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Lessons from the Czech Experience John C S4sso 1el el uS CORPORATE GOVERNANCE Public Disclosure Authorized IN CENTRAL EUROPE AND RussIA A RESEARCH PROJECT OF THE WORLD BANK AND THE CENTRAL EUROPEAN UNIVERSTY PRIVAZATION PROJECT Public Disclosure Authorized FILE COPY Institutional Investors in Transitional Economies: Public Disclosure Authorized Lessons from the Czech Experience John C Coffee Jr. Public Disclosure Authorized Transition Economics Division Policy Research Department The World Bank Institutional Investors in Transitional Economies: Lessons from the Czech Experience by John C. Coffee, Jr. Introduction This paper has a dual aim. On one level, it attempts to provide a detailed explanation of the Czech eperience with voucher privatization, because, put simply, that experience has been the success story of Eastern European mass privatization. But this paper also has a second oF, ctive. For those interested in corporate governance, Czech voucher privatization represents a natural experiment in ownership structure - one in which special monitors and a uniquely concentrated shareholder ownership structure were intentionally created to ensure the accountability of managers at the newly privatized companies. What happens under such an ownership structure? Will large finanial intermediaries created specifically to monitor managements function as planned? Or, are the incentives to monitor weaker and more problematic? Are there also perverse incentives that can lead such institutions to pursue ulterior ends unrelated to, or conflicting with, the interests of shareholders? Answers to these questions (if definitive answers were possible) would transcend the Eastern European context. For example, in the United States, the capacity and incentive of institutional investors to monitor managements has been the subject of a continuing John C. Coffee, Jr. is the Adolf A. Berle Professor of Law at Columbia University Law School. Professor Coffee would like to acknowledge the valuable assistance received from a variety of persons whose knowledge and experience with the Czech context vastly exceeds his own. A partial list would include: Dusan Triska, Jan Mliadek, Joel Turkewitz, and Stijn Claessens, and various commentators at The World Bank. 1 academic debate. On one side of this debate, one group of critics argues that institutional investors, if deregulated and liberated from existing restrictive federal regulations, would become active monitors and thus end (or at least reduce) the separation of ownership and control) On the other side, another group are skeptical that institutional investors have adequate incentives to monitor, both because of principal/agent problems and a general preference for liquidity that leads them to limit their ownership stakes. Thus, although they agree that much federal regulation is burdensome, they believe deregulation may produce only marginal differences. Against the backdrop of this debate, the Czech experience is particularly interesting because the tradeoff between liquidity and control present in economies with developed securities markets simply does not exist within the Czech system. Because the Czech equity markets are extremely "thin", lacking both liquidity and transparency, large shareholders are therefore locked-in and may not choose between "exit" and "voice." In fact, the Czech market may be among the most concentrated in the world, and thus the separation of ownership and control is minimized. As a result, the Czech market presents a unique natural experiment: to what degree will newly created institutional investors engage in costly monitoring when they are denied the opportunity to engage in other distractions (such as noise trading)? 1 See Mark Roe. A Political Theory of American Corporate Finance. 91 Colum. L R. 10 (1991); Bernard Black, Shareholder-Passily Reexamined. 89 Mich. L Rev. 520 (1990); Joseph Grundfest, Subordination of American Capital 27 J. Fin. Econ. 89 (1990). 2 See John Coffee, Liquidity Versus Control: The Institutional Investor As Corporate Monitor. 91 Colum. L Rev. 1277 (1991); Edward Rock, The Logic and (Uncertain) Significance of Shareholder Activism 79 Geo. L J. 445 (1991). 