Organization and Development of Russian Business: A Firm-Level Analysis

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Organization and Development of Russian Business

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Organization and Development of Russian Business A Firm-Level Analysis Edited by

Tatiana Dolgopyatova, Ichiro Iwasaki, and Andrei A. Yakovlev

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Selection and Editorial matter © Tatiana Dolgopyatova, Ichiro Iwasaki and Andrei A. Yakovlev 2009 Individual chapters © Contributors 2009 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6-10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2009 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan in the US is a division of St Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN-13: 978–0–230–21728–7 hardback ISBN-10: 0–230–21728–1 hardback This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Organization and development of Russian business : a firm-level analysis / edited by Tatiana Dolgopyatova, Ichiro Iwasaki, and Andrei A. Yakovlev. p. cm. Includes bibliographical references and index. ISBN 978–0–230–21728–7 (alk. paper) 1. Corporate governance – Russia (Federation) I. Dolgopyatova, Tatiana, 1951– II. Iwasaki, Ichiro. III. Yakovlev, Andrei A. HD2741.O74 2009 338.60947—dc22

2009013790

10 9 8 7 6 5 4 3 2 1 18 17 16 15 14 13 12 11 10 09 Printed and bound in Great Britain by CPI Antony Rowe, Chippenham and Eastbourne

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Contents List of Tables

vii

List of Figures

xi

Acknowledgments

xii

Notes on the Contributors

xiii

List of Abbreviations

xiv

Introduction Tatiana G. Dolgopyatova, Ichiro Iwasaki, and Andrei A. Yakovlev 1 The Emergence of Russian Corporations: From the Soviet Enterprise to a Market Firm Tatiana G. Dolgopyatova, Ichiro Iwasaki, and Andrei A. Yakovlev Part I

1

12

Ownership, Internal Control, and Management System

2 Stock Ownership and Corporate Control Tatiana G. Dolgopyatova

39

3 Legal Form of Incorporation Ichiro Iwasaki

62

4 The Structure of Corporate Boards Ichiro Iwasaki

89

5 Impact of Corporate Governance and Performance on Managerial Turnover Naohito Abe, and Ichiro Iwasaki

122

6

148

Management Team and Firm Restructuring Victoria V. Golikova Part II

Business Integration and Its Impacts on Corporate Governance

7 Organizational Patterns of Corporate Control and Business Integration Tatiana G. Dolgopyatova 8 Corporate Governance and Decision-Making in Business Groups Svetlana B. Avdasheva

173 195

v

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vi

Contents

9 Impact of Business Integration on Corporate Restructuring and Performance Svetlana B. Avdasheva

213

Part III The Role of External Agents in Corporate Governance 10 The Banking Sector and Corporate Finance Fumikazu Sugiura 11 Business Associations: Incentives and Benefits from the Viewpoint of Corporate Governance Victoria V. Golikova 12

State–Business Relations and Improvement of Corporate Governance Andrei A. Yakovlev

235

258

284

Conclusions Tatiana G. Dolgopyatova, Ichiro Iwasaki, and Andrei A. Yakovlev

307

Appendix: Outline of the Japan–Russia Joint Enterprise Survey Tatiana G. Dolgopyatova, and Ichiro Iwasaki

312

Index

321

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Tables I.1 1.1 1.2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3.1 3.2 3.3 3.4

3.5 4.1 4.2 4.3 4.4

Selected macroeconomic indicators of the Russian transition economy, 1992–2007 Chronology of enterprise reforms and related events in the USSR and Russia, 1986–2007 Privatization of state-owned enterprises and privatization revenue in Russia, 1993–2007 Intra-corporate disputes in 2001–2004 at different levels of ownership concentration Average percentage of ordinary shares owned by type of shareholder at different levels of ownership concentration Current economic situation of enterprises at different levels of ownership concentration Coefficients for the variable “concentration of ownership” in regression models Ownership and control in JSCs at different ownership and control concentrations Influence of board of directors on corporate decision-making at different levels of ownership concentration Structure of board of directors at different levels of capital concentration Differences in the legal framework between open and closed joint-stock companies in Russia Comparative advantages of open and closed companies over an alternative corporate form of joint-stock company Most important reason for being in the current corporate form Comparison between open and closed joint-stock companies regarding the ownership structure, capital demand and supply constraints, relationship with business groups, past policies on company start-ups, and company size Probit regression analysis of the corporate-form choice model Descriptive statistics on board size and number of directors by their attributes of 730 surveyed firms International comparison of board size and proportion of outsider directors Correlation matrix of board components Theoretical predictions of the impacts of firm organization and business activities on board components

2 17 23 44 45 49 51 54 54 56 66 70 71

77 80 95 96 101 107

vii

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viii

Tables

4.5

Definition, descriptive statistics, and data source of variables used in the empirical analyses and correlation coefficients with board components 2SLS system estimates of endogenous board formation Studies of managerial turnover in Russian firms Results from vote-counting analysis of the impact of different types of owners and changes in ownership structure on CEO turnover Descriptive statistics of independent variables by company group in terms of turnover type Logit regression analysis of the impacts of corporate governance and performance on CEO turnover Multinomial probit regression analysis of the impacts of corporate governance and performance on managerial turnover taking its magnitude into consideration Multinomial probit regression analysis of the impacts of corporate governance, corporate performance, and internal conflict on managerial turnover taking its magnitude into consideration Recruiting sources of general directors at independent enterprises and in HCGs Characteristics of managerial skills and experience by different status of company location Change of general director/board chairman at independent enterprises and HCGs depending on changes of main company shareholders in 2001–2004 Change of middle-level managers in JSCs in which the general director was changed by the status of the current director Logistic regression analysis of the propensity of proactive restructuring Ownership and management configuration at affiliated companies of holding company groups Characteristics of intra-corporate control Turnover of CEOs, boards of directors, and its chairs in 2001–2004 Comparison of JSCs with separation or combination of ownership and management Logistic regressions for shareholder choice of separated ownership and management Logistic regressions for shareholder choice of separated ownership and management and corporate integration Enterprises coordinating strategic decisions with outside stakeholders

4.6 5.1 5.2

5.3 5.4 5.5

5.6

6.1 6.2 6.3

6.4 6.5 7.1 7.2 7.3 7.4 7.5 7.6 8.1

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110 112 126

128 134 136

138

141 152 153

155 157 162 176 178 179 184 186 189 203

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Tables ix

8.2 8.3 9.1 9.2 9.3

10.1 10.2 10.3 10.4 10.5 10.6 10.7 11.1 11.2 11.3

11.4 11.5 11.6 11.7

11.8

12.1 12.2

Ownership and management in JSCs depending on their affiliation with BGs Boards of directors in subsidiaries of BGs in regulated and nonregulated industries Impact of membership in business groups on restructuring activity Impact of membership in business groups on performance indicators Total factor productivity in subsidiaries of BGs compared with independent enterprises (Cobb–Douglas production function, output in 2004) Financing sources of fixed investment Recent Sberbank financial undertakings Asset structure of Sberbank Definitions, descriptive statistics, and sources of variables used in the empirical analysis Results of regression analysis on enterprises with no external borrowings Certain characteristics of enterprises depending on main source(s) of external finance Results of regression analysis on enterprises with borrowings from Sberbank Characteristics of companies: Members and nonmembers of business associations Indicators of financial standing of joint-stock companies and membership in business associations Types of support rendered to authorities and aid through various channels depending on membership in business associations Benefits for members of associations from the establishment of steady contacts with authorities Logistic regression analysis of the determinants of participation in business associations Logistic regression analysis of probability to obtain financial and organizational support from the state authorities Utility of business associations and their contribution to the establishment of standards and rules of conduct of business, evaluated by respondents in 2002 and 2005 Evaluation of contribution of NGBOs to the solution of important problems of the business community by the respondent joint stock companies Construction of the CG_IDX Distribution of firms depending on the value of the CG_IDX

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204 207 221 224

226 237 240 244 249 250 251 253 263 264

265 266 270 274

276

277 290 290

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x

Tables

12.3 12.4 12.5 12.6 12.7 12.8 12.9 A.1 A.2 A.3 A.4 A.5

State-controlled companies and firms with a minority stake held by the government Construction of the POLCON variable Distribution of firms depending on the value of the POLCON variable Correlation matrix of the variables used in the regression analysis Definitions and descriptive statistics of control variables Ordinary probit regression analysis of the effect of state ownership on the quality of corporate governance Ordinary probit regression analysis of the effect of political connections on the quality of corporate governance Composition of respondents by their position in a company Geographical composition of the surveyed firms: Comparison with offical statistics Sectoral composition of industrial firms surveyed: Comparison with offical statistics Composition of the surveyed firms by total number of employees Breakdown of the surveyed firms by location, sector and industry, form of incorporation, and total number of employees

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291 292 292 293 294 297 300 314 315 316 316

318

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Figures I.1 Foreign direct investment inflow into Russia, 1995–2007 2.1 Classification of surveyed joint-stock companies by level of ownership concentration 2.2 Concentration of ownership in independent and integrated companies 2.3 Modernization activities of companies at different levels of ownership concentration 2.4 Classification of surveyed companies by participation of shareholders in their management 4.1 Board size of 730 joint-stock companies 4.2 Proportion of outsider directors for 730 joint-stock companies 5.1 Changes in CEO turnover frequency, 1993–2003 5.2 Changes in average ownership share by insiders, outside shareholders, and the state in industrial firms, 1994–2002 6.1 Change of managers in the departments following a new general director appointment by shareholders’ decision 7.1 Links between ownership and management in integrated and independent companies 8.1 Share of business groups (BGs) in number of companies and in employment 8.2 Instruments to solve the agency problem in Russian BG subsidiaries 9.1 Gains from joining business groups (BGs) according to directors of enterprises by time of merger 9.2 Restructuring activity in subsidiaries of BG vis-à-vis independent companies 9.3 Financial performance of different types of enterprises 10.1 Trend of major asset and liability items of Russian enterprises 10.2 Composition of bank credits in Russia 10.3 Existence of a main bank relationship 10.4 Maturity structure (the longest) of borrowings made during 2001–2004 10.5 External funds raised in 2004 and banks that offered the most 11.1 Membership in associations by type of settlement 11.2 Strategies of membership in associations A.1 Composition of the surveyed firms by sector and industry

4 42 43 48 53 98 100 124 125 157 175 198 210 217 218 223 238 242 245 246 246 268 272 315

xi

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Acknowledgments This volume presents one of the results from the Japan–Russia joint research project entitled “Corporate Governance and Integration Processes in the Russian Economy” conducted by staff members of the Institute of Economic Research of Hitotsubashi University, the Institute for Industrial and Market Studies of Higher School of Economics, and Teikyo University. These institutions provided considerable support with the organization of the study meetings and conference presentations within the framework of the project. As reported in the chapters, the authors received financial support from several research funds and state institutions, including those from the Inamori Foundation, the Japan Securities Scholarship Foundation, the Ministry of Education and Science of Japan, the Moscow Science Public Foundation sponsored by the USAID, the Program for Fundamental Studies of Higher School of Economics supported by the Ministry of Economic Development and Trade of the Russian Federation, and the Zengin Foundation for Studies on Economics and Finance. We also acknowledge the sponsorship from the Foundation of the Japan Legislation Society and the Russian Research Center of the Institute of Economic Research at Hitotsubashi University to carry out editorial work and English proofreading of the whole book. The editors thank all the contributors to this volume for their serious efforts and insights. The editors are also grateful to Yuka Miura and Asahi Nishihara for their administration of the project and to Akira Ishida, Elena Leont’eva, and Jim Treadway for their assistance with the preparation of the manuscripts. The authors appreciate their colleagues and the participants of the aforesaid study meetings and conferences for their valuable comments and suggestions on their research works published in this volume. Last but not least, all the authors would like to extend their thanks to Taiba Batool, Alec Dubber, and Gemma Papageorgiou of the editorial staff of Palgrave Macmillan, as well as Vidhya Jayaprakash and the team at Newgen Imaging Systems for their kind cooperation.

xii

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Contributors Naohito Abe is Associate Professor at the Institute of Economic Research at Hitotsubashi University, Tokyo. Svetlana B. Avdasheva is Professor of the Faculty of Economics and Deputy Director of the Institute for Industrial and Market Studies at State University – Higher School of Economics, Moscow. Tatiana G. Dolgopyatova is Chief Researcher at the Institute for Industrial and Market Studies and Professor of the Faculty of Economics at State University – Higher School of Economics, Moscow. Victoria V. Golikova is Senior Research Fellow at the Institute for Industrial and Market Studies at State University – Higher School of Economics, Moscow. Ichiro Iwasaki is Professor at the Institute of Economic Research at Hitotsubashi University, Tokyo. Fumikazu Sugiura is Assistant Professor of the Faculty of Economics at Teikyo University, Tokyo. Andrei A. Yakovlev is Director of the Institute for Industrial and Market Studies and Vice-Rector at State University – Higher School of Economics, Moscow.

xiii

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Abbreviations ANOVA BA BEEPS BG CEO CG CIS EACES EBRD FCSM FDI FFMS FGUP FIG FSU GAAP GDP HCG IAS IBRD IER IIA IMF IPO JACES JSC LSE M&A MBA MIC MNL MNP NASDAQ NCCG NYSE OECD

analysis of variance business association Business Environment and Enterprise Performance Survey business group chief executive officer corporate governance Commonwealth of Independent States European Association for Comparative Economic Studies European Bank for Reconstruction and Development Federal Commission for Securities Market of Russia foreign direct investment Federal Financial Markets Service of Russia corporatization of federal state enterprises financial-industrial group former Soviet Union Generally Accepted Accounting Principles gross domestic product holding company group International Accounting Standards International Bank for Reconstruction and Development Institute of Economic Research, Hitotsubashi University independence from irrelevant alternatives International Monetary Fund initial public offering Japanese Association for Comparative Economic Studies joint-stock company London Stock Exchange mergers and acquisitions master of business administration military-industrial complex multinomial logit estimator multinomial probit estimator National Association of Securities Dealers Automated Quotations National Council on Corporate Governance New York Stock Exchange Organization for Economic Cooperation and Development

xiv

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Abbreviations

OKONKH

Russian All-Union Classifier of the National Economy Branches ordinary least squares research and development Russian Economic Barometer Russian Federation return on assets Federal State Statistical Service of Russia Russian Soviet Federative Socialist Republic Russian Trading System Stock Exchange Standard & Poor’s Savings Bank of Russia state-owned enterprise small and medium-sized enterprise State University-Higher School of Economics Technical Aid to the Commonwealth of Independent States Program total factor productivity Think Tanks Partnership Program Unified Energy System of Russia United States Agency for International Development Union of Soviet Socialist Republics Bank for Foreign Trade of Russia

OLS R&D REB RF ROA ROSSTAT RSFSR RTS S&P SBERBANK SOE SME SU-HSE TACIS TFP TTPP UES USAID USSR VTB

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Introduction Tatiana G. Dolgopyatova, Ichiro Iwasaki, and Andrei A. Yakovlev

This book was published 17 years after the collapse of the Soviet Union in December, 1991. The transitional path to a market-oriented economy in the Russian Federation, where socialism had been developing for decades, clearly shows that the overall restructuring of a planned economy is a time- and resource-consuming social process. Due to such difficulties, there is a broad consensus among scholars that systemic transformation in Russia should continue into the future to achieve a well-functioning market economy. Nevertheless, government and citizen reform clearly extricated the country from a dire predicament. Russia is currently in its eleventh year of economic recovery from a severe financial crisis in 1998. Table I.1 shows that the gross domestic product (GDP) has averaged 7% annual growth from 1999 through 2007. The other macroeconomic indicators also suggest great improvements in the Russian economy. Most economists agree that this remarkable rise in macroeconomic performance occurred as a result of the rapid expansion of Russia’s export markets against the historical setting of increasing energy prices (i.e., oil and natural gas) in the world markets. It is noteworthy, however, that the long-lasting economic developments in Russia also depend on the extensive improvement of its corporate sector as a result of 17 years of structural reforms. Progress is undeniable regarding ownership reform and the management restructuring in Russian enterprises in the post-privatization period. Furthermore, Russian investors and business people are now very actively launching their own companies on the international stock markets. The expansion of Russian businesses in the world economy and the considerable growth of foreign direct investment (FDI) into the Russian real sector have also taken place. In fact, Figure I.1 indicates significant growth of FDI inflow into Russia in 2006 and 2007 in both gross and net terms. Despite a political backlash to market liberalization observed in recent years, these facts strongly attest to the intensive integration of Russia into the global markets and the openness of the Russian domestic markets for multinational enterprises and other foreign investors.1 1

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8.7

14.5

576

GDP growth rate (annual change in real term, %)a

GDP per capita (USD)a

839.9

14.0

4.0

1526.0 Consumer price (end-year, annual change, %)a

16.0

9.4

Industrial gross output (annual change in real term, %)b

Agricultural gross output (annual change in real term, %)b

40 Fixed capital investment (annual change in real term, %)b

12

0.8

GDP deflator (2006 = 100)a

0.1

1,237

1993

24

12.0

21.0

215.1

3.4

1,866

12.7

1994

10

8.0

4.6

131.3

8.3

2,112

4.1

1995

18

5.0

8.0

21.8

12.1

2,642

3.6

1996

5

2.0

1.0

11.0

14.0

2,736

1.4

1997

12

13.0

5.0

84.4

16.6

1,834

5.3

1998

5

4.0

9.0

36.5

28.5

1,328

6.4

1999

17

7.7

8.7

20.2

39.3

1,768

10

2000

10

7.5

2.9

18.6

45.8

2,096

5.1

2001

3

1.5

3.1

15.1

53.0

2,379

4.7

2002

Selected macroeconomic indicators of the Russian transition economy, 1992–2007

1992

Table I.1

13

1.3

8.9

12.0

60.3

2,975

7.3

2003

14

3.0

8.0

11.7

72.5

4,104

7.2

2004

11

2.3

5.1

10.9

86.4

5,326

6.4

2005

17

3.6

6.3

9.0

100.0

6,923

7.4

2006

21

3.3

6.3

11.9

113.5

9,075

8.1

2007

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1.4

15.3

15.9

40

28.1

NA

1.4

10.6

42.6

25

19.3

NA

Current account balance (% of GDP)a

Trade balance (Million USD)

General government balance (% of GDP)c

Private sector share in GDP (%)c

Private sector share in total employment (%)b

RTS index (end-of-year)d

NA

33.0

50

9.7

6.5

2.8

8.1

82.9

34.3

55

6.6

20.1

2.2

9.5

200.5

35.6

60

9.4

19.8

2.8

9.7

396.9

39.9

70

8.5

14.6

0.0

11.8

58.9

43.2

70

8.2

16.9

0.1

13.2

36.2

12.6

12.6

175.3

44.3

70

3.1

Sources: a IMF; b Rosstat; c EBRD; d RTS website (http://www.rts.ru/en/index/rtsi/).

5.9

5.2

Unemployment rate (endyear, %)b

143.3

46.1

70

3.2

60.1

18.0

9.8

260.1

47.7

70

2.7

48.1

11.1

8.8

359.1

49.6

70

0.6

46.3

8.4

8.5

567.3

50.2

70

1.4

59.9

8.2

7.8

54.1

65

8.1

118.4

11.0

7.1

55.4

65

8.4

139.2

9.5

6.7

56.4

65

3.7

132.1

5.9

5.6

614.1 1,125.6 1,921.9 2,290.5

51.8

70

4.9

85.8

10.1

7.9

4

Organization and Development of Russian Business 30,000

Net FDI inflow (EBRD) Gross FDI inflow (Rosstat)

25,000

(Million USD)

20,000

15,000

10,000

5,000

0

−5,000 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Figure I.1

Foreign direct investment inflow into Russia, 1995–2007

To study the development stage and organization of the contemporary Russian business sector is essential to assess the potential of the Russian economy in the global context. This book is designed to make a clear contribution to this issue through its focus on the following key aspects of Russian firms: (a) the mechanism of monitoring and the decision-making control given to a highly concentrated ownership structure, which is different from the case in developed countries; (b) the impacts of business integration via the formation of holding companies and other types of business groups upon corporate governance and firm performance of affiliated firms; and (c) the role and influence of various external agents, such as financial institutions, business associations, and the state, in the process of corporate governance of nonfinancial enterprises. We believe that a thorough examination of the outlined objectives will result in a clear understanding of current Russian business practices. To fulfill the research objectives stated above, we mainly utilize the results of an enterprise survey conducted throughout Russia by a Japan–Russia joint research team from Hitotsubashi University in Tokyo and the State University – Higher School of Economics (SU-HSE) in Moscow. The survey was performed over a five-month period, from February to June 2005, and 822 members of top management from industrial and

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Introduction 5

communications enterprises from 64 regions of the Russian Federation were interviewed. It was one of the largest-scale questionnaire surveys conducted in Russia. The sampling and the interviews were conducted by specialists of the well-known social research organization “Levada-Center” – the former USSR Public Opinion Poll Center. All samples are joint-stock companies (JSCs), and the average number of workers in each company is 1,884 (median: 465). The total number of workers of these surveyed firms is 1.55 million, and they accounted for 10.3% of the average workforce in both the industrial and the communication sectors through 2004, according to official statistics.2 In addition, our survey results are reinforced by the commercial Internet database of the two major company information agencies in Russia, SKRIN, and SPARK Co., in order to carry out empirical analyses on financial and operating performance of our sample firms that are compatible with those in earlier studies of listed companies in developed countries. Using this unique firm-level dataset as a common empirical basis, we present multi-angle pictures of the Russian corporate system from the institutional and microeconomic viewpoints. This is the most clearly distinguishing feature of this volume in comparison to prior literature dealing with firm organizations and corporate governance in the post-communist transitional countries, including Russia. In the framework of this joint project, we have also published several journal articles and books in English, Japanese, and Russian (Avdasheva 2007; Dolgopyatova 2006, 2007; Iwasaki 2006, 2007, 2008; Dolgopyatova, Iwasaki, & Yakovlev 2007; Sugiura 2007; Yakovlev 2007). Compiled in this volume are developed research and new products obtained from the project. The book consists of 12 chapters and a conclusion.3 Chapter 1 discusses how Russian firms developed from Soviet enterprises into market-oriented firms on the background of large-scale institutional changes in the national economic system. This chapter also addresses the issue of Russia’s peculiarities in terms of its business environment in comparison to countries at a similar level of socioeconomic development, such as Central and Eastern European countries, which passed through a transition from a planned to a market economy, and the possible impacts of those differences on the enterprise behavior in Russia. The next five chapters in Part I, entitled “Ownership, Internal Control, and Management System,” provide readers with deep insights into the organizational architecture of Russian enterprises, including their ownership structure, legal form of incorporation, board of directors, and managerial team. These chapters represent an attempt to examine the empirical relationship among the internal organizations and enterprise behaviors, including operating and financial performance. Chapter 2 examines the linkage between ownership structure and the corporate control system in Russian firms. In this chapter, evidence of simple

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6


hypotheses regarding the role of a high concentration of ownership in the evolution of intra-corporate control forms and business performance is provided. Our empirical data demonstrates that the largest shareholder owned more than 50% of the total stock in 70% of the companies and about 13% of companies had no block-holders (owners of more than 25% of the stock). The high concentration of ownership is paralleled by its hidden structure and affects intra-corporate relationships. We also show that some of these relationships include the development of a set of formal and informal tools used by dominant shareholders for the supervision of executive management in a weak institutional environment. A combination of ownership and control based on the direct participation of shareholders in management as top-managers is a characteristic of the vast majority of Russian JSCs; however, the current trend is for the separation of executive management from ownership. We argue that concentrated ownership will encourage the owners to restructure and develop their business and companies with dispersed ownership will thus be less competitive in performance, investment, and restructuring. Chapter 3 is a study of the legal form of incorporation of Russian JSCs. The vast majority of Russian corporations are compelled to become closed JSCs that lack a modern fundraising mechanism in order to attract capital from a wide range of private investors. The empirical results in this chapter suggest the following four factors encouraging many Russian firms to be closed JSCs. That is (a) a widespread insider-dominating corporate ownership structure emerging as a result of the mass-privatization policy; (b) a strong orientation among managers toward closed corporate organization due to the underdeveloped capital and managerial markets; (c) slumping needs for corporate finance; and (d) insufficient financial support from local financial institutions. The impact of ownership structure on the choice of corporate form exists, even if we assume that the two elements are determined endogenously. In Chapter 4, we examine the endogenous formation of corporate boards and its determinants. The findings reported in this chapter strongly suggest that the theories and empirical methods of financial and organizational economics help accurately pinpoint the determinants of board size, proportion of outsider directors, and appointment of outside chairmen in Russian firms. We also found that their board structure can be reasonably explained by the bargaining hypothesis. Furthermore, the empirical evidence demonstrated that Russia’s legal system and peculiarities as a transition economy also have a great deal of influence in determining board formation. Chapter 5 discusses the possible impacts of corporate governance and firm performance on managerial turnover. This study is different from most previous research in that we deal not only with CEO dismissal but also with managerial turnover in a company as a whole. We found that nonpayment of dividends is significantly correlated with managerial turnover. We also

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Introduction 7

found that the presence of dominant shareholders and foreign investors is another important factor in causing managerial dismissal in Russian corporations; however, these two kinds of company ownership reveal different effects in terms of turnover magnitude. Chapter 6 focuses on the relationship between the structure of a managerial team and firm restructuring. Following drastic changes in the distribution and redistribution of property rights in the Russian economy in the last decade, a new generation of professionally trained managers has appeared in top- and middle-level management. They are expected to be great promoters for enterprise restructuring in Russia. At the same time, many Soviet-generation manager-owners are still in business. These company executives were often accused of asset-stripping in the 1990s, and they are considered to be largely responsible for the poor managerial quality due to the lack of incentives for maximizing a firm’s value. However, no empirical evidence was available to support or refute this statement. The empirical analysis in this chapter revealed that neither changes in key owners nor the appointment of a new general director by shareholder decision contributed to more active firm restructuring. We also verified that firms with general directors who were large owners did significantly better than those with hired managers in the introduction of new technologies and marketing activities. Furthermore, our empirical evidence indicates that previous job experience of the CEOs in Western companies contributed positively to firm restructuring, whereas job experience in governmental bodies tended to have a negative effect. The next three chapters in Part II, “Business Integration and Its Impact on Corporate Governance,” deal with the vertical and horizontal integration of Russian companies. In Russia, almost 30 to 40% of middle- and largescale companies are currently involved in the formation of business groups. Chapters 7, 8, and 9 present examinations of the impact of this remarkable phenomenon in the current Russian economy on the organizational behavior and management effectiveness of group companies in comparison with independent (nongroup) firms. Chapter 7 deals with the role of business integration in the development of a form of corporate control based on the separation of executive management from ownership. As a result of our empirical investigation into the determinants of owner selection of hired management, we present the following results. First, business integration promotes the gradual separation of management from ownership in the rank-and-file membership of company groups. Second, company affiliation or non-affiliation with a company group predefines different roles of various factors in this choice. In addition, for rank-and-file members of company groups, a positive influence on the choice is connected with the complexity of corporate management in companies and in entire groups, and a negative influence is related with an incomplete restructuring of enterprises. Our findings also demonstrate

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8


that, for JSCs not affiliated with company groups or parent companies of the groups, the influence was identified for ownership and governance features supporting the protection of property rights and for the pressure of competition with manufacturers from developed countries as an incentive for improving management quality. In Chapter 8, we test a competing hypothesis on the nature of Russian business groups and possible tools for disciplining the executive managers in the subsidiaries of those groups. Our empirical results show that business groups act as integrated companies rather than a network of companies and that hierarchical coordination prevails inside the groups. We also confirmed that the most important way to resolve the agency problem in the groups is through the participation of the ultimate owners by themselves or represented by the parent company in the management. Corporate governance instruments are important, mostly in subsidiaries acting in regulating industries or in state-owned companies. However, one in three subsidiaries that is a private company in nonregulated industry also develops internal corporate governance. Corporate governance as a disciplinary tool is necessary in state-owned as well as new private companies. Chapter 9 examines the impact of business integration on enterprise restructuring and financial and operating performance of group subsidiaries in Russia. Directors of affiliated enterprises and, especially, of those merged after mass privatization acknowledge the impact of groups on the market competitiveness of the enterprises. A comparison of subsidiaries and independent enterprises supports the positive attitude of directors toward group membership. Our survey results indicate, as many other studies in Russia have shown, that group subsidiaries outperform independent enterprises in terms of corporate restructuring and financial and operative performance. However, it is not clear whether the comparative advantages of group enterprises are explained by higher productivity alone. The results of our comparison of total factor productivity in affiliated and independent enterprises are mixed. The higher productivity of affiliated enterprises is mostly due to companies that joined the groups before 1995. The advantages of affiliated enterprises over independent ones provide an additional explanation of the stability of a business group as an organizational form in Russian industry. Better firm performance helps to solve agency problems in subsidiary companies. The chapters in Part III, “The Role of External Players in Corporate Governance,” present the outcomes of our research on the relationship among industrial and communications companies and commercial banks, business associations, and the government. It is controversial whether the latter three economic entities have a specific influence on corporate governance and the performance of nonfinancial enterprises. Chapters 10, 11, and 12 present empirical evidence of these issues from a careful examination of the results of the enterprise survey.

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Introduction 9

The focus of Chapter 10 is on the banking sector. With the objective of clarifying the emerging role of commercial banks in corporate finance in economically buoyant Russia, we reveal the results of an analysis in this chapter conducted from a macro and micro standpoint. Macro-economically, the share of the banking sector in the overall corporate investment finance has been rising. The results from our joint survey reveal that about one-third of medium-to-large scale enterprises have no external borrowings, suggesting that there is still a large capacity for the banking sector to increase its role. These firms tended to be smaller, with a closely held ownership structure, and were not active in new investments. In this chapter, the role played by Sberbank, the largest Russian saving bank, is also examined; it is by far the largest major bank that has served as a main supplier of funds since the financial crisis of 1998. The enterprises that showed Sberbank as the largest financer were mostly large ones and had export records. They tended to have special relationships with the government, implying that the corporate financing mechanism had been evolving in close cooperation between the government and enterprises. Chapter 11 scrutinizes the relationship between the business associations and their member firms. Empirical literature on the membership of Russian firms in business associations provides no clear explanation of the main incentives of the firms to participate in collective action. In this chapter, we explore whether these incentives are inspired by market pressure, or, on the contrary, whether rent-seeking and a desire to establish personal relationships with authorities influence major decisions within a firm. To clarify these issues, we empirically examine the determinants of membership in associations and explore the reasons for simultaneous membership in different types of associations, that is, the phenomenon of multiple membership. Our estimation results reveal that the larger and better-performing enterprises are more interested in joining associations in situations of competitive pressure from the Baltic countries, Turkey, and China. We also confirmed that enterprises with general directors who are large owners significantly more often become members of associations than do firms headed by hired CEOs. The main benefits from joining these business associations are related to the close interactions with state authorities. We argue that this feature may help to overcome information asymmetry in the fragile institutional environment of Russian business. In addition, multiple membership significantly increases the chances to obtain financial and organizational support from the state and, thus, is a rational strategy of market players. In Chapter 12, we analyze the influence of the state on the improvement of corporate governance in Russia of the early 2000s. Taking into account the low quality of market institutions in the 1990s (i.e., the market failure phenomenon), we assume that state intervention as the second-best solution had a positive impact in this case. Using a firm-level dataset obtained from our enterprise survey, we test this hypothesis in two types of corporate

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10 Organization and Development of Russian Business

models: state-owned or mixed firms and politically connected firms. The first model confirmed a strong positive influence of state ownership on the corporate governance in Russia in 2001–2004. The estimation results are statistically robust in different model specifications. We connect this empirical evidence with attempts of the Russian government to use standard mechanisms and procedures of corporate governance to defend its property rights in its relationships with state-owned and mixed enterprises. The concluding chapter summarizes the major findings in this study and discusses the remaining issues and agenda for future research. We are hopeful that this volume will provide an insight into firm organization and management in Russian business and stimulate further discussion and research on this topic.

Notes 1. Many experts point out, however, that a large part of this remarkable growth of FDI inflow in recent years can be explained by active repatriation of offshore Russian capital. Nevertheless, it is also a fact that many Western companies, including several world-famous multinational enterprises, embarked or decided to embark on the Russian market, which also boosts direct capital investment into Russia. 2. We describe the details of the joint survey in the Appendix of this book. 3. Chapter outlines have been prepared by their individual authors.

Bibliography Avdasheva, S. (2007) Russian holding groups: New empirical evidence, Problems of Economic Transition, 50/5: 24–43. Dolgopiatova, T. (2007) Ownership concentration and Russian company development: Empirical evidence, Problems of Economic Transition, 50/5: 7–23. Dolgopyatova, T. (ed.) (2006) Integratsionnye Protsessy, Korporativnoe Unpravleniye i Menedzhment v Rossiiskikh Kompaniyakh. Seriya “Nauchnye doklady: Nezavisimyi Ekonomicheskii Analiz,” No. 180. (Moscow: Moskovskii obshchestvennyi nauchnyi fond i Proekty dlya budushchego). Dolgopyatova, T. G., Iwasaki, I., & Yakovlev, A. A. (eds.) (2007) Rossiiskaya Korporatsiya: Vnutrennyaya Organizatsiya, Vneshnie Vzaimodeistviya, Perspektivy Razvitiya (Moscow: Izdateliskii dom GU-VSHE). European Bank for Reconstruction and Development (EBRD), Transition Report (various issues) (London: EBRD). Federal State Statistics Service (Rosstat), Rossiiskii Statisticheskii Ezhegodnik (various issues) (Moscow: Rosstat). International Monetary Fund (IMF), World Economic Outlook Database (available at: http://www.imf.org/external/data.htm). Iwasaki, I. (2006) Korporativnoe pravo i organizatsionnyi vybor: Otkrytye i zakrytye aktsionernye obshchestva v Rossii, Rossiiskii Zhurnal Menedzhmenta, 4: 55–76. Iwasaki, I. (2007) Legal forms of joint stock companies and corporate behavior in Russia, Problems of Economic Transition, 50/5: 73–86.

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Introduction 11 Iwasaki, I. (2008) The determinants of board composition in a transforming economy: Evidence from Russia, Journal of Corporate Finance, 14: 532–549. Sugiura, F. (2007) Rosia kigyo no shikin choutatsu koudou: Kigyo chousa deta ni motozuku bunseki, Keizai Kenkyu, 58: 151–162. Yakovlev, A. (2007) Rossiiskaya korporatsiya i regionalinye vlasti: Modeli vzaimootnoshenii i ikh evoliutsiya, Voprosy Ekonomiki, 1: 124–139.

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1 The Emergence of Russian Corporations: From the Soviet Enterprise to a Market Firm Tatiana G. Dolgopyatova, Ichiro Iwasaki, and Andrei A. Yakovlev

Introduction In this chapter, the evolution of an enterprise model in the Russian economy is examined using two key events that predetermined major changes in enterprise behavior as division lines. The first was the disintegration of the Soviet Union, the swift dismantling of central planning, and the shock therapy of price liberalization in 1991–1992. The second event was the financial crisis of August 1998 and the political crisis that followed, which served as starting points for radical improvement in macroeconomic policy and strengthening of the role of the state. Prior to 1991, one could speak about socialist enterprise of the type that many researchers, from Josef Berliner to Janos Kornai, had been studying for several decades. The period from 1992 to 1998 in Russia was the time of classical transition firm, which disagreed with the forecasts of mainstream economists and led to serious challenges to the prevailing economic theory. These challenges were met by studies of economic transition and company behavior in transition economies, with the participation of leading economists of the world, including Andrei Shleifer, Gerard Roland, and Josef Stiglitz. Finally, after 1998, the specific features of the transition firm started to erode and, the patterns became more in agreement with the standard models established in developing and developed economies. Our research focuses on this transitional period in Russia. However, to clarify the contemporary trends, we focus on the features of the socialist enterprise and the transition firm and compare their Russian prototypes with counterparts in Eastern Europe and China. The remainder of this chapter is organized as follows: The first section is a discussion of the Soviet model of the socialist enterprise and its characteristics. The second section is an examination of Russian enterprise reforms in the initial stage of systemic transformation to a market economy. The 12

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The Emergence of Russian Corporations 13

third section traces the evolutionary process of Russian corporations after the 1998 financial crisis.

