Corporate Governance in Central Eastern Europe

Case Studies of Firms in Transition

Joseph C. Brada, Inderjit Singh

• Publisher: Routledge
• Year: 2019
• ISBN:
  9781315502472
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

This volume focuses on the performance of firms as a measure of the effectiveness of corporate governance, and then attempts to draw conclusions about the relative advantages of different ownership structures. The analysis is based on studies of firms in the Czech Republic, Hungary and Poland.

Part 1

Overview and Synthesis

1

Corporate Governance in East Central Europe: Issues and Summary of Case Studies

Josef C. Brada and Inderjit Singh

INTRODUCTION

It is generally agreed that the ultimate success of the transition in East Central Europe depends on developments that take place “on the factory floor,” that is, in the day-to-day operations of firms. A particularly valuable way of understanding such developments is through the use of case studies of firms in the transition process. In a previous volume, Estrin et al. (1995), thirty-six case studies of Czechoslovak, Hungarian, and Polish firms were presented and analyzed. These cases constituted systematic and in-depth evidence on the behavior of firms in these countries in response to early transition measures. These included responses to the emergence of factor and product markets, to the hardening of budget constraints, and, above all, to privatization.

These thirty-six cases painted a rather surprising picture of enterprise responses to transition, decisively showing that many firms were responding relatively actively and appropriately to changes in their environment. These findings thus constituted a systematic cross-country and cross-industry verification of earlier and more narrowly based findings of Pinto (1995), Pinto, Belka, and Krajewski (1993), and Pinto and van Wijnbergen (1994). A particularly important and striking finding of Estrin et al. was that strategic thinking about a firm’s future and efforts to implement strategic plans for transforming enterprises by managers were very much dependent on the autonomy enjoyed by managers and on the credibility of the prospects that the firm would be privatized in the future.

However, the case studies compiled in Estrin et al. were completed too early in the course of transition to shed light on the two key questions raised by these findings of the crucial importance of managerial autonomy and of the prospect of privatization for enterprise restructuring. The first of these questions is whether managers in East Central Europe were capable of devising and implementing strategic plans for their firms that would prove to be realistic and successful. There was considerable doubt about their ability to do so for two reasons. First, the economic environment in transition economies was a hostile one. There were large changes in relative prices, demand for many products collapsed, and there was little external funding to finance restructuring efforts. Second, there were doubts that managers brought up in the environment of a planned economy, where keeping up production was the overriding goal of each manager, could effectively master the marketing, finance, and management techniques required in a market economy.

A second question that was left unanswered by the case-study evidence in Estrin et al. was whether the promise of privatization would be realized. While the early case studies showed that the prospect of privatization was a stimulus to managerial action, privatization would have to be implemented at some future time. Once firms were privatized, the question of corporate governance would become paramount. That is, would the new owners want, and be able, to motivate managers to continue pursuing a strategic vision for their firm, to impose changes in strategy on managers, and to replace managers either who were unable to develop a strategic vision for their firm or who had adopted an unsuccessful strategy. As with the question of the abilities of East Central European managers, there was considerable reason to doubt the efficacy of corporate governance in the region. New owners were seen as inexperienced, lacking information about their firms, unable to act collectively to govern their firms, and disinterested in participating in corporate governance.

It is in the light of these questions that the case studies reported and analyzed in this volume were undertaken. As in the case of the Estrin et al. volume, these case studies were undertaken by the Transition Economics Division of the Policy Research Department of the World Bank as part of the World Bank’s research project entitled “Enterprise Behavior and Economic Reforms: A Comparative Study in Central and Eastern Europe,” with additional support from the Portuguese Ministry of Industry and Energy. The cases were researched and written up by teams of researchers led by Jana Matesová of the Czech Management Center at Čelákovice in the Czech Republic; by Ádám Török of the Research Institute for Industrial Economics in Budapest, Hungary; and by Marek Belka at the University of Łódź in Poland. Some of the firms that were the subject of case studies published in Estrin et al. were retained in the sample of firms covered by this volume, but new firms were added to the sample as well.

The focus of the case studies in this volume is explicitly on the corporate governance of firms, with a view to determining whether new owners were able to exert meaningful influence on managers and whether the pattern of corporate governance brought about by the rather different approaches to privatization in the Czech Republic, Hungary, and Poland had a systematic influence on the behavior of firms in these countries. Corporate-governance issues have arisen out of the privatization process because the pace of privatization has had a decisive impact on the continuing role of the state in corporate governance and because the method used to privatize firms has determined the type of owners who have emerged, including banks, investment funds, foreign investors, the government, often in the form of some specialized public agency for exercising the government’s ownership role, and individual shareholders. The latter consist of two distinct types: insiders, meaning managers and employees of the firm; and outsiders, that is, individuals who are not employees of the firm in which they own shares.

