Transition out of control : an analysis of corporate governance control and the performance of Russia’s privatized enterprises

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Mischa van Diepen

Thesis BSc Economics and Business

10594566

Faculty of Economics and Business

Supervisor: Junze Sun

University of Amsterdam

Transition out of control:

an analysis of corporate governance control and the

performance of Russia’s privatized enterprises

Abstract

Through a review of theoretical and empirical literature, this article analyses the extent to

which the development of mechanisms of corporate governance control improved the

performance of Russia’s privatized in the years 1994-1999. It departs from a description of

Russia’s mass privatization, which served to allevate principal-agent problems in state-owned

enterprises. Consequently, it argues for the relevance of control mechanisms to mitigate

agency costs in Russia’s privatized enterprises. The analysis of the development of internal

and external control mechanisms in Russia in the respective period concludes that these

mechanisms remained underdeveloped. Subsequently, empirical literature on the performance

of Russia’s privatized enterprises is summarized. The article argues that weak corporate

control was one of the main factors leading to the inefficient performance of Russia’s

privatized enterprises in the period 1994-1999.

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1. Introduction

The productive inefficiency of state-owned enterprises in the Soviet Union is often considered to be the consequence of severe principal-agent problems (Gregory & Stuart, 1986). The agents which controlled these enterprises, politicians and directors, did not personally benefit from any profits made by the respective enterprises. As a result, they applied their control rights to pursue their self-interest, thereby decreasing profits to the principal, the state. Consequently, after the dissolution of the Soviet Union, Russia’s new government implemented a program of privatization (Boycko et al., 1995). Under private ownership, the enterprises’ new principals were expected to actively pursue their self-interest in the maximization of profits, thereby improving the performance of these enterprises.

In the period 1992-1994, all of Russia’s small enterprises and around 16000 of its medium – sized and large enterprises were transferred to private hands, a privatization effort that was and remains to be unprecedented until this day (Blasi et al., 1997). However, in the years during and shortly after Russia’s privatization, no significant increases in efficiency were observed in the group of medium-sized and large enterprises (Sutela, 1994; Aslund, 1995). Instead, the managers of these enterprises often pursued short-term strategies that served their self-interest, e.g. by stripping company assets. Observers of Russia’s transition now pointed out new forms of agency costs.

Economic theory claims that under the condition of efficient mechanisms of corporate governance control, such agency costs are largely mitigated, leading to efficiency increases (John & Senbet, 1998). However, in Russia’s new-born market economy, the institutions that made up for these control mechanisms were freshly established and thus far from flawless. The present article considers the development of control mechanisms in Russia’s economy and links this to the performance of enterprises in the years following privatization, until the end of Yeltsin’s presidency in 1999. This period was selected because under Russia’s new President Putin significant changes in economic institutions were implemented (Puffer & McCarthy, 2003). Through an evaluation of existing

literature on the process of Russia’s transition, both theoretical and empirical, this paper addresses the central research question: Did the development of control mechanisms in Russia’s economy in the period 1994-1999 improve the efficiency of privatized enterprises? The article concludes that weak internal and external control mechanisms impeded improvement of the performance of Russia’s privatized enterprises.

The remainder of the present article consists of the following sections. Section 2 provides an overview of the process and short run results of Russia’s mass privatization. Section 3 discusses the influence of internal and external control mechanisms on productive efficiency and their relevance to Russia’s transition economy after privatization. Section 4 provides an analysis of the development of internal and external control mechanisms in Russia. Section 5 relates the development of control mechanisms to empircal evidence on the performance of Russia’s privatized enterprises. It gives

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special attention to the effect on performance of the particular ownership structures in Russia, which are argued to be the consequence of weak mechanisms of control. In conclusion, section 6 summarizes the arguments presented throughout the article

2. The historical background of Russia’s mass privatization

2.1 The inefficiency of Russia’s enterprises before privatization

Both in developed and in developing economies, agency theory serves as one of the major motivations for governments to implement programs of privatization of state enterprises. Denis and McConell (2003) argue that while state enterprises are financed with the people’s money, they belong to the state, the principal, and so do any cash flows resulting from their activities. Notably, the state is no natural person and thus highly depends on the behavior of its representatives in the advocacy of its interests. Moreover, those agents that are responsible for the management and performance of state-owned enterprises, namely politicians and the enterprises’ management, do not personally benefit from any of these cash flows and thus have no direct interest in the maximization of the enterprises’ profits. According to Boycko et al. (1995), this implies a principal-agent problem with severe agency costs, which privatization serves to mitigate.

In their analysis of the communist economic system in the Soviet Union, Gregory and Stuart (1986) have pointed out the high inefficiency resulting from principal-agent problems long before any serious debate about privatization was conducted. This inefficiency was obvious in the pursuit of vast and wasteful projects by party officials, an indifference to cost control on such projects and an overemployment of people (Aslund, 1995). Accordingly, increasing agency costs were believed to be one of the main reasons for the economic downfall of the Soviet Union in the 1980s. In the first years of the subsequent decade, socioeconomic decline reached such lows and public unrest soared so high, that Gorbachev’s position and the Soviet Union as a whole appeared unsustainable. After the

dissolution of the Soviet Union in 1991, a team of economic reformers under the wings of Russia’s newly-elected president Boris Yeltsin took to the job of establishing a market economy based on private property.

2.2 The program of mass privatization

While the main motivation for Russia’s privatization thus rests in economic inefficiencies, it is often argued that in its implementation, the reformers met the interests of various parties to facilitate the process. This is recognized by the reformers themselves in their description of Russia’s privatization provided in Boycko et al. (1995). While the medium-sized and large enterprises subject to

privatization were in principle owned by the state, the managers and workers (who will be referred to as insiders) in these enterprises possessed high degrees of control rights. Accordingly, these insiders

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were expected to oppose any program of privatization in which they were not actively involved. Moreover, as in the Soviet Union’s economy state assets were officially owned by ‘the people’, the reformers recognized that the privatization of these assets should benefit all Russian people.