The Soviet socialist enterprise The classical ideal model of a planned socialist economy implied that each enterprise was included in the system of central planning. This means that higher-ranking agencies of the state established output and input plans for an enterprise, identified suppliers and customers, and made decisions regarding capital investments and appointments of top managers. In this system, the main function of the enterprise was to achieve the target plan that had been set by the authorities. In this sense, the socialist enterprise has never been a firm. Rather, it was a production division or a shop in the gigantic “single factory,” as it had been described by Vladimir Lenin. In formal terms, the enterprise was considered a national property. However, in reality, the chief representative of the enterprise who protected the interests of the enterprise and its employees was the general manager – enterprise director. Physical resources were the main incentive for the socialist enterprise. They were the decisive factor, taking precedence over money. Decisions on the reallocation of resources for the next planning period were generally dependent on successfully meeting the targets of the preceding period. Product demand was insignificant to the socialist enterprise because the right to acquire products was not based on customer solvency but, rather, on the customers identified in the procurement plans. Physical demand was also a matter of certain importance. This demand was taken into account in the compilation of a plan for the next term, but the compilation was also affected by many other matters, such as the achieved volume of output by certain item. After the plan was adopted, the target received from higher authorities became the primary task, and the enterprise produced the products specified in the plan. However, product demand usually changed as the plans were being compiled, and some of the production then appeared to be unwanted by customers. At the same time, the products in high demand were always in short supply because changes in plans regularly lagged behind changes in demand. This process and its implications as a base for chronic shortages of resources in a planned economy are discussed in detail by Kornai (1980). The priority right to acquire products in short supply was given to the customers whose needs had been considered in procurement plans. However, suppliers had also some room for maneuvers in their relations with these customers. This was because each plan was initially compiled in physical terms (units of production). Prices were regarded as an auxiliary accounting instrument, which could be used for the aggregation of plan targets for individual enterprises into integrated plans for industrial sectors and the

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economy as a whole. However, total plan targets (excluding key designated items) were approved in value terms, as so-called “plans of gross output.” This enabled suppliers to operate on changes in assortment, producing (and imposing on customers) those products that were easier to make under regular shortage of key inputs. This enabled suppliers to operate with changes in product type and customer demand, and to produce products that were easier to manufacture in consideration of the regular shortages of key components. Simultaneously, enterprise managers were constantly involved in negotiations with their suppliers about the procurement of key resources; they were also involved with their superior agencies about getting their plans of gross output either considered as fulfilled despite deviations from the planned assortment or corrected for shortages of resources. Managerial success in this informal interaction, which was first described by Berliner (1952) and later analyzed in a series of Duke–Berkeley Occasional Papers on the Second Economy in the USSR, was one of the main factors in the fulfillment of the target plans of an individual enterprise. In turn, failure to fulfill a plan was a cause for superior agencies to penalize the enterprise to the point of dismissing its top manager from office. The role and functions of the socialist enterprise in the centrally planned economy led to a number of important consequences, which determined typical managerial behavior. Among them are the following: (a) attention was given to production and technology (typically, the absolute majority of enterprise directors in the USSR and other socialist countries were educated engineers and technicians); (b) the focus was on day-to-day operations of an enterprise with a short planning horizon (the management could make decisions within their approved annual plans, while decisions for more prolonged horizons that were related to the compilation and approval of five-year plans and implementation of investment projects came within the competence of higher levels of government); and (c) managers were involved in systematic informal negotiations with superior agencies about planned target volumes and resources allocated to the enterprise and with suppliers and customers on product mix and other terms of supply. This pattern of behavior was typical of enterprises in all socialist economies. However, a substantial number of national features were related to the planning system in the USSR as well as to ideological approaches to organization of the Soviet planned economy. There are five features primarily responsible for the transformation of the Soviet enterprise, and they are described in detail below. First, Soviet enterprises had a very low degree of independence, predetermined by the scale and detailed elaboration of central planning in the USSR.1 They had no access to real economic information, which was collected by the central economic agencies. Their experience in horizontal interaction with other enterprises was limited to mutual adjustment of terms of

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production and supply in the framework of adopted plans. Production outside of state plans in the USSR was regarded as criminal until the late 1980s. Outside of centralized planning, the only legal activity was food production on private plots in rural areas, whereas, in most of Eastern Europe, small private ownership was permitted. Economically and ideologically, the USSR was quite closed. Soviet enterprises had practically no contact with Western firms, and their managers had no knowledge of the operations of the modern market economy. In the best cases, they based their understanding on information gleaned from Das Kapital by Karl Marx. Second, deliberate industrial policy for higher concentration of output and product specialization, which was the strongest in the 1960s and 1970s in the Soviet Union,2 was the cause for the establishment of a noncompetitive industrial structure in which each enterprise had very limited numbers of suppliers and customers. As a result, enterprise directors knew each other well, and the whole managerial corps was a cohesive informal corporation. Readiness of the members of this corporation to help each other was one of the factors responsible for the survival of Russian enterprises and for the setup of barter networks under the crisis of arrears in the 1990s. However, the productive assets of Russian enterprises, which had been established under the industrial policy of preceding decades, were so specific that the enterprises were highly dependent on their partners. For this reason, after the launch of reforms, the activity of Russian enterprises became more disorganized than that of East European economies (Blanchard & Kremer 1997). Third, price disparities were greater in the USSR because the planning system lived longer and isolation from the world market was more complete. The disparities resulted from the desire of enterprises to overprice their products in order to fulfill their “plans of gross output” (Kornai 1980). Central economic agencies used administered prices to prevent this tendency, but price control produced sufficient effects only in mono-product extracting and primary processing industries. In industries with more differentiated products, producers bypassed this obstacle by operating on changes in assortment when modified old products were passed for new ones with higher costs. This enabled the enterprises to demonstrate higher volumes of “gross output” at unchanged volumes of output in physical terms. As a result, in the course of time, prices of primary materials became understated, and prices of products with high level of processing grew overstated in comparison with international prices. This historically established relative overstatement of costs and prices in some industries determined, to a large extent, the scale of competitive weakness of enterprises in these industries in Russia after prices in foreign trade were liberalized. Fourth, the Soviet Union was considered the heart of world socialism. It resisted the United States and what it referred to as “imperialist aggression” while emphasizing the expansion of its military industrial complex (MIC). As a result, the share of enterprises belonging to the MIC and dependent on

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military procurement orders was much higher in the USSR than in other socialist countries. For this reason, a sharp reduction in military spending in the age of reform had a stronger effect on the enterprises. Since many of these enterprises had been making technologically complex products and had been key customers of their suppliers, this reduction was an additional factor responsible for higher disorganization and a deeper slump in output (Blanchard & Kremer 1997). Finally, the Soviet model of a planned economy was very conservative, and Soviet enterprises had no experience of operation under reform. Eastern Europe started to reform its planning system and to introduce some elements of market economy as early as at the end of the 1960s. China began a similar process in 1979, but, until that time, enterprises had gone through several waves of centralization and decentralization and had also survived the Cultural Revolution. Against this background, the Soviet Union limited all experiments in the late 1970s and early 1980s to various schemes of distribution of final enterprise income and never touched upon the issues of industrial organization and planning. In general, a planned economy used quite different criteria for the assessment of enterprise performance and incentive mechanisms than those used in a market economy. As the Soviet economy reached a crisis level in the mid-1980s, changes in economic policy began to emerge. On the micro level, the logic of changes was focused on the transformation of incentives of economic agents. The formation of new incentive mechanisms took two directions. On the one hand, private initiative was allowed for the first time in services and supply of consumer goods. In 1986–1988, laws on personal labor and cooperative enterprises were enacted, and small private businesses were allowed. State-owned enterprises were permitted to launch joint ventures with foreign partners. Output prices for products and services of individual and cooperative, small-scale and joint ventures were unregulated. However, until 1992, the share of this private segment in the economy was too small to affect the behavior of state-owned enterprises. On the other hand, state-owned enterprises were given a greater extent of independence. This was regarded as a fundamental line of economic transformation aimed at the enhancement of efficiency of the Soviet socialist economy. Enterprise directors, willing to escape from the control of superior agencies, supported this line in every possible way. The Law on the StateOwned Enterprise, which was enacted in 1987 and came into effect in 1988, was an important step in this direction. This law provided for the creation of councils of labor collectives and the introduction of elected directors, which, indeed, made top managers independent from supervisory agencies. The law permitted labor collectives in agreement with a supervisory ministry to lease assets of a state-owned enterprise and, later, to buy out the leased property with profits (this was one of the displays of “nomenklatura

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The Emergence of Russian Corporations 17 Table 1.1 Chronology of enterprise reforms and related events in the USSR and Russia, 1986–2007

The Yeltsin administration and initial enterprise reforms

The perestroika period and collapse of the Soviet Union

Period

Year

Month

Eventsa

Category b

1986

Nov

USSR law on individual labor activities enacted

A

1987

Jan

C C C

Jun

Resolution on joint enterprises adopted by the USSR cabinet of ministers USSR law on state enterprises enacted

1988

May

USSR law on cooperatives enacted

1989

Nov

USSR leasing law enacted

E

1990

Mar Jun Jun Aug Dec Dec Dec Dec Dec Dec

USSR ownership law enacted USSR enterprise law enacted USSR law on corporate tax enacted 500-day plan announced USSR law on trade union enacted USSR law on investment activities enacted USSR banking law enacted RSFSR banking law enacted RSFSR law on ownership enacted RSFSR law on enterprises enacted

C C F A H G E E C C

1991

Mar

D

Jul Jul Jul Aug Dec Dec Dec

RSFSR law on competition and limitation of monopoly enacted RSFSR law on investment enacted USSR law on denationalization and privatization enacted USSR law on foreign investment enacted USSR anti-monopoly law enacted RSFSR law on privatization enacted Soviet coup d’état attempt RSFSR law on corporate tax enacted RSFSR law on value-added tax enacted Collapse of the Soviet Union

1992

Jan May Jun Jun Sep Oct Oct Nov

Liberalization of price and foreign trade Mortgage law adopted Mass-privatization program adopted Law on consumer cooperatives adopted Law on monetary system adopted Law on foreign exchange regulation adopted Voucher privatization begins Law on bankruptcy adopted

A E B C E E B B

1993

May Jun Jul Aug Sep– Oct

Treasure bills market initiated Customs code adopted New Russian ruble introduced Law on labor protection adopted Constitutional crisis

E F E H

Jun Jul

G B G D B F F

Continued

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18 Organization and Development of Russian Business Continued

Period

Year

Month

Eventsa

1994

Jul Oct Sep

Monetary privatization begins New civil code adopted Currency crisis

B C

1995

Jun

Law on small and medium-sized enterprises (SMEs) enacted Currency corridor system introduced Law on natural monopoly adopted Law on state regulation of trade activities adopted Loan-for-share privatization begins Law on financial-industrial groups adopted Law on production sharing agreement adopted

G

C H E C E

The Yeltsin administration and initial enterprise reforms

Table 1.1

Jul Aug Oct Nov Nov Dec

E D A B C G

1996

Jan Jan April May Jun Nov

Law on joint-stock companies enacted Law on trade union adopted Securities law adopted Law on producer cooperatives adopted Full currency convertibility introduced First IPO by Vympelkom at NYSE

1997

Jul Jul

First corporate Eurobond issued Privatization law adopted

1998

Jan Jan Feb Jul

Denomination of ruble conducted Bankruptcy law adopted Law on limited liability companies adopted Law on workers’ JSCs (people’s enterprises) adopted Financial crisis Float exchange rate system introduced Leasing law adopted

E B C C

New tax code (Part I) enacted Law on restructuring of credit organizations adopted New law on labor protection adopted Law on foreign investment adopted

F E

Aug Sep Oct 1999

Jan Feb Jul Jul

Development of Russian corporations under the Putin administration

Category b

2000

2001

May

B

E E

H G

Aug Jun

The program of national development strategy (Gref’s Program) announced New tax code (Part II) adopted Law on minimum wage adopted

A F H

May Aug Jul Nov Dec

Banking law amended Law on audit activities adopted Law on profit tax adopted Law on investment funds adopted New privatization law adopted

E E F G B Continued

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The Emergence of Russian Corporations 19 Table 1.1

Development of Russian corporations under the Putin administration

Period

Continued Year

Month

Eventsa

Category b

2002

Jan Feb Apr Oct Nov

Law on joint-stock companies amended New labor code enacted Corporate governance code endorsed New bankruptcy law enacted Law on unitary enterprises adopted

C H C B C

2003

May Oct

F

Dec

New customs code adopted Arrest of Mikhail Khodorkovsky, main owner of Yukos Oil company Law on deposit insurance adopted

2004

Dec

Court decision on Yukos affairs

E

2005

Jul

Law on special economic zones adopted

D

2006

Jul

Full liberalization of capital account transaction Competition law amended Securities law amended

A

Oct Dec 2007

May Jul Jul Now

Law on the development bank adopted Law on SME sector development adopted National corporation “Rosnanotekh” established Law on national corporation “Rostekhnologii” adopted

D E G G D D

Notes: a This table covers only selected events regarding enterprise reforms in Russia. “RSFSR law” denotes a law of the Russian Soviet Federative Socialist Republic. All laws adopted or enacted in 1992 onward are laws of the Russian Federation. b A: Market and trade liberalization, B: Privatization and bankruptcy measures, C: Organization and corporate governance reform, D: Competition and industrial policies, E: Financial and monetary reform and corporate finance, F: Tax reform, G: SME and investment policies, H: Labor policies. Source: Compiled by the authors.

privatization”). In general, the interests of managers and labor collectives could be considered unanimous. Enterprises had the right to choose suppliers and customers, and they had more freedom in the use of their profits. Later, state enterprises obtained the right to sell the above-mentioned target products at freely determined prices. However, in a noncompetitive industrial structure, this greater extent of enterprise independence became only an additional factor of greater macroeconomic imbalance along with the incompetence of Soviet party functionaries. As shown in Table 1.1, in the late 1980s, the Soviet government was quite rigid in adopting new pro-market legislation. The process of development of new legal institutions had accelerated only in 1990–1991, when the conflict between the USSR and RSFSR governments became acute.

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However, the quality of this new legislation was very low. With the adoption of new laws, both governments tried to secure support from enterprise managers and the population rather than provide the conditions for sustainable market development. This inter-government competition resulted in extremely populist policy3 and, in 1991, dramatic escalation of macroeconomic troubles in the Soviet economy predetermined the shock of further reforms and accelerated the transformation of the socialist enterprise into a transition firm.

The transition firm: The specific Russian type Radical changes in principles and regulations that determine the behavior of economic agents were the key feature of the transition from a planned to a market economy. In particular, these changes consisted of the liberalization of prices and foreign trade, privatization, the establishment of a tax system, the introduction of antimonopoly legislation, and the creation of a system of financial institutions. On the micro level, all of these large-scale changes resulted in great uncertainty on the activity of enterprises. At the same time, important features of the transition period were structural imbalances and price disparities, which were inherited from the planned economy and allowed the receipt of “transitional rent” (Polterovich 2001) and the coexistence of two major sectors of the economy: state-owned enterprises subject to privatization and newly created private firms. In both sectors, enterprises were independent to make decisions with regard to the choice of suppliers and customers, output, and prices, and, in this sense, they were firms. However, the way these firms in both sectors were doing business could not be described as market behavior. In most transitional economies, firms tended to violate the rights of minority shareholders, to develop shadow activities, and to resort to state capture and rent seeking in their relations with governments using the weakness of public institutions and the remaining soft budget constraint. The causes of such deformation will be examined with regard to the conduct of the transition firm. The central problem for state-owned and privatized enterprises was that, at the time of their creation, all of them were oriented toward entirely different criteria of efficiency. The transition to market principles resulted in the deterioration of the financial conditions of the firms; they need serious changes in organization and management as well as technological restructuring, and their central objective was survival (self-preservation) in the new situation. Changes in the external environment, such as price liberalization, abandonment of subsidies from the state, and opening of competition with private and foreign firms, were designed for the creation of incentives for enterprises to undertake restructuring. However, the basic tool for making

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them efficient was seen in privatization, which involved the transfer of liability from the state to private proprietors and opened opportunities for private initiative. Different countries with transitional economies used different methods of privatization. Russia realized the voucher scheme of mass privatization based on the free distribution of “privatization checks” (vouchers) to every citizen in the country. Later, the vouchers could be used to purchase shares in enterprises that were eligible for privatization. This method resulted in considerable dispersion of ownership rights, but because it entitled each citizen to become a private shareholder, it was considered to ensure the irreversibility of market transformation. During the mass-privatization period, October 1992 to June 1994, 67% of all Russian state-owned enterprises eligible for privatization adopted an option plan in which management and employees were allowed to acquire a maximum of 51% of a firm’s total stock at 70% of face value. In addition to this option, the federal government prepared two other schemes. Under the first one, 25% of the total preferred stock of each public enterprise was granted to its management and employees free, and 10% of the total ordinary stock was distributed to them at 70% of face value. The second scheme allowed both the management and the employees to purchase 20% of the total ordinary stock each on a preferential offer basis. However, firms that had adopted the former and the latter accounted for only 30% and 3%, respectively, of the total number of privatized enterprises (Iwasaki 2007). This design of the privatization program was a compromise resulting from pressure from industry, and it was clear that privatized Russian firms would be heavily controlled by insiders (Boycko et al. 1995; Blasi et al. 1997). At the same time, it should be emphasized that the insider type of privatization was typical of other transitional economies as well (Berglöf & von Thadden 2000). In 1994–1995, the Russian government shifted to monetary privatization, that is, the so-called investment tenders. The conditions of these tenders stipulated that a purchaser of a stake in equity of a privatized enterprise should not only pay the government in cash but also ensure capital investments in its development (the volume of investments was fixed in a separate contract). However, the government made no provision for monitoring compliance with these investment contracts and no provision for penalizing their breach; as a result, investors used this loophole for opportunistic behavior on a massive scale. Auctions of loans-for-shares introduced in December 1995 were the final stage of this phase. This scheme envisaged that banks would acquire the state-owned shares in 21 blue-chip public companies as collateral for granting credits to the federal government. Twelve auctions were implemented under this scheme, bringing a total of 5.1 trillion rubles of revenue (or about 1 billion US dollars in current prices) to the federal government.

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22


With loans-for-shares auctions, the Russian government drove a handful of commercial banks to snap up a large amount of shares of the biggest corporations. This scheme, which has been under continuous criticism for lack of transparency in the bidding process as well as inadequacy as an industrial policy itself, gave crucial momentum to the emergence of large industrial syndicates, including new business groups headed by so-called “oligarchs.” After loans-for-shares auctions, the peak of privatization in Russia was over, and the privatization program was gradually curbed. In total, more than 94,000 state-owned enterprises and organizations were made private under this program, including more than 22,000 industrial enterprises (see Table 1.2 for more details on privatization results). However, an enterprise, regardless of the scheme of privatization it had chosen, as a rule, received no benefits from the change of the form of ownership because the investors paid the state for the acquired stakes with either cash or money earned through stock transactions. It is true that the interests of managers and employees were already not as inseparable as they had been in a planned economy. On the one hand, managers tried to ensure the survival of their enterprises and to preserve their labor collectives because these were factors enabling them to maintain their own social status in their city and region. On the other hand, in an attempt to take complete control over their enterprises under the menace of upcoming external shareholders, managers regularly used their working capital to buy up the enterprise shares on the market and take from the hands of their employees. This worsened the financial condition of their enterprises and increased the arrears on wages of their workforce. External investors also made similar moves to buy controlling stakes because the legal institutions were too weak to protect their interests as minority shareholders. In a study by Berglöf & Pajuste (2003), this tendency is reported to be common throughout Eastern Europe; furthermore, these authors report that controlling shareholders is the second-best response to weak legal institutions. However, in Russia, this consolidation of ownership and control took separate directions depending on the industry. This diluted ownership structure was soon overcome in primary and processing industries because control over these businesses promised very large profits from the gaps between prices in domestic and global markets. A real concentration of ownership took place at the most efficient enterprises in the industries with low capital intensity (the food industry, light industry, and trade) because the initial investment levels were much lower there and potentially high returns were guaranteed by fast capital turnover in the domestic market. On the other hand, the majority of Russian industrial enterprises in capital-intensive high-tech industries, as well as major employer enterprises in one-factory towns burdened with social assets, found themselves in a state of “precarious balance.” Being uncompetitive in the world market, they did

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5,685

5,112

11,108

1,067

415

7,063

9,521

26,340

450

NA

Federally owned enterprisesa

Regionally owned enterprisesa

Total amount of privatization revenue (Million rubles)b

Total amount of privatization revenue (Million USD)d

835

630

4,530

26,230

3,815c 3,234c

548

374

2,743

1997

1,821

715

928

4,997

1996

3,354

6,960

1,317

1,875

10,152

1995

1,134

298

104

1,536

1999

1,830

274

170

2,274

2000

1,777

498

1,479

17,538 12,291 41,609

1,544

321

264

2,129

1998

2,245

226

86

2,557

2002

121

152

161

434

2003

135

246

121

502

2004

153

226

112

491

2005

92

254

98

444

2006

114

115

73

302

2007

574

728

2,893

3,129

3,089

3,449

4,267 e

16,756 22,857 88,673 90,143 87,462 93,607 109,077

1,931

231

125

2,287

2001

Source: Rosstat.

Notes: a By ownership type before privatization. Regionally owned enteprises denote public enterprises owned by the subjects of the Russian Federation. b It includes not only revenues from the sales of state-owned enterprises but also those from privatization of other state properties. Figures for 1993–97 are in billions of rubles. c It was a split of revenue from loan-for-shares auctions between late 1995 and early 1996. d Authors’ evaluation. e To evaluate the privatization revenue in the 2000s, it is necessary to take into account the strong increase of the RTS index in this period; therefore, at the end of 2007, the RTS index was 16 times higher than that in 2000 (see Table I.1 for details).

Municipal enterprisesa

21,905

42,924

1994

Total number of privatized enterprises

1993

Table 1.2 Privatization of state-owned enterprises and privatization revenue in Russia, 1993–2007


not offer potential long-term profits but required the largest expenditure on restructuring. As a result, in most cases, the investors did not replace the state, take responsibility for the enterprise, or initiate internal reforms. In practice, this yielded a specific model of corporate control with “dispersed ownership” (Dolgopyatova 2002) based on a framework with managers who managed the assets but had only minor stakes in their firms and were independent from the other owners and from the equity market. This situation objectively created conditions for opportunistic behavior, such as the transfer of liquid assets from large enterprises run by managers who were partial owners, to controlled intermediary and financial firms. In this way, historically established inefficient market structures were preserved, and the critical condition of this type of large enterprises was only aggravated. To explain the characteristics of the new private firms, it must be emphasized that, in all postsocialist countries, the incentives available to the new private sector were important aspects of the economic policy, along with the privatization of the state sector. There was a presumption that new private firms, springing up as small and mid-sized enterprises, could introduce a market spirit of initiative and entrepreneurship in the former planned economy. As we have already reported, the establishment of the private sector began in Russia in the mid-1980s when self-employment was permitted and legal grounds were set up for cooperatives and joint ventures. However, it must be pointed out that, even at that time, new private ventures engaged not in production sectors but, rather, in trade and profited mainly from the differences in prices between the state and private sectors. Price liberalization in January 1992 limited the scope of deriving this “transformation rent,” but the liberalization of external economic relations gave private intermediaries other opportunities for making profits, this time, from differences in prices between the domestic and world markets. At that time, the undervalued ruble encouraged exports in the first place, of primary goods, while the domestic market became saturated with cheap imported goods from Poland, China, and Turkey that arrived through the channels of “shuttle” trade. The establishment of a foreign currency market and vigorous speculation in US dollars (particularly in 1992–1994), along with mass privatization, opened great opportunities for private businesses in the financial sector. As soon as vouchers came into being in 1993, favorable conditions were created for interregional arbitrage. Later, private financial and investment companies and commercial banks strongly speculated in the purchase and resale of stakes in privatized enterprises. Unlike markets for goods, the Russian financial sector was closed to foreign competition for a long time, and this was, indeed, another source of rent for insiders. In general, by the late 1990s, the private sector enjoyed a fair amount of success, when new private companies that had started from trade and financial operations were gradually penetrating into the sector of privatized

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enterprises. The loan-for-share auctions reported above were the most obvious manifestation of this trend. At the same time, the tax policy had a very strong influence on the development of the new private sector in Russia, although its impact has been underestimated in the literature. In 1992, trying to cope with an acute fiscal deficit, the government introduced a 28% VAT and 40% social charges on salary payments. This measure, which represented a substantial increase in costs for all enterprises, was combined with an effort to toughen monetary policy and liberalize prices in the highly monopolized economic environment and resulted in an acute liquidity crisis as early as in the spring of 1992. However, the effects of the liquidity crisis were unequal in stateowned enterprises and in private firms. State-owned enterprises could borrow from state-run banks to finance their wage bills. Moreover, they were integrated into established economic ties and, relying on informal relations inside the director corps, agreed to deliver their products to their traditional customers on credit, getting raw and processed materials and components from their traditional suppliers in the same way. Therefore, they remained generally afloat on legal terms, and they calculated and even paid newly introduced taxes (mass tax arrears in the sectors of state-owned and privatized enterprises began only in 1994). On the contrary, firms in the private sector, which performed earlier as an appendix for redistribution in a planned economy, faced severe problems under liberalized prices and a greatly increased tax burden. Demand for their services had high elasticity and immediately and steeply declined. For this reason, private enterprises were forced to resort to all possible ways to reduce costs, including reliance on various schemes of tax evasion. The latter was facilitated by the fact that the government, having declared high tax rates, had no administration for tax collection. Therefore, the state actually pushed the new private sector toward mass tax evasion and to the development of “gray” business that basically relied on unrecorded cash transactions. On the other hand, the government, on alleged sociopolitical grounds, for a long time turned a blind eye to these developments in the sector of private business. It was believed that, while legal support of small businesses was weak, this policy line would help promote entrepreneurship and generally favor the expansion of the private sector. In turn, evolution and expansion of the private sector would help to cope with problems of excessive employment. At first glance, something like this really took place. Until the mid-1990s, the number of small firms was increasing at high rates, but official unemployment remained rather low in spite of a reduction in industrial output to one-half. It is logical to assume that, having lost jobs in the industry (to be exact, nominally staying on the payroll of the enterprises that had paid no wages for many months), people found jobs in the informal

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sector. However, this rapid development of private businesses in legal and semi-legal forms had contradicting results. On the one hand, indeed, social problems were alleviated, and new jobs were created. However, on the other hand, the effect of unequal or unfair competition took place when, under nominally equal taxation, a number of enterprises paid practically no taxes. This competition was one of the reasons that large state-owned and privatized firms, which initially had paid their taxes, later started to generate tax arrears on a massive scale. Furthermore, they bartered and used the money of surrogates to settle with their suppliers. As a result, by the mid-1990s, Russia had a sort of dual-sector economy. The generally prosperous first sector was mainly represented by new private enterprises that specialized in trade and financial operations and received rent from accumulated structural and price disproportions. The second sector, mainly represented by old state-owned and privatized industrial firms that were poorly adapted to market conditions, suffered a crisis. Simultaneously, the diffused structure of ownership rights and their uncertainty gave this sector the incentive to withdraw rapidly liquid assets and place limits on restructuring, which had poor prospects as it was. In both sectors, as individual firms engaged in more market-oriented behavior, they became more deeply integrated in the informal economy. However, this type of system, which, from a functional aspect, absorbed more resources than produced value and functioned with reliance on net borrowing (Gaddy & Ickes 1998; Ericson & Ickes 2000), was unable to exist for very long, and this predetermined the inevitability of a serious economic and political crisis, which occurred in August 1998. Summing up the features of the transition firm in its Russian version, in contrast to the market firm, which is oriented toward profit making and business development, state-owned and privatized firms were typically oriented toward survival and self-preservation under new conditions. Although they were given private status, in reality, the chief acting figure in such transition firms was its director, who enjoyed the support of labor collectives and regional authorities in his opposition to external investors. The difference between new private firms and the market firm was that, in an extremely unstable and uncertain external environment, the former were mostly oriented toward short-term profit making and set no goals for business development. At the same time, such enterprises were active in using opportunities for receiving “transformation rent” from structural imbalances and price disparities, which were inherited from a planned economy, and from irregularities in the implementation of reforms. The chief acting figures in such new private companies were their founders, who launched the business and simultaneously performed the roles of owners and managers. Nevertheless, as reported by Berglöf & von Thadden (2000), a soft budget constraint resulting from the weakness of public institutions was the

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essential feature that determined the behavior of firms in both sectors. As a consequence, firms in both sectors had many opportunities to resort to a strategy of state capture (Hellman, Jones, & Kaufman 2003; Iwasaki & Suzuki 2007), that is, to receive subsidies and benefits, and to evade taxes and customs duties. For the transitional firm, all of these lowered the incentives for the restructuring and development of business. These features were, in general, typical of transitional firms in other postsocialist countries as well. At the same time, the trajectories of evolution of transitional firms also depended on alternative methods of transition from the plan to the market taken in different countries. For instance, the greater competence of old institutions was an important factor in China (Kolodko 2002), along with the gradual speed of reforming and the relatively closed nature of the economy. Privatization in China was launched in the mid-1990s, 15 years after the reforms had begun (Qian 1999), and the domestic market was actually opened to foreign companies still later, after China joined the WTO. A more competitive industrial structure, which had been established in China in the framework of regionally organized central planning, was also essential for the change in motivation and behavior of the firms as well as competition between state-owned enterprises, which the Chinese government deliberately encouraged in the early stages of reform. Eastern Europe, primarily, carried out an alternative scenario of reforms, relying on the maximum openness of economies, including the financial sector, and on the active participation of foreign investors in privatization. The behavior of firms was also significantly influenced by their earlier experience gained in interaction with markets due to the existence of the private sector and trade contacts with foreign partners before the start of reforms. A desire to join the European Union, which was unanimously shared by citizens of most countries in Eastern Europe, regardless of their political views, was a no less important factor of the reforms. As a result, local companies and their insiders were much better prepared to meet the standards and requirements for newcomers, which were claimed by the EU. In this context, Russia’s public institutions were much weaker and exposed to different pressure groups, and reforms were carried out partially (Hellman 1998) with the preservation of the sources of rent for these pressure groups. Another important difference was a much larger amount of accumulated wealth under the command of the state and the availability of rich natural resources. On the one hand, this enabled the state to postpone the necessary reforms and enlarged its opportunities to influence economic activities. On the other hand, the struggle for getting these resources under control in the course of privatization made corporate conflicts much more acute, and property rights were violated much more brutally than in Eastern Europe (Woodruff 2004).

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28


These differences appear to be the reason that, in Russia, distortions of enterprise behavior in the framework of the model of “transitional firm” reached a much larger scale than in any other former socialist country.

On the road to the market firm The August 1998 crisis, which manifested itself in a default on government bonds and in a fourfold devaluation of the ruble, had serious economic as well as political consequences. It was a systemic crisis of distorted patterns and mechanisms of interactions between the state and the business that took shape in Russia in the 1990s. In September 1998, a government with the participation of prominent figures in communist opposition took power for the first time in an era of market-oriented reforms, producing the effect of a “cold shower” on the representatives of the new Russian elite, who had gained power from the reforms of the 1990s. The crisis reached a point at which the elite became aware of the possibility that they might lose their property or status (as demonstrated by specific politicians and businesspersons). In this context, the crisis served as a prerequisite for stretching the horizons of the interests of all actors and for reaching a consensus among members of the elite on such issues as the need for responsible macroeconomic and fiscal policies as well as the need for consolidated power and a strong state. As shown in Table 1.1, in the period of 1999–2003, the Russian government adopted a large set of new important legislation in such areas as taxation and customs regulation, corporate governance and bankruptcy, and labor regulation. For the firms, from the point of view of the choice of strategic behavior, these changes on the government side meant that the scope of state capture was limited, and budget constraints, which had been characteristically weak during the transition, were gaining in strength (Berglöf & von Thadden 2000). The crisis was a severe blow to the new middle class, who had emerged in large cities in the 1990s, as well as to companies that had been primarily engaged in financial operations and trade. At the same time, the crisis created opportunities for the development of companies in the industrial sector. The August 1998 devaluation of the ruble resulted in increased competitiveness of Russian exports along with dramatic growth of prices and fall of demand for imported products. Growing sales improved the performance of Russian business. As a result, the new owners of enterprises (both old “red directors” and new private investors) had the opportunity to recover their investments in block shares by not only withdrawing liquid assets from their enterprises but also generating revenues by doing business. This created incentives to invest in the development of enterprises that did not exist in the 1990s. One of the consequences of the new investment opportunities in Russia was a noticeable reduction in capital outflow. In 1997–1998, annual capital outflow from Russia was estimated at $20–25 billion, whereas, since

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2004, Russia received an inflow of capital and investments. At the same time, the volume of Russian FDI in production assets in other countries began to increase significantly (Vahtra & Liuhto 2004). However, to ensure revenue from these investments, both old “red directors” and new outside shareholders needed not only operational control over financial flows but also official legal control over relevant enterprises. This resulted in a stronger tendency toward the concentration of ownership and control. At this point, a new bankruptcy law provided additional momentum toward this tendency. Implemented in 1998, it triggered a new wave of ownership redistribution and acute corporate conflicts (Simachyev 2003). A very large amount of mutual nonpayment to suppliers and tax arrears, which had been accumulated by enterprises in the early and mid-1990s, was the prime cause of this phenomenon. Due to the rationality of such behavioral strategy, these nonpayments were typical of the absolute majority of enterprises, both inefficient and efficient ones. However, for this very reason, the simplification of bankruptcy procedures provided by the law of 1998 for creditors, combined with the gradually increasing efficiency of enforcement, resulted in a tendency to apply the new bankruptcy law mainly to viable, efficiently run enterprises. In fact, any overdue indebtedness of such enterprises, even minimal amounts, was used for the seizure of power and for gaining control of liquid assets. Mass protests against this practice of these corporate takeovers led to passing the third bankruptcy law in 2002, which provided protection of interests for creditors as well as debtors. Nevertheless, such an opportunistic use of any overdue debt, however small, to “intercept” control at successful enterprises provided the current owners with strong incentives to clear and settle the arrears accumulated in the 1990s. More adequate tax policy pursued by the government after 1998 also contributed to reducing the nonpayment problem. For instance, in 1999–2000, the government wrote off a significant amount of fines and penalties on overdue tax payments and provided a debt restructuring opportunity to enterprises, which had made current tax payments on a regular basis within a certain period of time. Eventually, by 2001, industrial arrears were concentrated in inefficient “lying” enterprises, distinctly from the mid-1990s, when they were typical of almost all major industrial enterprises. When free financial resources appeared in the economy from not only devaluation but also rising prices in energy carriers and metals in the world market, they reinforced tendencies toward corporate integration, with the establishment of integrated business groups. This tendency became clearly apparent in the second half of the 1990s, in the first place, as a reaction against an imperfect institutional environment (Avdasheva 2000; Pappe 2000). In the early 2000s, this tendency developed further, and, now, it is

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evident that there is a relatively steady distribution of crucial assets between the largest financial and industrial groups. Concentration of ownership and control in the hands of dominant shareholders practically provided a solution to conflicts between managers and owners, which had caused most blatant violations of shareholders’ rights and gave foreign experts grounds for describing corporate governance in Russia as “awful”. By now, in the absolute majority of Russian companies of any interest to investors, either outside shareholders have successfully changed old managers and taken supervision in their own hands or managers have gained control over their enterprises and ousted outside shareholders. The former course of affairs was more frequent, and the latter occurred rather rarely. In many cases, particularly in mergers and acquisitions, an intermediate solution took place when old managers retained their positions as junior partners. Nevertheless, a typical situation today is when a proprietor runs a corporation directly or exercises effective control over his managerial team. This situation has been equally typical of privatized and newly established firms, because of which their differences are obviously fading. As a consequence of the concentration of ownership and control, there was a decline in the number of corporate conflicts as well as a change in the motivation of dominant shareholders. In the 1990s, the main source of income in the corporate sector was control over financial flows, which went together with the withdrawal of liquid assets from industrial enterprises. This occurred to the detriment of interests of minority shareholders and the state. Since the beginning of the 2000s, new ways of appropriation of corporate income became widespread, such as the payment of dividends and increase in the market value of shareholdings, which better corresponded to the principles of a market economy. In turn, this created real demand for instruments of corporate governance (Razvitie Sprosa 2003). Owners of large companies found themselves interested in the use of standard instruments of corporate governance with the purpose of keeping the activities of hired managers under control. At the same time, a desire to give a better image of their expanding business in the global market gave companies an incentive to analyze the requirements of good corporate governance, including the disclosure of financial statements, invitation of outside directors, and respect for the rights of minority shareholders. The cause of all these positive shifts requires an explanation. It is doubtless that external factors have played a positive role, but the accumulation of experience in a market economy has also been very important. It is noteworthy that, in the 1990s, in spite of powerful incentives for an opportunistic rent-seeking strategy, there was also an alternative strategy in the Russian business community to retain some distance from the state (Yakovlev 2006). The raison d’être for this strategy was that not all firms were allowed to take

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part in the division of public assets, a strategy which some firms deliberately chose. Such firms have survived more hardships in the 1990s, but they could have learned more. Furthermore, it was they who created that potential for future economic growth which was first noticed by the McKinsey Co. in their report titled “Unlocking Economic Growth in Russia” and announced in Moscow in October 1999 (Palmeda & Lewis 2003). In general, describing the model of the Russian firm in the 2000s, we can point out that a significant part of Russian firms have assumed standard market incentives to develop business, such as making long-term profits, having higher company capitalization, and expanding their market share. In addition, majority shareholders, who, as a rule, maintain operational management in their hands and effectively control the activities of other managers, have become the key figures in most Russian firms. At the same time, the internal restructuring of Russian firms is far from completion. In terms of efficiency, Russian companies are still far behind the firms of other developing and emerging economies. For example, World Bank data show that, in 2004, labor productivity in the Russian industry was just slightly above the level of that in China but about a third of that in the South African Republic, less than half of that in Poland, and two thirds of that in Brazil (Desai & Goldberg 2007). However, these average figures conceal very large actual gaps in terms of added value between firms in the same industries. For instance, in 2004, the labor productivity gap between the best 20% and the worst 20% of firms was 11 times in transportation machinery, 16 times in light industry, and 24 times in the woodworking and food industries (Golikova et al. 2007). In actual practice, this means the coexistence of efficient and absolutely inefficient firms among Russian industries in the 2000s. This was possible because of an extensively growing domestic demand, which allowed inefficient firms to keep afloat. In this context, the global financial crisis, which started in 2007, may play an important role. It is clear that this crisis will test the durability of leading companies, and, on the other hand, it will help eliminate inefficient firms and eventually contribute to a more efficient economy. Now, by comparing the evolution of the transition firm in Russia with the trends in Eastern Europe at the present stage, the following key points can be identified. A shift of the government to responsible macroeconomic and fiscal policies, supported with substantial consolidation of public institutions, was very important for the change in firm behavior in Russia. It was a political result of the 1998 crisis, but, in Russia, strengthening of the government followed a different trajectory from that in the countries of Eastern Europe. In Eastern Europe, the state, oriented toward EU standards, was more inclined toward setting up the rules of the game and acting as an arbitrator. In Russia, however, the stronger government turned to active expansion of

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its presence in the economy by using investment programs, policy-based institutions of development, and state-owned companies (see Table 1.1). This could be defined as an attempt to repeat the experience of South-East Asian countries from 1960 through the 1980s through the building of a similar pattern of relations between the state and big business under state leadership. One of the reasons for following this path is the illegitimacy of the results of privatization. In the public opinion, the privatization of the 1990s is considered unjust (Denisova et al. 2007), and the representatives of the business community themselves acknowledge the legality of revising its results (Frye 2006). This lowers the degree of protection of property rights and gives the state an additional lever for keeping the largest companies under informal pressure, particularly those that received their assets at loans-forshares auctions. Being closed for foreign investors is Russia’s another major distinction. In Eastern Europe, the model of corporation was shaped under very strong influence of foreign shareholders, who gained control over most large companies (Andreff 2005; Stark & Vedres 2006). In Russia, in the 1990s, although the government more than once pledged support to foreign investments, company managers were typically hostile to foreign shareholders. In the 2000s, the government and businesses reversed their roles, but the real situation changed little. The companies that are controlled by Russian private owners are more inclined to cooperation with foreign investors, but, at the government level, foreign investments are truly welcome only in certain sectors. In a number of large-scale raw material projects, the government helped to oust foreign investors, and, in general, foreign shareholders in big business were assigned, under government pressure, to junior-partner positions. It is not by chance that here, in contrast to preceding sections of this chapter, we have made comparisons only with Eastern Europe. Although packages of reforms at the enterprise level were originally quite similar in Russia and in Eastern Europe in the 2000s, the East European and Russian models of a firm were divergent in their development, and Russia was inclined to an orientation more comparable to that of China. The differences that we have reported above confirm this thesis. As a consequence, in the future, we expect that Russian companies will be divided into two sectors: the largest firms will remain directly or indirectly controlled by the state, and mid-sized firms, by the standards of the global market, will be more independent and open to foreign participation (Yakovlev & Danilov 2007). The largest firms share similarities with the model of the development firm as defined by Berglöf & von Thadden (2000); they have informal relations with the state and investors, which are typical of this model. On the other hand, mid-sized firms will evolve toward the model of a closely held firm with the predominance of large shareholders

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in governance and a limited presence in the stock market. In this context, the gradual disappearance of the concept of the transition firm is a distinct possibility.

