Corporate governance in transition economies

The transition economies in Central and Eastern Europe have privatized their economies at an unprecendented speed in the 1990s. The expectation was that under private ownership, formerly state-owned firms would act as dynamic, profit-oriented players driving economic restructuring and growth. Yet, the expectation has rarely been fulfilled, and lack of effective corporate governance is often seen as a culprit. Transfer of ownership to private hands does not suffice to create powerful incentives for managers to engage in the market economies along the objectives of the new owners. This articles outlines the methods of privatization used in Central and Eastern Europe, and their consequences in terms of corporate governance. Many stakeholders acquired shares in ownership, which enhances their ability to influence management and creates complex challenges for managers to coordinate influential stakeholders. Central and East European economies may thus develop unique forms of capitalism, especially with respect to corporate governance systems. 31 1 The is an abbreviated version of a Keynote Address delivered at the Chemnitz East Forum delivered on March 22, 2003 in Chemnitz, Germany. Corporate governance in transition economies Corporate governance is often seen as a major obstacle to business in Central and Eastern Europe (CEE). Corporate governance refers to mechanisms that ensure that managers act in the owners’ best interest. In the transformation from central plan to market economy, privatization had a central place in policy agenda, yet the transfer of ownership alone does not suffice to create appropriate incentives for managers. The theory of property rights, primarily the principal-agent model, has been the ideological foundation of the privatization policy. However, many firms did not, as presumed by the model, end up in outside control but under the governance of a variety of stakeholders, including managers, employees, and the state. Throughout the capitalist world, governance systems are evolving towards the Anglo-American model, separating the shareholder function from that of other stakeholders, and monitoring firms through equity markets. Managers have to serve shareholders’ interests, who monitor them through the stock market, while other stakeholders normally have comparatively little influence. Shareholders’ lack of direct influence is compensated for by efficient stock markets. In particular, stock options provide powerful incentives for managers to act in shareholders’ interest. Moreover, takeovers provide a mechanism by which widespread equity ownership may rapidly become concentrated. Managers act in anticipation of potential hostile takeover and thus aim at keeping the share price high. In continental Europe and Japan, corporate governance systems assign banks and/or non-managerial employees a formal role in governance. In different ways, these systems of governance prevent self-serving managerial behavior. Yet, not only shareholders matter. Many groups or individuals can affect or are affected by the achievement of the firm’s objectives. The stakeholder literature questions the predominance of one stakeholder group that is, shareholders and assumes that the interests of all stakeholder groups have intrinsic value. Stakeholders can use both ‘voice’ and ‘exit’ strategies to influence the firm. The ability to exit strengthens effectiveness of the stakeholders’ voice within the firm, as does a financial stake. As a consequence of diverse forms of ownership in CEE, and diffuse control structures, theories considering stakeholders received considerable interest by analysts of corporate governance in transition economies [Buck et al. (1998), Mygind (2001)]. In this article, I briefly review the privatization process in CEE to show how diverse new ownership forms and stakeholder roles have evolved. On this basis, I outline some obstacles to effective corporate governance in the region. 32 The Journal of financial transformation How, and to whom, to privatize? To the general To current managers To previous To outside investors, such population and/or workers owners as foreign or domestic private firms By sale Stock market flotation: MBO, MEBO: Auction: Negotiated sale, tender: from mid 1990's only e.g. Poland, Romania everywhere for e.g. Hungary, small business Estonia By free Voucher Restitution: distribution privatization: e.g. Bulgaria, most countries East Germany Figure 1: Alternative methods of privatization Corporate governance in transition economies Methods of privatization Privatization schemes in CEE were implemented under less favorable conditions than those in the Western European countries, such as the U.K. in the 1980s. Some of the standard methods were not transferable to the transition context because capital markets were underdeveloped and private wealth was insufficient for citizens to buy large firms. Therefore a range of innovative methods of privatization have been developed and employed in the region. Figure 1 provides an overview of the methods of privatization, distinguishing recipients of the ownership titles, and whether or not they receive the ownership title for free. The most common method of privatizing large firms worldwide is stock market flotation, i.e. the general population would be invited to buy shares in an ‘initial public offering’ (IPO). Theoretically, this method has many advantages: it generates revenues for government budgets, it is generally transparent and thus perceived as fair, and it tends to create a dynamic process of change, which also eases the access to new resources. In practice, however, IPOs were not feasible in the transition context because they require developed stock markets, where the capital can be raised. Yet, investable financial assets were small in CEE, stock market regulatory institutions had not been established or there were no stock markets at all, and most crucially potential investors lacked detailed financial information on the state-owned firms. To overcome these obstacles, an innovative approach was developed, the ‘voucher privatization’. The basic idea of this approach is that all citizens receive a voucher, which they then can use to acquire shares in firms. Hence the basic idea of an IPO, the public bidding process, was created artificially without requiring domestic savings. Voucher privatization has been implemented in different ways across the region. Most transition countries, with the notable exception of Hungary, have implemented a voucher scheme as a main pillar of their mass privatization [World Bank (1996), Estrin (2002)]. The second major method of privatization has been the sale to outside investors. Auctions have been used extensively to sell smaller firms. This method leads to efficient outcomes if information on the firm is readily available and several potential buyers are interested in bidding. Larger firms have been sold through a tender process, in which a round of bidding is followed with direct negotiation with the winning bidder. Due to the complexity of tender processes, some businesses have also been sold through direct negotiations. However, considerable resources and time are required to assess each individual firm, and to negotiate with potential buyers. Hence, ownership transfer to the private sector has been slower in countries emphasizing this case-by-case approach, such as Hungary, Estonia, and Poland (East Germany is an exception due to the resources provided by West Germany to fund the process). Many privatization schemes also provided insiders of the firm access to ownership through management-buy-out (MBO) or management-employee-buy-out (MEBO) schemes. In some cases, this was combined with other methods to provide employees with a minority stake in the firm, as often seen in Poland. Elsewhere, managers and/or employees could acquire equity in the voucher privatization as in Russia, or with the help of financial incentives provided by governments, for instance access to loans under favorable conditions. MEBO-type privatization has been the most important method in countries, such as former Yugoslavia, where labor management had a long tradition going back to the special Yugoslav form of socialism, and in several countries of the former Soviet Union. In Hungary and Poland it was the second most important method of privatization. Last, in many countries where property had been expropriated after World War II, ownership titles were restituted to previous owners or their descendants. However, the clarification of ownership titles has in many cases been lengthy and cumbersome. This left many assets unattended while ownership conflicts were being settled. The choice of privatization method, and the selection of potential investors, is not a straightforward process that is implemented on a master plan. Political institutions, mostly the parliament, take basic decisions and privatization agencies