Recognizing the possibly short-term positive political momentum in favor of economic reforms, the reformers designed a program of privatizing Russia’s medium-sized and large enterprises, which will now be discussed.

Firstly, the general workers assembly of the enterprises selected for privatization was presented with the choice between three options in dividing a large part of the enterprise’s shares among its management and workers. This was a relatively democratic process and accordingly, the assembly of 73% of the enterprises elected option 2, which most benefited regular workers (Blasi et al., 1997). Under this option, 51% of the enterprise’s shares could be bought at a price that has generally been considered a bargain. Under option 1, elected by 25% of the enterprises, workers received 25% of the shares for free, whereas they could buy another 10% at a 30% discount to book value. Managers were allowed to buy 5% of the shares at a nominal price. Option 3 only applied to medium-sized enterprises and was chosen in just 2% of the enterprises. A management group was endowed with 30% of the company’s shares. 20% of the shares could be bought by workers and managers.

As for the remaining shares in the enterprises, the privatization design ordered that a minimum of 29% of the shares would be auctioned through a program of voucher privatization (Boycko et al., 1995). Every Russian citizen was entitled to a voucher with a nominal value of 10000 RUB. These vouchers could be deployed in a voucher auction organized by an enterprise in the process of

privatization, where individuals could acquire shares in this enterprise. However, as the vouchers were made tradable, they could also be sold to another individual or invested through to-be established investment funds (Lieberman & Kopf, 2008). The residual of shares in these enterprises, generally amounting to a 10-20% minority stake, often remained under state ownership for later privatization through cash auctions or investment tenders (Blasi et al., 1997).

2.3 Initial ownership structures

The execution of the privatization program came to a slow start but ended up reaching significant numbers. At the end of 1994, about 16000 of Russia’s 25000 middle-sized and large enterprises had been privatized (Blasi et al., 1997). The enterprises that had by then not (yet) been privatized were often either considered strategically important or not considered likely to function profitably in a market economy. Throughout the period 1992-1994, 97% of the Russian population collected their vouchers and either invested them in auctioned companies or sold them to others (Aslund, 1995).

In comparison with the original design of the privatization program, the Russian National

Survey, a survey of ownership structures in 350 large privatized enterprises from 1994-1996, found a

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Detailed results are presented in table 2 in the appendix. On average, insiders were in possession of 65% of companies’ shares, of which 25% was held by the companies’ managers. Furthermore, 21% of shares were held by outsiders and the state remained in possession of 13% of the shares. As was discussed previously, option 2 allowed for ‘only’ 51% ownership by insiders; this was the option that endowed insiders with the highest initial share. The 65% owned by insiders now indicates a significant addition to their initial stake. Furthermore, while under this option managers did not enjoy a

disproportionate endowment in comparison with regular workers, under the end-1994 allocation they possessed a significant minority stake. This indicates that the insider-biased reallocation of ownership that occurred during the process of mass privatization was also rather manager-biased.

2.4 Voucher trade during mass privatization

Notwithstanding extensive advertisement by the government to stimulate participation in voucher auctions, the Russian population generally showed reluctance to partake in the program. According to a poll conducted after the conclusion of the voucher privatization program, only 14% of the population directly invested their voucher in a company (Aslund, 1995). 30% had bought shares in a voucher fund, 26% had sold their vouchers, and 13% had simply given theirs away. According to the author, this lack of direct participation was largely due to the fact that, in the organization of their voucher auction, enterprises actively tried to limit participation by outsiders, primarily by withholding

information about the place and time of the actual auctions. As a result, voucher auctions often became local affairs, dominated by insiders, which likewise succeeded in increasing their shares in their own enterprises. According to an OECD report (Fine & Karlova, 1998), these fragmented and non-transparent voucher auctions were the consequence of deficient efforts to establish centralized regulation to provide a fair infrastructure for such auctions.

Moreover, observers often argue that in the process of Russia’s voucher auctions, disclosure of information towards bidders was very limited (Blasi et al., 1997). While insiders were well aware of the functioning of an enterprise, outsiders were not provided with sufficient information about the financial status of these enterprises. This subordinate position of outsiders, according to these authors, led to an undervaluation of the real value of a voucher by outsiders. Additionally, Appel (1997) argues that in Russia’s volatile socioeconomic environment, many Russians were subject to tight liquidity constraints, making it even more attractive to sell the voucher in return for some cash. As a result of these factors, insiders, who were aware of the true value of a voucher, could easily buy up bunches of undervalued vouchers to expand their shares in their enterprises (Aslund, 1995).

In markets with asymmetric information and costly information acquisition, well-functioning financial intermediaries serve to improve market efficiency, mitigating the cost of information transmission (Ellerman, 2003). Likewise, such intermediaries could have been foreseen to play an important role during Russia’s mass privatization. However, Kogul and Spicer (2002) observed that a lack of regulatory oversight led to the influx of various unlicensed financial intermediaries. Such

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intermediaries often exploited the Russian people’s lack of knowledge about financial markets in order to collect vouchers or funds and lost these in a bad gamble. As a result, the 30% of Russians that invested their vouchers through voucher investment funds were often left with empty hands (Aslund, 1995).

To summarize, we have seen not only that the initial design of the program of privatization in Russia was very much favored to insiders in enterprises, the conditions of voucher and share trading caused an even greater bias of ownership structures towards insiders. These conditions were

characterized by the absence of regulation surrounding voucher auctions and a lack of disclosure of information to outsiders.