Notes 1. According to the data given by Qian (1999), in 1940, the annual plan in the USSR was compiled for 500 commodity items; however, in the late 1950s, the product mix of Gosplan had more than 2,000 items, and, by the end of the 1970s, plans on the level of USSR ministries had about 60,000 items. On the other hand, in China, in 1957, the plan of the central government included 532 items, and, by 1973, their number increased to only 617. This had been the result of several campaigns of administrative decentralization conducted by Mao Zedong, and, later, it was related to the consequences of the Cultural Revolution, when, in 1967–1968, no annual plans were compiled at the level of the central government. 2. This policy was a logical outcome from the Soviet model of organization of centralized planning by industry, which implied the management of all enterprises from a single center, and the mere scale of the country required to reduce the number of managed objects to a minimum and to streamline their structure. On the contrary, the government of China, based on the idea of regional self-sufficiency in case of American or Soviet aggression, designed a regional system of centralized planning and deliberately supported the development of the same types of productive facilities in different regions. In the literature, these differences in economic organization in the USSR and China were labeled U-Form and M-Form, by analogy with the linear-and-functional and matrix structures of management in corporations (Qian & Xu 1993; Maskin, Qian, & Xu 2000). 3. For instance, according to data given by Sinelnikov et al. (1998), by the end of 1991, expenditures of the Union budget were three times as large as its revenue.

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Blanchard, O. & Kremer, M. (1997) Disorganization, Quarterly Journal of Economics, 112: 1091–1126. Blasi, J., Kroumova, M., & Kruse, D. (1997) Kremlin Capitalism: The Privatization of the Russian Economy (Ithaca, NY and London: Cornell University Press). Boycko, M., Shleifer, A., & Vishny, R. W. (1995) Privatizing Russia (Cambridge, MA: MIT Press). Denisova, I., Eller, M., Frye, T., & Zhuravskaya, E. (2007) Who wants to revise privatization and why? Evidence from 28 post-communist countries. Working paper No. 105. Moscow: Center for Economic and Financial Research and New Economic School. Desai, R. M. & Goldberg, I. (eds) (2007) Enhancing Russia’s Competitiveness and Innovative Capacity (Washington, DC: World Bank). Dolgopyatova, T. (2002) Corporate control in the Russian industry: Actors and mechanisms, East–West Journal of Economics and Business, 5: 197–215. Ericson, R. E. & Ickes, B. W. (2000) A model of Russia’s virtual economy. Discussion paper No. 10. Helsinki: Bank of Finland Institute for Economies in Transition (BOFIT). Federal State Statistical Service (Rosstat) Rossiya v Tsifrakh (Moscow: Rosstat) (various issues). Frye, T. (2006) Original sin, good works, and property rights in Russia, World Politics, 58: 479–504. Gaddy, C. & Ickes, B. W. (1998) Russia’s virtual economy, Foreign Affairs, 77: 53–67. Golikova, V., Gonchar, K., Kuznetsov, B., & Yakovlev, A. (2007) Russian Manufacturing at the Crossroads: What Prevents Firms from Becoming Competitive? (Moscow: Higher School of Economics). Hellman, J. S. (1998) Winners take all: The politics of partial reform in postcommunist transitions, World Politics, 50: 203–234. Hellman J. S., Jones, G., & Kaufman, D. (2003) Seize the state, seize the day: State capture and influence in transition economies, Journal of Comparative Economics, 31: 751–773. Iwasaki, I. (2007) Enterprise reform and corporate governance in Russia: A quantitative survey, Journal of Economic Surveys, 21: 849–902. Iwasaki, I. & Suzuki, T. (2007) Transition strategy, corporate exploitation, and state capture: An empirical analysis of the former Soviet states, Communist and PostCommunist Studies, 40: 393–422. Johnson, S., Kaufman, D., & Shleifer, A. (1997) The unofficial economy in transition, Brooking Papers on Economic Activity, 2: 159–239. Johnson, S., La Porta, R., Lopez de Silanes, F., & Shleifer, A. (2000) Tunneling. Working paper No. 7523. Cambridge, MA: National Bureau of Economic Research. Kolodko, G. W. (2002) From Shock to Therapy: The Political Economy of Post-Socialist Transformation (Oxford and Tokyo: Oxford University Press). Kornai, J. (1980) Economics of Shortage (Amsterdam: North Holland). Kornai, J. (1992) The Socialist System: The Political Economy of Communism (Princeton, NJ: Princeton University Press). Maskin, E., Qian, Y., & Xu, C. (2000) Incentives, information and organizational form, Review of Economic Studies, 67: 359–378. Palmeda, V. & Lewis, B. (2003) Unlocking economic growth in Russia. In: Hardt, J. P. (ed.) Russia’s Uncertain Economic Future (Armonk and New York: M.E. Sharpe). Pappe, Ya. (2000) Oligarkhi: Ekonomicheskaya Khronika 1992–2000 (Moscow: SU-HSE).

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The Emergence of Russian Corporations 35 Polterovich, V. M. (2001) Institutional traps. In: Klein, L. R. & Pomer, M. (eds) The New Russia: Transition Gone Awry (Stanford: Stanford University Press), pp. 93–116. Qian, Y. (1999) The process of China’s market transition (1978–1998): Evolutionary, historical and institutional perspectives. Paper prepared for the Journal of Institutional and Theoretical Economics symposium on “Big-Bang Transformation of Economic Systems as a Challenge to New Institutional Economics,” Wallerfangen/ Saar. Qian, Y. & Xu, C. (1993) Why China’s economic reforms differ: The M-form hierarchy and entry/expansion of the non-state sector, Economics of Transition, 1: 135–170. Razvitie Sprosa na Pravovoe Regulirovanie Korporativnogo Upravleniya v Chastnom Sektore. Seriya “Nauchnye doklady: nezavisimyi economicheskii analiz,” No. 148, Moskovskii obshchestvennyi nauchnyi fond, 2003 (Moscow: Moskovskii obshchestvennyi nauchnyi fond & “Proyekty dlya budushchego”) (available at: http:// www.mpsf.org/lib.html). Roland, G. (2000) Transition and Economics: Politics, Markets, and Firms (Cambridge, MA: MIT Press). Simachyev, Yu. (2003) Institut nesostoyatel’nosti v Russii: spros, osnovnye tendertsii i problemy razvitiya, Voprosy Ekonimiki 4: 62–82. Sinelnikov, S., Anisimova, L., Batkibekov, S., Medoev, V., Reznikov, K., & Shkrebela, E. (1998) Problemy Nalogovoi Sistemy Rossii: Analiz Situatsii i Perspektivy Razvitiya (Moscow: Evraziya). Stark, D. & Vedres, B. (2006) Social times of network spaces: Network sequences and foreign investment in Hungary, American Journal of Sociology, 111: 1367–1411. Vahtra, P. & Liuhto, K. (2004) Expansion or exodus? Foreign operations of Russia’s largest corporations, Turku School of Economics and Business Administration, Electronic Publications of Pan-European Institute, 8 (available at: http://www. tukkk.fi/pei). Woodruff, D. M. (2004) Property rights in context: Privatization’s legacy for corporate legality in Poland and Russia, Studies in Comparative International Development, 38: 82–108. Yakovlev, A. (2006) The evolution of business–state interaction in Russia: From state capture to business capture? Europe–Asia Studies, 58: 1033–1056. Yakovlev, A. & Danilov, Yu. (2007) Russian corporation development in the next 20 years: Ownership structure, the role of state, and corporate finance, unpublished working paper. Moscow: Higher School of Economics.

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Part I Ownership, Internal Control, and Management System

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2 Stock Ownership and Corporate Control Tatiana G. Dolgopyatova

Introduction Researchers of the Russian economy have unanimously identified the most important features of stock ownership and control. First, the concentration of capital in the corporate sector resulting from its aggressive redistribution for more than 15 years tends to be high. Second, the high concentration of ownership affected the development of corporate control and evolution of the mechanisms of corporate governance (Natsional’nyi Doklad 2008). This high concentration provides the basis for control by the majority shareholder or a consolidated group of such shareholders exercised by various formal and informal means (Dolgopyatova 2003, chapter 2). Majority shareholders are constrained only by the need to comply with the formal legal provisions and often imitate the activities of intra-corporate tools (bodies) (Razvitie Sprosa 2003). Third, the prevailing model of corporate control is that in which majority shareholders participate directly in management as top managers of companies (Insiders and Outsiders 2004; Stiglitz 1999). A combination of ownership and control has become a formal institution of Russian corporate practices, which restrict the demand for “outside” managers who do not own company shares. This institution has become widespread not only as a result of privatization (“red directors” becoming owners of enterprises) but also as a tool intentionally chosen by owners who established their businesses from scratch. In a situation of underdeveloped markets for managerial staff and institutions for protection of property rights, this arrangement was preferred as compared to high costs of preventing opportunistic behavior of hired managers.1 At the time of economic transition, this behavior would take the extreme form of asset stripping and business raiding. This resulted in the elimination of the agency problem of corporate governance. On the basis on quantitative data obtained from our representative survey and qualitative information of in-depth interviews with company owners and managers, in this chapter, we will discuss the relevance of simple 39

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hypotheses regarding the role of high concentration of capital in the evolution of intra-corporate control forms and business performance. We presume that a high concentration of ownership is linked with its hidden structure and that it affects intra-corporate relationships. The vast majority of Russian JSCs combine ownership and control despite the current trend to separate executive management from ownership. Concentrated ownership will encourage owners to restructure and develop their businesses. The second section contains a description of the structure of stock ownership that emerged in Russian companies in 2005 and the types of shareholders they include. The third section discusses the correlations between the level of ownership concentration and business performance, and the fourth section contains a description of the corporate control tools used by the majority shareholders. The results of the analysis are summarized in the fifth section.

Ownership composition Since the mid-1990s, empirical studies performed by many Russian and international institutions have focused on corporate ownership and the control mechanisms of Russian companies. These studies (e.g., Radygin & Entov 2001; Dolgopyatova 2003; Guriev et al. 2003; Yasin 2004; Kapelyushnikov & Dyomina 2005; Aukutsionek et al. 2007) suggested that, for many years, the economy underwent an extensive redistribution of stock ownership that was accompanied by entry of new shareholders. The Russian Economic Barometer (REB), the Center for Economic Conjuncture, and State University – Higher School of Economics (SU-HSE) have reported that the entry of new large owners affected from 5–7% of JSCs each year from the 1990s to the early 2000s.2 Quantification of ownership concentration Russian companies have a characteristically high level of stock ownership concentration that increases annually. Aggressive ownership redistribution in the wake of privatization resulted in the rapid emergence of large shareholders. According to various surveys, in the beginning of the 2000s, the largest shareholder would own, on average, 40–50% of the assets; JSCs including a blockholder accounted for 40–65% of the total sample, while those with a controlling stakeholder accounted for up to 45% of the sample. Respondents also suggested (Razvitie Sprosa 2003) that at least two-thirds of open JSCs had an owner in control of the company. Qualitative surveys (e.g., interviews and case studies) generally suggested a higher level of concentration of real control, as opposed to formal ownership, in one person and practically the universal presence of a controlling shareholder.

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Stock Ownership and Corporate Control

41

Other important trends in the evolution of the structure of stock capital were reduced to a growth of holdings of company managers, with a noticeable decrease of holdings of all employees and a higher participation of external owners, primarily Russian legal entities, against the background of corporate integration. Moreover, the role of public authorities at all levels against the background of ongoing privatization and the emergence of new businesses showed a decreasing trend almost up to the mid-2000s. Currently, the last trend is being reversed as the position of public authorities, primarily federal agencies, becomes stronger. In the area of nationalization, the federal government has demonstrated an active stance. 3 Today, federal authorities hold a predominant interest with major Russian companies in the real economy and financial sector. Through these agencies, the government not only controls the production of a sizeable portion of GDP but has also become a major stock market investor, the government’s share in capitalization of the Russian stock market being more than one-third in 2006 (Panov & Borissov 2006). By estimates of Troika Dialog (2008), the state controlled about 40% of capitalization at the end of 2007. Our studies have confirmed a very high degree of ownership concentration (more than 50% of shares owned by one shareholder) in the sample, which was observed in almost 70% of surveyed companies. Companies with the average level of concentration (25–50% of shares owned by the largest shareholder) were approximately 18% of the total, while those with a low level of ownership concentration (in Russian terms) with the blockholder (owner of more than 25% of total stock) yet not to emerge accounted for only 13% of the sample. High-concentration companies included two subgroups depending on whether there was the second large shareholder with at least a blocking minority ownership (counterbalance). Almost one-half of the companies had a dominant shareholder not contained by the stake of the second shareholder (Figure 2.1). A desirable level of concentration was achieved to a large extent, which almost 70% of respondents considered optimal for business development, with about 18% wanting an increase and only 13% wanting a decrease. A vast majority of respondents (over 87%) asserted that their company already had an owner (coalition of owners) in control of corporate operations. The area of real control turned out to be considerably wider than the ownership structure would suggest, and more in line with the evidence collected in in-depth interviews. Curiously, companies with a controlling owner included 50% of low-concentration companies and more than 86% of average-concentration companies. Studies dating back primarily to the late 1990s (for example, Dolgopyatova 2001) found that a higher concentration of capital was characteristic of smaller companies and businesses in relatively better-off industries, whose shares were attractive for their management and potential outside investors,

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42

Organization and Development of Russian Business Less than 25% of shares 13%

More than 50% of shares + absence of a counterbalance 48%

From 25% to 50% of shares 18%

More than 50% of shares + presence of a counterbalance 21%

Figure 2.1 Classification of surveyed joint-stock companies by level of ownership concentration Source: Author’s illustration based on survey data.

as well as of closed JSCs, in which it was easier for managers to reach capital consolidation.4 Unlike privatized enterprises, in which privatization by vouchers formed a still existing class of minority shareholders, new businesses may demonstrate a higher degree of concentration. It could be also presumed that concentration of the stock could be lower in those companies whose shares are tradable at stock markets and attractive to small investors. Our survey produced contradicting results. The pattern of distribution of businesses by the degree of ownership concentration was approximately the same in manufacturing and communications and was not dependent on company size, type of incorporation, corporate background, and lack of international or domestic tradability of stock. As the only significant (at the 1% level) difference, new companies had the second-largest shareholder twice as often as privatized and reorganized ones. A very high level of concentration was also characteristic of large public companies. According to a survey by Standard & Poor’s of 80 Russian companies with most liquid shares, about 71% of them had shareholders with more than 50% stock in 2007, and only 8% of companies did not have a blockholder (S&P 2007a). At 75 public companies accounting for 90% of the capitalization of the Russian stock market (S&P 2007b), the largest shareholder would own, on average, 58% of shares. Moreover, in internationally tradable companies, this share was almost 50% (56% in companies listed with LSE, and 34% in companies listed with NYSE/NASDAQ). A high concentration of ownership and control became an intrinsic feature of Russian companies and, at the same time, demonstrated a significant

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43

Independent jointstock companies

Affiliated companies of company groups

Parent companies of company groups 0

20

40

60

80

100

Concentration of ownership (%) Low

Medium

High with a counterbalance

High, absence of a counterbalance

Figure 2.2 Concentration of ownership in independent and integrated companies Source: Author’s illustration based on survey data.

link with corporate integration (Figure 2.2), which confirmed the ideas expressed by Deryabina (2001) and Radygin (2001) regarding the role of emerging market structures in the redistribution of property. A higher concentration is characteristic of subsidiary companies in a holding company group, while parent companies would more often include the second-largest shareholder. In 2001–2004, a change of the main owner was characteristic of 30% of companies covered by surveys (7–8% of companies each year, on average). The higher the concentration was, the more often it was foreshadowed by a change of owners; this change happened twice as often with a high concentration of capital than with a low one (33% compared to 16%) This change would most frequently happen in companies with the second control center and affected over 39% of companies. In onethird of companies, consolidation of control in one person was preceded by a change of the main owner, while the reverse was true for 13% of companies. Ownership concentration developed against the background of intracorporate disputes, which demonstrated a significant link with the change of owners taking place in this period: in the event of the change, disputes were characteristic of 41% of companies, as compared to 22% of the rest. In 2005, the extent of stock concentration correlated positively with internal disputes in 2001–2004, which peaked in the event of the second control center (Table 2.1). In JSCs with a controlling shareholder, the frequency of disputes was almost 30%, against 13% at those companies without a controlling owner.

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44 Organization and Development of Russian Business Table 2.1 Intra-corporate disputes in 2001–2004 at different levels of ownership concentration (% of the number of JSCs) Disputes:

Sample

Low

Were Were not Number of JSCs

26. 8 73.2 768

17.8 82.2 90

Medium 25.2 74.8 127

High

Presence of counterbalance

30.2 69.8 514

41.7 58.3 347

Absence of counterbalance 24.2 75.8 151

Significance of differences by three groups of JSCs, 0.042; by four groups, 0.000a Note: a 2 test. Source: Author’s calculations based on survey data.

Stock ownership structure As reported by Dolgopyatova (2007), an important fact of corporate reality is the non-transparency and complexity of ownership rights and the concealment of true owners behind a multilevel chain (5–8 levels) of affiliated individuals and companies, offshore firms, nominal holders, and multistage company management systems. This was the result of the general institutional environment of the Russian economy, in which the use of illegal finances and not always legitimate ways of property acquisition was common. The Standard & Poor study of transparency cited above (S&P 2007a) revealed that less than a quarter of the large public companies reported shareholders who owned 10 and more percent of stock. The situation in other companies was much worse. Recently, Chernykh (2008) conducted in-depth research on this issue based on formal and informal data of public companies and demonstrated that companies are controlled by anonymous insiders masking their holdings through nominee and foreign offshore arrangements. In fact, some of these owners (beneficiaries) are well known by the public and the media. Survey results based on voluntary estimates of respondents show an aggregated structure of ownership that sometimes differs from a formal structure. The studies cited above suggest a minor role of financial investors and foreign shareholders in the capital of a company; the core owners are company employees (mostly managers) and outside shareholders (legal entities). Normally, employees will account for 30–45% of shares, with managers accounting for 10–20% (as a matter of exception, REB data suggest almost one-third of total capital), but ownership of the management is always hidden. External holders, primarily Russian nonfinancial entities, will account for 50–60%. In a situation of ownership concentration, the predominant role in ordinary stock holding5 is played by large shareholders (individuals), paralleled by a meaningful total holding of minority shareholders, the third largest group of owners being Russian nonfinancial entities (Table 2.2).

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7.2 1.3 40.5 1.0 1.9 7.1 26.3 2.8

24.9 1.5 2.7

13.7

34.8

4.6

Low

4.7 1.9

Samplea

3.0

35.4

9.4

31.1 0.6 1.5

5.5 1.7

Medium

5.3

35.8

16.0

20.5 1.8 3.2

4.2 2.3

High

5.1

37.5

15.9

19.1 1.5 3.9

4.5 3.2


0.107/0.195 0.207/0.299

5.6

0.002/0.004

0.000/0.000 0.681/0.524 0.547/0.736

0.034/0.094 0.136/0.157

Significance of differencesb

34.8

16.6

20.9 2.0 2.8

4.1 2.0

Absence of counterbalance

Source: Author’s calculations based on survey data.

Notes: a The number of respondents varies from 698 to 720. b Kruscal Wallis test was used. The numerator presents significance of differences by three groups of JSCs, and the denominator presents significance by four groups.

Federal administration Regional and/or local administrations Minor individual shareholders Banks Investment funds and companies Russian nonfinancial enterprises Major external shareholders – individuals Foreign investors (individuals and legal entities)

Type of shareholder

Table 2.2 Average percentage of ordinary shares owned by type of shareholder at different levels of ownership concentration (% of charter capital)

46


Public authorities ranked fourth by holding more than 7% of ordinary shares. In each fifth company, the government was among the shareholders, with federal agencies holding a stake in each ninth company, while regional and municipal governments held a stake in each thirteenth company. REB data also suggest that state holding amounted to 7% in 2005, and increased to 9% in 2007 (Aukutsionek et al. 2007). Federal authorities hold 2.5 times more shares than regional and municipal authorities do. In companies in which public agencies are among shareholders, federal agencies hold an average of approximately 40% of shares, while regional and local authorities hold less than one-fourth. The share of small investors is naturally lower at high-concentration companies, while, at the same time, the share of Russian nonfinancial entities is at its highest. The share of federal agencies turned out to be the highest at low-concentration companies. In identified companies with/without the counterbalance, the formal ownership structures were practically identical. Interestingly, the differences in terms of shares held by large external shareholders were negligible. It is noteworthy that, at a high concentration of equity, almost one-fifth was held by different Russian financial and nonfinancial entities, which apparently represented the interests of the largest owners. Holdings of foreign investors (in the form of companies incorporated elsewhere) could also act as a shield. The ownership composition of ordinary stock confirmed the high concentration of capital along with the continued existence of sizeable dispersed holdings and the prevalence of large shareholders from among individuals and nonfinancial entities. Moreover, legal entities were used to cover up the holdings of the largest individual owners. Shares of banks and other financial investors were minor, only to reflect the weak role of financial intermediation and banking sector. The shares of foreign investors were still small.

Ownership concentration and business development Qualitative studies would repeatedly suggest that business incentives of large holders changed from asset stripping to development of the business. Owners became interested in developing their businesses, and the difference between former directors and owners and new holders gradually diminished (Yakovlev 2003; Yakovlev et al. 2006). When a company was purchased with the purpose of corporate integration, its prospects were originally underpinned by the development of the whole business. Meanwhile, attempts to measure statistically how ownership concentration affected the performance of Russian companies (which was normally done on current profitability indicators) did not produce clear results. While some researchers reported a positive impact (Radygin & Entov 2001), others found a negative influence (Kuznetsov & Muravyov 2000), and some reported no linkage at all (Yasin 2004). Some studies revealed a nonlinear dependence.

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47

According to studies of the major Russian companies (Kuznetsov & Muravyov 2000), concentration and profitability had a U-shaped linkage, the minimum being reached with 52% owned by the largest shareholder. According to a 2001 REB survey, the average level of concentration (10–50% of equity) proved to be the most efficient (Kapelyushnikov 2001). In a later REB survey based on 2003 data (Kapelyushnikov & Dyomina 2005), the concentration of ownership had a negative effect, resulting in lack of capacity, lower wages and profitability, and a higher risk of loss. Moreover, the authors produced evidence (in a small sample of companies) of the positive role of the size of shareholding owned by the second-largest owner. The analysis of quality of corporate governance in Russian companies identified a reversed U-shape linkage with ownership concentration. The concentration would improve corporate governance up to a certain threshold, but any further increase of the largest shareholding would no longer have a positive impact (Guriev et al. 2003). Golikova et al. (2003) demonstrated that, when there was a controlling owner, the company tended to use the best practices of corporate governance. Incidentally, econometric studies performed in other transition economies also reported conflicting findings. For example, Earle and Telegdy (2001) demonstrated with an example of Romanian firms that the concentration of ownership correlated positively with labor productivity. A positive effect (with a foreign investor as the owner) was also demonstrated in a study performed in the Czech Republic (Hanousek, Kocenda, & Svejnar 2004); on the other hand, another study reported a positive effect of dispersed ownership on the profitability of companies under the survey (Kocenda & Svejnar 2002). For Polish companies, the concentration was U-linked to performance, with competition being a complementing factor to improve the quality of corporate governance (Grosfeld & Tressel 2002). Interviews conducted at individual companies normally suggested a positive effect of stock ownership concentration by private shareholders on business restructuring and strategic development but an absence of a linear link to performance (the best performers were companies with the average level of concentration, and the worst, those with a low level). The project (Yasin 2004) also demonstrated, on the basis of nearly 40 interviews, that high-concentration companies were more active investors and had easier access to bank loans to finance their investments. A test of these assumptions based on a sample of more than 500 companies (Dolgopyatova & Uvarova 2006) did not produce any evidence in favor of better performance, investment, and restructuring preferences of highconcentration businesses. However, when there was a controlling interest, companies could more actively seek outside funds, bank loans, and funds of Russian partners and other private investors. A comparison of ownership structures and intensity of corporate restructuring performed by the Bureau of Economic Analysis as part of the survey of about 430 companies

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48


revealed a positive role of concentration by foreign investors for restructuring (Simachyev 2001). Based on this evidence, we speculated that the high concentration of ownership positively affected the long-term aspects of corporate operations to be paralleled by higher investment activities and a tendency for restructuring. Through our survey, we evaluated the linkages between the extent of the concentration and business performance/development indicators (Table 2.3). The best operating performance was demonstrated by entities with average levels of concentration, and the worst, by those with lower levels. Similar findings were produced when we compared companies by dynamics (adjusted for inflation) of sales and labor productivity for the period of 2001–2004.6 A comparison of companies by level of labor productivity in 20047 showed that, in terms of the average value of this indicator, the best companies were high-concentration companies, but no significant difference was found for medians. Moreover, the presence of the second control center, while not affecting a vast majority of ratings, impaired the dynamics of sales and labor productivity in the high-concentration group, which was contrary to the above findings reported by the REB. The survey revealed a positive correlation between ownership concentration and restructuring and business development policies (Figure 2.3). In

Successful introduction of essentially new products and services 70%

Increasing volume of exports

50%

Introduction of new production facilities

30%

Increasing R&D expenditures

Increase inexpenditures on marketing and advertising

10%

Horizon of planning is more than 3 years

Successful introduction of new technologies

Making of significant capital investments

Successful certification by international standards

Less than 25% of shares More than 50% of shares From 25 to 50% of shares Figure 2.3 Modernization activities of companies at different levels of ownership concentration Source: Author’s illustration based on survey data.

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Medium

65.7 61.4 0.71 (0.36)

44.4 0.61 (0.29)

45.8 49.6 4.6

39.6

26.8 56.7 16.5

4.11 (0.40)

55.6

57.9

36.7 50.9 12.4

High

2.56 (0.38)

47.7

54.1

38.2 49.0 12.8


4.89 (0.40)

58.0

59.7

36.3 51.7 12.0


0.015 (0.330)/ 0.027 (0.438)

0.071/0.028

0.005/0.023

0.001/0.005

Significance of differencesa, b

Source:

Author’s calculations based on survey data.

Notes: a Comparison of frequencies was based on 2 test, comparison of means used Krukcal Wallis test, and comparison of medians was based on median test. b The numerator presents significance of differences by three groups of JSCs, and the denominator presents significance by four groups. c Median or median test in parentheses.

JSCs increased gross sales in 2004 (% of the number of JSCs) JSCs increased labor productivity during 2001–2004 (% of the number of JSCs) Labor productivity in 2004 (mln rubles per employee)c

Business performance

Good or quite good Fair Rather poor or poor

Financial and economic state (% of the number of JSCs)

Low

Current economic situation of enterprises at different levels of ownership concentration

Indicators of business performance

Table 2.3


production upgrading (production capacities commissioned, principally new products introduced), the best performers were companies with an average level of concentration, and, in higher exports, those with a high concentration. Similarly, companies with the second-largest shareholder were more active in the introduction of new products and in the expansion of capacity, and there were no significant differences in the other indicators observed. All companies with a blockholder would behave similarly, while those with dispersed ownership were the least prone to restructuring in any respect (except R&D expenditures). Some advantages of companies with an average concentration were explained by the fact that they normally started restructuring later than those in which the process of ownership consolidation was completed for the most part. In 2001–2004, investment activities were characterized by the fact that almost one fourth of the sample did not invest while 40% of respondents estimated the amount of investments as considerable. The higher the concentration of ownership, the more frequent the assessment of investments. In companies without a counterbalance, enterprises with considerable investments accounted for almost 47% of the total. At the same time, the decision-making horizon, which indirectly characterized the development of strategic planning, was invariable to capital consolidation profiles. To check these revealed correlations, we conducted multivariate regression analysis controlling for size (number of employees) and industrial affiliation of companies with various levels of ownership concentration (high, medium, and low). In the list of independent variables, we also included other characteristics important for business modernization, such as the indicators of competition with different market players (this external factor may increase propensity for restructuring activities); a dummy for being a new company established after 1992 (these companies are more flexible and adjusted to market environment); and company affiliation to holding company groups (we assume that independent companies are less involved in restructuring).8 First, we constructed nine binary logistic regression models for each modernization action illustrated by Figure 2.3 (the dependent variable was equal to “1” in the case of implementing of the action and “0” otherwise). For the second step, we applied an ordinal probit regression and a Poisson model for a special count-dependent variable INDRES, constructing it as a sum of values of the seven partial variables (excluding increasing exports and strategic planning for more than 3 years as events, as those are not considered modernization activities). This measure of the intensity of restructuring assumes values from zero up to seven. Selected results of calculations are presented in Table 2.4. Logistic models demonstrated that, in a majority of cases, dispersed ownership had negative influence on the choice of a modernization action,

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Stock Ownership and Corporate Control Table 2.4 modelsa

51

Coefficients for the variable “concentration of ownership” in regression

Dependent variables Horizon of planning is more than 3 yearsb Significant capital investmentsb Introduction of new production capacitiesb Increasing of exportsb Increasing of marketing and advertising expendituresb Increasing R&D expendituresb Successful introduction of new productsb Successful introduction of new technologiesb Successful certification by international standardsb INDRES (intensity of restructuring)c INDRES (intensity of restructuring)d

Medium concentration

Pseudo R 2

0.407

0.19

0.232

0.24

0.555**

0.308

0.18

0.719** 0.671**

0.421 0.001

0.29 0.15

0.591* 0.047

0.122 0.455*

0.20 0.15

0.138

0.248

0.11

0.422

0.208

0.28

0.386***

0.077

0.22

0.227***

0.040

Low concentration 0.104 0.933***

Notes: a Basic category is high concentration of ownership. b Binary logistic model. c Ordinal probit model. d Poisson model. ***: significant at the 1% level, **: at the 5% level, *: at the 10% level. Source: Author’s estimation.

but medium- and high-concentration JSCs had no significant differences. Medium concentration was positively correlated with the introduction of essentially new products. In addition, an empirical study reported that dispersed ownership had a significantly negative effect on the intensity of restructuring.9 Russian companies demonstrated a dominating trend for self-financing, although it could be assumed that high-concentration entities would use external funds more actively. Simultaneously, informal and personalized relationships in economic operations specific to Russia could, on the contrary, encourage creditors to cooperate with the “Master” of the enterprise they know. As a result, we did not reveal any differences in terms of funds and their percentage in the structure of investments between companies with varying levels of ownership concentration.10

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Corporate control under concentrated ownership The existence of controlling shareholders brings to another level the solution of the key problem of corporate governance, i.e. coping with opportunistic behavior of the management (Stiglitz 1999). On the one hand, the free-rider problem copes with principal shareholders with incentives to develop and provide control of the business. On the other hand, there are various opportunities, including formal and informal tools, to achieve corporate control. The Russian practice includes the entire range of control procedures. Combination of ownership and management Control through direct participation of the principal shareholder in corporate management in the capacity of top manager (CEO and/or other top managers) has been widely practiced, thereby resolving the agent problem. In this case, the data of interviews demonstrate (Insiders and Outsiders 2004) that the combination of ownership and management usually charges managers with the responsibilities of the boards. Shareholders, executives, and nonexecutive directors make a unified group that represents itself across all corporate bodies and places intra-corporate procedures under its control. Then, it becomes futile to try to define good corporate governance. Our survey gave two variables of the inseparability/separation of ownership and management. The first variable is the question of whether large shareholders work as company managers; the second, that of whether a company CEO holds company shares. Without considering those who indicated that it was difficult to answer, large shareholders were managers of 48% of the surveyed companies, and the CEOs were shareholders in 63% of them. As anticipated, these indicators are significantly correlated. Joint consideration of these questions makes it possible to divide the surveyed JSCs into a number of groups (Figure 2.4). We can define JSCs in which large shareholders are managers as a group with a combination of ownership and management. This group includes two unequal subgroups. One group, called M&D_S,11 has a large group of shareholders who are managers, and, at the same time, the CEO is a shareholder (as a rule, large). This subgroup is identified as having “complete inseparability.” In the small subgroup, large shareholders are company’s managers, but the CEO is not a shareholder (M_S). Such situations occur infrequently; they are usually temporary or related to the geographical isolation of an enterprise from its major owners. However, a number of such cases were revealed during the in-depth interviews (Yasin 2004). In JSCs in which respondents gave negative answers to both questions, the ownership was formally separated from management. There is a substantial subgroup in which only the CEO is a small or medium shareholder (D_S). The CEO’s stake may be the result of privatization because “red directors” were still preserved or new owners tend

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Stock Ownership and Corporate Control Large shareholders are not managers, and the CEO is not a shareholder 29%

Large shareholders are not managers, but the CEO is a shareholder 23%

53

Large shareholders are managers, and the CEO is a shareholder 40%

Large shareholders are managers, but the CEO is not a shareholder 8%

Figure 2.4 Classification of surveyed companies by participation of shareholders in their management Source: Author’s illustration based on survey data.

to appoint CEOs from the ranks of former managers who were minority shareholders or because the owners endowed him with some shares. Even a modest stake in the hands of a top manager gives him additional control, especially in situations in which working teams or public administration has a stake in the capital and in cases involving dispersed property. There were clear differences in the organization of governance at entities with various levels of stock ownership concentration (Table 2.5). A combination of functions was found to be more characteristic of the average level of concentration and companies with a counterbalancing large shareholder. In division of functions, a high concentration was characteristic of 78% of companies, while the controlling owner was found in 85%. However, when the managers or directors were large shareholders, high-concentration companies accounted for only 68 and 64% of the total, while a controlling owner was found in 91 and 82%, respectively. This finding confirms the possibility to combine executive management and ownership in strengthening the control of shareholders. Other control tools of large shareholders Along with the practice of inseparable functions, large shareholders have other ways of gaining control over companies. One of them is to capture the corporate boards. Through domination, principal shareholders can legally adopt basic decisions at the meeting of shareholders, including the formation of the board of directors and management boards while ignoring the interests of minority shareholders. Although such a method allows a jointstock company to be virtually controlled as a private company, it remains

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54


Table 2.5 Ownership and control in JSCs at different ownership and control concentrations (% of the number of JSCs) Indicators of control types

M&D_S M_S D_S Separation

Controlling owner is present

Concentration of ownership:

Yes

No

Low

Medium

High



41.6 8.4 22.2 27.8

28.7 4.3 33.0 34.0

29.2 5.6 38.2 27.0

53.7 4.1 23.6 18.7

37.7 9.6 20.9 31.8

40.4 9.9 21.2 28.5

36.8 9.3 20.9 33.0

Significance of differences by three group, 0.016, 0.000 by four groups of JSCsa Note: a 2 test. Source: Author’s calculations based on survey data.

