for concern in the future if the latter two entities were to take a less "hands on" approach to its oversight duties.

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" � � � � � � �

The integrity and independence of the external auditing process is enhanced by the presence of an international accounting firm with a strong local presence. In 2000, Bank Mandiri changed auditors from Prasetio, Utomo & Co. (Arthur Andersen) to Ernst & Young Hanadi, Sarwoko & Sandjaja as a result of a competitive tendering process. Ernst & Young was not the auditor for any of the four legacy banks, although it had performed some non-audit services for Bapindo prior to the merger. Furthermore, it did not perform any non-audit work for Bank Mandiri. In fact, Bank Mandiri over the past two years had awarded all major outside consulting mandates (Corporate Governance, Information Technology, and Retail Banking Credit Policy and Analytics) to other foreign firms. Ernst & Young also advised us that in order to avoid any conflict of interest, they have adopted a policy in Indonesia of dropping any non-audit engagements if they become a company's auditor. Bank Mandiri will also comply with Bank Indonesia's requirement that banks rotate their external auditor every five years. Once Bank Mandiri is listed locally, it must also comply with securities regulator Bapepam's requirement for auditor rotation every three years. As is typical in Indonesia, however, Bank Mandiri does not publicly disclose the amount of professional fees it pays to auditing firms.

The Audit Committee, which is chaired by Commissioner Soedarjono (a former Chairman of the Indonesian Institute of Accountants), consists of two independent auditing professionals and actively oversees the audit process. While Mr. Soedarjono's professional background as a career civil servant suggests a strong alignment with the government, he can be viewed as independent vis-à-vis Bank Mandiri's management and the BOD. Audit Committee meetings take place at least monthly and usually include members of the Internal Audit Group. On an as needed basis, the external auditor and key members of senior management, including the Chief Financial Officer and the President Director, may also attend these meetings.

While the ongoing integrity and independence of the internal audit function might be better served over time if it reported directly and solely to the Audit Committee, the existing system appears to

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work well at the present time given the frequency of meetings and the wide participation of the different Board level groups. The Internal Audit Group interacts extensively with the BOD, to which it is directly accountable, as well as the Audit Committee, the BOC, and the external auditor. It provides an executive summary of every major audit during weekly meetings with the BOD. The head of the group also meets with the BOC every two weeks. The 200+ person staff audits almost half of the bank's 155 branches each year. The work of this group provides a tremendous amount of detailed information to the senior management, the BOD, and the BOC.

Management of the Internal Audit function is the direct responsibility of the President Director and the BOD. Under the current BOD/BOC structure that is characterized by the small number of board members, frequent meetings, extensive management reporting to the two boards, and a democratic, inclusive culture of interaction, the system appears to work well in ensuring process integrity and independence. In the future, however, as board membership grows to reflect a broader shareholder base, the bank's business matures, and the bank's reporting and oversight requirements expand to meet the needs of international shareholders, smaller and less frequent meetings with the BOC and Audit Committee may become the norm in order to achieve more efficiency. To the extent that the BOC members become less immersed in the details, the process could lose some of the independent checks and balances that the current practices provide. Under such a scenario, the lack of a primary reporting line between the internal audit function and the Audit Committee could lead to concerns about process integrity and independence.

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Component 4: Board Structure and Process ( � ) * � � � � � ��+ � � � 6� � �

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The existing two-tier board structure and composition provides a good balance of executive (BOD) and non-executive (BOC) members, with appropriate representation of management and shareholder interests given the current government ownership. Fair representation of minority shareholder interests on the BOC will be a key concern post IPO.