2.5 Agency problems in insider-owned enterprises

As has been argued in section 2.1, agency theory was proposed as the major motivation for

privatization. However, shortly after Russia’s mass privatization, there were concerns that the shift of ownership from the state to private individuals had not led to the anticipated improvement of

performance by enterprises (Sutela, 1994). At this time, the largest average share in privatized enterprises, namely 40%, was owned by the workers in these enterprises (Blasi et al., 1997). On the other hand, the average share officially owned by managers was estimated to be at 25%. Although these distributions suggest that workers were the most dominant owners, practice shows that privatized enterprises generally pursued the interest of their managers. Firstly, their position above workers in the company’s hierarchy supplies them with means to prevent worker-owners from obstructing the

strategies managers pursued, e.g. through the threat of the workers’ discharge (Filatotchev et al., 1999). Secondly, according to Boycko et al. (1995), the fact that the sheer number of worker-owners was high and shares owned by workers as individuals were therefore low, impeded them from effectively exerting control. The opposite applied to managers, who enjoyed highly concentrated shareholdings and could thus more easily organize themselves

Managerial ownership, according to economic theory, does not necessarily interfere with efficiency (Jensen & Meckling, 1976). On the contrary, a frequently used way of aligning the managerial interest with profit maximization is to endow managers with shares in the respective enterprise, thereby motivating the manager to pursue a profit maxmizing strategy. However, various studies on the behavior of manager-owners in Russia’s privatized enterprises indicate that in practice, managers often improperly exploited their control over these enterprises (Black et al., 2000;Freeland, 2000). Firstly, managers were regularly involved in practices of asset-stripping, the transfer of firm assets to their small, privately owned enterprises. In addition, it was feared that many of the managers in Russia’s transition economy did not possess the skills required to operate an enterprise in a market-economy, as they lacked any experience in doing so (Black et al, 2000; Boycko et al, 1995). Under the presumption that managers fully controlled insider-owned enterprises, this would logically imply that bad managers would stay in their place.

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3. The relevance of internal and external corporate governance mechanisms

The primary objective of privatization is to alleviate the severe principal-agent problem in state-owned enterprises and thereby increase the productive efficiency of these enterprises (Dharwadkar et al., 2000). However, the previous section argued, this objective was not achieved in the short run after Russia’s mass privatization. On the contrary, privatized enterprises now saw new types of agency problems. In this regard, economic theory attributes great importance to the functioning of

mechanisms of corporate governance control, which will be referred to as control mechanisms. If such mechanisms function efficiently, agency costs are mitigated, resulting in increases in improvements in the performance of enterprises (Walsh & Seward, 1990). The following paragraphs firstly address the particular principal-agent problems in Russia’s enterprises. Subsequently, the relevance of control mechanisms that serve to mitigate these principal-agent problems is discussed.

3.1 Principal-agent problems in Russia’s privatized enterprises

From the brief discussion of the behavior of Russia’s managers shortly after privatization, provided in section 2.5, it follows that this behavior deviated from a strategy of profit maximization. In economic theory, deviations from the maximization of profits by agents controlling an enterprise are commonly classified as agency costs (Eisenhardt , 1989). The mainstream explanation for these agency costs is that the agents controlling an enterprise have self-interests different from the maximization of profits, which is the interest of the owner of the enterprise (Jensen & Meckling, 1976). Therefore, when left out of direct control by the enterprise’s owners, this misalignment of interests results in the pursuit of the self-interest of agents, e.g. through practices of shirking, stripping of company wealth or by engaging in status-increasing activities (Eisenhardt , 1989).

In response to such behavior by agents, non-managerial owners are expected to address control mechanisms in order to align the behavior of managers with the owners’ interest (Walsh & Seward, 1990). However, the identification of these non-managerial principals in Russia’s enterprises is not as straightforward as suggested by classical agency theory, which commonly only considers the interaction between managers and outside equity holders. In Russia, workers endowed with property rights in their own enterprises formed a third group of interest. Although as individual workers the influence of their behavior as agents in firms is neglegible, the control rights provided to worker-owners as a group made them a prominent new principal. Theoretical considerations (Blanchard & Aghion, 1996) and a survey on the interests and behavior of Russia’s enterprises’ insider-owners (Filatotchev et al., 1999) suggest that the interests of workers deviate from that of the other non-managerial owner type, outsiders. While the outsiders’ sole interest is presumably the maximization of profits, workers prioritze wage increases and maintainance of their empoyment.

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Therefore, the incentives for workers to control the strategy pursued by managers were different from those to outside owners of Russia’s enterprises. That being said, the following section proceeds with a brief discussion of the types of control mechanisms that non-managerial owners can address to control the management of their enterprises.

3.2 Internal and external control mechanisms

Internal mechanisms of control are those channels through which a firm’s owners can directly influence the actions of its management (Shleifer & Vishny, 1997). In most developed economies, some basic internal control mechanisms are legally arranged (Walsh & Seward, 1990; Dharwadkar et al., 2000). Firstly, the legal protection of shareholders against self-dealing by managers serves to prevent the practices of asset-stripping that occurred in Russia shortly after mass privatization. Secondly, publicly owned enterprises have legal obligations to hold shareholder meetings, providing owners with the opportunity to exercise their control rights. Moreover, a board of directors more closely monitors the behavior of managers and represents the interests of shareholders. More delicate forms of internal control include writing incentive-based contracts, which serve to align the self-interest of the managers with the maximization of profits (Jensen & Meckling, 1976). As the active ownership associated with internal control mechanisms necessitates the provision of adequate

information about the firm’s performance to its owners, Walsh and Seward (1990) argue that this leads these owners to incur monitoring and control costs.

According to Walsh and Sewards (1990), external mechanisms of control rely on the efficiency of markets surrounding a firm, which are argued to push the respective firm towards efficiency. Firstly, competitive capital markets provide incentives for firms to improve their

performance, as underperforming firms are punished through discounts on their stock value and thus have inferior opportunities to raise external capital (Bonin & Wachtel, 2003). Moreover, transparent and liquid securities markets facilitate hostile takeovers of underperforming firms. As managers in such firms are likely replaced after a hostile takeover, they supposedly act to maximize the firm’s value in a continuous effort to maintain their position. Although these mechanisms of external control imply a relatively passive and thus low-cost role to the firm’s current owners, they rest heavily on cheap and publicly available information about a firm’s performance on capital markets (Dharwadkar et al., 2000).