Table 2.6 Influence of board of directors on corporate decision-making at different levels of ownership concentration (% of the number of JSCs) Ranks of influence Strong influence Moderate influence Practically no influence Number of JSCs

Sample

Low

Medium

High



66.3 26.8

66.3 27.9

79.6 16.5

62.0 29.6

57.2 31.8

64.2 28.4

6.9

5.8

3.9

8.4

11.0

7.3

772

86

127

513

154

341

Significance of differences by three groups of JSCs, 0.006; by four groups, 0.008a Note:

a

2 test.


legal and even helps shareholders to become accustomed to the use of intracorporate tools. As estimated by respondents, the board of directors was the most influential of corporate bodies (Table 2.6), having a heavier clout than the meeting of shareholders. Almost one half of the respondents reported that shareholder meetings had a strong influence, whereas 18% expressed the opposite. Assessments of the influence of shareholder meetings were not linked to the extent of concentration as they were in the case of the board of directors. With regards to board of directors, companies with the average ownership concentration earned the highest ratings. Apparently, a high concentration was also associated with other means of corporate control, since the subgroup with a counterbalancing shareholder did not result in a significantly different outcome.

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55

With regard to the composition of the board of directors, corporate managers, who might also be shareholders, prevailed, and representatives of large external shareholders ranked second. As a result, these insiders held more than 78% of the votes, while independent directors and minority shareholders held 11% (Table 2.7). As the ownership concentration increased, the shares of managers and rank-and-file employees declined, and those of representatives of large external shareholders grew. At companies with low and average levels of concentration, the management, together with the employees, had the majority of votes. Moreover, JSCs with/without a counterbalancing interest demonstrated a similar structure of their boards. Another control tool is the possibility of dismissal of the management staff (or threat of dismissal), which comes easy in the case of stock domination. Personalities may cause problems in these cases. In addition, opportunistic behavior on the part of the new managers may also contribute. This mechanism of control is well studied: a series of works were dedicated to the analysis of change of managers, especially due to ineffectiveness of companies, and empirical studies produced different results (see Chapter 5 for details). Another possibility for gaining control is related to having additional links to the company’s executive management by establishing head companies or by including special supervisory managers into the procedure for coordination of decision-making; often, these are not staff members of a given company, or they may have a title that is not true to their real functions (“commissioners”). Such links are normally governed by in-house business management regulations and operated beyond the scope of intra-corporate procedures. Finally, another possibility is the use of informal schemes of control directly through the owners on a regular or case-by-case basis. In fact, such a possibility means a permanent, direct intervention of principal owners into the management procedures (which can be done without any agreement or taking into account other shareholders’ or stakeholders’ interests) or a constant threat of such intervention. Either one or more of the methods of control indicated above can be implemented. Corporate governance procedures must be followed despite the cost entailed in complying with laws and instructions. Building additional regulated and/or informal schemes for managerial control will bring the additional costs of duplicating corporate governance and management procedures. Additional control in the organizational chain can be used as a temporary tool (Dolgopyatova 2001). When principal shareholders act as executive managers, there is no need for additional supervision; however, the costs of intra-corporate procedures will be incurred nonetheless. The combination of having one individual be the manager and the owner does not resolve all of the issues related to efficient management. Two issues

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88

22.2 5.4 4.0 1.7 6.6

32.0 4.7 6.2 0.7 6.7

736

54.9 8.0 3.9

46.4 5.0 5.0

Low

121

25.0 5.5 7.1 0.2 6.7

49.2 6.0 7.1

Medium

487

35.5 4.0 6.6 0.8 6.7

44.1 4.2 4.9

High

143

39.7 3.7 7.1 1.1 6.7

40.5 2.9 5.1


329

33.3 4.0 6.6 0.6 6.7

45.6 4.8 5.1



—

0.000/0.000 0.183/0.208 0.925/0.914 0.641/0.836 0.877/0.912

0.013/0.010 0.011/0.012 0.063/0.152

Significance of differencesa, b

Notes: a Kruskal Wallis test. b The numerator presents significance of differences by three groups of JSCs, and the denominator presents significance by four groups.

Number of JSCs

Company managers Rank-and-file workers, trade union Federal, regional/local administrations Major outside shareholders Minority outside shareholders Independent directors Others Total membership, in number of persons

Sample

Structure of board of directors at different levels of capital concentration (% of total membership)

Representatives on the board

Table 2.7


57

that businesses face are described in the following. First is the unity of managers, shareholders, and hired managers within a single management team. In such a case, the coordination of interests and differentiation of incentive mechanisms are needed.12 The second issue pertains to the efficiency and quality of self-management from the point of view of a company’s development, in which case market mechanisms for the selection of skilled managers fail to work. The second issue took a significant amount of time to be added to the agenda because, in the 1990s, Russian manager-owners were considered professionals. They were either representative of the pre-reform managerial corps or founders of new firms, and their skills were considered adequate to serve in the transition environment. At the present time, most top managers have received additional advanced training. Most significantly, they have gained experience in the market-based environment, and many former communist-era directors have been eventually assimilated into the new environment and become as good business promoters as new entrepreneurs (Yakovlev 2004). However, weak institutions for the protection of property rights would give no assurance that opportunistic behavior of managers would be checked through implementation of formal corporate governance standards; therefore, control by a combination of management and ownership became the most widespread practice.

Concluding remarks Russian companies demonstrated that a high level of equity concentration was an inherent feature of business. The highest concentration was observed at subsidiaries of holding company groups, in which it was used to keep them within the corporate orbit and partially hidden behind the holdings of legal entities. Redistribution of assets and corporate conflicts preceded the consolidation of equity, which resulted in the emergence of a dominating shareholder who would establish control over corporate governance. The presence of the second-largest shareholder at the company often did not affect either corporate activities or intra-corporate mechanisms. It could be presumed that this shareholder did not have full power of the second control center and formed a coalition with dominating owners. A vast majority of Russian JSCs demonstrated control through a dominating owner or a consolidated group of owners, but they showed preference for combining the ownership and control functions for direct involvement in daily operations as the top managers of companies. This formal institution is not the only opportunity of control, as there are other widely used instruments, including informal ones, which take company decision-making outside of the scope of corporate governance procedures. The hypothesis of a positive effect of high stock ownership concentration in corporate operations was mainly confirmed. While it was not

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always associated with the best-performing companies, companies with dispersed ownership in Russian terms would lose to other companies in indicators of performance and intensity of restructuring. At the average level of concentration, these companies would clearly take the lead in terms of better performance and the introduction of new products. Where there was a controlling interest, companies demonstrated higher current labor productivity, although respondents were more conservative in their assessment of the economic condition of their companies. Thus, in the given institutional environment, the shortcomings of dispersed ownership found certain empirical confirmation. The findings in this chapter could be interpreted as a lack of incentives to develop business in a situation of low concentration of ownership. At the same time, it cannot be ruled out that potential owners did not show interest in the assets of these companies, precisely because of the weak prospects of their business development.

Acknowledgments The chapter was prepared with financial support of the Program for Fundamental Studies of SU-HSE granted by the Ministry of Economic Development and Trade of the Russian Federation in 2006–2008 and a research grant from the Moscow Science Public Foundation sponsored by the U.S. Agency on International Development in 2005–2006. I would like to thank Svetlana Avdasheva, Ichiro Iwasaki, Xavier Richet, Andrei Shastitko, and Yurii Simachyev for their useful comments and suggestions and Olga Uvarova for her assistance in data processing.

Notes 1. The word “hired” is used to emphasize that these mangers either do not own company shares or have small holdings. 2. See a detailed description of ownership redistribution trends in the 1990s–2000s in Dolgopyatova (2007). 3. Its stronger influence was manifested in an increase of government shares of large companies and the emergence of holding company groups that are predominantly state-owned. Along with a desire to establish public control over the most attractive assets in the oil and gas industry, there is a trend for better supervision over the defense industry and other sectors (for example, aviation, automobile, and shipbuilding industries), which can count on government support, and also for the consolidation of enterprises to secure their market shares. In addition, large JSCs with state holdings increasingly purchase shares of other companies, although it is problematic to evaluate the expansion of these practices of indirect ownership. Companies with federal government participation have become major players in M&A markets. OECD experts believe that these activities were not always initiated by the government but reflected their own corporate strategies, which could be contrary to government purposes (OECD 2006).

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59

4. A closed JSC is a legal form of a joint-stock company in Russia (see detailed explanation of the peculiarities of this form in Chapter 3). In particular, a closed form of incorporation has limitations for the turnover of shares, giving advantages to existing shareholders. In the course of privatization, closed companies were established as those owned by employees (reorganized from Soviet-type “leasing enterprises”); that is, in the 1990s, top managers received control over sales of shares and placement of new emissions. This form gave them the potential for quick accumulation of shares. 5. The issues of stockholding were formulated separately in the form of a range scale for each type of shareholder; thus, the sums of average shares calculated by range medians are considerably less than 100%. This fact has to be taken into account in evaluating the results, which should be adjusted upwards by a factor of at least 1.12. For a comparative analysis, the derived data can be used without adjustment. 6. We used the binary variable of increase/decline in labor productivity. 7. The indicator was calculated as a ratio of sales in 2004 to the number of employees at the beginning of 2005. 8. Specific features of management were not considered, as they may be endogenous and depend on ownership peculiarities. In addition, the effects of management on restructuring are discussed in Chapter 6. 9. The Poisson model indicated that practically all our hypotheses concerning other factors were confirmed. All industrial dummies were significant at the 1% level. A positive effect was observed for the size of a company, its start-up history, and affiliation to company groups (significant at the 1% level), competition with manufacturers from developed market economies (at the 5% level), and severe competition with Russian companies (at the 10% level). Other types of competition (with foreign companies located in Russia or with manufacturers from the CIS countries or market countries including Turkey and China) were not significant. The results of the ordinal regression model are close to the ones presented. 10. The structure of investment sources was evaluated on an aggregated scale. 11. These abbreviations are used in the tables and figures presented in this chapter. 12. In practice, this issue can be resolved by uniting top managers and owners within a single team by offering the former high wages, bonuses, and options, as well as a unique corporate culture. At the same time, research points to a gap that often occurs between this small group and other managers in perceiving the company’s goals and objectives as well as attitudes toward cultural standards (Kabalina 2005).

Bibliography Aukutsionek, S., Dyomina, N., & Kapelyushnikov, R. (2007) Ownership structure of Russian industrial enterprises in 2007, Russian Economic Barometer, 16/3: 3–13. Chernykh, L. (2008) Ultimate ownership and control in Russia, Journal of Financial Economics, 88: 169–192. Deryabina, M. (2001) Restrukturizatsiya rossiiskoi ekonomiki cherez peredel sobstvennosti i kontrolya, Voprosy Ekonomiki, 10: 55–69. Dolgopyatova, T. (2001) Modeli i mekhanizmy korporativnogo kontrolya v rossiiskoi promyshlennosti, Voprosy Ekonomiki, 5: 46–60. Dolgopyatova, T. (ed.) (2003) Russian Industry: Institutional Development (Moscow: SU-HSE Publishing House).

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Dolgopyatova, T. (2007) Corporate ownership and control in Russian companies: Trends and patterns. In: Dallago, B. & Iwasaki I. (eds), Corporate Restructuring and Governance in Transitional Economies (Basingstoke: Palgrave Macmillan). Dolgopyatova, T. & Uvarova, O. (2006) Empiricheskii analiz transformatsii sobstvennosti, effektivnosti i investitsionnoi deyatel’nosti promyshlennykh predpriyatii, Ekonomicheskaya Nayka Sovremennoi Rossii, 1: 89–104. Earle, J. & Telegdy A. (2001) Privatization and productivity in Romanian industry: Evidence from a comprehensive enterprise panel. Discussion paper No. 326. Bonn: Institute of the Study of Labor. Golikova, V. et al. (2003) Spros na pravo v oblasti korporativnogo upravleniya: Empiricheskie svidetel’stva. In: Razvitie Sprosa na Pravovoe Regulirovanie Korporativnogo Upravleniya v Chastnom Sektore, Seriya “Nauchnye Doklady: Nezavisimyi Ekonomicheskii Analiz,” No. 148: 229–239 (Moscow: Moskovskii obshchestvennyi nauchnyi fond i “Proekty dlya budushchego”) (available at: http://www.mpsf.org/lib.html). Grosfeld, I. & Tressel, T. (2002) Competition and ownership structure: Substitutes or complements? Evidence from the Warsaw Stock Exchange, Economics of Transition, 10: 525–551. Guriev, S. et al. (2003) Korporativnoe Upravleniye v Rossiiskoi Promyshlennosti, Seriya “Nauchnye Doklady: Nezavisimyi Ekonomicheskii Analiz,” No. 149 (Moscow: Moskovskii obshchestvennyi nauchnyi fond i Tsenter ekonomicheskikh i finansovykh issledovanii i razrabotok) (available at: http://www.mpsf.org/lib.html). Hanousek, J., Kocenda, E., & Svejnar, J. (2004) Ownership, control and corporate performance after large-scale privatization. Working paper No. 652. Ann Arbor: William Davidson Institute, University of Michigan. Insiders and Outsiders (2004) Insiders, outsiders, and good corporate governance in transitional economies: Cases of Russia and Bulgaria. Working paper No. 2–5. TTPP (available at www.ttpp.info/library). Kabalina, V. (ed.) (2005) Praktiki Upravleniya Personalom na Sovremennykh Rossiiskikh Predpriyatiyakh (Moscow: Institut sravnitel’nykh issledovanii trudovykh otnoshenii). Kapelyushnikov, R. (2001) Sobstvennost’ i control’ v rossiiskoi promyshlennosti, Voprosy Ekonomiki, 12: 103–124. Kapelyushnikov, R. & Dyomina, N. (2005) Vliyanie kharakteristik sobstvennosti na rezul’taty ekonomicheskoi deyatel’nosti rossiiskikh promyshlennykh predpriyatii, Voprosy Ekonomiki, 2: 53–68. Kocenda, E. & Svejnar, J. (2002) The effect of ownership forms and concentration on firm performance after large-scale privatization. Working paper No. 471. Ann Arbor: William Davidson Institute, University of Michigan. Kuznetsov, P. & Muravyev, A. (2000) Struktura aktsionernogo kapitala i rezul’taty deyatel’nosti firm v Rossii: Analiz “golubykh fishek” fondovogo rynka, Ekonomicheskii Zhurnal VShE, 4/4: 475–504. OECD (2006) OECD Economic Surveys: Russian Federation 2006 (Paris: OECD). Panov, A. & Borissov, N. (2006) Samyi glavnyi investor, Vedomosti, February 13: 1. Pervyi Vypusk (2008) Natsional’nyi Doklad po Korporativnomu Upravleniyu (Moscow: Natsional’nyi sovet po korporativnomu upravleniyu). Radygin, A. & Entov, R. (2001) Korporativnoe upravlenie i zashita prav sobstvennosti: Empiricheskii analiz i aktual’nye napravleniya reform. Nauchnye Trudy Instituta Ekonomiki Perekhodnogo Perioda No. 36. Radygin, A. (2001) Sobstvennost’ i integratsionnye protsessy v korporativnom sektore (nekotorye novye tendentsii), Voprosy Ekonomiki, 5: 26–45.

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Razvitie Sprosa na Pravovoe Regulirovanie Korporativnogo Upravleniya v Chastnom Sektore (2008) Seriya “Nauchnye Doklady: Nezavisimyi Ekonomicheskii Analiz,” No. 148 (Moscow: Moskovskii obshchestvennyi nauchnyi fond & “Proekty dlya budushchego”) (available at: http://www.mpsf.org/lib.html). Standard & Poor’s (S&P) (2007a) Issledovaniye Informatsionnoi Prozrachnosti Rossiiskikh Kompanii v 2007 Gody: Znachitel’nye Izmeneniya v Desyatke Liderov (Moscow: Standard & Poor’s, November 14). Standard & Poor’s (S&P) (2007b) Portret Soveta Direktorov Rossiiskoi Kompanii kak Otrazheniye Kontsentrirovannoi Struktury Sobstvennosti Kompanii i Prepyatstvii na Pyti Razvitiya Korporativnogo Upravleniya (Moscow: Standard & Poor’s, March 16). Simachyev, Yu. (2001) Napravleniya i factory reformirovaniya promyshlennykh predpriyatii, Ekonomicheskii Zhurnal VShE, 5/3: 328–348. Stiglitz, J. (1999) Quis custodiet ipsos custodes? Corporate governance failures in the transition. Paper presented at the World Bank’s Annual Conference on Development Economics (ABCDE), Paris, June 1999. Troika Dialog (2008) Who owns Russia? Corporate governance annual (Moscow). Yakovlev, A. (2003) Spros na pravo v sfere korporativnogo upravleniya: Evolutsiya strategii ekonomicheskikh agentov, Voprosy Ekonomiki, 4: 37–50. Yakovlev, A. (2004) Obuchenie deistviem, Ekspert, 3: 44. Yakovlev, A., Golikova, V., Dolgopyatova T., & Simachyev, Yu. (2006) Corporate governance in transition: New trends and challenges, In: Sell, A. & Krylov, A. (eds), Corporate Governance (Francfurt am Main: Peter Lang GmbH). Yasin, E.G. (ed.) (2004) Structural Changes in the Russian Industry (Moscow: SU-HSE Publishing House).

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3 Legal Form of Incorporation Ichiro Iwasaki

Introduction The Russian corporate sector went through a fundamental transition to a capitalist economy triggered by the collapse of the Soviet Union. As of 2005, private corporations accounted for about 65% of the country’s GDP, nearly 88.6% of its industrial production, and about 91.5% of its total employment (EBRD 2005; Rosstat 2007).1 Even though state control over “strategic industries” continues, the overwhelming dominance of state-owned enterprises in the Russian economy is already a thing of the past. In addition, in recent years, there have been a growing number of new market entries by private firms against the background of a remarkable economic recovery, and new small and medium-sized companies led by entrepreneurs of the new generation have been popping up one after another, tapping new markets by filling every niche in the national economy. However, the fact is that Russia’s business sector is mainly composed of former socialist enterprises that underwent corporatization as a result of the mass-privatization policy in the early 1990s followed by the monetary privatization of the largest companies. To achieve the political goal of redistribution of state assets to the general public in an equal manner, these former state-owned enterprises were compelled by law to transform themselves into joint-stock companies (JSCs). Most of their shares were transferred for free or at extremely low prices to citizens, especially to the worker collectives and managers of the enterprises (Blasi et al. 1997). This means that leading Russian business firms were founded in a completely different way from those in the US and other industrialized countries. In addition, considering the underdeveloped financial sector and the premature markets for capital and managers in this country, which has only a short history as a capitalist state, Russian enterprises are in a very peculiar business environment compared to their Western counterparts. The preponderance of closed JSCs in comparison to open JSCs is one of the most distinguishing features of the Russian corporate sector. This 62

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Legal Form of Incorporation 63

phenomenon may be revealed under the special circumstances surrounding Russian enterprises mentioned above. Both open and closed JSCs are statutory legal forms of incorporation, as defined in the Federal Law on Joint-Stock Companies (hereinafter, the Law on JSCs). As we will later detail, these two corporate forms refer to the legal names of the two types of JSCs that are decisively different from each other in terms of share transferability to a third party. All JSCs established in Russia must choose either of the two company types as their statutory organizational form. As of January 1, 2005, there were only 58,400 open JSCs registered in Russia compared with as many as 389,200 closed JSCs.2 Regarding large-scale companies that require raising funds from outside sources, the number of open JSCs exceeds that of closed JSCs, with the latter number still being fairly significant. In fact, a survey conducted in 2003 by the Federal State Statistics Service found that, of the 32,266 JSCs surveyed, excluding micro- and small enterprises, 19,407 were open companies, and the remaining 12,859 were closed ones (Rosstat 2004). In other words, four of every ten medium-sized and large Russian corporations were operating under a governance mechanism that put rigorous restrictions on the liquidity of their own shares. In many developed countries, JSCs are allowed to achieve “virtual” organizational closedness by, for instance, making a special resolution at their general shareholder meeting that bans, in principle, the transfer of their shares to a third party, or by adding a provision to this effect in their corporate charter. For example, in Japan, JSCs intending to make it mandatory for their shareholders to seek their approval for the transfer of their shares must provide a provision to that effect in their corporate charter in accordance with Article 107 of the Company Law, and companies with such a provision are generally called “closed companies.” This practice is common among smaller companies. There is no formal closed JSC as a legal corporate form in the continental European countries either. In the UK, on the other hand, business firms are formally classified according to Company Law into public companies and private companies depending on how they raise funds, and private companies have similar statutory characteristics to those of closed JSCs in Russia. Furthermore, several states in the US have a Company Law that allows closed corporations to impose restrictions on the issuance and transfer of common stock in accordance with a shareholder agreement, in contrast to general corporations. In most of these states, the number of shareholders for closed corporations is strictly limited (e.g., to 30 in Nevada and Delaware and to 50 in Georgia and Wisconsin), as in Russia.3 This suggests that the Russian company law had broken away from the tradition of continental law and boldly incorporated some elements of common law. However, in Russia, there are clear distinctions between closed and open JSCs in terms of not only the restrictions on the number of shareholders but also the modes of securities issuance, the required levels of minimum capital, and disclosure obligations. From this viewpoint, Russia has an extremely

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unique legal framework in comparison with the UK and US. Moreover, as reported above, even though almost all of the Russian leading companies are former state-owned firms, about 40% of them are still operated as closed JSCs after more than 10 years of mass privatization. This highlights the sharp contrast with the situation of closed corporations in the UK and US, most of which are family-run or privately held companies.4 Inspired by the economic theory on internal organization that has been developed from suggestions made by Coase (1937), a large number of empirical studies have been conducted with regard to the determinants of organizational choice and the relationship between organizational form and behavior, including corporate performance (Brickley & Dark 1987; Denning & Shastri 1993; Weir 1996; Harhhoff et al. 1998; Blass & Carlton 2001; Deli & Varma 2002; Arruñada et al. 2004; Damodaran et al. 2005). Surprisingly, however, except for a valuable case study by Karpoff & Rice (1989), there is little empirical work investigating organizational choices by JSCs and their possible impacts on corporate governance and firm performance. Thus, the corporate forms of Russian JSCs are a very important research subject to be explored from the viewpoint of the study of law and economics. Furthermore, this topic is of great significance to understanding the Russian economic system. As long as the primary nature of a public company can be defined as a modern economic mechanism that attracts capital from a wide range of private investors and multiplies their wealth in the most effective way possible, an open company, which guarantees free share transferability, is the basic form of a stock company. In this sense, a closed JSC is one that distances itself from the fundamental purpose of a modern corporation. In addition, agency theory suggests that an open organizational architecture is quite effective in inhibiting the opportunistic behaviors of company managers and disciplining them toward the maximization of shareholder equity under the separation of ownership and management (Fama & Jensen 1983a, 1983b). This can also be said of the modern Russian economy still in transition to a market economy. Nevertheless, as previously reported, the reality in Russia is that not only small corporations but also large enterprises are still being organized and operated as closed JSCs. It is quite possible that the high degree of orientation towards closed organization in the Russian business sector is inseparably linked to its poor corporate governance practices and its investment behavior, which remains inactive regardless of significant economic recovery in recent years. In other words, it is highly likely that there are severe agency problems within these Russian closed companies which prevent the enhancement of their corporate value. In order to redress this situation, it is critical to empirically investigate what factors drive many Russian firms to choose to become closed companies and how much harm is done to corporate management and maximization of shareholder wealth by this choice. Therefore, particular attention should

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also be given to research on the legal forms of incorporation of Russian JSCs in the context of Russian economic studies. To date, there have been only a handful of economic studies touching on this topic, including that of Dolgopyatova (1995), and virtually no detailed research has been conducted in this area. Using the results from the Japan–Russia large-scale enterprise survey – the common empirical base in this book (see Appendix in this book for more details) – we examine a variety of factors as to why Russian firms elect to become closed JSCs. We found that Russian firms tend to choose the closed JSC as their legal form of incorporation due to factors such as significant insider ownership, a strong orientation among managers toward closed organizations, slumping needs for corporate finance, and underdeveloped local financial institutions. The impact of ownership structure on the choice of corporate form by Russian firms exists even when the two elements are explicitly endogenized. The remainder of the chapter is organized as follows: The next section looks into the legal framework regulating the corporate forms of Russian JSCs as well as its significance in the context of corporate management. The third section presents the theoretical mechanism of organizational choices between open and closed JSCs. The fourth section conducts empirical analysis. The last section concludes.

Corporate forms of joint-stock companies in Russia: Institutional framework and its significance for company management In this section, the institutional diversity of open and closed JSCs is discussed, and the significance of each of these two corporate forms is then clarified in terms of company management and how the managers interviewed in this survey perceive the main factors determining their firm’s choice of their current legal form of incorporation. As reported in the Introduction, an investor who intends to establish a stock company in Russia must choose to make it either an open JSC or a closed JSC as required by the provisions of Russian corporate law,5 which provides for statutory distinctions between these two types of corporate forms in the following six areas: (a) share transferability; (b) method for issuing securities; (c) required minimum capitalization; (d) number of shareholders; (e) government funding; and (f) disclosure obligations (see Table 3.1). First, a shareholder of an open JSC may freely transfer his/her shares to any third party other than another shareholder of the company or the company itself; on the other hand, a shareholder of a closed JSC must sell his/ her shares first to another shareholder of the company or the company itself due to the right of preferential purchase. Specifically, a shareholder of a closed JSC who intends to transfer his/her shares to a third party must, at

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Table 3.1 Differences in the legal framework between open and closed joint-stock companies in Russia Open JSC

Closed JSC

Share transferability

No restrictions are imposed on share transfers. No preferred purchase rights may be arranged for any shareholders, including the company, with regard to the transfer of shares to third parties (Art. 7(2)).

The company shareholders have the right to purchase the shares of other shareholders in preference to third parties. The company may only exercise such a preferred purchase right when no shareholder elects to do so (Art. 7(3)).

Share subscription

Open JSCs are incorporated by having all of their shares subscribed by their promoters or by having some of their shares subscribed by their promoters, and the remaining shares subscribed by other investors (Art. 7(2)). After incorporation, they can make a public share placement without any restriction (Art. 39(1) & Art. 39(2)).

Closed JSCs are incorporated only by having all of their shares subscribed by their promoters. All of their shares issued after their incorporation must be offered only to their promoters or persons specified in advance (Art. 7(3) & Art. 39(2)).

Issuance of company bonds

Open JSCs may issue any kind of bonds (including convertible bonds) to the public in accordance with the procedures set by law (Art. 39(2)).

Closed JSCs are prohibited from issuing convertible bonds to the public (Art. 39(2)).

Statutory minimum capitalization requirement

1,000 times the minimum statutory wage on the date of registration (Art. 26).

100 times the minimum statutory wage on the date of registration (Art. 26).

Number of shareholders

No upper limit is placed on the number of shareholders (Art. 7(2)).

The upper limit on the number of shareholders is 50 (Art. 7(3)). However, this limit does not apply to closed JSCs established by the end of 1995 (Art. 94(4)).

State involvement in investment

The state may not become the promoter of a joint-stock company, in principle (Art. 10(1)). However, state agencies may become the promoters of open JSCs in certain cases as provided for by law (Art. 7(4)).

Only former state-owned enterprises and other former municipal enterprises may become the promoters of closed JSCs (Art. 7(4)).

Disclosure requirements

Open JSCs are required to disclose certain information as requested by the law on JSCs and other statutes and by government agencies (Art. 92(1)).

Closed JSCs that issue bonds or securities at the same price and in the same manner as instructed by the Federal Financial Markets Service (FFMS) are required to disclose certain information in accordance with the rules adopted by the FFMS (Art. 92(2)).

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Legal Form of Incorporation

67

his/her own expense, notify all other shareholders of the company and its executives in writing concerning the selling price of the shares by the selling shareholder as well as other terms and conditions included in an agreement between the seller and the purchasing third party. This is done in order to confirm whether any of the other shareholders of the company or the company itself wishes to execute its right of preferential purchase. This obligation enables a closed JSC and its shareholders to detect in advance every action by any shareholder seeking to transfer his/her shares to a third party and to allow the other shareholders to effectively prevent a stock drain to outside parties by bearing the necessary expenses to purchase these shares.6 Second, unlike open JSCs, whose shares issued at the time of formation may be allocated to the company founders and to the general public (i.e., establishment with outside offering), closed JSCs are only required to issue their shares to their founders and to other investors specified in advance. Even after incorporation, closed JSCs are not allowed to offer new shares to the general public, although they may issue corporate bonds other than convertible bonds on the securities market as a means of raising funds from outside sources. Third, the minimum capitalization (share capital) for open JSCs needs to be at least 1,000 times the statutory minimum wage at the time of their registration, while closed JSCs are required to secure only 100 times the statutory minimum wage. For example, the effective statutory minimum wage for the period from January to August 2005 was 720 rubles (about $25) monthly.7 Therefore, there is a difference of 648,000 rubles (about $23,000) between these two legal forms of JSCs established during this period with respect to their minimum share capital as required by the Law on JSCs, not a trivial difference for small and venture businesses seeking incorporation. Fourth, closed JSCs may not have more than 50 shareholders. If the number of shareholders exceeds this limit, they must reduce it to 50 or less, turn it into an open JSC, or dissolve within a period of one year. However, this regulation does not apply to closed companies established by the end of 1995 before the enforcement of the current law on JSCs. This is primarily because of the consideration given to former state-owned enterprises that transformed into JSCs during the course of the mass-privatization policy implemented in the early 1990s. In addition, the August 1996 presidential decree, in which closed JSCs with more than 25% of their shares owned by the government were ordered to become open companies to accelerate the sales of state-owned shares, was not a very strong legally binding instrument, since no effective penalties or sanctions were imposed on those violating the decree (Iwasaki 2007a).8 As a result, there are still a large number of closed JSCs with 50 or more shareholders, many of which are either former state-owned enterprises and ex-municipal companies that were privatized in the process of the mass-privatization policy launched in the early 1990s or affiliates of private firms and brand-new companies opened in those days.

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68


Fifth, no state authority, including a local government, can be the founder of a JSC in principle. In addition, even when a JSC is established by a government or state organization using a company separation package in which the newly established joint company inherits the assets of the government or state organization, that newly established company must be an open JSC. However, this regulation does not apply to cases in which a corporation is established by a government or state agency as a result of its separation from a privatized firm. This is one of the reasons that there are still many closed JSCs whose shares are held by the state. Last, open JSCs are obliged to disclose information such as annual business reports, financial statements, asset securities reports, and other materials required by statute or requested by the Federal Financial Markets Service (FFMS) and other government authorities.9 On the other hand, closed JSCs are not subject to such disclosure requirements, except in cases in which they issue bonds and other securities using the schemes and prices specified by financial authorities. Meanwhile, as pointed out by Emery et al. (1988) and Gordon & MackieMason (1994), tax distortion can have a significant impact on the decisionmaking process for investors and enterprises concerning organizational choices. However, in Russia, there is no rule similar to that of the “S” corporation in the US,10 and there are no differences in the applicable tax provisions between open and closed JSCs, including the corporate profit tax and the personal income tax on dividend earnings from invested companies. Both of these corporate forms are regulated by the principle of equal taxation with respect to corporate ownership, investors, and capital sources.11 Moreover, Russia has no provisions set out in the Federal Law on Bankruptcy, the Corporate Governance Code, or any other legislation that could seriously affect the choice of the corporate form by a JSC. The results of the Japan–Russia joint enterprise survey, in which company executives were asked to explain how they perceived the significance of the aforesaid legal framework in the context of their corporate management as well as to indicate the most important reason for them to keep their company in the current corporate form, revealed that many of the respondents recognized that the choice between an open and a closed JSC had a considerable impact on their management strategies. Of 793 firms that provided valid responses to the survey, 602 (75.9%) replied that their corporate-form choice would or might affect their business development; this is far more than the 191 (24.1%) that answered that there was no connection between these two factors. The difference between the group of open JSCs and the group of closed JSCs covered in the survey regarding the proportion of firms that confirmed a connection between their organizational choice and their business development is statistically significant at the 10% level (2 3.209, p 0.073), but, in actuality, it was quite small (77.8% vs. 72.0%). Of the 602 firms that said that their performance was influenced by their corporate

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69

form, 518 (86.0%) perceived such an influence to be positive for their business growth, many more than the 84 firms (14.0%) that regarded it as negative. The difference between the group of open JSCs and the group of closed JSCs regarding the number of firms that positively perceived such an influence on their performance was very small (85.7% vs. 86.7%) and not statistically significant (2 0.098, p 0.754). Regardless of the difference in the corporate form of their companies, a great number of corporate executives see an inseparable relationship between their organizational choice and business activities. Table 3.2 summarizes the answers given by company managers to a question about the comparative advantages of each of the two corporate-form options. Of the enterprises reporting that open JSCs were institutionally superior to closed JSCs, 395 firms (68.3%) answered that open JSCs were better than closed JSCs in building a reliable relationship with investors and partners or in raising funds from outside financial sources. This number is greater than the number of firms reporting that an organizational advantage of open JSCs is the flexibility of share transfers, which reflects their current focus. A substantial and statistically significant difference is evident between the open and closed JSCs in the breakdown of their answers to this question. Compared with the respondents of open JSCs, those of closed JSCs pay more attention to the fact that open JSCs enjoy good fundraising capabilities. At the same time, however, there are many managers of closed JSCs who do not see any advantage in the corporate form of open JSCs. As for closed JSCs, most executives, regardless of whether they are working for closed or open JSCs, agree that closed companies can more effectively prevent their firms from transferring stocks to outsiders and avoid the threat of hostile takeovers. There is no remarkable difference between the two company groups in the breakdown of their answers to the above question. Table 3.3 contains the results of the answers of our respondents to the question of what was the most important reason for their companies maintaining their current corporate form. Compared with 11.8%, who identified it as being related to legal restrictions concerning the number of shareholders and the minimum required capital, 75.5% replied that it was because of the mass-privatization policy in the early 1990s or because of a management decision made on their own or by their shareholders. The result that 54.4% of the open JSCs reported that they had become open JSCs due to the mass-privatization policy is quite understandable, given that the Federal Government had strongly encouraged soon-to-be-privatized enterprises to become open JSCs by facilitating a swap between privatization vouchers distributed to the general public free of charge and the shares of state-owned and municipal enterprises. On the other hand, in consideration of the fact that managers are still the dominant shareholders in many Russian firms and in light of the strong orientation of these company insiders toward organizational closedness, it is reasonable for them to favor a closed JSC

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Total

49.0 6.0 0.0 18.2 100.0

350 43 0 130 714

100.0

753 8.4 18.3

12.7 0.3 23.2

96 2 175

60 131

11.3 21.2

85 160

464

0 95

29

218

30 92

527

67 2 99

60 97

202

No. of affirmative respondents

Open JSCs

100.0

0.0 20.5

6.3

47.0

6.5 19.8

100.0

12.7 0.4 18.8

11.4 18.4

38.3

Share (%)

250

0 35

14

132

30 39

226

29 0 76

25 63

33


100.0

0.0 14.0

5.6

52.8

12.0 15.6

100.0

12.8 0.0 33.6

11.1 27.9

14.6

Share (%)

Closed JSCsa

Source: The joint enterprise survey.

a

Notes: Closed JSCs include four workers’ joint-stock companies (people’s enterprises). b Test for the equality of the composition of the responding firms by corporate form that gave a positive answer to each item: 2 = 51.079 (p = 0.000). c Test for the equality of the composition of the responding firms by corporate form that gave a positive answer to each item: 2 = 12.480 (p = 0.014).

Total

(b) Advantages of closed JSCs over open JSCsc Managers can effectively control companies. Very strict regulations imposed by the state on open joint-stock companies can be avoided. The transfer of stock to outsiders can be prevented, and companies are protected from hostile takeover. Even a small-scale enterprise could be set up as joint-stock company. Others There is no comparative advantage.

31.2

Share (%)

235


All companies

Comparative advantages of open and closed companies over an alternative corporate form of joint-stock company

(a) Advantages of open JSCs over closed JSCsb Company transparency can be emphasized to business partners and investors. Corporate governance can be improved. Better access to financial markets and increased ability to attract potential investors Shareholders may sell stocks freely. Others There is no comparative advantage.