2 In truth, the Czech experience with privatization is still too brief to permit any quantitative assessments. But preliminary date and qualitative evidence does lead to one conclusion. Institutional and legal detail is critical. Concentrated ownership without more may not lead to active monitoring because the economic incentives to monitor may be weak or overshadowed by more powerful incentives. In this light, the Czech experience suggests that the incentives of outwardly similar institutions to engage in monitoring can vary greatly, depending in large part on their own institutional affiliations and sponsorships. At first glance, the Czech institutional context seems roughly to resemble that of Germany, where a small number of 'universal" banks have long played a significant role in corporate governance.3 But there is an important difference: the major Czech financial institutions which founded the majority of the investment privatization funds (or IPFs) on which this paper will focus do not themselves hold, directly or indirectly, significant equity stakes in the newly privatized companies. Although they may possess de facto control over the IPFs that they have sponsored, their relationship with their IPFs is that of an agent, rather than an owner, they receive a management fee, but do no- share in equity appreciation. In turn, this means that they may have control over, but not ownership of the portfolios that their IFFs in turn hold in the newly privatized Czech companies. Control without ownership can create perverse incentives, particularly when Czech financial 3 For the traditional view of German banks as active monitors, see J. Cable, Capital Market Information and Industrial Performance: The Role of West German Banks 95 The Economic Journal 118 (1985); see also, Gary Gorton and Frank Schmid, Universal Banking and the Performance of German Firms (Wharton School Working Paper October 1994). But for a revisionist view that doubts the extent of such monitoring, see Jeremy Edwards and Klaus Fisher, BANKS, FINANCE AND INVESTMENT IN GERMANY (1994) (discussed infra at notes 116 to 127). 3 institutions have a direct creditor relationship with the newly privatized companies. Either because of such a creditor relationship or the desire for it, there is the prospect of a conflict of interests. Both these factors - control without ownership and a potentially overshadowing creditor relationship - can undercut the incentive to be an active monitor, even when the structure of share ownership is uniquely concentrated. In overview, the contemporary Czech pattern of corporate governance is probably best characterized as a hybrid of the German system of corporate governance (Le., heavily bank centered and characterized by thin equity markets) and the U.S. and U.K. systems (in which institutional investors hold substantial equity stakes in companies traded in deep and active equity markets). The key financial intermediaries in the Czech system are specially designed investment privatization funds (or IPFs), which basically resemble a U.S. or U.K. closed-end mutual fund, but these funds are often affiliated with banks or other financial institutions (as under the German approach) and their shares trade in a market that has little liquidity. Many observers have predicted that Czech corporate governance will evolve in the direction of the German banking modeL But the likely future evolution of Czech governance may depend in substantial part on Czech regulatory policy, which seems today uncertain as to whether Czech financial institutions should be able to integrate their creditor and equity operations in order to achieve monitoring synergies The likely costs and benefits of a "German" policy of consolidating equity and credit operations in one "mega- monitor" need to be contrasted with those of the alternative "American7 approach of 4 The leading example of this tendency is the Ministry of Finance's position that "firewalls" should be maintained between the parent bank and the IPF. See text infra at notes 85 to 86. 4 requiring strict firewalls between banks and their equity-trading affiliates. The final section of this paper will focus on these tradeoffs, which are important for all transitional economies. However, for most of Eastern Europe, the leading current issue in privatization is not how the Czech system will evolve, but how it can be emulated. Alone among the several Central European nations that began at the same starting point with the collapse of the Communist Bloc in 1989, the Czech Republic has created functioning capital markets and a truly privatized corporate structure. In this respect, voucher privatization has been an unqualified success. With the completion of the second privatization wave at the end of 1994, the post-privatization landscape of the Czech economy can be sketched in at least its broader outlines, as follows: 1. Over 80% of adult Czech citizens are now shareholders in the 1,849 companies that were privatized (in whole or in part)5 2. Although estimates vary, between 65% and 90% of all assets in the Czech economy is now privately owned (up from a mere 4.5% in 1990).' 3. The Czech economy has the lowest rate of inflation in Central Europe (currently, s For detailed recent reviews, see "Czechs Turn Out to Buy Into Industry Privatizationf" Los Angeles Times, November 26, 1994 at D-1; see also, "Czech Sell-off
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