John and Senbet (1998) argue that internal and external mechanisms of control can be considered to be substitutes for one another, as they have the same effect of increasing productive efficiency. Accordingly, in an environment of efficient markets, there is lower need for active internal control and in the presence of strong institutions of internal control, the need for external control is lower. However, this view of substitutability of control mechanisms rests on the notion that both control mechanisms lead to productive efficiency. Section 3.1 finds that worker-owners have

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exert direct internal control to pursue their objectives (Dharwadkar et al., 2000). On the contrary, the nature of external control mechanisms suggests that these mechanisms, regardless of owner-type, push enterprises to productive efficiency. This possibly varying effect of control mechanisms in Russia, dependent on principal types, is a point to keep in mind.

3.3 The relevance of corporate control in transition economies

In the context of privatization, the present mechanisms of corporate control are commonly considered of great relevance to the success of privatized enterprises. Dharwadkar et al. (2000) argue that

privatization processes in developed economies have often turned out to be a success, as they were completed in the context of efficient mechanisms of either one or both internal and external control. In developing economies, the success of privatization is far less secure, as these control mechanisms are often underdeveloped (Bonin & Wachtel, 2003).

Shleifer and Vishny (1997) sketch the possible consequences of failure of corporate control. As deficient internal and external control mechanisms fail to mitigate agency costs to shareholders, this can lead to high troubles for firms to raise external funds. Moreover, weak corporate control can lock a country’s resources in an inefficient allocation. Becht, Bolton and Roell (2003) address problems of corporate governance in emerging economies as a major cause of crisis in emerging economies, such as the 1997-crisis in East Asia. Accordingly, observers of Russia’s transition

anticipated that the development of corporate control mechanisms would be of great importance to the future efficiency of Russia’s market economy (Sutela, 1994; OECD, 1998).

4. The development of control mechanisms in Russia’s privatized

enterprises (1994-1999)

4.1 Internal control

As has been discussed in section 2, the combination of control and property rights possessed by managers in Russia’s enterprises often led to the exploitation of company assets and managerial entrenchment in the short run after Russia’s mass privatization. Given that such practices imply high agency costs to the other owners in the enterprises, these owners shared an interest in the development of mechanisms of corporate governance control, through which they can control the behavior of managers.

The following praragraphs discuss the development of internal control mechanisms in Russia in the period 1994-1999. It is argued that for the bigger part of this period, deficient legal protection of shareholders resulted in an underdevelopment of internal control in Russia’s privatized enterprises. Subsequently, the underdevelopment of Russia’s banking sector is discussed. The article argues that banks failed to provide a monitoring function over Russian enterprises.

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According to Blasi et al. (1997), the early years after mass privatization were characterized by widespread efforts by manager-owners to limit the voting rights of worker-owners or to gain control over these votes. For example, in newly privatized enterprises, general directors were elected by shareholders. The employees’ voting was often manipulated by managers who made them sign proxies to transfer their voting rights to the managers. If employees did vote themselves, they could frequently not vote anonymously, as voting occurred on basis of a show of hands or by signing a ballot with one’s signature. Such practices facilitated the pursuit of the managerial interest.

There is wide agreement that in the following years, the violation of shareholders’ rights did not disappear and assumed more delicate forms (Puffer & McCarthy, 2003; Radygin, 1999). Such violations include the unlawful dilution of capital, the issuing of additional shares to majority

shareholders, the disclosure of insufficient or incorrect information about the enterprise’s performance and the refusal to pay out any dividends. Moreover, practices of self-dealing or transfer pricing persisted. It is rather intuitive that such a situation, in which property rights are frequently violated, deters outsiders and other agents from acquiring ownership in an enterprise.

In recognition of the negative effect of such deficient internal control on the performance of Russia’s privatized economy, governmental authorities sought to introduce legislature to protect (minority) shareholder rights. In 1996, two laws, the Law on Stock Companies and the Law on the Securities Market, were passed. However, active enforcement of these laws was successfully opposed by a group of Russian oligarchs that had gained significant political influence over the unstable and indebted Russian government in the respective period (Puffer & McCarthy, 2003).

Only after a couple more years would legal enforcement of laws protecting minority

shareholders assume more tangible forms. As Puffer and McCarthy argue (2003), Yeltsin’s economic policy introduced firmer state involvement after the mid-1998 economic crisis in Russia. The Law on Stock Companies and the Law on the Securities Market, which were passed in 1996, were now more actively enforced and the Law on the Protection of Investor Rights was passed in 1999. Although these developments of law on paper indicate movements in the rights direction, law enforcement was still considered a fundamental problem in the 1999 transition report of the European Bank of

Reconstruction and Development (ERBD, 1999). Arbitration courts lacked capacity, experience in interpretation of the law was low and bribable courts often favored capital-rich majority shareholders. 4.1.2 Russia’s banking sector

In economic theory, economic systems that rely more on internal than on external control are often associated with a predominance of bank lending for external financing choices (Walsh & Seward, 1990). The functioning of banks in terms of corporate governance control is twofold. Firstly, reductions in free cash flows resulting from interest payments decrease opportunities of rent-seeking. Secondly, to secure interest payments, banks have incentives to monitor the (financial) behavior of

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their borrowers. The following paragraphs address the development of Russia’s banking sector in order to evaluate whether or not bank lending developed sufficient volume for it to be considered of importance as a factor controlling enterprises.