Table 3.2

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21 73 791

Time and cost of changing the corporate form

Others

Total

100.0

9.2

2.7

0.9

31.4

44.1

11.8

535

40

10

3

133

291

58

Share No. of affirmative (%) respondents

Open JSCs

100.0

7.5

1.9

0.6

24.9

54.4

10.8

Share (%)

256

33

11

4

115

58

35


Closed JSCsa, b

100.0

12.9

4.3

1.6

44.9

22.7

13.7

Share (%)


a

Notes: Closed JSCs include four workers’ joint-stock companies (people’s enterprises). b Test for the equality of the composition of the responding firms by corporate form that gave a positive answer to each item: 2 = 74.240 (p = 0.000).

7

248

Judgment by the managers and shareholders

Lack of consensus among managers and shareholders

349

Mass-privatization policy for state-owned enterprises

93


All companies

Most important reason for being in the current corporate form

Legal restrictions on the number of shareholders, minimum required capitalization (minimum share capital)

Table 3.3


as the legal form of incorporation for their company due to the uncertain social environment typical of a period of transition.

Choice of corporate form: Theoretical consideration In Russia, the growing trend toward a market economy and its integration into the global economy is forcing domestic firms to tackle the issue of optimal adaptation to ever-changing business environments. Hence, it is not uncommon for Russian corporations to make a major change in their company profile, including their form of incorporation.12 For instance, companies change from limited to joint-stock stature and vice versa much more frequently than they do in Western countries. Needless to say, transformations from open JSCs to closed JSCs and vice versa take place all the time, although the latter can only take place by amending the company charter through a special resolution at a general shareholders’ meeting and then officially registering such an amendment (Tikhomirov 2001: 91). Although the law on JSCs stipulates that the amendment of a company charter must be made through a special resolution passed by a majority of at least three-fourths of the votes cast by the shareholders with voting shares in attendance, this provision is not a serious obstacle to such amendments. This is due to the fact that, in many Russian companies, a small number of shareholders own a significant amount of the total shares, which means that, for the top management and major shareholders of Russian stock companies, the issue of whether their firms should be open or closed JSCs is just an “operational” variable, even after their establishment. The discussion in the previous section highlights the differences between open and closed JSCs as a corporate-form option available in Russia and the significance of these two corporate forms from the viewpoint of corporate management as well as the impact of the mass-privatization policy on the decision-making process of stock-issuing companies with respect to whether they should be open or closed JSCs. Based on these facts revealed by our enterprise survey, this section theoretically considers the organizational choice mechanism of Russian corporations. According to the economic theory of the organization and the firm advocated and developed by Alchian & Demsetz (1972), Jensen & Meckling (1976), Mayers & Smith (1981), Williamson (1985, 1996), Milgrom & Roberts (1992), Jensen (2000), Furubotn & Richter (2005), and others, the differences between the institutional settings of open and closed JSCs would affect the incentives and decision-making processes of corporate managers and shareholders with respect to their choice of corporate form through the following three mechanisms. The first mechanism is the asset effect of restrictions on share transfers; that is, any restrictions imposed on a closed company’s share transfers will undermine the liquidity and value of such shares as financial commodities.

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Furthermore, as explained in the previous section, a shareholder of a closed JSC intending to transfer his/her shares to a third party must bear all the costs needed to confirm if any of the other shareholders in the closed JSC or the company itself wishes to execute their right of preferential purchase. Therefore, those who invest money mainly to gain a capital return on their investment (i.e., portfolio investors) will buy the shares of open JSCs rather than those of closed JSCs, all else being equal. By the same logic, corporate executives would prefer the corporate form of an open company from the standpoint of issuing securities to raise funds from outside sources, since a closed company must pay for all the marginal capital costs equal to the transaction costs for the transfer of its own shares to a third party and the cost of a low liquidity premium on its own shares. Closed JSCs are further placed at a disadvantage over open JSCs due to the ban on issuing any convertible bonds. Furthermore, as indicated in Table 3.2, choosing to adopt the open company as its legal form of incorporation will increase the transparency of a firm’s management, making it easier for the firm to receive loans from banks and other financial institutions. Considering the above, we hypothesize that the higher a firm’s fundraising demand, the more likely it is to be operated as an open JSC. The second mechanism is the governance effect of share transfer restrictions. Tight restrictions imposed on a closed JSC as to the transfer of its shares significantly decrease the possibility of a change in its internal control or ownership that might otherwise come about due to an “exit” from the company of its shares sold, a tender offer, a proxy fight, or a bankruptcy. Such restrictions pose a serious impediment to the reshuffling of a management body that has failed to institute effective corporate discipline and achieve the expected results. Therefore, from the standpoint of which corporate form has a relatively better corporate governance mechanism, shareholders are more inclined to invest in open JSCs. On the other hand, as illustrated in the previous section, the understanding by corporate executives that the biggest advantage of a closed company lies in the protection it offers against outside environments suggests that they have a strong inclination towards managerial entrenchment that enables them to eliminate supervision and intervention from outside as much as possible and to avoid external discipline. Accordingly, we predict that corporate managers who wish to retain their managerial discretion to behave in an opportunistic way or who wish to avoid the risk of outsiders attempting a hostile takeover will choose to establish and maintain their firms as closed stock companies. The third mechanism is the information effect of state disclosure regulations. The disclosure obligation imposed only on open JSCs by the state produces the effect of alleviating the information asymmetry between executives and investors in favor of the latter. This, in turn, causes more shareholders to invest in open JSCs, which have a better governance system than closed JSCs, and more managers to operate their firms as closed companies. The discussions on both the second and the third mechanisms as to the organizational

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choice of a corporate form can be summarized in the following hypothesis: the influence of nonmanagerial shareholders increases the possibility of firms becoming open JSCs as their organizational choices, while, on the other hand, the influence of managers increases the possibility of firms becoming closed JSCs. In addition to the three mechanisms above, it is necessary to focus on the widespread existence of business groups (i.e., financial-industrial groups or holding companies) as a factor having a significant impact on the organizational choices between open and closed JSCs in Russia.13 In fact, the joint survey revealed that 35.7% of the manufacturing companies (268 of 751 firms) and 77.5% of the communications companies (55 of 71 firms) were controlled by certain business groups through shareholding. From this point of view, a fourth mechanism of organizational choice may be imposed; that is, a company’s participation in a business group is effective in protecting it from outside threats, especially intervention into company management by state administrations and public bureaucrats, which is a serious problem for Russian firms. This is due to the political countervailing power of the business group the company belongs to and the corrective cohesion among member firms (Iwasaki & Suzuki 2007). As a result, the organizational advantages of a closed JSC as an “institutional defense barrier” may become less important for managers of group companies. Furthermore, it is undesirable for management of a holding company or a core company of a business group to impose severe restrictions on the transfer of shares by its controlling companies, not only from the standpoint of a large shareholder of the group firms but also from that of the group’s goal of ensuring effective asset management within the group. Therefore, we assume that a firm’s participation in a business group increases the possibility of the firm being operated as an open JSC. However, with the hierarchy within such business groups expanding, enterprises in the lower echelons are more likely to be established by their hierarchically upper companies as wholly owned subsidiaries or dummy firms for account-rigging or tax evasion purposes, and these enterprises are usually closed companies bound by less strict disclosure obligations. Consequently, we also predict that the organizational scale of a business group is positively correlated with the proportion of closed JSCs in the member firms of that group. Lastly, as explained above, taking into account the background of Russia’s privatization policy and its legal restrictions on state investment, the past policies on company start-ups may have a historical path-dependent impact on organizational choices between open and closed JSCs. This is the fifth mechanism. From this consideration, we hypothesize that privatized enterprises and companies separated from state-owned or municipal companies are more likely to choose to operate as open JSCs in comparison with private companies newly established after the fall of the communist regime. In summary, Russian stock companies branch away to either open JSCs or closed JSCs through the interaction of the aforementioned five mechanisms of organizational choice.

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75

Empirical analysis In this section, we empirically test the theoretical mechanism of making a corporate-form choice discussed in the previous section, as well as its impact and statistical significance of choosing each alternative. We estimate our organizational choice models by probit methods using a discrete variable, which takes a value of 1 for closed JSCs as the dependent variable (CLOCOM), as well as adapting the following independent variables: (a) ownership variables representing the influence of shareholders and managers over organizational strategies, (b) variables concerning the constraints affecting capital demand and supply of the company; (c) variables regarding the linkage between a company with a business group and the organizational scale of that group; (d) variables concerning the impact of past policies on company start-ups; and (e) other control variables. Variables The variables of outside ownership utilized in our estimation are the 6-point-scale ownership share of nonmanagerial shareholders excluding domestic individuals (OWNOUT) and that of the state (OWNSTA) and private shareholders (OWNPRI), each of which is further classified into the federal government (OWNFED), regional and local governments (OWNREG), commercial banks (OWNBAN), investment funds and other financial institutions (OWNFIN), nonfinancial corporate shareholders (OWNCOR), and foreign investors (OWNFOR). As for managers, a large management shareholder dummy (MANSHA) is adapted. In it, if a manager or group of managers is a major shareholder of his or her own company, that company is assigned a value of 1.14 The variables used as proxies of a company’s capital demand are a securities-issuing planning dummy (SECPLA). In it, if the company has a plan to issue securities in Russia in the near future, it is assigned a value of 1, whereas, if the company has a plan to issue shares and bonds in foreign financial markets, where more stringent rules than those in Russia are enforced with respect to organizational management and disclosure, it is assigned a value of 2. If neither of these two conditions applies, it is assigned a value of 0. A relationship-banking dummy (RELBAN) is used for companies with a long-term credit relationship with a certain commercial bank. On the other hand, as a proxy for representing the constraints affecting the capital procurement of a company, the number of financial institutions per 1,000 nonfinancial corporations in a federal district where the company is located (NUMFIN) is introduced. NUMFIN is used because, except in a few big cities, local commercial banks and investment firms play a critical role in the field of investment financing and financial consulting services for the corporate sector, and the development of these local financial institutions is an overriding factor affecting the fundraising abilities of local companies.

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The variables for the relationship between a company and the business group to which the company belongs are a group firm dummy (GROFIR) assigned a value of 1 if the company is a member of a certain holding company or another business group by owning stocks; and a core corporation dummy (GROCOR) and an affiliate firm dummy (GROAFF), both of which reflect the characteristics of the company’s group membership. The organizational size of the business group is represented by the natural logarithm of the total number of its member firms (GROSIZ). The impact of past policies on company start-ups is assessed using two dummy variables from the standpoint of the importance of the massprivatization policy and the statutory regulations on investments by state agencies. Namely, PRICOM is assigned a value of 1 if the company is a privatized firm of a former state-owned or ex-municipal enterprise. SPIOFF captures firms spun off from state-owned enterprises or privatized companies.15 The control variables include the natural logarithm of the total number of employees representing the company size (COMSIZ) and a series of industry dummy variables that control industrial fixed effects. Univariate analysis In accordance with our theoretical considerations in the previous section, we expect that the ownership by nonmanagerial shareholders represented in OWNOUT and other variables restrains companies from being closed JSCs; in other words, outsider ownership is negatively correlated with the choice of a closed JSC. The sign of MANSHA cannot be specified at this stage, as it varies depending on which element is more powerful: the marginal assessment value of shares owned by a manager or a group of managers or the additional benefits the manager obtains by operating a closed company. All three variables concerning capital demand and supply are expected to be negative. The three dummy variables representing a company’s participation in a business group would be negatively correlated with the company’s choice of the corporate form of a closed JSC, whereas GROSIZ would have a positive sign. PRICOM and SPIOFF, both of which reflect the impact of past policies on company start-ups, would be negative. COMSIZ is also expected to be negative; this is because the larger the size of a company is, the more shareholders and the more capital the company has, and the requirements for choosing the corporate form of an open JSC are thus gradually fulfilled. Table 3.4 compares open and closed JSCs using the above independent variables. Open JSCs, regardless of their type, have a higher average outside ownership than closed JSCs, and the difference between the two forms of incorporation in this regard is statistically significant at the 5% or less significance level for all types of nonmanagerial shareholders. In contrast, the percentage of companies with large numbers of management shareholders in all samples of closed JSCs is 15% higher than that of open JSCs, and the difference between them is statistically significant at the 1% level.

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Outsider ownership share (OWNOUT) State ownership share (OWNSTA) Federal government agencies (OWNFED) Regional and local government agencies (OWNREG) Private ownership share (OWNPRI) Commercial banks (OWNBAN) Investment funds and other financial institutions (OWNFIN) Non-financial corporations (OWNCOR) Foreign investors (OWNFOR) Proportion of firms with a large managerial shareholder (shareholder group) (MANSHA) Proportion of firms planning to issue securities in the near future (SECPLA) Proportion of firms with a long-term credit relationship with a certain commercial bank (RELBAN) Proportion of member companies of a business group (GROFIR) Proportion of core corporations of a business group (GROCOR) Proportion of affiliated companies of a business group (GROAFF)

Variablesa

2.21 0.66 0.49 0.23 1.72 0.19 0.31 1.06 0.37 0.43 0.12 0.85 0.41 0.05 0.35

527 449 529 553 553 553

1.00 0.00 0.00 0.00

0.00

0.00

2.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

Mean/ Median proportion

448 473 480 478 449 470 465 463 469

N

Open JSCs

256 269 269 269

256

255

223 236 238 237 223 231 233 237 234

N

Continued

1.00### 0.00 0.00 0.00

0.76††† 0.36 0.06 0.31

1.00###

0.58†††

0.00

0.00### 0.00### 0.00### 0.00### 0.00### 0.00### 0.00### 0.00### 0.00 ##

1.18*** 0.12*** 0.09*** 0.05*** 1.06*** 0.07** 0.09*** 0.69*** 0.31

0.08

Mediand

Mean/ proportionc

Closed JSCsb

Table 3.4 Comparison between open and closed joint-stock companies regarding the ownership structure, capital demand and supply constraints, relationship with business groups, past policies on company start-ups, and company size

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Continued

7.67 0.78 0.09 2414.77

553 553 553

0.00 600.00

1.00

0.00

Mean/ Median proportion

536

N

Open JSCs

269 269

269

261

N

0.00 300.00###

1.00###

0.51††† 0.11 794.19***

0.00

Mediand

9.98

Mean/ proportionc

Closed JSCsb


Notes: a “Ownership share” means an ownership share rated on the following 6-point scale: 0: 0%; 1: 10.0% or less; 2: 10.1 to 25.0%; 3: 25.1 to 50.0%; 4: 50.1 to 75.0%; 5: 75.1 to 100.0%. OWNOUT and OWNPRI exclude ownership by domestic individual shareholders. MANSHA, SECPLA, RELBAN, GROFIR, GROCOR, GROAFF, PRICOM and SPIOFF are dichotomous variables, which take a value of 1 to corresponding firms. b Workers’ joint-stock companies (people’s enterprises) are excluded from observations. c *** : The difference of the means in comparison with open JSCs is significant at the 1% level according to the t-test (the Welch test was performed instead of the t-test when the null-hypothesis that the two samples have the same population variance was rejected by F-test for homoscedasticity), **: at the 5% level; †††: The difference of the proportions in comparison with open JSCs is significant at the 1% level according to the 2 test. ### : The difference in comparison with open JSCs is significant at the 1% level according to the Wilcoxon rank-sum test, ##: at the 5% level

Total number of member companies of a business group that a company belongs to (GROSIZ) Proportion of former state-owned or ex-municipal privatized firms (PRICOM) Proportion of firms that separated from a state or privatized company (SPIOFF) Average number of employees (COMSIZ)

Variables a

Table 3.4


Furthermore, the differences between open and closed JSCs regarding the proportion of companies having a long-term credit relationship with a specific commercial bank, the proportion of privatized firms, and the average number of employees are also statistically significant and consistent with our theoretical hypotheses. The remaining variables need to be reexamined using a regression analysis technique, since their statistical significance was not detected by simply comparing the descriptive statistics. Multivariate regression analysis The basic sample for our estimation consists of 557 observations, excluding all stock companies that have already issued securities in the past (Sample type I). In order to validate the robustness of the estimation results, a supplementary estimation is performed using the following three cases: Sample type II, which is made up of the firms included in Sample type I excluding all communications firms; Sample type III, which excludes firms whose number of employees exceeds the mean of the number of employees of the closed JSCs plus/minus 1 standard deviation from the basic sample set; and Sample type IV, which consists of firms with a stable ownership structure that did not experience changes in major shareholders from 2001 to 2004. An estimation using the former two cases focuses on the estimation bias arising from the characteristics of newly emerged telecommunication businesses and those of mega corporations. On the other hand, the estimation using Sample type IV deals with the possible endogeneity relating to corporate forms and ownership structures. As an alternative way to deal with the endogeneity of two elements, we also conducted a two-stage probit estimation16 by introducing the following four variables to be utilized as additional instruments together with all exogenous variables in the right-hand side on the first stage of regression: a dummy variable of shareholding by an incumbent CEO (or president) (CEOSHA); a dummy variable that is assigned a value of 1 if there is a shareholder or a shareholder group that substantially controls corporate management (DOMSHA); the age level of the CEO or company president (CEOAGE); and a three-point-scale assessment of the intensity of competition with domestic firms in a product market (COMDOM).17 The White’s estimator of heteroskedasticity-consistent standard errors is used for various statistical tests. The following is the basic equation of our regression, and the marks in parentheses stand for the expected signs: Pr[CLOCOM = 1] = F(constant, OUTOWN(-), MANSHA(?), SECPLA(-), RELBAN(-), NUMFIN(-), GROFIR(-), GROSIZ(+), PRICOM(-), SPIOFF(-), COMSIZ(-), industry dummies) Table 3.5 shows the estimation results.18 The coefficients of the independent variables represent their marginal effects.

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SECPLA

MANSHA

OWNFOR

OWNCOR

OWNFIN

OWNBAN

OWNPRI

OWNREG

OWNFED

OWNSTA

OWNOUT

Model

Sample constraintsa

0.100** (0.05) 0.131* (0.07)

0.055*** (0.01)

[1]

Type I

0.093** (0.05) 0.124* (0.07)

0.041*** (0.01)

0.120*** (0.03)

[2]

Type I

0.023 (0.05) 0.071 (0.04) 0.057*** (0.01) 0.019 (0.03) 0.099** (0.05) 0.129* (0.07)

0.106*** (0.03) 0.143*** (0.04)

[3]

Type I

CLOCOM

0.104** (0.04) 0.113 (0.08)

0.058*** (0.01)

0.056*** (0.01)

0.102** (0.05) 0.133** (0.07)

[5]

Type II

[4]

Type I

Probit regression analysis of the corporate-form choice model

Dependent variable

Table 3.5

0.105** (0.05) 0.116 (0.08)

0.058*** (0.01)

[6]

Type III

0.110** (0.05) 0.175* (0.10)

0.050*** (0.01)

[7]

Type IV

0.210* (0.11) 0.124** (0.06)

0.169** (0.07)

[8]

Type I

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557 0.19 295.70

0.098** (0.05) 0.390*** (0.06) 0.173*** (0.06) 0.062** (0.03) Yes

0.148 (0.06) 0.188** (0.06) 0.217** (0.10)

555 0.20 290.69

0.088* (0.05) 0.383*** (0.06) 0.162** (0.06) 0.058** (0.03) Yes

0.153** (0.06) 0.191*** (0.07) 0.216** (0.09)

555 0.21 286.06

0.085* (0.04) 0.403*** (0.06) 0.166*** (0.06) 0.060** (0.03) Yes

0.146** (0.06) 0.194*** (0.07) 0.209** (0.09)

557 0.19 295.44

0.232*** (0.08) 0.196** (0.10) 0.094** (0.05) 0.394*** (0.06) 0.178*** (0.06) 0.064** (0.03) Yes

0.149** (0.06) 0.192*** (0.06)

525 0.16 283.83

0.084* (0.05) 0.376*** (0.06) 0.160*** (0.06) 0.049* (0.03) Yes

0.138** (0.06) 0.164** (0.07) 0.179* (0.10)

534 0.19 284.18

0.115** (0.05) 0.388*** (0.06) 0.168** (0.07) 0.070** (0.03) Yes

0.158** (0.06) 0.185*** (0.07) 0.253*** (0.09)

389 0.17 211.91

0.067 (0.07) 0.423*** (0.07) 0.200*** (0.07) 0.068** (0.03) Yes

0.134* (0.07) 0.142 (0.08) 0.169 (0.14)

527 0.17 282.43

0.122** (0.05) 0.392*** (0.06) 0.180*** (0.06) 0.037 (0.03) Yes

0.143** (0.07) 0.146** (0.07) 0.225** (0.09)

Source: Author’s estimation. The number of financial institutions per 1,000 firms in the location (NUMFIN) was calculated by the author based on Rosstat (2005) and CBR (2005). Other variables are based on the results of the joint enterprise survey.

Notes: a Type I: basic sample (available observations without firms that already issued securities in the past); Type II: excluding communications firms from the basic sample; Type III: excluding those with the total number of employees exceeding the mean of number of employees of closed JSCs (794.19 person) plus/minus 1 standard deviation (3,149.14) from the basic sample; Type IV: excluding those that experienced a change in the major shareholders from 2001 to 2004 from the basic sample. *** : significant at the 1% level, **: at the 5% level, *: at the 10% level.

N Pseudo R 2 Log likelihood

Industry dummies

COMSIZ

SPIOFF

PRICOM

GROSIZ

GROAFF

GROCOR

GROFIR

NUMFIN

RELBAN


Except for the variables representing ownership by financial institutions including commercial banks and foreign ownership, all of the explanatory variables for Models 1 through 4 estimated using the basic sample have the predicted signs with high statistical significance.19 The presence of nonmanagerial shareholders diminishes the probability that an investmenttarget firm will become a closed JSC. Another interesting aspect is that the marginal effect of state involvement is much stronger than the influence of private owners. The impact of capital demand and the development of local financial institutions also reduce the probability of the choice of closed JSCs. Companies linked with a business group through ownership tend to choose to become open JSCs. However, the larger a business group becomes, the higher the number of closed companies that are included among its member firms. Privatized firms are more likely to be open companies, as are JSCs spun off from state-owned or municipal enterprises or from other privatized companies. In addition, as the size of a company grows, the likelihood of the company operating as a closed JSC significantly decreases. On the other hand, the result that a large management shareholder dummy (MANSHA) is significant and positive illustrates a special characteristic of the Russian economy. This implies that Russian managers place far more importance on maintaining effective control of their company than on obtaining capital gains by having stock in their companies. Furthermore, it suggests that they have a strong desire to prevent outside intervention by their company management and discipline by shareholders, even at the cost of a somewhat reduced value and lowered transferability of their own shares.20 In other words, as suggested by agency theorists who elucidate the behavioral pattern of company executives in the developed countries, the inclination toward managerial entrenchment is also significant among Russian managers. Furthermore, this result clearly demonstrates that the most attractive reason for Russian managers to operate their firms as closed JSCs is the variety of fringe benefits they obtain by doing so. Even at the time of the joint survey, which was 14 years after the systemic transformation to a market economy, it was highly likely that many corporate executives still held such perceptions, given the underdeveloped capital and managerial markets in the Russian economy. It is logical that the SECPLA for Models 5 and 6 is slightly less significant than that for the other models since the sample set does not include any communications companies,21 which represent the emerging industry in Russia, or the largest corporations, which have substantial financial needs and are highly motivated to raise equity capital. It is not surprising that the GROFIR and GROSIZ for Model 7 are insignificant, considering that an impressive 46.4% of the surveyed firms (110 of 237) that experienced a substantial change in their ownership structure from 2001 to 2004 were almost group firms. What is more important from the viewpoint of the statistical robustness of the estimation results is that the explanatory power and

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significance of the ownership variables in Model 7 are almost at the same level as those of the estimates for Model 1.22 In addition, the result of a twostage probit estimation of Model 8 also strongly suggests that there is an empirical relation between the corporate form and the ownership structure even if we assume that both of them are determined endogenously.

Concluding remarks In Russia, an overwhelming number of JSCs choose to become closed companies despite the fact that this corporate form strays far from the primary nature of stock companies, that is, an economic mechanism intended to raise capital from a wide range of private investors and increase shareholder wealth as effectively as possible. This trend is equally obvious for medium-sized and large enterprises in the manufacturing and communications sectors. In this chapter, we attempted to conduct theoretical and empirical examinations on this quite interesting economic phenomenon using the results of the Japan–Russia large-scale joint enterprise survey. We illustrated the mechanism behind the organizational choice between two alternative corporate forms and identified the following four factors that encourage many Russian firms to be closed: (a) a widespread insider-dominating corporate ownership structure emerging as a result of the mass-privatization policy; (b) a strong orientation among managers toward closed corporate organization due to the underdeveloped capital and managerial markets; (c) slumping needs for corporate finance; and (d) insufficient financial support from local financial institutions. The empirical relation between ownership structure and corporate form does exist even if the endogeneity of the two elements is assumed. The fact that the above four factors still have a significant impact on the behavioral patterns of Russian corporations even after well over a decade since the collapse of the Soviet Union is a reminder of the difficult and timeconsuming transition process from a centrally planned to a market-based economic system. We also found that, in addition to the four determinates outlined above, the historical path-dependency of the enterprise privatization in the early 1990s and the intense formation of business groups, both of which represent peculiarities of the transforming Russian economy, have a significant impact on the choice of corporate form by Russian firms.

Acknowledgments The research was financially supported by the Japan Securities Scholarship Foundation (JSSF), the Foundation of Japan Legislation Society, and grants-in-aid for scientific research from the Ministry of Education and Science of Japan (Nos. 16530149 and 17203019) in FY2004–8. I also thank Naohito Abe, Tatiana G. Dolgopyatova, Martin Gilman, Satoshi Mizobata,

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Andrei A. Yakovlev for their valuable comments and suggestions. Needless to say, all remaining errors are mine.

Notes 1. Including companies of mixed ownership. 2. According to unpublished official statistics. 3. For more details, see the studies on comparative law by Kraakman et al. (2004) and McCahery et al. (2004). Concerning closed corporations in the US, Allen & Kraakman (2003), Pinto & Branson (2004), and Mitchell & Mitchell (2006) provide detailed descriptions and useful case studies. 4. For instance, an overwhelming majority of US closed corporations are familyowned firms that represent 95% of all American businesses and are responsible for about 50% of US employment (Bauman et al. 2007: 339). 5. These provisions refer to the Civil Code, Part I, chapter 4, Articles 96 to 104, and to the Law on JSCs. This section was written taking into account the laws and regulations that were effective in Russia during the period in which the enterprise survey was conducted and which was used as the base material for this empirical study. 6. Article 7 of the Regulations for Joint-Stock Companies approved by the Resolution of the RSFSR Cabinet of Ministers No. 601 of December 25, 1990, which was later replaced by the current Law on JSCs, provided that the shareholders of a closed JSC were prohibited from transferring their shares without the approval of the majority of all the shareholders of that closed JSC. The share transfer restriction provided in the Law on JSCs now in effect is less severe than that in the Regulations for Joint-Stock Companies that was in force until the end of 1995. 7. Refer to Article 1 of the amended Federal Law on Minimum Wages of December 29, 2004. 8. Refer to the Presidential Decree on Measures to Protect the Rights of Shareholders and to Ensure the Interests of the State as an Owner and Shareholder of August 18, 1996. This decree lost its effect in February 2005 with the amendment of the Bankruptcy Law. 9. After the Russian government adopted International Accounting Standards (IAS) in 1997, the nation’s accounting system saw some improvements every year in compliance with the Generally Accepted Accounting Principles (GAAP) for industrialized countries. However, there are still some problems in terms of the accuracy and transparency of disclosed company information because of the failure to enforce the IAS at all enterprises as well as because of the insufficient number of auditing firms and accountants (Saito 2003; Iwasaki 2007a). 10. In the US, a company with an “S corporation” status granted by the Internal Revenue Service (IRS) may file a composite tax return of corporate income and loss together with stakeholder’s personal income in order to prevent double taxation of corporate profits for general corporations and personal income tax for dividends. 11. Refer to Article 3 of Part I of the Tax Code. Although it is not reported in Article 3, it is widely recognized that the principle of equal taxation is construed to be applicable to both open and closed JSCs (Abrosimov et al. 2005: 10). In fact, in Russia, joint-stock companies are treated in the same way as limited and other types of companies in terms of taxation.

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85

12. In fact, experts at the Levada Center Social Research Institution who assisted with the enterprise survey, drawing upon their experience with panel surveys conducted before and after 2005, confirmed that only about 600 to 700 of 1,000 firms could claim that their company profile was nearly unchanged for a period of 3 years after being surveyed. The remaining 300 to 400 firms were excluded from the panel surveys because they had already closed, changed their business, or made significant organizational changes. 13. See Johnson (1997), Perotti & Gelfer (2001), Hoffman (2002), Klepach & Yakovlev (2004), and Guriev & Rachinsky (2005) for details on the financial-industrial groups and oligarchs in Russia. 14. In other words, domestic individual shareholders, including employee shareholders, are treated as a reference category. The experience of our joint research team and that of other researchers indicates that many Russian top managers do not have sufficient data on company ownership by employees, ownership by other managers, or ownership by the relatives, families, or acquaintances of employees, all of whom are categorized as outside individual shareholders. Therefore, their answers to our questions about their insider ownership may contain substantive measurement errors. In addition, the reason that we used a large management shareholder dummy variable that represents the position of managers as corporate owners is that it is quite difficult to ask managers to submit accurate data on their own shareholding rate; making such a request of managers is very likely to result in their refusal to participate in the survey. 15. Hence, newly established private firms after the collapse of the Soviet Union are treated as the reference in our estimation. 16. The two-stage procedure would be to estimate the reduced forms for ownership variables by probit or ordered probit maximum likelihood and estimate the corporate-form choice model by probit after substituting the predicted values for ownership variables. For more details regarding the two-stage estimation methods, see Maddala (1983), Newey (1987), and Rivers & Vuong (1988). 17. The correlation coefficients for CLOCOM and each of the newly introduced 4 variables range between 0.032 and 0.019 and are statistically insignificant. 18. The correlation coefficients for the independent variables used in each model are well below a threshold of 0.70 for possible multicollinearity in all combinations (Lind et al. 2004). 19. The non-significance of ownership by financial institutions and foreign ownership is consistent with the statements pointed out by many researchers pertaining to the passive attitude of commercial banks and investment funds as institutional investors, the weak presence of foreign shareholders, and the widespread share purchases by managers and their affiliates through offshore companies (Iwasaki 2007b). 20. This is closely associated with the fact that the sample firms used for the empirical analysis in this section as well as the overwhelming majority of Russian companies are unlisted and have stock prices that are not particularly sensitive to management performance, which leads to an extremely low incentive effect of stock ownership by managers. 21. In fact, the Russian communication sector, which has been developing in recent years at a breathtaking speed, driven by cellular phone and Internet service businesses, saw an average annual real growth rate of 22.4% between 2001 and 2004. This growth is much higher than the 4.2% for the eight manufacturing sectors covered by our enterprise survey and is the reason that the telecommunication sector is regarded as the new economy in Russia.

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86


22. On the other hand, all models were re-estimated by logit, and the results were found to be almost the same as those indicated in Table 3.5.

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4 The Structure of Corporate Boards Ichiro Iwasaki

Introduction Despite the fact that a general shareholder meeting is a supreme decision-making organ within a corporation, few challenge the argument by Jensen (1993) that a board of directors plays the most important role in an internal control system. In a modern corporate system separating management from ownership, “boards are the overlap between the small, powerful group that runs the company and huge, diffuse, and relatively powerless group that simply wishes to see the company run well” (Monks & Minow 1996: 167). Accordingly, the primary mission of the directors is to supervise the corporate management on behalf of shareholders by adhering to their duties of due care and loyalty. In other words, if the responsibility of senior managers is to make decisions at their own discretion regarding business operations, that of the board of directors is to exercise control over such management decisions. Only this division of power prevents the management from being the sole evaluator of the business performance as well as ensuring the safeguard of invested shareholder capital (Baysinger & Hoskisson 1990). In Russia, competition in product markets is not weak in many industries (Broadman 2000). The capital market and the market of corporate control also remain underdeveloped (Sugiura 2007). Under such circumstances, Russia is expected to establish internal controls that are as strong and functional as those of developed countries in order to effectively promote discipline in corporate management. Meanwhile, the role of a board of directors cannot be limited to the monitoring of management even in a broad sense that would include CEO appointment and turnover, the assessment of financial performance, and the determination of managerial remuneration. A board of directors is hierarchically superior to management. In fact, it provides strategic management expertise, advice, and recommendations regarding management activities (Baysinger & Butler 1985). In addition, as suggested by Hermalin and Weisbach (1988), a corporate board is 89

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a competitive training site for CEO candidates. Accordingly, a corporate board is not necessarily comprised of persons whose roles are limited to managerial supervision. Moreover, as Bathala and Rao (1995) argue, outsider directors do not always account for the majority of board members because corporations naturally use other governance mechanisms when alleviating a conflict between owners and managers in order to optimize board functions. In fact, board structure differs depending on the region, country, economic system, industrial sector, market, corporate form, and business activity of the company. To understand this organizational diversity, scholars have turned to agency theory (Jensen & Meckling 1976; Fama 1980; Fama & Jensen 1983), the theory of property rights (Demsetz 1967; Alchian & Demsetz 1972) and other management theories, such as the resource-dependent theory (Pfeffer & Salancik 1978) and the stewardship theory (Muth & Donaldson 1998). In addition, the development of empirical tools has continued through interaction mainly with research works on American and European companies, which share the set of standards that is now applicable to postcommunist economies as well. Nevertheless, to the best of our knowledge, there has never been any thorough study on the determinants of board structure in Russia and other transitional countries. To deepen our understanding of transition economies, this study represents an attempt to identify the economically and statistically significant factors determining the formation of a board of directors in Russian companies through a comprehensive reexamination of the theoretical and empirical implications of board structure in developed countries. This is the primary objective of this chapter. In this research field, Hermalin and Weisbach (1998) propose a bargaining hypothesis in which the structure of a corporate board is determined through a bargaining process between the CEO and outside board members, presenting a different theoretical model from the traditional agency theory, which implicitly assumes a preestablished harmony in the self-organization of the firm. As is discussed later, the bargaining hypothesis and the agency theory assume different positions regarding the manner in which the bargaining power of corporate managers and their countervailing parties affects their company’s board structure. Judging the applicability of these two approaches to Russian firms from this viewpoint is a matter of great importance for understanding the organizational behavior of business firms in a transition period and is the second objective of this chapter. These two objectives raise the question of which dimension of a firm’s organization and which business activities are essential for the empirical analysis of Russian corporations. To address this issue, the potential determinants of board structure are classified into two categories. The first is governance variables in a narrow sense, which include those relating to a firm’s organization, such as ownership structure and company size. The second is

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The Structure of Corporate Boards 91

business-activity variables, consisting of those relating to business type, competition environment, fund-raising activities, and financial performance. Furthermore, the governance variables are divided into bargaining variables, which reflect the bargaining power of managers and that of interested parties who are in conflict with the managers, and other governance variables for the examination of the second objective of this research. In this chapter, the impacts of the three variable groups are empirically compared within the structure of corporate boards. As a third objective, we propose and empirically validate several theoretical hypotheses concerning the interrelation of board structure with the special features of corporate law and the transition economy in Russia. While Russian corporate law adopts the Anglo-American type of corporate model in general, it introduces several unique regulations regarding the governance mechanism in joint-stock companies, including placing a lower limit on board size, prohibiting the vesting of the two titles of company top manager and board chairman in one person, and not allowing other executive directors to concurrently assume one quarter or more of the board membership (Black & Kraakman 1996; Iwasaki 2007a). An investigation of the impact of these legal arrangements on board structure would definitely be worthwhile. In addition, for researchers of transition economies, it is an intriguing subject to study how influential the succession of the “common properties of the working class” in the socialist era is over the internal organization and management system in former state-owned enterprises in comparison to newly established private firms in the transition period (Djankov & Murrell 2002). Furthermore, the potential impact of integration with so-called business groups on corporate governance in their affiliate companies cannot be overlooked. An empirical study of the above specific features in the Russian economy in terms of their effects on board structure will contribute valuable findings and theoretical viewpoints to the study of transition economies as well as to the field of financial and organizational economics. To investigate three objectives stated above, we conduct an empirical analysis of the determinants of (a) board size, (b) proportion of outsider directors (board composition), and (c) appointment of board chairmen (board leadership structure) dealing with their endogeneity. We assume that these three board components are interrelated and simultaneously determined. This is called endogenous board formation. Recent theoretical and empirical work gives considerable attention to this structural aspect in corporate boards (Lehn et al. 2005; Adams & Ferreira 2007; Boone et al. 2007; Coles et al. 2008; Linck et al. 2008). As the basis for the empirical analysis in this chapter, we utilize the results of the Japan–Russia large-scale enterprise survey conducted in 2005. The survey results include information on the size of the boards, basic attributes of board directors, and methods used for the appointment of board chairmen,

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92


which made it possible to carry out a detailed investigation of 741 board chairmen and 4,818 directors. In addition, databases belonging to SKRIN and SPARK Co., both of which are major company information agencies in Russia, were used in this study to obtain data on the financial performance, the industrial classification, and the percentage of ownership shares held by the managers and board members of our sample firms. The remainder of this chapter is organized as follows. The next section describes the legal framework of the board structure in Russian joint-stock companies. The third section reports the general characteristics of board structure based on the results of the joint enterprise survey. The fourth section presents testable hypotheses. The fifth section conducts empirical analysis of the determinants of board formation. Concluding remarks follow.