A good deal of the extant literature on corporate governance is based on a prioristic theorizing and tends to emphasize problems of collective action that prevent shareholders from monitoring managers and problems that emerge in the agent–principal relationship. Other works tend to establish rather ad hoc definitions of corporate governance, such as dismissals of top managers (Kenway and Chlumsky), that may or may not reveal much about the effectiveness of corporate-governance mechanisms. In this volume, we propose a model or standard of effective corporate governance that is based on the outcomes rather than on the process of corporate governance. In this way, we try to judge whether the ability of owners to evaluate and to influence managerial behavior can be, and is being, exercised and whether some ownership structures have an advantage over others in promoting managerial behavior that is congruent with shareholder interests.

OWNERSHIP AND GOVERNANCE: INSTITUTIONS AND THEORY

Owners and Laws

The pattern of corporate governance that is emerging in transition economies is, at least in the short term, path dependent, reflecting the means used to privatize state-owned enterprises (SOEs), the laws that have been enacted or revived, and the institutions that have emerged to facilitate corporate governance. In this section, we briefly sketch the privatization paths adopted in the three countries under review, paying particular attention to the ownership structure that has evolved. We then review, in schematic form, the laws regarding corporate governance.

Intercountry differences are greater in terms of paths to privatization than in the laws affecting corporate governance. One common element of the privatization process was that of corporatization, whereby SOEs were converted into corporations whose shares were held by the state until privatization took place. Although seemingly only symbolic, corporatization had important effects on corporate governance and managerial power and behavior. Corporate governance changed through corporatization in that the state exercised its ownership role by appointing outsiders, often not, or not all, government officials, to the corporate bodies that represented shareholders in the corporate-governance process. In Poland, this marked a significant shift in power from the workers’ council, which had been the main locus of power within the SOEs. In Hungary and the Czech Republic, the shift was more subtle, but, in all cases, the power of managers was strengthened. This shift in power to managers and the impending privatization that corporatization signaled led to the first efforts at restructuring and strategic responses to the transition on the part of firms being privatized (Estrin et al. 1995).

In Czechoslovakia, and subsequently the Czech Republic, privatization of large industrial units was implemented primarily by means of mass or voucher privatization. In this process, newly privatized firms ended up being owned by a combination of owners, including individual shareholders; investment privatization funds (IPFs), which collected the vouchers of individual investors and used them to construct portfolios of stock holdings; foreigners; insiders, including managers and workers; and the government, which retained holdings of various size in most SOEs that were privatized. Although the weight of each type of owner in the ownership structure varied from firm to firm, the fact that the IPFs obtained nearly three-fourths of the vouchers in the first wave of privatization and almost two-thirds in the second means that these funds and the banks that are their founders dominate corporate governance for most of the Czech private sector (Desai 1996).

In Hungary, privatization occurred largely through the sale of firms either to domestic investors, often the managers of the firms being privatized, or to foreigners. Thus the ownership role of financial institutions has been less important than in the case of the Czech Republic. On the other hand, given the emphasis on sales to foreign investors, their ownership role in Hungary is considerably greater than it is in the Czech Republic or Poland. Also important in Hungary has been privatization through corporate restructurings, which has created spinoffs of successful new firms from illiquid and moribund SOEs (Brada, Singh, and Török 1994; Stark 1994) in which former managers have emerged as the major owners.

Due to the delays that have plagued the Polish mass privatization scheme, the bulk of private firms in Poland are new start-ups with a relatively smaller role played by former SOEs in which foreigners have obtained an ownership stake or that have been privatized to Polish owners through either liquidation or direct privatization. Of these last two methods, liquidation, wherein the SOE is liquidated and its assets are sold to private investors who must put up 20 percent of the value of the firm and undertake to repay the remaining 80 percent to the state over time, is more common. While such buyouts make provision for broad employee stock ownership, in practice workers have often proven to have neither the interest nor the means to participate in the ownership of firms being privatized in this way. Of course, in firms that have as yet to be corporatized, the workers’ council remains a key decision maker. Thus the mix of owners in Poland resembles less that of the Czech Republic and more that of Hungary, with due allowance for the greater role of entrepreneur-owners of newly formed firms in Poland.

Despite these differences in the means of privatizing firms and in the type of owners who have emerged, the laws that determine how corporate governance is actually carried out are quite similar in the three countries, as may be seen from Table 1 (see pages 10–11), which compiles information on legal requirements and practices in Czech, Hungarian, and Polish corporations. For the so-called joint-stock companies, there are three bodies of owner representation. The one with the greatest power is the general assembly of shareholders. In their annual or, if called, extraordinary meeting, the shareholders accept reports on the firm’s performance, approve the strategic direction of the firm, decide on the distribution of profits, and give their consent to the emission of shares, to the issuance of bonds, and to major capital expenditures. The shareholders must also approve the dissolution of the firm and any changes in the firm’s statutes.