In the first years following mass privatization, according to Blasi et al. (1997), the Russian banking sector showed little signs that it would develop to an important monitor in the context of corporate governance control. The authors indicate that Russian banks were very hesitant to provide loans for long-term restructive projects . Black et al. (2000) argue that this is mainly a consequence of the fact that any strategies towards restructuring presented by insider-owned enterprises were not perceived to be convincing enough, e.g. because they did not cut working force or replace bad managers. Consequently, the banking sector focused more on smaller, short-term loans with a more secure and quicker return on investment, or on investing through direct ownership and control. Moreover, high levels of volatile inflation and the crowding-out effect of high levels of governmental borrowing made bank credit even more scarce and thus expensive. According to Wright et al. (1998), almost half of the enterprises subject to their 1995-1996 survey indicated not having raised capital through bank loans, referring to excessively high interest rates.

The resulting picture of Russia’s banking sector was one that raised concerns with the EBRD (1999). This sector was characterized by a concentration of most banking activities under a selection of banks, the majority of which were still state-owned, and a scattered field of newly established, small banks seeking rents in the instable economic environment of Russia. According to the EBRD (1999), a lack of regulation and wrongful incentives given to banks by arbitrage opportunities, resulted in a sector abundant in participants with too low buffers. The default by the Russian government in 1998 on its bonds, in which many Russian banks were heavily invested, thus led to high numbers of bank defaults, destabilizing the entire sector. Moreover, Russians were very reluctant to invest their savings through financial intermediaries, as a result from early experiences with pyramid schemes and the non-transparent process of mass privatization (Kogut & Spicer, 2002). In this underdeveloped state, Russia’s banking sector did not provide a role of mitigating information costs and monitoring the behavior of agents in enterprises. This leads the present article to conclude that factors crucial to efficient internal control, being the protection of property rights and the stringency of bank lending, did not develop sufficiently.

4.2 External control

Economic theory on external control mechanisms discussed in section 3.2 outlines the role of capital markets as mechanisms of external control. The functioning of these mechanisms is twofold. Firstly, competition for capital is argued to push managers to increase the efficiency of their business (Walsh & Seward, 1990). Moreover, efficient stock exchanges signal underperforming managers through discounts on their enterprises’ stock price and facilitate hostile takeovers. Accordingly, efficient

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capital markets promote the efficient allocation of resources (Levine & Zervos, 1998). In the context of Russia’s transition this implies that efficient capital markets would punish those managers involved in practices of asset-stripping or other pursuits of their self-interest. As the enterprises in transition were in dire need of external capital for the modernization of their production lines, competition for such capital in efficient markets was expected to increase their productive efficiency (Sutela, 1994; OECD, 1998).

The following paragraphs firstly consider the development of Russia’s securities markets, which are argued to have developed insufficient trade volume and liquidity to exert external control on most enterprises. Moreover, relevant information and data on the development of external investment to Russia’s enterprises are summarized, leading to the conclusion that in the absence of efficient markets for capital, enterprises diverted to undesirable sources of credit.

4.2.1 Share trading

The early development of securities markets during the process of mass privatization in Russia, briefly discussed in section 2.4, led to a trading environment with characteristics opposing this picture of efficiency (Fine & Karlova, 1998). One of the factors explaining this picture of fragmented trade was the lack of regulation designed to harbor centralized securities trading. Over the following years, little improvement in the development of Russia’s official stock exchanges occurred (Berglof & Bolton, 2002; Claessens et al., 2000). Data provided by Berglof and Bolton (2002) indicate that in the period 1994-1999, the number companies noted on Russia’s official stock markets never surpassed 240. This indicates that the shares of most of the 16000 medium-sized and large enterprises that were privatized during Russia’s mass privatization, were traded off the market.

Other parameters of the development of Russia’s stock markets, provided in a Worldbank report by Claessens et al. (2000), confirm the image of official stock markets of neglegible size. Until 1998, the market capitalization of the Russian stock markets remained under 10% of GDP, while in a selection of non-transition economies, this parameter was on average at 38%. Moreover, market turnover as a part of the total market capitalization, an indicator for the stock market activity in a country, was at 40% in Russia; this was significantly lower than that of Poland, the Czech Republic, Estonia and Moldova and put it at an equal level with stuggling transition economies like Romania and Macedonia.

As a result of the underdevelopment of Russia’s stock markets, shares in most privatized enterprises were not traded on official markets. Insiders, notably managers, in the respective enterprises often exploited this situation to take over bundles of small shareholdings at low prices (Morgenstern, 1995). According to Blasi et al. (1997), managers sometimes addressed (unlawful) means to acquire shares in their enterprise from workers or outsiders. Employment was supposedly guaranteed to worker-owners in exchange for their vote, or schemes were set up leading to workers selling off their shares at well below market prices to their managers.

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Simultaneously, managers often put effort into preventing the sale of employees’ shares to outsiders. This behavior was facilitated by two factors. Firstly, according to Blasi et al. (1997), they could threaten employees with the loss of employment in case they sold their shares to outsiders or reward them in the opposite case. Secondly, managers sometimes unlawfully applied their control over the shareholders’ registry. Russian law required registered ownership of shares and thus prevented anonymous trade in shares (Morgenstern, 1995). However, in most instances, share registries were not maintained by an independent party, but they were under the control of an enterprise’s management. According to Willer (1997), there were numerous occasions when management manipulated share registries or simply refused to register new shareholders of their dislike.