Legal framework of the board structure in Russian joint-stock companies In Russia, the legal basis for joint-stock companies is provided by the provisions of the Civil Code and the Federal Law on Joint-Stock Companies (Law on JSCs) and supplemented by the Corporate Governance (CG) Code.1 According to corporate law, not all joint-stock companies founded in Russia are required to establish a board of directors. Article 64 of the Law on JSCs provides that the general shareholder meeting of a joint-stock company whose voting shares are held by fewer than 50 persons may perform the same functions as those of the board of directors. This measure is construed as a legal device for enabling comparatively small companies directly managed by their shareholders to avoid establishing an unnecessary corporate organ and reduce management costs (Tsepov 2006). The number and appointment of board members are determined exclusively by an ordinary resolution of a shareholder meeting (Law on JSCs, Art. 48(1), Para. 4). Nevertheless, there are strict legal requirements as to the minimum number of directors. They provide that companies with 10,000 or more voting shareholders must have no fewer than 9 directors; those with 1,000 or more but fewer than 10,000 voting shareholders must have no fewer than 7 directors; and those with fewer than 1,000 voting shareholders must have no fewer than 5 directors (Art. 66(3)). On the other hand, there is no statutory upper limit. The term of office for directors is one year (defined as the date of appointment to the date of the next year’s shareholder meeting), and all of their seats must be contested at a regular shareholder meeting to be held no earlier than two months and no later than six months from the commencement of the fiscal year (Art. 47(1)). In other words, a staggered board is not allowed in Russia, in contrast to the cases of the US and France, where such a system is quite common. All directors must be elected through cumulative voting, a system that aims to protect the interests of minority shareholders (Art. 66(4)).2 Every shareholder who holds one-fiftieth or more

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of the total issued shares (2% or more voting equity) has a right to nominate directors (Art. 53(1)). Shareholders with one-tenth or more of the total issued shares also have the right to convene an extraordinary shareholder meeting and file a motion seeking the replacement of incumbent directors (Art. 55(1)). A board chairman is elected among the directors approved at a shareholder meeting by a simple majority. Directors may replace their chairman at any time by a resolution adopted by the majority of their votes unless otherwise stipulated in the articles of incorporation (Law on JSCs, Art. 67(1)). The most distinctive feature of the management and supervisory bodies of Russian joint-stock companies lies in comparatively strict restrictions regarding managers assuming board memberships. The Law on JSCs prohibits the top manager (single executive organ) from serving as his company board chairman. It also prevents members of the collective executive organ (the management/administration division), consisting of senior managers, from accounting for one-quarter or more of the board membership (Law on JSCs, Art. 66(2)).3 In addition, members of the audit committee established as a subordinate organ to the general shareholder meetings for the purpose of investigating financial and management activities may not become board members (Art. 85(6)). The Law on JSCs, however, includes no provision preventing the board chairman from being elected from among insider directors; moreover, it allows joint-stock companies to determine at their own discretion whether to establish a collective executive organ (Art. 69(1)). Soon after the enactment of the Law on JSCs in 1996, it became clear that joint-stock companies might easily evade the restrictions on managers assuming board memberships by not establishing a collective executive organ. As explained in another paper (Iwasaki 2007a), the adoption of a collective executive organ requires an amendment of the articles of incorporation and is determined by a supermajority resolution at a general shareholder meeting (passed by a majority of not less than three-quarters of the votes of present shareholders owning a majority of voting shares); this makes it highly possible for managers to attempt to reject requests from outside shareholders to increase the level of managerial monitoring in collusion with affiliated companies and employees. It is also likely that a top manager with significant ownership could appoint an individual under his influence to a board chairmanship. The CG Code is a kind of government decree issued by the Federal Commission for Securities Market (FCSM) in April 2002. The CG Code stipulates rules to be followed by all joint-stock companies operating in Russia with regard to matters pertaining to corporate management, basic principles of corporate governance (chapter 1), and the settlement of internal disputes (chapter 10). The CG Code devotes much space to matters regarding the board of directors setting forth detailed rules on board structure as well as the appointment of board members (chapter 3, section 2). The CG Code,

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however, contains very few numerical targets of board composition; one of those mandates that joint-stock companies include in their articles of incorporation is the provision that they have at least three “independent directors”4 who account for no less than one-quarter of the board membership (section 2.2.3). The CG Code has not had a significant effect yet because it is a relatively new government decree with no legal binding force. Nevertheless, it is also a fact that some securities exchanges closely examine whether domestic corporations that have applied for listing their stock or issuing their bonds are compliant with the code, in accordance with administrative directions issued by the FCSM. Therefore, the CG Code possibly has some influence on Russian companies seeking to raise funds from capital markets.

The structure of Russian corporate boards: A statistical overview As already mentioned, in Russia, joint-stock companies with fewer than 50 voting shareholders may determine at their discretion whether or not to set up a board of directors. Of the 298 surveyed firms whose total number of shareholders immediately before the survey was known to us, 46 (15.4%) had fewer than 50 shareholders, including 3 (1.0%) without a board of directors. The average (median) number of shareholders for these three firms was only 1.3 (1), much smaller than 18.1 (14) for the other 43 enterprises.5 This difference is statistically significant (t 1.665, p 0.051 (one-sided); Wilcoxon Z 2.356, p 0.019). Hence, there are only a few companies with an extremely small shareholder base that do not have a corporate board despite the institutional consideration allowing small firms not to set one up. Of the 822 surveyed firms, 730 (88.8%) responded to our questions regarding their board size and the basic attributes of their board members. As Table 4.1 demonstrates, as of the first half of 2005, joint-stock companies in Russia had an average number of 6.6 board members (standard deviation: 2.4, median: 7), of which only 76 firms or 10.4% had 10 or more board members. These figures have been stable throughout the transition period and are consistent with the results of past surveys by Blasi and Shleifer (1996), Dolgopyatova (2003), and Yasin (2004). Compared with approximately 18,600 enterprises in 19 countries throughout the world surveyed in 22 prior studies, the average board size of Russian companies is smaller than that of large listed firms in the US and other major developed countries but almost the same as that of initial public offering (IPO) firms in those large nations and that of listed companies in small countries (Table 4.2). Considering that most of the enterprises covered by the joint survey were unlisted companies, Russian corporations are expanding the scale of their internal organs, following the path of major Western countries.

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95

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2.94 2.59

1.13 0.77 0.75

0.43 0.18

0.21

2.40 2.43 2.21 1.15

S. D.

3.42 2.55

6.64 3.22 2.90 0.32

Mean

0

0 0

3 2

7 3 3 0

Median

0

0 0

0 0

3 0 0 0

Min.

6

10 8

17 17

23 21 15 21

Max.

0

0 0

1 0

5 1 1 0

25 percentile

0

0 0

5 4

7 5 5 0

75 percentile

Descriptive statistics on board size and number of directors by their attributes of 730 surveyed firms

Board size Insider directors Managers Representatives of employees and labor unions Outsider directors Representatives of nonemployee private shareholders Independent directors Representatives of federal government agencies Representatives of local governments

Table 4.1

152

314 135

2,466 1,865

4,818 2,352 2,117 235

Total

3.2

6.5 2.8

51.2 38.7

100.0 48.8 43.9 4.9

Share (%)

96

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U.S. IPO firms1 U.S. IPO firms2 U.S. listed firms3 U.S. large industrial firms4 U.S. large commercial banks4 U.S. large public firms 4 U.S. listed firms5, a Canadian listed firms6 Canadian public firms7 Europe U.K. listed firms8 U.K. listed firms9 U.K. listed firms6 French IPO firms10 French listed firms6 German listed firms6 Italian listed firms6 Spanish listed firms6

North America 1,116 1,019 508 100 100 100 9,436 79 38 1,271 250 66 299 42 33 56 28

1993–96 1994 1996 1993–99 1996 1996 1996 1996

Sample size

1978–87 1988–92 1989–95 1999 1999 1999 1990–2003 1996 2000

Analysis period

8.01 8.07 12.03 5.30 12.93 15.06 9.23 12.29

6.07 6.21 11.88 11.79 16.37 11.46 8 12.34 10.81

Mean

2.32

2.64 2.84

3.07

2.95 2.94 5.01 2.74

1.87

S. D.

8 8 12 5 13 16 9 11

12 12 16 11 7 12 11

6

Median

Board size (no. of directors)

Table 4.2 International comparison of board size and proportion of outsider directors

42.7 39 48 53.1 81 60 74 75

62 55.3 71.8 81.3 80.5 65.2 74 89.4

Mean

14.4

10.6

17.1 12.1 6.9 11.7

S. D.

82 58 81 80

50

42.9

56.2 73.0 83.1 83.3 70.0 79 90.0

Median

Proportion of outsider directors (%)

97

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1,280 113 530 251 199 135 147 63–105

730

2005 1990–2001 1996 1996 1998 1990–99 1989 1995 1991–95

17 165 37 94 12 98 879

1996 2001 1996 1996 1996 1996–98 1992–94

13.97 10.13 9.8 8.19 10.51 5.56 8.04 6.60

6.64

9.12 6.59 6.84 4.95 13.17 8.18 3.71

7

4.18 8.36 2.03 2.08 2.15 5 8 6

13

7

3

9 6 7 5 11.5

6.55 3.18

2.40

2.01 1.52

1.83

2.33

62 57 55.7

20.0 30 41

48.9

84.3 76 84

90 87

27 21 25.7

19.7 24

35.3

13

19.9

15

67 57 60.0

14.3

55.6

100 81

90 89

Sources: 1: Baker & Gompers (2003); 2: Boone et al. (2007); 3: Fich & Shivdasani (2006); 4: Booth et al. (2002); 5: Linck et al. (2008); 6: de Andres et al. (2005); 7: Bozec (2005); 8: Peasnell et al. (2005); 9: Vefeas & Theodorov (1998); 10: Roosenboom (2005); 11: Beiner et al. (2004); 12: van Ees et al. (2003); 13: Randøy & Jenssen (2004); 14: Eisenberg et al. (1998); 15: This study; 16: Abe (2003); 17: Tian & Lau (2001); 18: Peng (2004); 19: Yeh & Woidtke (2005); 20: Kim (2005); 21: Arthur (2001); 22: Mak & Li (2001); 23: Prevost et al. (2002).

Notes: a The proportion of outsider directors is calculated by the author using the data of the percentage of executive directors. b Board of auditors. c The proportion of outsider directors covers only independent directors.

Swiss listed firms6 Swiss listed firms11, b Dutch listed firms6 Dutch listed firms12 Belgian listed firms6 Swedish listed firms13 Finnish small and medium-scale firm14 Russian joint-stock companies15 Asia-Pacific Japanese listed firms16 Chinese IPO firms17, c Chinese listed firms18 Taiwanese listed firms19 Korean listed firms20 Australian listed firms21, c Singapore listed firms22 New Zealand listed firms23


Figure 4.1 demonstrates that the board sizes of Russian enterprises are influenced by the abovementioned legal restrictions as to the minimum required number of board members according to the number of shareholders. In fact, of the 730 joint-stock companies, as many as 520 firms, or 71.2%, have a total of 5, 7, or 9 board members. Table 4.1 also shows the breakdown of 4,818 board members from the 730 surveyed firms by classifying them into six groups with basic statistics of specific attributes. From this point forward, a director appointed from among company managers, rank-and-file employees, and representatives of a labor union is referred to as an “insider director,” and a director identified by other circumstances is referred to as an “outsider director.”6 According to the survey results, the board of directors in a typical joint-stock company consists of an average of 3.2 insider directors and 3.4 outsider directors. Contrary to general belief, Russian corporate boards do not appear to be insider-dominated. A significant percentage (90.0%) of insider directors is appointed from among senior managers. Insider directors of this type account for 43.9% of all directors, and they hold positions on the board in 640 (87.7%) of the 730 surveyed enterprises. However, 152, or 23.8%, of these 730 companies have only one insider director with a managerial background (probably, a top manager). Companies with (an) insider director(s) representing the interests 275 245

250 225

208

No. of companies

200 175 150 125 100 67

75 50

44

40 27

38 23

25

20 2 8

0

4 1

1 1

1

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 Board size (total number of directors) Figure 4.1

Board size of 730 joint-stock companies (frequency distribution)


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of workers or of a labor union account only for 16.0% (117 companies) of all our samples. On the other hand, of outsider directors, 75.6% represent private outsider owners. Of those, 240, or 12.9%, assume directorships for the interest of minority shareholders. This outcome could be considered a positive effect of mandatory cumulative voting. Of the 730 surveyed firms, 481 (65.9%) have an average number of 3.9 (standard deviation: 2.3; median: 4) directors representing private outside shareholders. As for independent directors,7 they account for 6.5% of all directors and 12.7% of all outsider directors. However, only 138 (18.9%), or nearly one-fifth, of the 730 surveyed enterprises have (an) independent director(s). Despite active efforts by the FCSM, independent directors are still not common in Russia. As in the case of independent directors, the number of state representatives is quite small, accounting for 6.0% of all directors and 11.7% of all outsider directors. Although no statistical background is provided here due to space limitations, we confirmed that state representatives were sent in large numbers to large-scale formerly state-owned enterprises operating in strictly regulated industries. The results of struggles among these interested parties reflect the extent of outsider representation on the board. Among the 730 responding enterprises, the average proportion of outsider directors was 48.9% (median: 55.6%). As shown in Table 4.2, this level is nearly the same as that for listed firms in the UK, US, China, and the Asia-Pacific region, much lower than that for companies in Europe, and much higher than that for Japanese companies. Since most of the surveyed firms are unlisted, it appears that the typical Russian company has the same level of openness as its counterpart in industrialized countries despite the commonly held opinion that they are insider-dominated. On the other hand, as shown in Figure 4.2, most of our sample firms do not have the typical board structure. Rather, the majority of Russian companies are either governed by a board of directors with an extremely high proportion of outsider representation on the board or completely dominated by insider directors. As reported by Barnhart et al. (1994), Peasnell et al. (2005), and Roosenboom (2005), the extent of outsider representation of listed and unlisted companies in developed countries has a bell-shaped distribution in general. Moreover, Table 4.2 indicates that the standard deviation of the outsider directorship ratio in our samples (35.3%) is much higher than those in other studies. Therefore, it would be quite appropriate to perceive the reality of Russian enterprises from the viewpoint of polarization in terms of the proportion of outsider directors. As reported earlier, Russian law prohibits a top manager from assuming the formal leadership of his company’s board; however, that does not prevent an insider director from becoming a board chairman. Furthermore, in Russia, vertical or horizontal business integrations, including participation in holding companies or other company groups through stock ownership, are becoming more prevalent in a dynamic context, prompting corporate

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Proportion of outsider directors (%)

90–100

103

80–90

112

70–80

50

60–70

71

50–60

53 62

40–50 23

30–40

59

20–30 31

10–20

166

0–10 0

20

40

60

80

100

120

140

160

180

No. of companies Figure 4.2 Proportion of outsider directors for 730 joint-stock companies (frequency distribution) Source: The joint enterprise survey.

managers to accept individuals from these business groups or partners as board chairmen. Needless to say, it is likely that a business group or partner affiliated with an enterprise could place its representative on its board of directors to have him perform a pure monitoring role as an outsider chairman. However, when two companies are affiliated through cross shareholding or joint ownership and maintain a good relationship with each other, it would also be possible for one company to place its representative on the other company’s board in defiance of the will of the other company’s management team. Taking this into account, we refer to board chairmen appointed from among those working in a business group or a business partner to as “quasi-outsider chairmen” and position them as the intermediate category between “insider chairmen,” who are promoted from within the company, and “outsider chairmen,” who have other characteristics.8 The relationship among the three types of board chairmen in terms of appointment route is hereinafter expressed as “the outsideness of chairman appointment.” A higher degree of outsideness in a board chairman suggests a higher degree of board independence. According to the answers from 741 enterprises that responded to the question regarding the manner in which they appointed their board chairmen, 340, or 45.9%, of all chairmen are insiders. Outsider chairmen (229 or 30.9%) and quasi-outsider chairmen (172 or 23.2%) follow. This picture corresponds almost precisely to the balance of power between managerial

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The Structure of Corporate Boards 101 Table 4.3 Correlation matrix of board components Board size Board size (number of board directors) Proportion of outsider directorsa Outsideness of chairman appointmentb

1.0000 0.2058*** (0.000) 0.0161 (0.674)

Proportion of outsider directors

Outsideness of chairman appointment

1.0000 0.3386*** (0.000)

1.0000

Notes: a Continuous variable with 0.00 ≤ x ≤ 1.00. b An ordered data with a value of 1 for firms with a quasi-outsider chairman, 2 for firms with an outsider chairman (default – firms with an insider chairman). Figures in parentheses are p-values. ***: significant at the 1% level. Source: Author’s calculation based on the joint enterprise survey.

directors and outsider directors in average Russian enterprises, suggesting that the negotiation between company managers and opposition parties has significant influence over the appointments of board chairmen, as asserted by Hermalin and Weisbach (1998). As already discussed, we assume endogeneity among board size, the proportion of outsider directors, and the outsideness of chairman appointment. The correlation matrix in Table 4.3 indicates the possibility of such a relationship among these board components. They are positively associated, and the correlation between the board size and the proportion of outsider directors and that between the proportion of outsider directors and the outsideness of chairman appointment are statistically significant at the 1% level.

The logic of board formation As we stated in the Introduction, the factors affecting board structure can be divided into governance variables and business-activity variables. The former include those relating to firm organization, such as ownership structure and company size, and the latter, those relating to business type, market environment, fund-raising activity, and financial performance. The governance variables contain variables reflecting the bargaining power of managers and that of interested parties who are in conflict with the managers. These variables are called “bargaining variables” (Arthur 2001). In order to examine the applicability of the bargaining hypothesis to a Russian firm in comparison with the traditional agency theory, we adapt this terminology and separate bargaining variables from other governance variables.

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102


By hypothesizing an endogenous relationship among the dependent variables, namely, the board size (BOASIZ), the proportion of outsider directors, i.e. board composition (BOACOM), and the outsideness of chairman appointment, i.e. board leadership structure (BOALEA), the formula for the determination of board formation can be expressed in the following three functions: BOASIZ f(BOACOM, BOALEA, BARVARs, GOVVARs, BUSVARs), BOACOM g(BOASIZ, BOALEA, BARVARs, GOVVARs, BUSVARs), BOALEA h(BOASIZ, BOACOM, BARVARs, GOVVARs, BUSVARs), where BARVARs, GOVVARs, and BUSVARs denote the bargaining variables, other governance variables, and business-activity variables, respectively. In the following subsections, we consider specific factors included in the above three variable groups and their possible impacts on board structure in more detail. We also discuss the possible interrelations within a board structure. Bargaining variables As bargaining variables, we test the impacts of (a) ownership share of large outsider shareholders and management group, (b) affiliation with a business group, and (c) CEO tenure on board structure. The agency theory hypothesizes that the existence of major outsider shareholders renders supervision by outsider directors less necessary because these large shareholders have a sufficient incentive and capability to actively perform monitoring functions by exercising their influence when necessary or because they can discipline managers effectively by increasing the possibility of takeover by third parties (Rediker & Seth 1995). However, shareholders can use their bargaining power to reinforce the monitoring function of the board to increase their ability to collect managerial information or strengthen their authority to dismiss managers who fail to elevate corporate values. This is particularly true if shareholders live in countries where the corporate control market is still underdeveloped or selling all of their shares would be too costly (Whidbee 1997). The current state of the Russian economy is clearly closer to the latter. Furthermore, in the case of Russia, where social distrust of corporate managers is quite high, it is highly possible that large shareholders would maximize their presence in their invested companies by using any channel available to them. Therefore, the ownership share of major outsider shareholders is probably positively correlated with board size and independence, although the marginal effects of their additional share on the expansion of their voting rights may decrease. With regard to the possible influence of management ownership on board structure, the traditional agency theory assumes that shareholding by managers reduces the need for the corporate board to perform its monitoring function, as it creates common interests between top managers and outside owners (convergence effect). On the other hand,

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the bargaining hypothesis suggests that an increased bargaining power of top managers decreases the chances of outsider directors being appointed. Thus, both theories support the idea that shareholding of corporate officers reduces board size and independence. On the other hand, as mentioned in the previous section, in Russia, business alliances are now burgeoning both at the federal level, as represented by financial-industrial groups led by commercial banks, major industrial enterprises, and newly emerged financial cliques called “oligarchs,” and at the regional level. In fact, our survey indicates that 323 (39.3%) of the 822 surveyed firms are affiliated with a certain business group through shareholding. The most important and, probably, most dominant owners for these business groups are holding companies and core group firms whose corporate governance functions are drawing attention from researchers involved in Russian economic studies (Iwasaki 2007b). In this regard, prior studies, such as those by Perotti and Gelfer (2001) and Guriev and Rachinsky (2005), empirically confirmed that affiliation with a business group helped a company improve its managerial discipline and promote its restructuring activity. Hence, we also expect that participation in a business group will enhance the monitoring role of a corporate board in member firms. The tenure of the top manager can also be a bargaining variable. A newly appointed top manager is more likely to have a large company board with a high proportion of outsider directors for a short time; this is likely to be due to his weak influence on the director appointment process or his strategy to ask for managerial advice and counseling from outsiders until the company management is on track under his leadership (Weisbach 1988). Thus we predict that new appointment of top manager is positively correlated with board size and independence. Other governance variables In addition to bargaining variables, we give attention to three additional elements reflecting the organizational characteristics of Russian corporations as governance variables: (a) soon-to-retire top managers; (b) the political background behind a company’s foundation; and (c) company size. First, according to Hermalin and Weisbach (1988) and Baker and Gompers (2003), a company in the US with a soon-to-retire CEO is more likely to accept the CEO’s successor as a member of its corporate board, resulting in a significant increase in the proportion of insider directors, although the impact of the acquisition of board membership by the successor on board size may be trivial. Other empirical studies also assert that a retiring CEO has a strong tendency to assume board chairmanship, probably with the objective of making it easier to transfer power to the successor he deems most desirable (Mak & Li 2001; Booth et al. 2002). The hypothesis of the negative impact of soon-to-retire top managers on board independence is worth testing with our dataset with respect to Russian corporations.

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104


The second point is closely connected with the current state of the Russian transition economy. It is common knowledge that the vast majority of middle- and large-scale enterprises in Russia are privatized enterprises, many of which still have state shares. These former state-owned enterprises, which used to be called “common properties shared by workers” in the Soviet era, still draw much more public attention than de novo private firms. Therefore, compared with 100% privately owned companies established during the transition period, traditional former state-run enterprises are likely to have more outsider directors in order to be properly accountable to the state and the public as well as receive various kinds of support from the government (Li 1994; Beiner et al. 2004). Consequently, former state-owned corporations are expected to have corporate boards with a higher level of independence than ordinary private enterprises ceteris paribus. The third point is company size, which is a primary governance variable. The expansion of the organizational size of a company is accompanied by the complication of firm organization and the expansion of the relationship among the company, state, and society. In addition, company size expansion requires managers to improve their skills in various management areas, resulting in an increase in board size (Mayers et al. 1997; Denis & Sarin 1999; Baker & Gompers 2003). On the other hand, there is disagreement among researchers as to whether additional directorships are more likely to be held by insiders or by outsiders (Eisenberg et al. 1998; Shivdasani & Yermack 1999; Agrawal & Kneober 2001; Peng 2004). Furthermore, it is not obvious how company size affects the probability of a CEO concurrently assuming board chairmanship (Brickley et al. 1997; Arthur 2001; Booth et al. 2002). Thus, we assume that the organizational size of a company has a positive impact on both the board size and the extent of outsider representation and that the statistical significance of the impact on board size is greater than that on the proportion of outsider directors. In addition, considering that the appointment of a board chairman may be decisively dependent upon the bargaining process between managers and their opponents, we presume that it is difficult to find a significant impact of company size on the outsideness of chairman appointment. Business-activity variables As business-activity variables, we include (a) business diversification, (b) outside financing, (c) R&D/innovation strategy, (d) financial performance, (e) debts, and (f) business internationalization. Business diversification increases the chances that an expert familiar with the new market will become a board member although it is not clear from which group of persons the expert will be selected. In other words, business diversification is expected to have a significantly positive correlation with the number of appointed directors, whereas its effect on the proportion of outsider directors is not clear.9

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Financing from capital markets encourages managers to make decisions in the interests of investors and helps resolve agency problems. Information disclosure for fund-raising also has the effect of constraining the opportunistic behavior of managers. Furthermore, obtaining financing from capital markets increases the potential risk of hostile takeovers, leading to an improvement of managerial discipline. Hence, it can be assumed that outside financing replaces the monitoring function of corporate boards. Conversely, however, it is possible that issuing stocks or corporate bonds on security markets leads to the appointment of fund-raising directors or the addition of outsiders with expert knowledge about financial engineering (Borokhovich et al. 2004). Particularly in Russia, enterprises are required by financial authorities and securities exchanges to establish an effective internal governance system in compliance with the CG Code, as described in the second section. Therefore, the results of our empirical analysis must be examined inductively to determine which hypotheses best account for the current state in Russia. Performing an intensive R&D/innovation strategy encourages companies to evaluate the performance of their managers on the basis of the quality of their decisions rather than on the basis of financial results specific to the business they manage because of its technical uncertainty and risky nature (Hill & Snell 1988). Insider directors are the most appropriate for conducting such evaluations. On the other hand, outside board members are ineffective in supervising firms with deep firm-specific knowledge and high growth opportunities because higher information asymmetry results in higher monitoring costs (Lehn et al. 2005; Linck et al. 2008). Hence, enterprises actively engaged in product development and innovation are expected to have a significantly smaller number and proportion of outsider directors. Many researchers have confirmed that a company that performs poorly compared with its rivals and other companies in the same trade has an impact on its dismissal of insider directors and its appointment of their successors from the outside regardless of differences in period and country (Kaplan & Minton 1994; Hermalin & Weisbach 1998; Peng 2004). Our empirical analysis can be expected to present trends similar to those explained in these earlier studies. Nevertheless, as reported by Yermack (1996), Eisenberg et al. (1998), and Perry and Shivdasani (2005), board size is rarely influenced by past performance, and this may be applicable to Russian firms. Therefore, we assume that poor financial performance in the past is positively correlated with the proportion of outsider directors but has little impact on board size. In many earlier studies, including Kaplan and Minton (1994) and Linck et al. (2008), it has been acknowledged that the higher the debt ratio of a company, the stronger the managerial monitoring function of its corporate board. This is because increased monitoring pressure on a company from

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106


creditors trying to recover their credit and from outsider owners afraid of bankruptcy has a strong effect on board structure. Nonperforming accounts payable and bank loans are still a serious economic concern in Russia despite the fact that its economy has already pulled out of the transformational recession.10 It is often the case in Russia that creditors become unable to recover their loans; therefore, it is quite reasonable to assume that creditors are subject to all possible kinds of monitoring pressure from their business partners and financing institutions. For these reasons, we predict that bank loans and other debts have a statistically significant and positive impact on both the overall number of directors and the proportion of outsider directors. The remaining business-activity variable is business internationalization. Increased overseas operations and international transactions may result in the company having more expert directors and foreign directors in order to gather information and know-how to deal with the foreign market and foreign business customs as well as secure useful contacts for expanding overseas operations. In the case of Russia, where there are strict government regulations on major export commodities, enterprises actively involved in overseas business may be more inclined to employ those who are skillful in dealing with high-ranking officials and bureaucrats in the fields of trade and tariffs. According to an analysis by Li (1994), who surveyed enterprises in 10 industrialized states, however, the share of overseas sales affects the appointment of an outsider director in a nonlinear fashion. Hence, we expect that a high level of business internationalization is positively related to the proportion of outsider directors. On the other hand, following the same logic as that used for previous discussions concerning the relationship between company size and chairman appointment, we assume that all of these business-activity variables have, if any, a small or neutral effect on outsideness of chairman appointment. Endogenous interrelation of board components There are possible interactions among board components, such as board size, proportion of outsider directors, and appointment of outsider chairman. With regard to this point, prior research11 suggests that companies with a larger corporate board are more likely to have more outsider directors. The more pressure companies receive from the state and investors to improve their internal control system and increase the transparency of their management activities, the more likely they are to expand their board size and, of course, to appoint an outsider as their board chairman. Board chairmen appointed from the outside are expected to encourage the presence of outsider directors in an attempt to secure their influence over strategic decision-making and enhance their comprehensive bargaining power against company managers. If it is impossible to replace insider directors

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with outsider directors due to resistance by the management side, the board may be enlarged by increasing the absolute number of outsider directors. To sum up, we expect that the all board components are positively correlated with each other. Table 4.4 summarizes the theoretical discussions in this section. The prediction on the squared term of bargaining variables is set assuming the bargaining hypothesis is greater applicable to Russian firms than the traditional agency theory.

Table 4.4 Theoretical predictions of the impacts of firm organization and business activities on board components Type of board component

Bargaining variables Ownership share of large outsider shareholders/squared term Ownership share of company managers Affiliation with a business group New appointment of top manager Other governance variables Soon-to-retire top manager Inherited state assets Company size Business-activity variables Business diversification Financing from capital markets Competitions in product markets Intensity of R&D/innovation activities Poor financial performance Debts Business internationalization/ squared term Endogenous variables Board size Percentage of outsider directors Outsideness of chairman appointment

Board size

Proportion of outsider directors

Outsideness of chairman appointment

/

/

/

?

()

?

?

?

? ?

? ? () ()

() /

/

() () ()/()

—

() —

— ()

Note: ‘’ stands for a positive correlation, ‘,’ for a negative correlation, ‘(),’ for a positive but statistically weak correlation, and ‘(),’ for a negative but statistically weak correlation, and ‘?’ indicates that the effect is unpredictable.

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Empirical results This section vindicates the logic of board formation explained in the previous section in the case of Russian joint-stock companies using the following datasets based on the results of the 2005 joint survey and on the SKRIN and SPARK open resources. With regard to the variables of board components, BOASIZ (board size) takes the total number of directors on board, BOACOM (proportion of outsider directors) is defined as the number of outsider directors divided by the total number of board members, and BOALEA (outsideness of chairman appointment) takes a value of 1 for firms with a quasi-outsider chairman and 2 for firms with an outsider chairman. The default category is firms with an insider chairman. As for ownership of outside investors and corporate officers, both of which are major bargaining variables, we utilize a 6-point scale of the combined ownership share of corporate ownership and foreign investors (OWNOUT)12 and a large management shareholder dummy with a value of 1 if the company has a specific manager or a specific managerial group as its large shareholder (MANSHA). The presence of a business group as a major owner is represented by a group firm dummy (GROFIR) for participation in a business group through share ownership. Moreover, a new appointment of a top manager is represented by a dummy variable (NEWCEO), which takes 1 for the firms with a top manager appointed in or after 2001. The dummy variables used for investigating the impacts of other governance variables are CEOAGE, indicating that the enterprise has a top manager of retirement age (61 or older) and PRICOM, which denotes that the company is a former state-owned (or ex-municipal) privatized enterprise. COMSIZ, the natural logarithm of the total number of employees, is used in a series of regression analyses as a proxy for company size. Concerning the business-activity variables, the level of business diversification is measured by BUSLIN, which denotes the number of business lines in accordance with the 2-digit industrial classifications in the Russian AllUnion Classifier of the National Economy Branches (so-called “OKONKh” in Russian).13 Financing from capital markets is expressed as MARFIN, a dummy variable, with 1 assigned to the enterprises that issued stocks or company bonds on domestic or foreign securities exchanges. The impact of R&D/innovation activities on board structure is measured using NEWPRO, a dummy variable that has a value of 1 if a company successfully developed brand-new products or worked out innovation businesses in the period from 2001 to 2004. The average rate of return on assets in 2001–2004 (ROAAVE) is utilized as a proxy of past financial performance. It is predetermined variables reflecting the business results of our samples for a period of several years prior to the 2005 joint survey, which makes it possible to avoid any possible simultaneous bias between board structure

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and firm performance. Moreover, ROAAVE takes industry-adjusted values using a method proposed by Eisenberg et al. (1998) and represents the distances from the median performance in each industry. The impact of debts on board structure is tested using BANCRE, a variable for the extent of bank credits to the surveyed firms during the period from 2001 to 2004. EXPSHA, the share of total exports in total sales, represents the degree of business internationalization. The definitions, descriptive statistics, and sources of the above datasets are listed in Table 4.5. This table also provides correlation coefficients of each variable with board components, most of which supports our testable hypotheses.14 We assume that there is an endogenous relationship among board size, the proportion of outsider directors, and the outsideness of chairman appointment. To handle the endogeneity of board structure, we utilize the simultaneous-equations model. This method, however, may unexpectedly provide false results due to a small but grave error in the model specification affecting the system as a whole. As long as the true structure of a given corporate governance model is unknown, it is rather risky to randomly select the independent variables to be evaluated (Barnhart & Rosenstein 1998). Against this background, we adopt, as the second-best way of model specification, the following models using the three endogenous variables and the 17 independent variables whose coefficients were found to be comparatively robust at higher than the 10% significance level in the singleequation models, which we estimated as the first stage of empirical analysis (not reported), as well as 8 industry dummy variables (INDDUMs).15 As Boone et al. (2007) argue, the inclusion of industry fixed effects has the potential to control the unobserved industrial heterogeneity. The results are shown below: BOASIZ f(BOACOM, BOALEA, OWNOUT, PRICOM, COMSIZ, BUSLIN, MARFIN, BANCRE, EXPSHA, EXPSHA2, INDDUMs), BOACOM g(BOASIZ, BOALEA, OWNOUT, OWNOUT2 MANSHA, GROFIR, NEWCEO, CEOAGE, COMSIZ, NEWPRO, ROAAVE, BANCRE, INDDUMS), BOALEA h(BOASIZ, BOACOM, OWNOUT, INDFIR, OWNOUT INDFIR, CEOAGE, PRICOM, COMSIZ, INDDUMs), where INDFIR is a dummy variable with 1 assigned to independent companies. At the first stage of the empirical analysis, we found that contrary to our prediction, OWNOUT is insignificant for single-equation models that take BOALEA as the dependent variable. This result is possibly connected with the fact that this variable partly covers the shareholding by business groups as major owners. Therefore, we estimated an alternative model taking INDFIR, instead of GROFIR, and its intercept variable with OWNOUT to

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110

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Mean

Business-activity variables (BUSVARs) Number of business lines (BUSLIN)h 2.15

Bargaining variables (BARVARs) Ownership share of outsider shareholders 1.87 (OWNOUT)c, d Large managerial shareholder dummy 0.48 (MANSHA) Business group participation dummy 0.39 (GROFIR) Dummy for newly appointed top 0.39 manager (NEWCEO)e Other governance variables (GOVVARs) Dummy for firms with top manager of 0.10 retirement age (CEOAGE)f Dummy for former state-owned or 0.69 ex-municipal privatized companies (PRICOM) Total number of employees (COMSIZ)g 1884.44

Definitions (variable name)

0 0

0 1

0.49 0.49

0.30 0.46

2.05

1

465

0

0.50

5570.00

0

Median

2.14

S. D.

1

106

0

0

0

0

0

0

Min.

Descriptive statistics

12

74000

1

1

1

1

1

5

Max.

0.210***

0.322***

0.165***

0.207***

0.015

0.013

0.103***

0.045

0.067*

0.117***

0.216***

0.068*

0.101***

0.114***

0.344***

0.162***

0.204***

0.016

0.521***

0.136***

0.164***

0.038

0.412***

(b) (c) Proportion Outsideness of outsider of chairman directorsb appointmentb

0.238***

(a) Board sizea

Correlation coefficients with board components

Table 4.5 Definition, descriptive statistics, and data source of variables used in the empirical analyses and correlation coefficients with board components

111

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0.34 0.48 0.90 1.45 1.20

0.13 0.62 0.12 2.53 0.88

0

0.00 3

1

0

0

8.08 0

0

0 0.021

0.351***

5

0.053

4.26 0.029 5 0.166***

1

1

0.050 0.015 0.046

0.072*

0.019

0.044

0.114*** 0.093**

0.038

0.281***

Source: The SKRIN databases were used for the numbers of business lines (BUSLIN). The SPARK’s databases were used for the annual average ROA (ROAAVE). All of the other variables were created on the basis of the results of the joint enterprise survey.