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2 � �7 + � � � �� � � � � � � � �� � �! 2 � � � � � �� � � �� � � . . � � �@ % �� � � �� � -� 4 � ! + � � � � �� � � � � � � � � � � �� � � @ � � � �� A � � � � � � �

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Bank Mandiri's two-tier board structure provides a workable framework for facilitating independent oversight over management and fair representation of stakeholders under the existing ownership structure. As is required under Indonesian law, Bank Mandiri has a Board of Commissioners and a Board of Directors. The two boards are separate, and no individual may be a member of both boards. The BOC's mandate is to supervise and give recommendations to the BOD, while the BOD is responsible for day-to-day management. The four Commissioners are all non-executives and are independent vis-à-vis the bank and its management. The three Directors are all bank executives. President Commissioner Binhadi and President Director Neloe fill the roles of Chairman and CEO respectively. A positive governance feature of the Indonesian Board structure is the inherent separation of these two positions.

A major concern post IPO relates to how the BOC can fairly represent minority shareholder interests when all of its members are government appointees and three members are former civil servants. While plans are underway to recruit a foreign professional for the BOC, the government will ultimately approve this and all future appointments so long as it maintains it majority ownership stake. Although the existing BOC members all have strong professional credentials and have demonstrated integrity and a strong commercial orientation to date, the extent to which the government is ultimately a positive or negative governance factor is largely at the government's discretion.

Other concerns relate to the small size of both the BOD and BOC and the lack of Board level Nomination and Remuneration committees. The size of the BOD and BOC is small by local standards and just meets the minimum requirements per Indonesian law and the bank's own Articles of Association. Bank Mandiri is Indonesia's largest bank, and the challenges posed by the ongoing integration of the four legacy banks, execution of the business plan, and the eventual development of an international shareholder base justify a larger and more diverse Board membership. The previously cited plan to add a foreign professional will be a positive step. The bank also plans to activate its Nomination and Remuneration committees post IPO. There is currently no role for such committees since the government decides all appointment and compensation matters. Post IPO, these committees can provide a platform to represent all shareholder interests in these processes.

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The BOC is highly engaged and very actively involved in the business, and the BOD/BOC structure appears to work well under the existing ownership structure. However, the BOD's and BOC's respective roles and responsibilities overlap somewhat, and the BOD lacks direct accountability to the BOC.

�� � ��� � � � � � + � � ��� � � � � �� � � � � ) � � � �

2 � �$ 0 � �� � � � � �1 � � # � % �� � � �� � �� � � � � � � � �� � �� 2 � �� � � � � � � � . �� 2 � �@ + � � � � � � ��� A � � � � � � �

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2 � � $ 0 � = � $ 0 : = � � � � � � � � � � � � � � � � � � � � � � � � � � . � � ? + � � � � % � � � � � 1 � # � � � � � � � � � � = � ! � � � @ � � � � � � �

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" � � � � � � �

Bank Mandiri's BOC members appear to be more involved in operational and strategic issues than their non-executive counterparts in most other countries. The BOC's high engagement level and immersion in the details of the bank's business is a key to its effectiveness in advising and supervising management. Chairman Binhadi convenes BOC meetings at least once per week, usually for a full day. A typical meeting includes periodic presentations by a major functional area such as risk management, information technology, or internal audit. BOC meetings often include BOD members as well as key senior managers depending on the agenda. The culture is one of openness and inclusiveness with a goal of achieving consensus on most decisions. As previously cited, the Audit Committee is also highly engaged and actively oversees the internal and external audit processes.

However, this hands on approach – particularly on the Chairman's part - raises some concerns about an overlap of responsibility amongst the BOC and the BOD. Sources from both within and outside Bank Mandiri have also voiced this concern. The frequency of BOC meetings is high even by local standards; monthly meetings are more the norm in Indonesia. One explanation for the BOC's deep involvement in the business relates to the bank's recent history. The bank is only three years old, and the government is keen to accelerate the integration of the legacy banks and execute the various business initiatives so that it can begin to recover its massive investment. Once the bank is past this transitional period, then presumably the management and the BOD can focus on running the business, and the BOC can assume a more traditional Board role of providing oversight and checks and balances with less day-to-day involvement.