The relevance of capital markets to the present article lays in their functioning as external control mechanisms. Control by managers over share registries evidentally impedes the functioning of such external control mechanisms. In the light of hostile takeovers, control over the share registry can be expected to increase managerial entrenchment, as managers could simply refuse to register new outside-owners that might favor to dismiss them. In recognition of this problem, a 1995 presidential decree ordered that share-registries of enterprises with over 1000 employees would be held

independently (Iwasaki, 2007). While the enforcement of this decree lagged behind, the subsequent period did give rise to independent share registries and gradually, more large enterprises had their shares registered here (Willer, 1997). However, as this decree did not touch upon middle-sized enterprises, improvements that were to be made in their share-registries depended on managerial goodwill or the realization that safeguarding fair trading in shares in their enterprises might result in increases of its share value

4.2.2 Investment by financial outsiders

As the preceding paragraphs demonstrate, Russia’s securities markets did not provide sufficient liquidity and transparency to generate a substantial threat of hostile takeovers. The second part of the argument for capital markets as external control mechanisms proposes that, in competition for external investment, enterprises are pushed towards productive efficiency. The following paragraphs provide information and data on the development of sources of external investment and consider this

investment in its exertion of external control.

On Russia’s securities markets analyzed in the above paragraphs, transaction costs associated with the direct participation in share trading by individuals were considered too high for them to invest their savings in enterprises without the intermediation by investment funds and banks (Fine &

Karlova, 1998). Moreover, in the situation of poor internal control described in section 4.1, small minority shareholdings to individuals were highly unattractive. In such an environment of high trade and governance costs, financial intermediaries could provide an important venue to external

investment. Investment funds, for example, can own a share substantial enough for them to take on monitoring costs involved with direct corporate governance, enabling depositors to share these costs

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However, the degree of involvement of these financial intermediaries in the ownership structures of Russia’s privatized enterprises has often been considered suboptimal. The average stake owned by financial outsiders, such as banks or investment funds, remained at a mere 10% in 1999 (Kapelyushnikov, 2001). As the present article argues in section 4.1.2, a bad first experience with financial intermediaries led common Russians to keep hidden high numbers of savings from financial intermediaries, such as banks or investment funds. Conservative estimates are that in 1997, Russians had $20-30 billion of saving kept away from official financial intermediaries, depriving the Russian economy of investment capital for which enterprises would be likely to compete (Kogut & Spicer, 2002).

Moreover, according to Ellerman (2003), forecasts of an important role in ownership to be played by financial intermediaries have often neglected the agency problems that were present within these financial intermediares. While the managers of investment funds, for example, were supposed to rigidly push the enterprises they owned a stake in towards efficiency in their pursuit of

profit-maximization, this presumption neglects the self-interest of these agents. As financial intermediaries acted in the same legislative void as the enterprises they were supposed to reform, their managers were often observed to instead tunnel assets into their own pockets. Ellerman (2003) argues that in many cases, the sole consequence of the inclusion of financial intermediaries into the ownership structure of firms has been the extension of present agency chains.

4.2.3 Foreign direct investment

Economic theory claims that, in competition for capital, enterprises are to increase their productive efficiency. The preceding paragraphs indicated that in the years after its mass privatization the Russian economy lacked efficient stock markets and financial intermediaries to channel savings from

households to firms. In this context, a possible alternative source of capital for which enterprises could be expected to compete was Foreign Direct Investment (FDI). However, the development of FDI into Russia did not bring about substantial influxes of capital for which enterprises could compete. According to Sinn and Weichenrieder (1997), cumulative FDI per capita to January 1996 was only higher than the respective number in Ukraine, Belarus and Moldova, while all other transition economies widely surpassed Russia. In the following years, FDI into Russia did not show much improvement. In 2002 inward FDI stock, the value of foreign investors’ equity and net loans in Russia’s firms, as a percentage of GDP was at 6.5% the lowest of all transition economies (Andreff, 2006).

This is a striking development, as Russia´s economy could have served as an attractive investment target for foreign investors, e.g. because of its abundance in natural resources and its well-educated labor force (Fabry & Zeghni, 2002). Many observers explain the underperformance of FDI into Russia through the unattractiveness of Russia’s investment climate. Firstly, on a micro-level, the

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weak protection of minority shareholders and underdevelopment of corporate governance mechanisms decreased the likelihood that foreigners could influence the strategy of an enterprise they acquired ownership in (Sinn & Weichenrieder, 1997). Secondly, observers point out high levels of corruption and the political instability surrounding economic reforms.

According to economic theory, efficient capital markets can provide external control over enterprises as in the contest for investment, enterprises will pursue efficient strategies (Walsh & Seward, 1990). The data on the development of capital markets provided above indicate that, firstly, Russia’s securities trading developed insufficient volume and liquidity to create a threat of hostile takeovers. Moreover, as a result of the poor circumstances for investing in Russia’s enterprises, there was insufficient capital on these markets to instigate competition for external investment.

Consequently, these enterprises often seeked nonconventional credits to maintain their operations. According to survey results provided by Wright et al. (1998), a majority of enterprises used high levels of trade credits and wage arrears. Moreover, an economy-wide lack of cash gave rise to high levels of industrial barter. Brana and Maurel (1999) state that in 1998, barter as a percentage of industrial sales was nearly 55%.

5. The effect of Russia’s weak control mechanisms on the performance of

privatized enterprises

The development of internal and external control mechanisms in Russia in the period 1994-1999 has been far from sufficient. Provisions of economic theory on the consequences of weak control are numerous (Shleifer & Vishny, 1997). These include difficulties for firms to raise capital, the entrenchment of bad managers and the efficient allocation of resources. The following paragraphs address empirical data on the performance of Russia’s privatized enterprises in the years following mass privatization to quantify the effects of weak corporate control on firm performance. The article suggests that the environment of weak corporate control indeed influenced the enterprises’

performance negatively. Moreover, the current section establishes links between the

underdevelopment of control mechanisms and the trends in ownership structures in Russia’s privatized enterprises from 1994-1999. It is argued that weak control led to the entrenchment of owners that controlled their enterprises particularly poorly.