Notes: a A unit is the number of directors. In the regression analyses, its natural logarithm is utilized. b The definition is the same as that in Table 4.3. c “Ownership share” means an ownership share rated on the following 6-point scale: 0: 0%; 1: 10.0% or less; 2: 10.1 to 25.0%; 3: 25.1 to 50.0%; 4: 50.1 to 75.0%; 5: 75.1 to100.0%. d Excluding domestic individual shareholders. e “New top manager” denotes a top manager (CEO, company president, or general director) appointed during the period from 2001 to 2004. f “Top manager of retirement age” denotes a top manager aged 61 or older as of the survey date. g In the regression analyses, its natural logarithm is utilized. h Based on the OKONKh two-digit classification. i Industry-adjusted. j “Firms which used bank credits and their average lending period” falls under one of the following 6 categories: 0: Did not use any bank credits during the period from 2001 to 2004; 1: Used bank credits, and their average lending period was less than 3 months; 2: Used bank credits, and their average lending period ranged from 3 months to less than 6 months; 3: Used bank credits, and their average lending period ranged from 6 months to less than one year; 4: Used bank credits, and their average lending period ranged from one year to less than 3 years; 5: Used bank credits, and their average lending period was more than 3 years. k “Share of exports in total sales” falls under one of the following 6 categories: 0: 0%; 1: 10% or less; 2: 10.1 to 25.0%; 3: 25.1 to 50.0%; 4: 50.1 to 75.0%; 5: More than 75%. ***: significant at the 1% level; **: significant at the 5% level; *: significant at the 10% level.

Dummy for firms which issued shares or bonds on capital markets (MARFIN) Dummy for development of new products or services in 2001–04 (NEWPRO)i Annual average ROA in 2001–04 (ROAAVE) Firms which used bank credits and their average lending period (BANCRE)j Share of exports in total sales (EXPSHA)k

112

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NEWCEO

OWNOUT×INDFIR

INDFIR

GROFIR

MANSHA

OWNOUT 2

Exogenous variables OWNOUT

BOALEA

BOACOM

0.0225*** (0.008)

0.0930 (0.133) 0.0819 (0.205)

0.0613** (0.026)

0.0671** (0.028) 0.0107* (0.006) 0.2276*** (0.046) 0.1030*** (0.031)

0.3848* (0.208)

0.1871 (0.246)

0.0436 (0.076) 0.0399** (0.020)

0.0275 (0.035)

0.7009 (1.365) 0.5229*** (0.142)

0.1432 (1.413)

0.0791 (0.385)

1.0468*** (0.142)

Const.

Endogenous variables BOASIZ

BOALEA

BOACOM

BOASIZ

[A] a

2SLS system estimates of endogenous board formation

Dependent variable

Model

Table 4.6

0.0231*** (0.008)

0.0181 (0.150) 0.0511 (0.194)

0.9345*** (0.150)

BOASIZ

0.0366 (0.028)

0.0597** (0.031) 0.0072 (0.006) 0.2448*** (0.044) 0.1115*** (0.032)

0.2504* (0.150)

0.1957 (0.184)

0.0095 (0.248)

BOACOM

[B] b

0.0718 (0.075) 0.0554** (0.023)

0.0342* (0.020)

0.1033 (0.411) 0.6685*** (0.143)

0.4864 (0.421)

BOALEA

113

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536 0.30 18.98***

Yes

0.1344*** (0.035) 0.1057*** (0.013)

536 0.40 24.11***

Yes

0.0077 (0.028)

0.0984** (0.044)

536 0.04 4.66***

Yes

0.1293 (0.087) 0.1947 (0.199) 0.1034 (0.148)

403 0.34 11.37***

0.0203* (0.011) 0.0636* (0.033) 0.0170** (0.008) Yes

0.1097*** (0.036) 0.0896*** (0.017) 0.0131** (0.007) 0.1085* (0.058)

403 0.52 19.14***

Yes

0.0604** (0.029) 0.0305** (0.014) 0.0173* (0.010)

0.0001 (0.024)

0.0794* (0.046)

403 0.21 4.70***

Source: Author’s estimation.

Yes

0.0668 (0.076) 0.0882 (0.072) 0.0415 (0.048)

Notes: a Hausman test for the specification of the 2SLS model and 3SLS model: 2 = 1.98, p = 1.000. b Hausman test for the specification of the 2SLS model and 3SLS model: 2 = 2.77, p = 1.000. The figures in parentheses show standard errors. ***: significant at the 1% level, **: significant at the 5% level, *: significant at the 10% level.

N Adj. R 2 Wald test (2)

Industry dummies

EXPSHA2

EXPSHA

BANCRE

ROAAVE

NEWPRO

MARFIN

BUSLIN

COMSIZ

PRICOM

CEOAGE

114


distinguish the impact of shareholding by outside investors from that by business groups on the outsideness of chairman appointment. We estimate this simultaneous-equations model by the 2SLS method. Estimations are conducted both for the case in which the independent variables are limited to the governance variables and for the case in which the business-activity variables are also included in the independent variables for robustness check. With regard to the variable of the outsideness of chairman appointment, we use the log of BOALEA+1 to achieve a better fit for the 2SLS estimations. Table 4.6 shows the results. We confirm that the explanatory power and statistical significance of the individual independent variables are not as severely affected as to require that the primary analysis results obtained from the single-equation estimations be reviewed even if these simultaneous-equations models are used to deal with the endogeneity of board formation. Nevertheless, PRICOM, a dummy for the political background behind the corporate establishment, and COMSIZ, a proxy of company size, considerably lose their significance in the regression models in which BOACOM or BOALEA is used as the dependent variables. We also find that NEWCEO remarkably decreases its statistical significance when the business-activity variables are introduced. A Hausman specification test suggests that there are no comparatively and statistically significant advantages and disadvantages between 2SLS and 3SLS models. In fact, no distinctive differences have been identified between these two methods regarding the estimation results. Overall, we confirm an endogenous relationship that exists between the proportion of outsider directors and the outsideness of board chairman in the sense that these board components are positively related to each other. We also verified that almost all exogenous variables estimated to be comparatively significant and robust in single-equation regression models have economically and statistically meaningful impacts on board structure, consistently with the theoretical hypothesis, even when we explicitly deal with the endogeneity of board formation.

Concluding remarks In this chapter, we present a comprehensive analysis of the determinants of board formation in Russian firms using the results of a Japan–Russia joint enterprise survey conducted across the country in the first half of 2005. The findings strongly suggest that the long years of study by many researchers in the fields of organizational economics and corporate finance in industrialized countries are quite effective for analyzing the industrial economy and organization of firms in Russia, a state which is still in transition to a market economy even after more than a dozen years since the collapse of the Soviet Union. To be more specific, the theories and empirical methods

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of financial and organizational economics help pinpoint the determinants of board size, proportion of outsider directors, and outsideness of chairman appointment in Russian firms. Conversely, it can be said that corporate managers and investors in contemporary Russia organize their monitoring and supervisory systems in accordance with the economic and organizational logics applied to mature capitalist economies. The long-standing and difficult attempt to shift to a market economy in Russia is now starting to bear fruit. However, the results of the empirical analysis do not support all the testable hypotheses proposed in the fourth section. In other words, our empirical evidence demonstrates the higher explanatory power and statistical significance of the bargaining variables in comparison to other governance variables and business-activity variables as the determinants of board structure in Russian firms. Moreover, the estimation results of the bargaining variables strongly suggest that, if it is more reasonable to interpret the board structures of listed companies in developed countries by the classical agency theory, which implicitly assumes the self-organizing nature of a well-balanced corporate governance system, it is also more reasonable to interpret the board formation in Russian enterprises by the bargaining hypothesis developed by Hermalin and Weisbach (1998). This is supported by the fact that the bargaining variables of Russian firms, such as those for the ownership shares of management executives, outside investors, and outsider chairmen, as well as the tenure of the top manager, have distinctive explanatory power pertaining to the determination of board formation process, strongly suggesting that, in Russia, corporate boards are possibly a site for struggle for hegemony over corporate management among managers, outside investors, and their board representatives, who seek to maximize their power and benefits. This image is intuitively consistent with our understanding of the modern Russian economy. Even today the country is still unable to cast off its negative image as unreliable state. The awareness of Russian people of the importance of contracts and property rights and the business ethics of Russian managers are improving but still remain poor. In this social environment, it is no wonder that investors do not expect much from other owners and creditors concerning their managerial discipline and choose to directly monitor corporate managers using all channels available in an attempt to maximize their interests. In response, corporate managers always behave opportunistically by being on the alert against those hostile investors. It is true that such a deep-seated mutual distrust serves as a mechanism to make business enterprises functional. However, engaging in a heated battle for hegemony over the board of directors tends to be excessively time- and energy-consuming, contrary to the case of a society that is capable of achieving effective managerial discipline by harmoniously and autonomously organizing different corporate governance mechanisms. In

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this sense, the applicability of the bargaining hypothesis to Russian firms may reflect the immaturity of the Russian socioeconomic system. Furthermore, this study demonstrated that Russia’s legal system and its peculiarities as a transition economy have a great deal of influence in determining the board structure. The management alliance with business groups that intensively took place all over Russia as a byproduct of the enterprise privatization in 1990s also considerably affects the governance system in their affiliated companies. In addition, the political backgrounds of startups, as well as several rules set by the corporate law and the CG Code, have statistically significant impacts on the decision-making process of Russian firms regarding board structure. On the other hand, the federal administrative directives that have been issued to encourage companies to add more independent directors and the provisions of the Law on JSCs preventing corporate managers from concurrently holding the post of board chairman have not yet produced the desired outcome, partly because they are not sufficiently enforced and partly because of their institutional flaws. Until a certain level of mutual trust is established among Russian citizens, increased state regulations on the structure and functions of corporate boards and other statutory corporate organs may be effective for alleviating the aforementioned problems. From this standpoint, and in many other respects, it is to be hoped that the legal and institutional framework of Russian jointstock companies will become more sophisticated.

Acknowledgments The research was financially supported by grants-in-aid for scientific research from the Ministry of Education and Science of Japan (No. 16530149; No. 17203019) in FY2006 and FY2007. I thank Naohito Abe, Svetlana Avdasheva, Charles Becker, Tatiana Dolgopyatova, Timothy Frye, Jeffry M. Netter, Fumikazu Sugiura, and Andrei Yakovlev for their valuable comments and suggestions.

Notes 1. These provisions refer to Part I, chapter 4 (Art. 96 to 104) of the Civil Code of November 30, 1994 (effective January 1, 1995), the Federal Law on Joint-Stock Companies of December 26, 1995 (effective January 1, 1996), and the resolution of the Federal Commission for the Securities Market dated April 4, 2002, regarding the recommendation of the adoption of the Corporate Governance Code. This section was written by taking into account the laws and regulations that were effective in Russia during the period of the 2005 enterprise survey. 2. The February 2004 amendment of the Law on JSCs made it mandatory for all joint-stock companies to elect board members by cumulative voting, a measure that aimed at strengthening the protection of the interests of minority shareholders. Until the amendment, the cumulative voting procedure had been enforceable only on joint-stock companies with 1,000 or more voting shareholders.

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The Structure of Corporate Boards 117 3. A collective executive organ headed by a company president is an internal executive organization, and its function is, together with a single executive organ, to supervise daily management matters except for those that fall within the authority of the shareholder meetings and the board of directors (Law on JSCs, Art. 69(2)). It is assumed that the role of a collective executive organ is to clarify managerial responsibilities and to make the board of directors more independent from the management of the company (Iwasaki 2007a). 4. The CG Code defines an “independent director” as one who meets seven criteria for independence, which include (a) that the director has not been a manager or an employee of the company over which he assumes the directorship or its parent company for three years before the date of appointment; (b) that the director is not an affiliate of the company; and (c) that the director is not a representative of the government. 5. These numbers are based on the SKRIN database on the total number of shareholders as of Q4 2004 or Q1 2005. These data do not provide the exact number of voting shareholders at the time of our survey; however, this would not result in a serious bias in the analyses conducted in this chapter because the list of shareholders expected to be present at a shareholder meeting must be finalized 45 to 65 days prior to the date of the meeting (Law on JSCs, Art. 51(1)), our survey was conducted before the high season of shareholder meetings, and nonvoting shares are not very common in Russia. 6. Here, due to constraints of the methodology used in the survey, no distinction was made between affiliated and non-affiliated individuals with regard to outsider directors (except for independent directors), as in many earlier studies involving developed countries. 7. Here, independent directors fit the definition in the CG Code mentioned in the second section 2. 8. On the other hand, supplemental examinations confirmed that the empirical evidence and the conclusions reached in this study and presented from this section forward were not greatly affected even when quasi-outsider chairmen were treated as insiders. 9. In fact, empirical evidence of prior studies is mixed. See Hermalin and Weisbach (1988), Li (1994), Mayers et al. (1997), Prevost et al. (2002), and Coles et al. (2008), for instance. 10. In fact, the results of the joint survey show that, as of the first half of 2005, 333 (41.0%) of 813 surveyed enterprises had arrears in their accounts payable. 11. In particular, see Li (1994), Rediker and Seth (1995), Yermack (1996), Whidbee (1997), Shivdasani and Yermack (1999), Arthur (2001), Mak and Li (2001), Prevost et al. (2002), Lehn et al. (2005), Boone et al. (2007), and Linck et al. (2008). 12. OWNOUT excludes all domestic individual shareholders in order to eliminate the impact of ownership by managers and employees families, relatives, and acquaintances, all of whom are categorized as outside owners in a formal sense, and in order to accurately identify the level of ownership concentration by corporate owners and foreign owners, whose number is usually small in a Russian corporation. 13. These 2-digit classifications best measure the level of the non-related diversification (conglomerate) strategy. 14. Here, we do not examine the impacts of the difference in corporate form and the adoption of a collective executive organ, because we found that these two factors did not affect board structure at the fist step of our empirical analysis.

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15. See Iwasaki (2007c) for details of estimation results of the single-equation models.

Bibliography Abe, N. (2003) Keieisha turnover to keieisha insentibu mekanizumu, Discussion paper No. A435. Tokyo: Institute of Economic Research, Hitotsubashi University. Adams, R. B. & Ferreira, D. (2007) A theory of friendly boards, Journal of Finance, 62: 217–250. Agrawal, A. & Knoeber, C. R. (2001) Do some outsider directors play a political role? Journal of Law and Economics, 44: 179–198. Alchian, A. A. & Demsetz, H. (1972) Production, information costs, and economic organization, American Economic Review, 62: 777–795. Arthur, N. (2001) Board composition as the outcome of an internal bargaining process: Empirical evidence, Journal of Corporate Finance, 7: 307–340. Baker, M. & Gompers, P. A. (2003) The determinants of board structure at the initial public offering, Journal of Law and Economics, 46: 569–598. Barnhart, S. W., Marr, M. W., & Rosenstein S. (1994) Firm performance and board composition: Some new evidence, Managerial and Decision Economics, 15, 329– 340. Barnhart, S. W. & Rosenstein, S. (1998) Board composition, managerial ownership, and firm performance: An empirical analysis, Financial Review, 33: 1–16. Bathala, C. T. & Rao, R. P. (1995) The determinants of board composition: An agency theory perspective, Managerial and Decision Economics, 16: 59–69. Baysinger, D. B. & Butler, H. N. (1985) Corporate governance and the board of directors: Performance effects of changes in board composition, Journal of Law and Economics, 1: 101–124. Baysinger, B. & Hoskisson, R. E. (1990) The composition of boards of directors and strategic control: Effects on corporate strategy, Academy of Management Review, 15: 72–87. Beiner, S., Drobetz, W., Schmid, F., & Zimmermann, H. (2004) Is board size an independent corporate governance mechanism? Kyklos, 57: 327–356. Blasi, J. & Shleifer, A. (1996) Corporate governance in Russia: An initial look. In: Frydman, R., Gray, C. W., & Rapaczynski, A. (eds), Corporate Governance in Central Europe and Russia. Volume 2: Insiders and the State (Budapest: Central European University Press). Black, B. & Kraakman, R. (1996) A self-enforcing model of corporate law, Harvard Law Review, 109: 1911–1982. Boone, A. L., Field, L. C., Karpoff, J. M., & Raheja, C. G. (2007) The determinants of corporate board size and composition: An empirical analysis, Journal of Financial Economics, 85: 66–101. Booth, J. R., Cornett, M. M., & Tehranian, H. (2002) Boards of directors, ownership, and regulation, Journal of Banking and Finance, 26: 1973–1996. Borokhovich, K. A., Brunarski, K. R., Crutchley, C.E., & Simkins, B. J. (2004) Board composition and corporate use of interest rate derivatives, Journal of Financial Research, 27: 199–216. Bozec, R. (2005) Board of directors, market discipline, and firm performance, Journal of Business Finance and Accounting, 32: 1921–1960. Brickley, J. A., Coles, J. L., & Jarrell, G. (1997) Leadership structure: Separating the CEO and chairman of the board, Journal of Corporate Finance, 3: 189–220.

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The Structure of Corporate Boards 119 Broadman, H. G. (2000) Reducing structural dominance and entry barriers in Russian industry, Review of Industrial Organization, 17: 155–176. Coles, J. L., Daniel, N. D., & Naveen, L. (2008) Boards: Does one size fit all? Journal of Financial Economics, 87: 329–356. de Andres, P., Azofra, V., & Lopez, F. (2005) Corporate boards in OECD countries: Size, composition, functioning and effectiveness, Corporate Governance, 13: 197–210. Demsetz, H. (1967) Toward a theory of property rights, American Economic Review, 57: 347–359. Denis, D. J. & Sarin, A. (1999) Ownership and board structures in publicly traded corporations, Journal of Financial Economics, 52: 187–223. Djankov, S. & Murrell, P. (2002) Enterprise restructuring in transition: A quantitative survey, Journal of Economic Literature, 40: 739–792. Dolgopyatova, T. (2003) Ownership and corporate control structures as viewed by statistics and surveys, Russian Economic Barometer, 12: 12–20. Eisenberg, T., Sundgren, S., & Wells, M. T. (1998) Larger board size and decreasing firm value in small firms, Journal of Financial Economics, 48: 35–54. Fama, E. F. (1980) Agency problems and the theory of the firm, Journal of Political Economy, 88: 288–307. Fama, E. F. & Jensen, M. C. (1983) Agency problems and residual claims, Journal of Law and Economics, 26: 327–349. Fich, E. M. & Shivdasani, A. (2006) Are busy boards effective monitors? Journal of Finance, 61: 689–724. Guriev, S. & Rachinsky, A. (2005) The role of oligarchs in Russian capitalism, Journal of Economic Perspectives, 19, 131–150. Hermalin, B. E. & Weisbach, M. S. (1988) The determinants of board composition, RAND Journal of Economics, 19: 589–606. Hermalin, B. E. & Weisbach, M. S. (1998) Endogenously chosen board of directors and their monitoring of the CEO, American Economic Review, 88: 96–118. Hill, C. W. & Snell, S. A. (1988) External control, corporate strategy, and firm performance in research-intensive industries, Strategic Management Journal, 9: 577–590. Iwasaki, I. (2007a) Corporate law and governance mechanism in Russia. In: Dallago, B. & Iwasaki, I. (eds), Corporate Restructuring and Governance in Transition Economies (Basingstoke: Palgrave Macmillan). Iwasaki, I. (2007b) Enterprise reform and corporate governance in Russia: A quantitative survey, Journal of Economic Surveys, 21: 849–902. Iwasaki, I. (2007c) Endogenous board formation and its determinants in a transition economy: Evidence from Russia. Working paper No. 2007-1. Tokyo: Center for Economic Institution, Institute of Economic Research, Hitotsubashi University. (available at: http://cei.ier.hit-u.ac.jp/working/2007/2007WorkingPapers/wp20071Revised.pdf) Jensen, M. C. (1993) The modern industrial revolution, exit, and the failure of internal control systems, Journal of Finance, 48: 831–880. Jensen, M. C. & Meckling, W. H. (1976) Theory of the firm: Managerial behavior, agency costs, and ownership structure, Journal of Financial Economics, 3: 305–360. Kaplan, S. N. & Minton, B. A. (1994) Appointments of outsiders to Japanese boards: Determinants and implications for managers, Journal of Financial Economics, 36: 225–258. Kim, Y. (2005) Board network characteristics and firm performance in Korea, Corporate Governance, 13: 800–808.

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Lehn, K., Patro, S., & Zhao, M. (2005) Determinants of the size and structure of corporate boards: 1935–2000. Unpublished working paper, University of Pittsburgh. Li, J. (1994) Ownership structure and board composition: A multi-country test of agency theory predictions, Managerial and Decision Economics, 15: 359–368. Linck, J. S., Netter, J. M., & Yang, T. (2008) The determinants of board structure, Journal of Financial Economics, 87: 308–328. Mak, Y. T. & Li, Y. (2001) Determinants of corporate ownership and board structure: Evidence from Singapore, Journal of Corporate Finance, 7: 235–256. Mayers, D., Shivdasani, A., & Smith, C. W. (1997) Board composition and corporate control: Evidence from the insurance industry, Journal of Business, 70: 33–62. Monks, R. A. & Minow, N. (1996) Watching the Watchers: Corporate Governance for the 21st Century (Cambridge, MA and Oxford: Blackwell). Muth, M. & Donaldson, L. (1998) Stewardship theory and board structure: A contingency approach, Corporate Governance, 6: 5–28. Peasnell, K. V., Pope, P. F., & Young, S. (2005) Board monitoring and earnings management: Do outsider directors influence abnormal accruals? Journal of Business Finance and Accounting, 32: 1311–1346. Peng, M. W. (2004) Outsider directors and firm performance during institutional transitions, Strategic Management Journal, 25: 453–471. Perotti, E. C. & Gelfer, S. (2001) Red barons or robber barons? Governance and investment in Russian financial-industrial groups, European Economic Review, 45: 1601– 1617. Perry, T. & Shivdasani, A. (2005) Do boards affect performance? Evidence from corporate restructuring, Journal of Business, 78: 1403–1431. Pfeffer, J. & Salancik, G. R. (1978) The External Control of Organizations: A Resource Dependence Perspective (New York: Harper & Row). Prevost, A. K., Rao, R. P., & Hossain, M. (2002) Determinants of board composition in New Zealand: A simultaneous equations approach, Journal of Empirical Finance, 9: 373–397. Randøy, T. & Jenssen, J. I. (2004) Board independence and product market competition in Swedish firms, Corporate Governance, 12: 281–289. Rediker, K. J. & Seth, A. (1995) Boards of directors and substitution effects of alternative governance mechanisms, Strategic Management Journal, 16: 85–99. Roosenboom, P. (2005) Bargaining on board structure at the initial public offering, Journal of Management and Governance, 9: 171–198. Shivdasani, A. & Yermack, D. (1999) CEO involvement in the selection of new board members: An empirical analysis, Journal of Finance, 54: 1829–1853. Sugiura, F. (2007) Economic transformation and corporate finance in the postcommunist world. In: Dallago, B. & Iwasaki, I. (eds), Corporate Restructuring and Governance in Transition Economies (Basingstoke: Palgrave Macmillan). Tian, J. J. & Lau, C. M. (2001) Board composition, leadership structure and performance in Chinese shareholding companies, Asia Pacific Journal of Management, 18: 245–263. Tsepov, G. V. (2006) Aktsionernye Obshestva: Teoriya i Praktika (Moscow: Prospekt). van Ees, H., Postma, T., & Sterken, E. (2003) Board characteristics and corporate performance in the Netherlands, Eastern Economic Journal, 29: 41–58. Vefeas, N. & Theodorou, E. (1998) The relationship between board structure and firm performance in the UK, British Accounting Review, 30: 383–407. Weisbach, M. S. (1988) Outsider directors and CEO turnover, Journal of Financial Economics, 20: 431–460.

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The Structure of Corporate Boards 121 Whidbee, D. A. (1997) Board composition and control of shareholder voting rights in the banking sector, Financial Management, 26: 27–41. Yasin, E. (ed.) (2004) Strukturnye Izmeneniya v Rossiiskoi Promyshlennosti (Moscow: Izdatel’skii dom GU VSHE). Yeh, Y. H. & Woidtke, T. (1985) Commitment or entrenchment? Controlling shareholders and board composition, Journal of Banking and Finance, 29: 1857–1885. Yermack, D. (1996) Higher market valuation of companies with a small board of directors, Journal of Financial Economics, 40: 185–211.

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5 Impact of Corporate Governance and Performance on Managerial Turnover Naohito Abe, and Ichiro Iwasaki

Introduction Establishing an effective governance system to discipline top management to produce maximized shareholder wealth is very important because the diffuse ownership structure in public companies means that shareholders must delegate the daily management of a business to professional managers, who are not always willing to make extra efforts to satisfy their principals. To control the potential agency conflicts between shareholders and managers, several mechanisms of internal control reside in modern corporations. In this regard, the corporate governance literature pays close attention to insider ownership, boards of directors, and a dual leadership system (i.e., a separation of chief executive officer (CEO) and board chairman positions) as well as to the shareholders’ right to remove ineffective managers. In many countries, including Russia and other post-Communist countries, corporate law provides that the contract relationship between a company and its management officers may create a trust that enshrines the right of arbitrary dismissal of executives. This right may be given to the general shareholders’ meeting and the board of directors, if such an authority is delegated to the latter by the former. This legislative ordination is intended to be a formal tool for governing corporations to allow necessary managerial renewals in favor of shareholders’ interests. From this point of view, an empirical test to examine the likelihood of managerial dismissal initiated by a shareholder(s) or through an entrusted board member(s) and the positive link between poor corporate performance and managerial turnover is of considerable significance to measure the viability of the aforesaid shareholders’ right, that is, the enforcement of the corporate law in a concerned state. In the context of transition economies, this kind of empirical work is also important to assess the development of the private corporate sector in a country undergoing what Kornai (2006) 122

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Corporate Governance and Managerial Turnover 123

called “the great transformation” and the degree of adaptation by its citizens to the new principles of life in a market economy. Although the empirical results are mixed, many financial economists confirm the statistically significant impacts of the governance mechanism and corporate performance on managerial turnover in developed countries.1 As we will discuss later, empirical evidence does exist concerning the close relationship between ownership structure and managerial turnover in Russia. With regard to the impact of corporate performance on the dismissal of poor performing managers, however, there are only a handful of papers supporting the empirical relation between the two elements (Muravyev 2001, 2003a, 2003b; Kapelyushnikov & Demina 2005). As many researchers of the Russian economy have pointed out, the insignificant or neutral association between bad performance and managerial turnover in Russian firms is due to the obstinate managerial entrenchment in the background of substantial insider ownership as a result of the mass-privatization policy, weakly functioning internal corporate organs, and deep informational asymmetry between management and outside shareholders (Iwasaki 2007b). Although their arguments are convincing, taking the degree of economic transformation and the current social circumstances in Russia into consideration, we feel that there is room for more detailed research on this topic. In this chapter, we deliberate the possible impacts of governance systems and corporate performance on managerial turnover in Russian firms. As in other chapters of this book, we utilize the results of the joint survey as the basis for our empirical analysis. From a methodological perspective, this study is different from most previous work in that we deal not only with CEO dismissals but also with managerial turnover in a company as a whole, assuming that different types of shareholders may have distinct impacts on the removal of poorly performing managers.2 We found that nonpayment of dividends is significantly correlated with managerial turnover in our samples. We also found that the presence of dominant shareholders and foreign investors is another important factor causing managerial dismissals in Russian corporations, but these two kinds of company owners reveal different effects in terms of turnover magnitude. The remainder of this chapter is organized as follows. The next section reviews preceding studies on managerial turnover in Russian firms. The third section discusses testable hypotheses and empirical methodology. The fourth section describes the data. The fifth section presents our empirical results on the determinants of managerial turnover, and the sixth section concludes.

Managerial turnover in transition Russia: Literature review3 Many studies have been devoted to the CEO turnover observed in developed countries because this phenomenon offers a unique dimension to corporate

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governance theory. Likewise, this theme is also a center of attention for those involved in the study of Russian corporate governance. In fact, many researchers and research teams have conducted studies on CEO turnover from the viewpoint of the appointment date of the current president and the reason for the resignation of the predecessor in order to use the data in empirical studies. Although abundant information on managerial turnover in Russia is available from these survey papers, most of them simply show the percentage of enterprises that experienced a CEO replacement during a given survey period but not changes in the turnover rate over time. Therefore, we estimated the annual CEO turnover for each year from 1993 to 2003 by examining the relevant data available in 14 papers. Figure 5.1 contains a plot of simple means as well as weighted means by sample size in individual surveys. Dolgopyatova (2003) suggested that CEO turnover increased after the 1998 financial crisis. However, the data in Figure 5.1 suggest that it is highly possible that such an upward trend started earlier than that event. In fact, the differences between the average turnover for 1996 and that for 1997 are statistically significant at the 1% level by the one-tail test (t 3.55, p 0.004), whereas the differences between 1997 and 1998 are not significant (t 0.474, p 0.323). Furthermore, a regression analysis of CEO turnover adapted from the reform years (setting 1993 to 1 as the starting point) and the use of a level-shift dummy (set at 1 for 1997 onwards) as an explanatory variable led to the conclusion that there was a statistically significant average divergence of 5.8% in CEO turnover between the two subperiods of 1993 to 1996 and 1997 to 2003.4 15 12 (%)

9 6

Figure 5.1

01 20 02 20 03

00

20

99

20

98

Simple mean

19

97

19

96

19

95

19

94

19

19

19

93

3

Weighted mean

Changes in CEO turnover frequency, 1993–2003

Source: Authors’ illustration based on Klepach et al. (1996) (covering 66 firms); Linz (1996) (1,714 firms); Filatotchev et al. (1999a) (314 firms); Filatotchev et al. (1999b) (98 firms); Radygin & Arkhipov (2000) (872 firms); Goltsman (2000) (217 firms); Kapelyushnikov (2001) (135 to 156 firms); Rachinsky (2001, 2002) (110 firms); Gurkov (2002) (530 firms); Muravyev (2003a) (413 firms); Dolgopyatova (2003) (523 firms); Dolgopyatova (2004) (20 firms); and Dolgopyatova & Kuznetsov (2004) (328 firms).

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Corporate Governance and Managerial Turnover 125 70.0 60.0 50.0 40.0 (%) 30.0 20.0 10.0 0.0 Just after 1994 1995 1996 1997 1998 1999 2000 2001 2002 mass privatization Insiders (incumbent managers and workers) Outside shareholders (without state shareholding) The State Figure 5.2 Changes in average ownership share by insiders, outside shareholders, and the state in industrial firms, 1994–2002 Source: Authors’ illustration. The ownership share of each category of shareholders was calculated on the basis of survey results reported in 25 different papers investigating the ownership structure of industrial firms for various periods. For more details, see Iwasaki (2007b).

As indicated in Figure 5.2, after the mass privatization of state-owned enterprises conducted in early 1990s, the year of 1997 became the first year when the average share of insider ownership fell below 50%.5 In the same year, the average age of top managers was nearly as high as their retirement age, with the proportion of CEOs older than 60 topping 28%. In addition, the average CEO tenure (7 to 8 years) and turnover frequency (10 to 11%) for Russian corporations over the past few years have been almost the same as those for American and Japanese companies. In terms of the frequency of outside CEO succession (40 to 50%), Russian firms have kept their level 10 to 20% higher than the average for corporations in developed countries (Weisbach 1988; Martin & McConnell 1991; Kang & Shivdasani 1995; Muravyev 2001; Rachinsky 2002; Muravyev 2003a; Abe & Oguro 2004; Yasin 2004). Therefore, the increasing upward trend of CEO turnover frequency shown in Figure 5.1 can be attributed to the accelerated development of flexibility of CEO appointment against the background of declining insider control and the aging of Soviet-generation managers (so-called “red executives”). Empirical studies that scrutinize the linkage between CEO turnover and corporate restructuring in Russia are listed in Table 5.1. All studies, except

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Table 5.1

Studies of managerial turnover in Russian firms

Paper Barberis et al. (1996) Frydman et al. (1996) Klepach et al. (1996) Linz (1996) Filatotchev et al. (1999a) Filatotchev et al. (1999b) Basargin & Perevalov (2000) Goltsman (2000) Bevan et al. (2001) Kapelyushnikov (2001) Muravyev (2001, 2003a) Rachinsky (2001) Rachinsky (2002) Dolgopyatova (2003) Peng et al. (2003) Wright et al. (2003) Dolgopyatova (2004) Dolgopyatova & Kuznetsov (2004) Krueger (2004) Yasin (2004) Kapelyushnikov & Demina (2005)

Analysis period

Tested interrelationsa

Empirical methodb

1992–1993 1994 1995 1992–1995 1992–1996 1995–1998 1994–1999 1999 2000 2001 1999–2000 1997–2000 1997–2001 2001 1995 1997 2003 2001 1994–1997, 1999 2003 1995–2003

II I II I I III I I I I I II I I II I I III II

RA (OLS, 2SLS)* RA (LOG) DS RA (PRO) DS DS, RA (LOG) RA (PRO) RA (PRO, TOB) DS DS DS, RA (PRO) RA (OLS) DS, CS DS RA (PRO) DS DS DS RA (OLS)

III I

DS, PS DS, RA (PRO)

Notes: a Each code represents the following: I: Ownership structure and/or corporate performance have an impact on managerial turnover; II: Managerial turnover has an impact on corporate performance and/or restructuring; III: I+II. b Each code represents the following: CS: Case study; DS: Descriptive statistical analysis (t-test of differences in means, ANOVA, etc.); RA: Regression analysis (OLS: Ordinary least squares; 2SLS: Two-stage least squares; PRO: Probit; LOG: Logit; TOB: Tobit; *: Analysis dealing with selection bias for privatized enterprises); PS: Point systems for individual survey items. Source: Compiled by the authors.

that by Linz (1996), highlight the critical effects of ownership structure on managerial renewal. They share the following four common perceptions. First, outside ownership is positively and highly statistically correlated with CEO turnover frequency. Second, in contrast, insider shareholding significantly hampers CEO changes, as 40 to 50% of enterprises with dominant ownership by managers and worker collectives have a holdover CEO from the Soviet days, a much higher proportion than that in other types of corporations (15 to 20%). Third, substantial changes in ownership structure resulting from the replacement of the largest or dominant shareholders are highly likely to cause CEO turnover. Fourth, the higher the investment share of a top shareholder and the ownership concentration rate are, the more

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frequently CEO turnover occurs.6 Moreover, there are two other noteworthy points. The first is that the government does not necessarily speak for the current management, considering that state ownership increases CEO turnover as well (Kapelyushnikov 2001; Muravyev 2001, 2003a), and the second is that the frequency of insider CEO succession is positively correlated with shareholding by insiders and the federal government, while the presence of outside investors and local governments enhances the possibility of outsider succession (Muravyev 2003b; Kapelyushnikov & Demina 2005). Table 5.2 shows the results from vote-counting analysis of the impact of different types of owners and changes in ownership structure on CEO turnover based on the 12 estimation results available in the papers listed in Table 5.1.7 Here, multiple estimation results were taken from one study only when regression modeling, analysis period, and other conditions were substantially different from others in that study. In cases in which more than one estimation result was available from one study regarding the same subject, the most appropriate was selected by judging the coefficient of determination (R2) and selection of control variables and by considering the simultaneous equation bias, among other factors. This table confirms the reversed relationship between insiders and outsiders regarding the direction of their impact on CEO turnover. Except for state ownership, all types of outside owners had a positive impact on managerial turnover if they are estimated statistically significant at the 5% level or less. Domestic individual shareholders and financial institutions enjoy a relatively high probability to affect the renewal of company top officers in comparison with domestic nonfinancial corporate shareholders and foreign investors. Changes in ownership structure also exert positive effects on CEO turnover. Regarding the interrelation between managerial turnover and corporate performance, eight studies shown in Table 5.1 examine the effects of the renewal of top-notch managers on ex-post corporate performance and restructuring activities. Four of them evaluate the refreshment of management as positive (Barberis et al. 1996; Klepach et al. 1996; Filatotchev et al. 1999b; Krueger 2004), and the other four have a neutral or negative view of its influence (Rachinsky 2001; Peng et al. 2003; Dolgopyatova & Kuznetsov 2004; Yasin 2004), leaving room for further discussion. A more debatable aspect in this regard is the reverse angle of the relationship between these two elements, that is, the role of corporate performance as a trigger of CEO turnover. The majority of researchers do not provide clear evidence that corporate performance affects the frequency of managerial turnover. Many papers have suggested an extremely limited correlation between these two factors (Kapelyushnikov 2001; Dolgopyatova & Kuznetsov 2004) or denied a significant correspondence (Goltsman 2000; Yasin 2004). An exhaustive event study by Rachinsky (2002) covering 110 listed corporations also supports these mainstream views. According to his

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1 1 2 1 5 2 2 2 0

0

Not significant

2 3 0 0 0 0 0 2

Significantly negative

2

3 4 4 3 7 5 3 6 0.0

66.7 75.0 0.0 0.0 0.0 0.0 0.0 33.3

Total Significantly negative

Source: Compiled by the authors on the basis of previous studies listed in Table 5.1.

2

0 0 2 2 2 3 1 2

Significantly positive

Number of samples

Note: The significance level for the verification was set to the 5% level.