The assembly also elects members of the other two bodies of corporate governance, the supervisory board and the board of directors or management board, although national laws differ in the details of this procedure and in the rules governing the composition of these boards. The supervisory board meets three to four times per year, accepts and approves the firm’s financial statements, and presents these and other proposals to the general assembly. In addition, the supervisory board has to approve significant investment outlays and purchases of shares of other firms. It also serves as a check on management and on the board of directors or management board and may also set the salaries of the management team. Thus the supervisory board serves as representative of shareholder interests but not as a body for formulating company strategy. As a generalization, it is more removed from the day-to-day running of the firm than is the board of directors of a firm in the United States, in large part because all or nearly all its members are outsiders rather than members of the management team.

Under Polish and Czech law, the management board consists of the top managers of the firm, who serve under contracts determined by the supervisory board and who are responsible for the day-to-day functioning of the firm. In the Hungarian case, the board of directors has several insiders, and the president of the board becomes the president of the firm. Hungarian boards, however, also have outside members, who may represent the interests of major shareholders or who may be outside experts with technical or professional competence relevant to the firm’s business. Thus, the general assembly may change the top managers of the firm, and the supervisory board may check the strategic initiatives of management by refusing to permit major investments, but neither body is intended or designed to exercise direction over the strategy or the day-to-day operations of the firm. These responsibilities fall to the board of directors, which, with the partial exception of the Hungarian case, consists of the managers of the firm.

Corporate Governance: Theory and a Framework for Analysis

A major difficulty in evaluating corporate-governance structures is that all models of corporate governance represent second-best solutions to the principal—agent problem. Owners, the principals, cannot perfectly and costlessly elicit the first-best effort from the managers who are their agents in operating the firm. Two models of corporate governance, each with its own defects, exist in developed market economies. In one form, often identified with corporate governance in Germany and Japan, a bank that is a major shareholder in a firm will exercise governance, closely monitoring the behavior of managers and disciplining them, in part through its control over the firm’s access to capital. This model is often proposed for transition economies because it reduces the difficulty of organizing the actions of widely dispersed shareholders, makes use of the bank’s expertise and close relationship with the firm, and is said to provide governance that takes a long-term perspective of the firm’s future (see Litwack 1995 for these arguments in the context of a transition economy). In practice, this system may not have worked in developed market economies in the way described, in part because of the incentives banks face (Miyazaki 1993). Indeed, this system of governance is now seen as fading in importance in Japan, and the movement toward “managing to maximize shareholder value” has become the buzzword in Western Europe, suggesting that a bank-centered system of governance has palpable drawbacks, some of which are evident in the financial crisis that has shaken Southeast Asian economies.

The other system of governance, based on dispersed share ownership with discipline over managers exercised by the capital market through its effect on the firm’s shares and through mechanisms such as takeovers (Hart 1995), also suffers from weaknesses. These include a general inability by shareholders to monitor and collectively discipline managers, a system of incentives that orients managers toward shortterm goals, and an emphasis on financial maneuvers to boost financial results at the expense of sound business practices and the long-term development of the firm’s productive potential. Some critics find this system of governance so inefficient as to view its existence as a historical anomaly, and even its supporters accept the need for improvement (Cadbury 1995).

Table 1

Bodies of Corporate Governance and Their Responsibilities in the Czech Republic, Hungary, and Poland

Czech Republic	Hungary	Poland
	General Assembly (GA)
	• Consists of all holders of voting shares
	• Must meet at least once per year
	• Elects members of supervisory board and of board of directors, except for employees’ representatives to the supervisory board
	• Approves changes in articles of assiciation and share capital
	• Approves accounts and distribution of profits
	• Approves liquidation of corporation
Supervisory board (SB)	Supervisory board (SB)	Supervisory board (SB)
• Minimum of 3 members • Firms with over 50 workers must have one-third of SB seats for worker representatives • Elects own chair • Reviews performance of BD • Reports to the GA on financial statements and proposal for dividend payout	• Usually 3–4 members • At least 1 employee representative • Accepts balance sheet, income statement, and auditor’s report • Elects own chair, who also attends BD meetings • Meets 3–4 times per year	• At least 3 members • Members may not belong to MB • Gives consent to capital transactions over 5 percent of capital • Accepts and approves financial statements • Sets salary and employment contract of MB
Board of directors (BD)	Board of directors (BD)	Management board (MB)
• Minimum of 3 members • All have full right to act on behalf of the firm • Convenes annual meeting of GA • Responsible for operating decisions	• Usually 6–11 members, 2–3 “insiders (top managers and rest “outside” directors) • Elect chair, who b...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Table of Contents
• List of Abbreviations and Exchange Rates
• Preface
• Part 1. Overview and Synthesis
• Part 2. Foreign-Owned Firms
• Part 3. Domestic Outsider-Owned Firms
• Part 4. Domestic Insiders as Owners
• Bibliography
• Index
• About the Editors