5.1 General effects on the performance of Russian enterprises

The first decade of Russia’s economic transition was characterized by severe economic decline. According to a report by the McKinsey Global Institute (1999) on the performance of both

manufacturing and industrial enterprises, Russia’s GDP had fallen by 40% in the period 1994-1999. While part of this drop in GDP was arguably a consequence of, for example, the volatile political conditions and high levels of corroption surrounding Russia’s economy, the authors provide data that

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suggest a significant portion of this slumber to be the result of micro-economic inefficiencies. In 1999, the Soviet assets that remained in privatized enterprises only reached 50% of their productivity levels in 1992. Moreover, very few new assets were added to the production facilities since the dissolution of the Soviet Union. From these observations, the authors deduce that levels of restructive investment have been very low throughout this period.

A report by the EBRD (1999) points out weak internal control in Russia’s enterprises as a major cause for this lack of restructive investment. As a result of weak control over managers and insufficiently hard budget constraints, many enterprises failed to implement programs of

reconstruction. A parameter that supports this notion, is the level of external investment into Russian enterprises. Data provided by the ERBD (1999) indicate that in mediun-sized and large enterprises just 5% of funds came from bank lending and only 1% from equity finace. Instead of acquiring external funds necessary for restructive investment, the absence of control caused most enterprises to divert to internal funds to maintain their everyday businesses. As the present article has addressed in section 4.2.3, this also led to high levels of wage and tax arrears (Wright et al., 1998)

According to economic theory, the relevance of efficient corporate governance mechanisms translates into the valuation by capital markets of shareholding in enterprises (Shleifer & Vishny, 1997). With limited mechanisms to control an enterprise, possible owners will be aware of high agency cots and evaluate ownership in an enterprise lower. This notion is confirmed by empirical data provided by Black (2001). The author compares the actual market capitalization of a sample of Russian enterprises in 1999 to an estimated ‘potential Western’ value of these enterprises. He finds discounts of 50% up to 99,99% on their stock value, which were signifcantly related to the rankings of internal corporate control mechanisms in these enterprises. Interpreting market value as a proxy for enterprise performance, this shows the detrimental effect of weak corporate control on the latter.

Black et al. (2000) provide an extensive review of literature to support their argument that the main result of Russia’s privatization in an environment of weak corporate governance was the

entrenchment of self-dealing managers. Although it goes beyond the scope of this article to provide concrete evidence on self-dealing by managers, the projection of managerial entrenchment has been subject to empirical research. Filatotchev et al. (1998) and Muravyev (2003) provide evidence that managerial turnover was significantly lower in insider-owned enterprises. In such enterprises, managers arguably used their control over worker-owners to maintain their position. In this regard, managerial entrenchment is not only facilitated by weak mechanisms of control, but also a

consequence of the ownership structures in Russia’s privatized enterprises. More empirical evidence suggests varying effects of ownership on performance. The following sections address this empirical literature and illustrates how Russia’s environment of corporate control can explain these differences in performance of enterprises with different ownership structures.

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5.2 Ownership concentration as a substitute for control mechanisms

Economic theory claims that high concentrations of ownership can serve to mitigate agency costs in an environment of weak internal and external control and can therefore lead to increases in efficiency (Dharwadkar et al., 2000). Denis and McConell (2003) predict that in such environments, equity holders look to consolidate their control by acquiring large blocks of shares, leading to concentrations of ownership higher than what is common in developed economies.

This forecast fulfilled largely in Russia’s environment of weak internal and external control. Departing from the highly diffuse ownership structures resulting from its mass privatization, the majority of Russia’s privatized enterprises saw the rise of a shareholder owning more than 20% (Kapelyushnikov, 2001). Table 1 shows the distribution of enterprises in the author’s panel in 1999, according to the size of the single largest block of shares owned by one principal. Dharawadkar et al. (2000) propose that in developing economies with efficient control mechanisms, a share of 5-20% is usually sufficient to exert efficient control over an enterprise. However, the average single largest block of shares in this Russian sample was 32%. Moreover, according to Kapelyushnikov (2001), in more than half of the enterprises with a largest shareholder owning over 20% of total equity, this shareholder was an outsider.

Table 1: Distribution of firms by size of the single largest block of shares

Stake of the single largest shareholder as a part of total equity in 1999

0-10% 10-20% 20-50% >50% Unknown

Percentage of firms 19 21 25 22 12

Sub-sample of 117 firms, (Kapelyushnikov, 2001)

Empirical evidence on the effect of ownership concentration and performance in Russia’s privatized enterprises does not support the prediction that higher concentrations of ownership might lead to efficiency increases. In Kapelyushnikov’s panel (2001), firms with a single largest shareholder owning 10-20% of total equity outperformed others in terms of sales and various parameters of the efficient usage of resources. Enterprises with a majority shareholder, owning more than 50% of total equity, showed the worst performance. This negative effect of large shareholders is confirmed by Filatotchev et al. (2001), who found that large-block shareholding is negatively related with firm investment and performance in a panel surveyed in 1999. This effect held irrespectively of the identity of this majority shareholder.

Filatotchev et al. (2001) suggest that such underperformance is the result of the extraction of resources by controlling shareholders. Accordingly, the possibly positive effect of a large shareholder in terms of effectively monitoring an enterprise cancelled out by the pursuit of self-interest by this principal. As such behavior by a large stakeholder harms minority shareholders, economic theory classifies it as a principal-principal problem (Young et al., 2008). In developed economies, rent-seeking by large shareholders is heavily restricted by the legal protection of minority shareholders.

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However, the weak protection of property rights in Russia that was discussed in section 4.1.1 failed to prevent such practices. In this sense it prevented high concentrations of ownership to mitigate the consequence of weak control in Russia’s enterprises.

5.3 The entrenchment of bad principals

Another factor that is of interest in considering the performance of Russia’s privatized enterprises, is the influence of different owner types on this performance. The paragraphs at the beginning of this section suggest an overall negative effect of the weak control mechanisms in Russia on the

performance of its privatized enterprises. However, numerous empirical studies have indicated that different owner-types have different impacts on firm performance. The following paragraphs briefly discuss this empirical literature on the relation between owner-types and firm performance.