The government's control over the appointment, removal, evaluation, and remuneration of BOD members partially undermines the BOC's role as a check and balance against management. While the BOC's hands on involvement partly offsets this concern for now, the BOC should ideally begin to step back and assume less of a hands on approach over time as the senior management becomes more settled and the bank's strategic initiatives progress further along. However, this can eventually shift the

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balance of power toward the BOD and senior management. It is not clear whether the government will grant the BOC more authority over the BOD over time. Without an empowered BOC, minority shareholders will lack a strong voice at the Board level.

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As a matter of practice, independence is a key requirement for BOC membership even though this is not explicitly codified. Commissioner duties require a substantial time commitment that precludes any significant external responsibilities. Post IPO, a key concern is Commissioner independence in relation to the government.

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As previously noted, Bank Mandiri's BOC (comprised entirely of non-executives) plays an active leadership role. The BOC meets frequently and involves itself in certain key operational and strategic matters. The demands of the job leave little time for Commissioners to take on a significant number of external Board memberships. Furthermore, each Commissioner's professional background demonstrates a high degree of independence in relation to the bank and its management. Bank Indonesia also must deem all BOD and BOC candidates to be "fit and proper" with respect to their prior professional background and character.

Commissioner independence in relation to the government will be a key concern post IPO. Bank Mandiri does not have a publicly articulated policy relating to minimum qualifications or independence criteria, probably because the government has controlled this process. Markus Parmadi is currently the only Commissioner without a public sector background. Plans to add a foreign Commissioner can address this concern if minority shareholders are allowed to appoint their own candidate. It is not clear at this time whether the government will allow this to happen. On the other hand, the Jakarta Stock Exchange's ("JSE") new listing rules relating to good corporate governance require at least 30% of Commissioners to be independent, and that minority shareholders should at least nominate if not appoint the independent Commissioners at the AGM. Furthermore, the JSE definition of independent means that the candidate is not affiliated with the controlling owner and /or other Commissioners and Directors and does not sit as a Director with an affiliated company. While these requirements are not yet strictly enforced, the government may be compelled to comply with these conditions once Bank Mandiri is listed on the JSE.

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Existing remuneration packages do not link pay to the bank's performance. The government controls the internal processes relating to compensation, evaluations, nominations, appointments, and removals, which are not transparent, thus raising concerns as to how such processes will appropriately consider the interests of all shareholders post IPO. While the Nomination and Remuneration Committees have been set up to address these issues, they are not yet fully functional.

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The fact that BOD and BOC compensation is not linked to the bank's long-term financial performance raises concerns that their interests are not optimally aligned with those of shareholders. BOD members receive a fixed salary set by the government, while the BOC members also receive a fixed salary that is set as a percentage (30%-35%) of the BOD amount. By some accounts, the salaries paid to Bank Mandiri's Board members are below local standards for private sector companies of similar size, although individuals' compensation information is not disclosed. This in turn raises concerns about Bank Mandiri's ability to attract qualified candidates for future Director and Commissioner positions. This has been less of an issue under the current ownership structure where the majority of the Commissioners are career civil servants. Post IPO, the need to attract more private sector and international candidates will require a more flexible approach to remuneration. A new compensation structure for the BOD that may involve an Employee Stock Ownership Plan and/or stock options is under discussion. However, since details of the plan are not yet available, it is not possible to judge whether it will appropriately incentivize members to act in the long-term best interests of all financial stakeholders.

Likewise, Bank Mandiri lacks an articulated policy regarding evaluation of BOD/BOC members and succession planning. As previously noted, the government controls these processes in a non-transparent manner. Post IPO, this will become a more serious governance concern to the extent that minority shareholders lack formal channels through which they can express their views on such matters and realistically impact the outcomes. The BOC members' advanced ages also raise additional concerns about succession planning. Messrs. Binhadi, Sodarjono, and Sabana Kartasasmita are 65, 62, and 68 years of age respectively, and thus may not stand for re-election when their terms expire in October 2003.

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