Accordingly, the article argues that the persisting presence of owners in the ownership structures of Russia’s enterprises is a logical consequence of weak external control on these enterprises.

To begin with, the development of ownership structures has been subject to multiple surveys. Shortly after Russia’s mass privatization, many observers argued that insider ownership had a negative effect on firm performance and restructuring, as it facilitated the pursuit of the self-interest of

managers (Sutela, 1994; OECD, 1998). In recognition of this relevance of ownership, Blasi et al. (1997) followed the development of ownership structures in a sample of 350 large firms in the period 1994-1996, the detailed results of which are provided in table 2 in the appendix. Their main findings were that there were indications of a reallocation of shares from insiders to outsiders, while from 1995 to 1996, the managerial share also increased slightly.

Graph 1: Average ownership structures, 1995-1999

Based on (Kapelyushnikov, 2001). For exact equity distributions, see table 3 in the appendix

Kapelyushnikov (2001) provides results of the analysis of ownership structures in a sample of 140 privatized enterprises in the years 1995, 1997 and 1999. The author’s findings, which are

represented in graph 1, correspond with the early trends indicated by Blasi et al. (1997); a decrease of

0 5 10 15 20 25 30 35 40 45 50 1995 1996 1997 1998 1999 A ve rag e sh ar e o wn e d b y gr o u p (% ) Managers Workers Non-financial outsiders Financial outsiders State

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worker-ownership accrued to managers and outsiders. In the 1999 sample, the aggregate workers’ share had been reduced to 31%, while the managerial share had increased to 15% and the aggregate outsiders’ share was at 3%.

Evidence relating the performance of Russian enterprises to their ownership structure contains mixed results. For example, some data suggest that dominant ownership by managers positively influences levels of investment and restructuring (Aukutsionek et al., 1998; Kapelyushnikov, 2001), while other empirical research proposes that such ownership increases managerial entrenchment (Filatotchev et al., 1999). Moreover, the effect of outside ownership is often found to depend on the more specific categorization of hs identity, e.g. whether the outsider is an individual or a financial outsider (e.g. Aukutsionek et al., 1998). However, an overview of empirical research on the effects of Russia’s privatization on enterprise reform by Iwasaki (2007) suggest that workers always turn out to be ‘bad owners’, exerting a negative influence on performance parameters such a sales, external investment and employment reductions.

These observations correspond to the notion, addressed in section 3.1, that workers as principals have objectives that deviate widely from the maxmization of profits (Blanchard & Aghion, 1996). The fact that workers, who are generally considered to be bad owners, remained significantly represented in the ownership structures of Russia’s enterprise, can be argued to be a consequence of the inefficiency of Russia’s capital markets. Economic theory claims that efficient external control mechanisms push underperforming enterprises to increase their productive efficiency in competition for capital (Bonin & Wachtel, 2003). If such efficiency increases are not attained, a hostile takeover will introduce new owners that are expected to exert control and make adjustments aimed at

improving performance. In efficient capital markets, differences in performance based solely on ownership type would not be sustainable. The lasting presence of workers in the ownership structures of Russia’s enterprises is yet another negative consequence of Russia’s weak control mechanisms.

6. Concluding remarks

Through a review of theoretical and empirical literature on Russia’s privatization, the present article has engaged with the central research question: Did the development of control mechanisms in Russia’s economy in the period 1994-1999 improve the efficiency of privatized enterprises? Departing from a description of Russia’s mass privatization and its outcomes, it indicates the

relevance of the development of internal and external control mechanisms in mitigating agency costs in Russia’s privatized enterprises.

The article’s analysis of the development of internal and external control mechanisms after Russia’s mass privatization suggests that both these forms of control developed insufficiently. The underdevelopment of internal control mechanisms was mainly the consequence of a severe lack of protection of shareholders. A study of Russia’s capital markets as external control mechanisms led to the conclusion that these markets neither functioned through a threat of hostile takeovers, nor were

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there sufficient external investment funds to instigate competition for capital.

In order to relate the underdevelopment of mechanisms of corporate control in Russia to the performance of Russia’s privatized enterprises, the article summarized empirical literature on this performance. Parameters of investment, productivity and stock value on a country level are in line with a negative effect of weak corporate control. Moreover, the article argues that enterprises with high concentrations of ownership or with entrenched ‘bad owners’ were the logical consequences of weak corporate control. The article reviews empirical literature that indicates that these firms underperformed in comparison with other enterprises in the Russian economy.

The article concludes to state that the weak environment of control has been one of the explanatory factors for the failure of Russia’s transition in the 1990s. These findings urge the importance of policies aimed at establishing efficient mechanisms of corporate governance control.

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Appendix

Categories of shareholders 1994 1995 1996 Insiders, total 65 55 58 Managers 25 16 18 Workers 40 39 40 Outsiders, total 21 32 32

Non-financial outsiders, total - 24 21

Outside individuals - 9 6

Other firms - 15 15

Financial outsiders - 8 9

The State 13 13 9

Other shareholders - 1 2

Table 2: Ownership structure in privatized medium-sized and large enterprises in Russia, according to the Russian National Survey, as cited in (Blasi et al., 1997). Grand total might not add up to 100% due to rounding off

Categories of shareholders ₁₉₉₅ ₁₉₉₇ ₁₉₉₉

Insiders, total 55 52 46

Managers 11 15 15

Workers 44 37 31

Outsiders, total 35 39 42

Non-financial outsiders, total 26 29 32

Outside individuals 11 14 19

Other firms 15 15 14

Financial outsiders 9 10 10

The State 9 7 7

Other shareholders 1 2 4

Table 2: Ownership structures in privatized medium-sized and large enterprises in Russia, according to the Russian Economic Barometer, as cited in (Kapelyushnikov, 2001). Grand total might not add up to 100% due to rounding off

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