Insiders Workers Outsiders Domestic individuals Domestic corporations Financial institutions Foreign investors State Changes in ownership structure

Type of owner

0.0

33.3 25.0 50.0 33.3 71.4 40.0 66.7 33.3

Not significant

100.0

0.0 0.0 50.0 66.7 28.6 60.0 33.3 33.3

Significantly positive

Composition (%)

100.0

100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

Total

Table 5.2 Results from vote-counting analysis of the impact of different types of owners and changes in ownership structure on CEO turnover


study, only 19.5% of all 113 CEOs who left their post from 1997 to 2001 resigned to take responsibility for the worsening of their business results.8 This percentage is much lower than that of CEOs who stepped down for nonmanagerial reasons, such as career changes, age-limit retirements, internal reassignments resulting from organizational changes, and nonmanagerial problems (51.3% in total) and even lower than that of those who resigned for other reasons, such as managerial intervention by local governments, social conflicts including labor disputes, legal procedures concerning corporate rehabilitation, takeover, and others (24.8% in total). Judging from the above findings, Rachinsky (2002) reports that it is difficult, even in the listed companies, to drive out top management on the grounds of poor performance, and, consequently, CEO changes are not sensitive to corporate performance in Russia. In contrast, the remaining two studies, by Muravyev (2003a) and Kapelyushnikov & Demina (2005), demonstrate that poor corporate performance is positively related to managerial turnover. Using data obtained in the survey of 437 Russian enterprises, Muravyev (2003a) regressed CEO turnover in the period from January 1999 to May 2000 on industry-adjusted labor productivity and other control variables, including ownership structure, board composition, and company size, and he found a statistically robust relationship between past performance and turnover frequency. He concludes with the following statement: “The fact that bad managers (either incompetent or opportunistic) are punished implies that the widely held assumption about virtual nonexistence of corporate governance in Russia is not valid” (p. 168). The study by Kapelyushnikov & Demina (2005) is the most recent one on managerial turnover in Russia. Using the results of a longitudinal questionnaire survey of industrial firms9 carried out in 1997–2003, they performed a probit estimation of the CEO-turnover model and confirmed that, on average, the possibility of CEO replacement in loss-making firms is 8.5% higher than that in profitable corporations. Moreover, Kapelyushnikov & Demina (2005) also examined the impact of corporate performance on new CEO appointment and substantiated that the appointment of incumbent workers to top management is less probable in underperformed enterprises than in profitable ones. Indeed, according to their regression results, the possibility of succession by insiders to company presidents in loss-making firms is 68.8% lower on average than in well-performing firms. Because their dataset consists of many unlisted firms and ex-state-owned privatized firms, their empirical evidence may suggest that the positive link between poor performance and CEO renewal becomes usual governance practice in daily management life in contemporary Russia. Although their empirical analysis clearly indicates that bad corporate performance enhances CEO turnover in Russian firms, Muravyev (2003a) and Kapelyushnikov & Demina (2005) are still in the minority. In the following

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sections, we will show additional evidence supporting the empirical relationship between corporate performance and managerial turnover, relying on a complete new dataset of Russian corporations.

Hypothesis and empirical methodology As we discussed in the previous section, most prior studies on Russian companies do not find a significant impact of company performance on CEO turnover. We can think of various reasons for the absence of a statistically significant relationship between these two factors in Russia. It is possible that previous literature simply did not have a sufficient number of observations of turnover events. Another possibility is that top managers in Russia do not play the same role in other countries, such as the United States. In the US, the CEO is the bridge between the board of directors and management team and is solely responsible for management outcomes in general. In other words, American CEOs are very powerful and accountable. In contrast, in other developed countries, such as Japan, CEOs or company presidents are not as powerful and accountable as their American counterparts. Rather, they are regarded as a key member of the management team in their company. In such a case, when company performance is poor, it does not have to be the CEO alone who should accept full responsibility; other management members are to share in the responsibility (Abe & Jung 2004). Furthermore, in such countries, it is highly likely that the management team in a company will take collective responsibility and resign as a group when the company performs extremely badly or when there is a great scandal about its corporate affairs. With regard to Russia, management researchers argue that, because of the national culture of social collectivism, the 70-year-long history of the riskaverse way of life in the Soviet period, and the Continental European nature of corporate law, the management system in Russian corporations, especially in the former socialist enterprises, leans toward team leadership and the collective decision-making practice on everyday management (Holt et al. 1994; Puffer & McCarthy 1995; Ralston et al. 1997; Elenkov 1997, 1998). Indeed, Russian company presidents do not generally stand aloof from other executives, and they do not have sole responsibility for all company matters, including poor performance. In other words, Russian managers often share the fruits of collective achievement in corporate management, and, at the same time, they jointly sustain damage from any failure as a team member. Consequently, it is conceivable that not only the top corporate managers but also other high-ranking executives leave their company in response to bad corporate performance caused mainly by their mistakes. It is also possible that the entire management team in a Russian company may resign together due to an irrecoverable loss in its shareholder wealth or company reputation.

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Furthermore, it may be optimal for outside shareholders, who have a certain insight into management style in a company they own, to call for the resignation not of its company president but of one or more senior managers, depending on the cause and seriousness of the company problems. Such a decision can be justified when outside shareholders expect that the top-manager dismissal may not bring enough positive effects on the ex-post management of that company to offset the loss of the top manager’s firmspecific knowledge and experience. This is particularly true of dominant shareholders, mainly Russian oligarchs and business groups, who have a strong incentive to monitor the management because they have a large share in ownership and can easily obtain definite and reliable information on top-management activities in their companies. In Russia, foreign investors are also regarded as active shareholders. However, due to the cautious attitude of Russian managers toward the possibility of hostile takeovers, the non investor-friendly disclosure system of Russian companies, and the incompleteness and low enforceability of the FDI-related laws, many difficulties attend the attempt of foreign shareholders to obtain access to insider information of their invested companies if they do not control their own firms. If the above were more accurate concerning company management life in contemporary Russia, we should examine the impact of corporate performance not on CEO turnover alone but also on managerial turnover in a company as a whole. In addition, with regard to the influence of ownership structure on managerial turnover, we should pay attention to the deep gap between domestic shareholders and foreign investors in terms of accessibility to insider information on management in their own companies. Relying on these presumptions, we attempt to investigate turnover events of not only top managers but also other high-ranking corporate officers who are in charge of finance, accounting, strategic planning, marketing, or sales management. There are four possible events to examine. They are the turnover of both CEO and senior managers (Type I), the turnover of only the CEO (Type II), the turnover of only senior managers (Type III), and no turnover (Type IV). This means that we now have four mutually exclusive outcomes. Taking informational asymmetry between Russian large shareholders and foreign investors into consideration, we adapt the next testable hypotheses: Hypothesis H1: When a company’s performance is poor, the company tends to experience Type I or Type III turnover if the company has a dominant shareholder. Hypothesis H2: When a company’s performance is poor, the company tends to experience Type I or Type II turnover if the share is owned by foreign investors.

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The rationale for the above hypotheses is that dominant shareholders with sufficient information on top management are so capable of specifying the cause and responsibility of bad performance in their companies that they incline to dismiss only responsible person(s). In contrast, foreign owners are prone to demand the removal of the top managers or the whole management team in reaction to their bad financial performance because foreign shareholders are more ineffective in pinpointing company problems than dominant shareholders because higher information asymmetry results in higher monitoring costs. Let the value to the ith company of choosing turnover type j (j = 1,..,4) be yij * and assume that yij * depends on company performance (Performance), corporate governance-related variables, such as ownership structure (CG), and other variables, including firm size, legal form of incorporation, industrial dummies (X), and an error term Hij: y* ij

j j j j a b Performance b CG b X e . 1 2 i 3 i ij i

(1)

Using Type IV (no turnover) as the base case, we adopt the multinomial probit (MNP) model to estimate the relationship between company performance and the type of turnover.10 The probability of observing Type j turnover, yij = 1, is: P ij

Pr[ y ij

1] Pr[ y * ! y * , k z j | Performance , CG , X ].11 ij i i i ik

(2)

If there are only two outcomes, such as no turnover and CEO turnover, (2) can be written as a standard probit or logit model.

Data description To perform regression analysis based on the abovementioned methodology, we employ detailed micro data of Russian nonfinancial joint-stock companies with more than 100 employees. The data are derived from the jointenterprise survey conducted in 2005 by Hitotsubashi University and State University Higher School of Economics. See Appendix of this volume for more details on the dataset. Of 822 observations, we dropped workers’ joint-stock companies (people’s enterprises) due to the specific nature of their internal control system stipulated by a special law on these legal entities.12 We also dropped companies that refused to answer at least one of the questions regarding managerial turnover, relationship between shareholders and managers, and company performance, which gave us 602 observations. Our survey contains many items on turnover of not only CEO or board members but also of senior managers. One of the drawbacks of the survey is its weakness in accounting information. Most surveyed companies are

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not listed. Although we asked questions on company performance, such as profit, dividends, and sales growth, such variables most likely contain many measurement errors. In the following empirical analyses, it is important to take the characteristics of the data into account.13 The variables we use in our empirical model (2) are as follows: y: The CEO-turnover dummy takes unity if the CEO left the company between 2001 and 2004 on the initiative of shareholders; otherwise, the dummy takes zero. The turnover dummy of senior managers takes a value of 1 if the company reports that many managers who are in charge of finance, accounting, planning, marketing, and sales left the company between 2001 and 2004. The turnover index is created from these two dummy variables, which gives us four mutually exclusive outcomes. Performance: We use two different indices as independent variables representing corporate performance. First, we use a dividend payment dummy (DIVPAY), which takes unity when dividends on common stock were paid between 2001 and 2004 and zero otherwise; second, we use a sales growth index (SALGRO), which captures the relative sales growth to the industrial median from 2000 to 2004. The original variable is an index (1 for doubled or more sales growth during the period, 2 for 1.5 times less than doubled, 3 for less than 1.5 times, 4 for not changed, and 5 for declined). We take the industrial medians of the variable and subtract the company level variable. CG: As independent variables of the governance mechanism, we adapt two ownership variables taking into account the findings of prior studies on managerial turnover in Russia, as reported in the second section. They consist of: first, an index for ownership share by foreign investors (OWNFOR) that takes 0 for zero, 1 for 10% or less, 2 for 10.1–25%, 3 for 25.1–50%, 4 for 50.1–75%, and 5 for more than 75%; and second, a dummy for the existence of dominant shareholders (DOMSHA). The dominant shareholder is defined as the shareholder who owns more than 50% of common stock and has a controlling interest.14 X: Furthermore, we introduce the next three variables to control other firm specificity. Namely, (a) Natural logarithms of the number of employment as a proxy of company size (COMSIZ), (b) Open joint-stock company dummy (OPECOM),15 and (c) Industry dummies for nine classifications. Table 5.3 contains the descriptive statistics for all 602 observations and those for each turnover type. Among 602 companies, 68 firms (11.3%) report that they experienced turnover of both CEO and managers (Type I). Combining Types I and II, about 27% of the companies went through CEO turnover initiated by shareholders. SALGRO is positive for the no-turnover case (Type IV) but positive for all other cases, which suggests that companies that experienced any type of turnovers grew more slowly than other companies. The mean of DIVPAY is 0.45 for Type IV and 0.28 for the turnover of only the CEO (Type II), which suggests companies whose CEO had recently

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75 (12.5)

107 (17.8)

352 (58.5)

Firms with CEO turnover only (Type II)

Firms with turnover of senior managers only (Type III)

Firms with no turnover (Type IV)

6.389 (1.190)

6.393 (1.203)

6.614 (1.308)

6.802 (1.506)

0.253

0.336

0.693

0.618

0.364

Mean (S.D)

OWNFORb Mean (S.D)

OPECOMd

0.667 (0.475)

0.682 (0.466) 0.659 (0.475)

0.738 (0.442) 0.729 (0.447)

0.760 (0.430)

0.912 (0.286) 0.794 (0.407)

0.728 (0.446) 0.688 (0.464)

Mean (S.D)

DOMSHAc

Mean (S.D)

DIVPAYf

0.318 (0.468)

0.032 (1.226) 0.432 (0.496)

0.149 (1.220)

0.051 (1.406) 0.280 (0.452)

0.132 (1.234) 0.426 (0.498)

0.029 (1.249) 0.392 (0.489)

Mean (S.D)

SALGROe

Source: Authors’ calculation.

Notes: a Company size measured by the total number of employees. b Ownership share of foreign investors rated on the following 6-point scale: 0: 0%; 1: 10.0% or less; 2: 10.1 to 25.0%; 3: 25.1 to 50.0%; 4: 50.1 to 75.0%; 5: 75.1 to100.0%. c A dichotomous variable with a value of 1 if the company has a dominant shareholder. d A dichotomous variable with a value of 1 if the company is operated as an open joint-stock company. e Changes in gross sales during 2000 to 2004. The original variable is an index (1 for doubled or more sales growth during the period, 2 for 1.5 times less than doubled, 3 for less than 1.5 times, 4 for not changed and 5 for declined). We take the industrial median of the variable, and then subtract the company level variable from the industrial median. f Frequency of dividend payments during 2001 and 2003.

68 (11.3)

6.464 (1.251)

Mean (S.D)

Number (%)

602 (100.0)

COMSIZa

Observations

Descriptive statistics of independent variables by company group in terms of turnover type

Firms with turnover of CEO and senior managers (Type I)

All firms

Table 5.3


resigned did not pay dividends. There tended to be more open joint-stock companies that experienced a Type I turnover. Companies with more foreign shareholders went through more Type I and Type II turnovers than other types of turnover. The most noticeable point of Table 5.3 is probably the role of dominant shareholders in turnover. More than 90% of companies whose CEO and mangers resigned had a dominant shareholder, while less than 70% of the companies that did not experience any managerial turnover had a dominant shareholder. On the whole, the information in Table 5.3 suggests that a company that has a dominant shareholder, low sales growth, and more ownership share by foreigners experienced a Type I turnover. A company without dividend payments went through a Type II turnover. Overall, these findings seem to be consistent with the hypothesis discussed in the previous section.

Empirical results In this section, to evaluate the impacts of corporate performance and governance mechanism on managerial turnover, we conduct regression analysis in a multivariate setting. Our analysis begins with an examination of the determinants of CEO turnover by the logit model, taking the CEO-turnover dummy as a dependent variable. Next, we perform the multinomial probit estimation of managerial turnover using the four mutually exclusive turnover indices capturing the magnitude of managerial removal in a company as a whole. Table 5.4 contains the standard logit estimates. Model [L1] in Table 5.4 uses the full sample consisting of 602 companies. In addition, in order to validate the robustness of the estimation results, a supplementary estimation is performed using the following three cases. In other words, we estimate the model [L2] using the full sample excluding all firms with no dividend payment. Model [L3] uses the sample with a negative relative sales growth index, and Model [L4] is estimated on the basis of the sample with no dividend payments and negative relative sales growth. The marginal effects of each independent variable are reported in the next column to the coefficients.16 The results of Models [L1] and [L4] show that company performance, represented by DIVPAY and SALGRO, do not have significant effects on CEO turnover. We can observe several positive significant effects of foreign ownership (OWNFOR) and the presence of a dominant shareholder (DOMSHA) on the dismissal of a CEO initiated by shareholders. The results of Models [L2] and [L3] suggest that a company with poor performance tends to experience CEO removal more often if their ownership share by foreign investors is high or if there exists a dominant shareholder. A serious problem in this specification is the statistically weak effects of performance on CEO turnover in the full sample estimation of Model [L1]. Largely, our logit estimates in Table 5.4 confirm the main findings of preceding studies, which suggest

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602 312.4620

Yes

0.0278 (1.88) 0.0442** (3.03) 0.1200*** (3.41) 0.0206 (0.53) 0.0006 (0.04) 0.0665 (1.84)

dF/dx

Yes

0.0247 (1.12) 0.0475* (2.49) 0.0582 (1.15) 0.0040 (0.08) 0.0053 (0.30)

dF/dx

366 199.5589

2.3804* (2.35)

0.1364 (1.12) 0.2621* (2.42) 0.3338 (1.11) 0.0222 (0.08) 0.029 (0.30)

Coef.

[L2]

0.0127 (0.22)

0.0127 (0.48) 0.0369 (1.27) 0.0877 (1.57) 0.1409* (2.48)

dF/dx

237 117.7487

Yes

0.0789 (0.22) 2.5268** (2.75)

0.0788 (0.48) 0.2284 (1.26) 0.5756 (1.47) 0.4026 (2.20)

Coef.

[L3]

136 68.1209

Yes

0.0089 (0.22) 0.0327 (0.92) 0.0294 (0.38) 0.1443 (1.92)

0.0544 (0.22) 0.2004 (0.91) 0.183 (0.38) 0.9402 (1.75)

2.0095 (1.62)

dF/dx

Coef.

[L4]

Source: Authors’ estimation.

Notes: a Model [L1] is estimated using a full sample; Model [L2], firms without dividend payment; Model [L3], firms with lower sales growth than the industrial average; Model [L4], firms without dividend payment and with lower sales growth than the industrial average. dF/dx denotes the marginal effects of independent variables. t-values are in parentheses. *, **, and *** denote the 5%, 1%, and 0.1% significance, respectively.

N Log likelihood

0.1635 (1.86) 0.2594** (2.95) 0.7696** (3.05) 0.1221 (0.52) 0.0033 (0.04) 0.3933 (1.79) 2.7456*** (3.79)

Coef.

[L1]

Logit regression analysis of the impacts of corporate governance and performance on CEO turnover

Industry dummies

Constant

DIVPAY

SALGRO

OPECOM

DOMSHA

OWNFOR

COMSIZ

Modela

Table 5.4


a weak correlation between corporate performance on CEO turnover and a significant impact of ownership structure on top-management removal. Next, we look into the joint turnover of company presidents and senior managers in our samples. Table 5.5 contains the regression results by the multinomial probit maximum likelihood. The base category for our MNP estimation is firms with no-turnover events (Type IV). Models [M1] to [M4] use the same sample criteria and control variables as Models [L1] to [L4], respectively. This time, we can confirm the negative significant impacts of performance on CEO turnover (Type II). That is to say, DIVPAY has negative significant effects on CEO dismissal under all specifications. Although SALGRO does not have statistically significant impacts on CEO removal, the sign is positive under most specifications, which suggests that poor company performance in terms of sale growth reduces the probability of the turnover of top managers. The MNP estimation results contrast with previous literature and our logit regressions reported in Table 5.4. We believe that the difference is due to two reasons. The first is the fact the multinomial probit model is statistically more powerful than the standard logit model. It is noteworthy that, although the DIVPAY dummy variable in Table 5.4 is insignificant, the sign is negative. Utilizing information of various turnovers simultaneously, we can increase the statistical powers to reject the null hypothesis. The second reason is the importance of the distinction between the turnover of CEOs and other high-ranking managers. As we discussed in the third section, when company performance is poor, it is not always the CEO who is responsible. It is likely that other senior manager(s) may resign instead of the company president, especially if companies are running under a collective management system. Although it is almost impossible to identify who should take the responsibility from the data, by controlling for ownership structure and other company characteristics, we believe that we can obtain information on how companies react differently to the occurrence of bad company performance. Another noteworthy result in Table 5.5 is that shareholding by foreign investors (OWNFOR) has positive and significant effects on the turnover of the CEO alone (Type II), although the effects on other turnovers are not significant. The effects of the dominant shareholder dummy (DOMSHA) are significant in the Type I turnover, that is, the turnover of both the CEO and senior managers, but not significant in the turnover of the CEO alone. As for Type II turnover, i.e., the turnover of CEO only, and Type III turnover, i.e., the turnover of senior managers only, DOMSHA is generally insignificant, while OPECOM dummy is generally positive and significant. We interpret this result as follows. It is very difficult for foreign owners to monitor the activities of the CEO and other company managers in Russian firms for several reasons, including weak disclosure requirements and management hostility to foreigners. Therefore, when the outcome from

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Modela

SALGRO

OPECOM

DOMSHA

OWNFOR

COMSIZ

Constant

DIVPAY

SALGRO

OPECOM

DOMSHA

OWNFOR

COMSIZ

0.125 (1.50) 0.2135* (2.56) 0.3058 (1.44) 0.0121 (0.06) 0.0052 (0.07)

0.1338 (1.57) 0.2021* (2.26) 1.0467*** (3.85) 0.3457 (1.47) 0.0501 (0.64) 0.1524 (0.73) 3.0772*** (4.23)

Coef.

0.0145 (1.35) 0.0195 (1.78) 0.1038*** (4.71) 0.0381 (1.42) 0.0039 (0.39) 0.0061 (0.23)

dF/dx

0.0157 (1.29) 0.0255* (2.18) 0.0169 (0.58) 0.019 (0.59) 0.0038 (0.35)

[M1]

0.0878 (0.75) 0.2472* (2.51) 0.2128 (0.80) 0.0403 (0.16) 0.0174 (0.20)

3.4906** (3.20)

0.1577 (1.29) 0.1399 (1.12) 0.5959 (1.87) 0.2900 (0.99) 0.0796 (0.82)

Coef. 0.0032 (1.07) 0.0018 (0.59) 0.0096 (1.65) 0.0053 (0.82) 0.0014 (0.60)

dF/dx

0.0114 (0.56) 0.0421* (2.50) 0.0115 (0.25) 0.0290 (0.63) 0.0020 (0.12)

[M2]

0.1379 (0.90) 0.0598 (0.34) 0.1698 (1.51) 0.7861* (2.05)

0.0097 (1.19) 0.0060 (0.63) 0.0052 (0.31) 0.0258 (1.57)

0.0143 (0.86)

0.0032 (0.45) 0.0109 (1.38) 0.0315* (2.45) 0.0254 (1.82)

0.0882 (0.53) 0.1915 (1.07) 0.9293* (2.05) 0.9409* (2.19)

0.1743 (0.49) 1.9006 (1.43)

dF/dx

Coef.

[M3]

0.1360 (0.69) 0.0199 (0.10) 0.0453 (0.11) 0.6447 (1.59)

0.6846 (0.44)

0.2831 (1.16) 0.0509 (0.25) 0.3676 (0.73) 0.9054 (1.79)

Coef.

[M4]

0.0110 (0.33) 0.0127 (0.36) 0.0011 (0.02) 0.0701 (1.18)

0.0236 (0.95) 0.0157 (0.72) 0.0348 (0.80) 0.0641 (1.57)

dF/dx

Table 5.5 Multinomial probit regression analysis of the impacts of corporate governance and performance on managerial turnover taking its magnitude into consideration



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Constant

DIVPAY

SALGRO

OPECOM

DOMSHA

OWNFOR

COMSIZ

Constant

DIVPAY

Yes

0.0049 (0.32) 0.0028 (0.17) 0.010 (0.28) 0.0351 (0.99) 0.0158 (1.23) 0.0488 (1.45)

0.0758** (2.73)

602 640.8457

0.0217 (0.27) 0.0873 (0.98) 0.2471 (1.28) 0.2267 (1.15) 0.0864 (1.27) 0.3824* (2.05) 0.9618 (1.52)

0.6183** (2.95) 1.8564** (2.79)

Yes

0.0102 (0.44) 0.0003 (0.01) 0.0833 (1.72) 0.0742 (1.56) 0.01625 (0.95)

366 403.6555

2.3899* (2.56)

0.0731 (0.66) 0.0678 (0.63) 0.4635 (1.79) 0.3388 (1.39) 0.080 (0.97)

1.8015 (1.96)

Yes

0.0666 (1.11)

0.0211 (0.74) 0.0488 (0.98) 0.0082 (0.14) 0.1289* (2.22)

0.0196 (1.25)

237 234.7226

0.3551 (1.11) 0.0764 (0.07)

0.0975 (0.67) 0.2025 (0.88) 0.0985 (0.32) 0.7977* (2.24)

0.4496 (1.30) 2.7905* (2.25)

Nob

0.019 (0.50) 0.0784 (1.00) 0.0032 (0.04) 0.0516 (0.79)

141 150.0274

0.2816 (0.23)

0.1564 (0.80) 0.3806 (0.95) 0.0374 (0.10) 0.5033 (1.35)

0.7308 (0.59)

Source: Authors’ estimation. The base category for estimation is firms with no turnover (Type IV).

Notes: a Model [M1] is estimated using a full sample; Model [M2], firms without dividend payment; Model [M3], firms with lower sales growth than the industrial average; Model [M4], firms without dividend payment and with lower sales growth than the industrial average. b Industrial dummies are not included because the marginal effects are not estimated clearly probably due to the small number of Type I turnovers (11 out of 140) dF/dx denotes the marginal effects of independent variables. tvalues are in parentheses. *, **, and *** denote the 5%, 1%, and 0.1% significance, respectively.

N Log likelihood

Industry dummies

Firms with turnover of senior managers only (Type III)

140


company management is poor, foreign investors are unable to identify its main cause. In such a case, the foreign shareholders may simply call for the CEO to take the responsibility following practices in place in the United States and Western Europe. On the other hand, if the dominant shareholder, who is in many cases either a rich Russian private investor or a nonfinancial corporate shareholder including holding companies and other business groups, exists in a company, such a shareholder has a strong incentive to monitor the activities of its company managers. With intensive monitoring, it might be possible for him or her to identify who is really responsible for the poor outcome. Hence, the dominant shareholders with deep insight into management activities in the companies they fund may exert pressure on an individual manager to resign for his/her bad performance, possibly through unofficial contact with the management. It is also possible for them to call on the whole management team to leave their companies, when, for instance, bad corporate performance has its roots in the ineffective coordination of collective decision-making on strategic management matters or in very poor opportunistic behavior as a team. Comparing the marginal effects of Model [M3] with those of [M1], the former coefficient of DOMSHA is greater than that of the latter. Recall that Model [M3] uses the observations with lower sales growth. In other words, the dominant shareholders increase the turnover of both CEO and senior managers when the company performance measured by sales growth is poor. This is consistent with the view that the dominant shareholder plays a disciplinary role in Russian companies. Turnover of a CEO or senior managers could take place when internal conflict occurs between outside shareholders and management. In Russia, company infighting is not an extraordinary case, rather an everyday incident. In fact, 206 or 25.1% of 822 surveyed firms responded that they experienced a harsh internal conflict(s) at least once from 2001 to 2004.17 Apparently, an internal conflict is not a random event. Poor company performance or ownership structure and other company characteristics could trigger the conflict. It is possible that the statistical relationship between turnover and other variables is spurious and the conflict could explain the turnover. To evaluate this possibility, we performed additional multinomial probit regressions by including an internal conflict dummy (INTCON), in which the value of 1 is assigned to companies that experienced infighting between managers and shareholders in 2001–2004, as independent variables. The results are shown in Table 5.6.18 First of all, we observe that the log likelihood of Model [M5] is 620.49 in Table 5.6, which is much larger than that of Model [M1] (640.85) in Table 5.5. This implies that internal conflict itself has a large explanatory power for our turnover model. Second, although it is not always statistically significant, INTCON has positive significant effects on various turnovers. Third, there are no remarkable differences in the estimated coefficients of other variables, such as

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Modela

DIVPAY

SALGRO

OPECOM

DOMSHA

OWNFOR

COMSIZ

Constant

INTCON

DIVPAY

SALGRO

OPECOM

DOMSHA

OWNFOR

COMSIZ

0.0899 (1.04) 0.1987* (2.31) 0.2489 (1.14) 0.008 (0.04) 0.0228 (0.31) 0.7448*** (3.38)

0.1214 (1.41) 0.1938* (2.15) 1.0019*** (3.65) 0.3204 (1.34) 0.0608 (0.77) 0.2193 (1.03) 0.4004 (1.88) 2.9050*** (3.92)

Coef.

dF/dx

0.0105 (0.87) 0.0223 (1.91) 0.0094 (0.32) 0.0151 (0.47) 0.0016 (0.16) 0.0881** (3.23)

0.0143 (1.31) 0.019 (1.70) 0.1020*** (4.48) 0.0367 (1.32) 0.0046 (0.45) 0.0006 (0.02) 0.0430 (1.39)

[M5]

0.0647 (0.55) 0.2091* (2.05) 0.1226 (0.45) 0.0139 (0.05) 0.0325 (0.37)

0.5371 (1.86) 3.3167** (3.02)

0.1344 (1.10) 0.1252 (0.99) 0.5356 (1.66) 0.2890 (0.96) 0.1005 (1.02)

Coef.

dF/dx

0.0087 (0.43) 0.0351* (2.02) 0.0025 (0.05) 0.0169 (0.36) 0.0004 (0.02)

0.0134 (1.09)

0.0037 (0.99) 0.0021 (0.55) 0.0116 (1.53) 0.0065 (0.78) 0.0023 (0.73)

[M6]

0.5398 (1.48)

0.0727 (0.46) 0.0853 (0.48) 0.0942 (0.27) 0.6804 (1.77)

0.3147 (0.85) 0.4336 (1.08) 1.5881 (1.16)

0.1418 (0.82) 0.2067 (1.14) 0.9742* (2.09) 0.9558* (2.18)

Coef.

dF/dx

0.0182 (1.46)

0.0048 (0.82) 0.0054 (0.78) 0.0008 (0.07) 0.0148 (1.24)

0.0151 (1.07) 0.0102 (0.99)

0.0036 (0.64) 0.0088 (1.43) 0.0243* (2.45) 0.0195 (1.83)

[M7]

0.1547 (0.78) 0.026 (0.13) 0.0399 (0.10) 0.5882 (1.45)

0.2537 (0.47) 0.5843 (0.37)

0.2901 (1.18) 0.0489 (0.24) 0.3851 (0.75) 0.8878 (0.75)

Coef.

[M8]

Continued

0.0144 (0.44) 0.0123 (0.34) 0.0172 (0.25) 0.0619 (1.03)

0.0251 (0.54)

0.0242 (0.97) 0.0161 (0.72) 0.0379 (0.87) 0.064 (1.56)

dF/dx

Table 5.6 Multinomial probit regression analysis of the impacts of corporate governance, corporate performance, and internal conflict on managerial turnover taking its magnitude into consideration



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Modela

Table 5.6

0.1119 (0.56) 0.7478 (1.15)

Yes

0.0572 (1.68)

0.0105 (0.87) 0.0223 (1.91) 0.009 (0.32) 0.0151 (0.47) 0.0016 (0.16) 0.0881** (3.23)

0.0572 (1.68)

dF/dx

586 620.4855

0.0091 (0.11) 0.0889 (0.99) 0.2224 (1.14) 0.1706 (0.86) 0.0966 (1.41) 0.3858* (2.03)

0.4424* (2.09) 1.5278* (2.21)

Coef.

[M5]

Yes

0.0493 (0.84)

0.0047 (0.20) 0.0001 (0.01) 0.0754 (1.51) 0.0643 (1.30) 0.0195 (1.11)

0.0597 (1.10)

dF/dx

358 394.0279

0.3562 (1.36) 2.1102* (2.22)

0.0426 (0.38) 0.0596 (0.55) 0.4007 (1.53) 0.3066 (1.23) 0.098 (1.17)

0.4370 (1.58) 1.6151 (1.71)

Coef.

[M6]

Yes

dF/dx

0.0211 (1.19)

0.0182 (1.46)

0.0048 (0.82) 0.0054 (0.78) 0.0008 (0.07) 0.0148 (1.24)

0.0211 (1.19)

231 227.9279

0.4212 (1.22) 0.2478 (0.22)

0.2489 (0.75)

0.1389 (0.93) 0.2039 (0.86) 0.1150 (0.36) 0.7906* (2.17)

0.3219 (1.93) 2.1186 (1.68)

Coef.

[M7]

NOb

0.0931 (1.15)

0.014 (0.44) 0.0123 (0.34) 0.0172 (0.25) 0.0619 (1.03)

0.0931 (1.15)

dF/dx

140 136.0024

0.3853 (0.88) 0.2216 (0.18)

0.1513 (0.77) 0.3978 (0.95) 0.0464 (0.12) 0.4877 (1.30)

0.3570 (0.86) 0.6078 (0.49)

Coef.

[M8]

Source: Authors’ estimation. The base category for estimation is firms with no turnover (Type IV).

a

Notes: Model [M5] is estimated using a full sample; Model [M 6], firms without dividend payment; Model [M7], firms with lower sales growth than the industrial average; Model [M8], firms without dividend payment and with lower sales growth than the industrial average. b Industrial dummies are not included because the marginal effects are not estimated clearly probably due to the small number of Type I turnovers (11 out of 140). dF/dx denotes the marginal effects of the independent variables. t-values are in parentheses. *, **, and *** denote the 5%, 1%, and 0.1% significance, respectively.

N Log likelihood

Industry dummies

Constant

INTCON

DIVPAY

SALGRO

OPECOM

DOMSHA

OWNFOR

COMSIZ

Constant

INTCON

Continued

Firms with turnover of senior managers only Firms (Type III) with CEO turnover only (Type II)


DIVPAY, OWNFOR, and DOMSHA, between the MNP estimations with and without the internal conflict dummy variable. Since it is possible that the estimated coefficients of INTCON are biased due to the correlation between this variable and error terms, we should be careful to interpret the results. However, it is safe to say that the relationships between turnover and company characteristics, such as corporate performance and ownership structures observed in Table 5.3, are not spurious due to the effects of the intracompany infighting.

Concluding remarks Although the corporate governance literature provides a significant amount of empirical evidence of the significant association between corporate performance and CEO turnover in developed countries, the majority of research on Russian firms is quite negative in this respect. The little correlation between two factors may be due to not having a sufficient number of observations of turnover events. It is also possible that the reason of the insignificant relation between bad performance and CEO turnover in prior studies is that the authors implicitly assume that the Russian manner of managerial dismissal is very similar to that in the United States, disregarding the collective nature of the management system in Russian firms, especially in ex-socialist enterprises. Using a unique firm-level dataset obtained from our large-scale enterprise survey conducted in 2005, we attempted to deal with the above two problems. The estimation results of the multinomial probit model reported in the previous section strongly suggest that nonpayment of dividends as a proxy of bad corporate performance is significantly correlated with managerial turnover, in stark contrast to the standard logit estimation of CEO turnover, as in preceding studies. By using information of various turnovers simultaneously, we could increase the statistical powers to reject the null hypothesis. We also found that the presence of a dominant shareholder or foreign investor is another important factor causing managerial dismissal in Russian corporations. This finding is mostly consistent with previous work. However, it is more important to point out from the analytical viewpoint that these two kinds of shareholders may have different effects on managerial turnover in terms of magnitude. That might be because there is a perceptible difference in the behavioral patterns between Russian and foreign investors. Large shareholding may also play a significant role in inspiring dominant shareholders to conduct intensive monitoring over management activities in companies they own. By not simply removing company presidents in response to poor management outcomes, dominant shareholders may utilize human capital in their companies more effectively than minority shareholders, including foreign investors, do.

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At any rate, the presence of an empirical relationship between dividend payment and managerial turnover indicates the growing respect for shareholder wealth in Russia among domestic investors. As the transition to a market economy proceeds, we may see more defined changes in the empirical results of this country, even in the near future.

Acknowledgments This chapter is an outcome from the Japan–Russia joint research project entitled “Corporate governance and integration processes in the Russian economy” launched by the Institute of Economic Research, Hitotsubashi University (Tokyo) and the Institute for Industrial and Market Studies, State University – Higher School of Economics (Moscow). Our research work was financially supported by the Japan Securities Scholarship Foundation (JSSF) and grants-in-aid for scientific research from the Ministry of Education and Science of Japan (No. 16530149; No. 17203019) in FY2005–6.

Notes 1. See Coughlan & Schmidt (1985), Weisbach (1988), Martin & McConnell (1991), Kang & Shivdasani (1995), Denis et al. (1997), Goyal & Park (2002), Abe & Oguro (2004), Huson et al. (2004), and others. 2. In Russia, the title of CEO is a relatively new appointment, appearing only recently among listed firms. The majority of Russian companies still use the title of General Director or Company President for their top executives. With this in mind, in this chapter we utilize the title of CEO for all levels of top management in Russia for simplicity 3. This section quotes Iwasaki (2007b) but is substantially modified for discussion in this chapter. 4. The OLS estimation result is as follows: Turnover = 7.64 * 0.27 Reformyear + 5.79 * After 1997, (8.00) (1.18) (4.69) N = 56, R2 = 0.480, Adj. R2 = 0.461, F = 24.484*. The t-values are in parentheses. * denotes that the coefficient is significant at the 1% level. 5. During the mass-privatization period from August 1992–June 1994, 67% of all state-owned enterprises eligible for privatization adopted an option plan in which management and employees were allowed to acquire a maximum of 51% of a firm’s total stock at 70% of face value. As a result, the vast majority of the privatized firms were heavily controlled by insiders. However, in the second half of the 1990s, shareholding by insiders was remarkably decreased mainly due to massive sales of their own shares by rank and file workers (Iwasaki 2007b). 6. For instance, a survey covering 334 industrial firms revealed that, as of the end of 2001, the largest shareholders in enterprises whose CEOs were appointed in or after 1998 had an average ownership of 45.1%, whereas those in enterprises whose CEOs had been in office for 10 years had an average ownership of 24.2% (Dolgopyatova 2003).

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Corporate Governance and Managerial Turnover 145 7. For details of the vote-counting method, see Hunter & Schmidt (2004). 8. CEO turnover occurred in 69 of the 110 companies surveyed. Twenty companies experienced the phenomenon twice, and 9 companies experienced it three or more times during the survey period (Rachinsky 2002). 9. It is called the “Russian Economic Barometer” survey project and is one of representative longitudinal enterprise surveys in Russia. More information is available at: http://www.imemo.ru/barom/. 10. In this paper, we do not use the multinomial logit (MNL) model for our empirical analysis because the IIA (independence from irrelevant alternatives) assumption for MNL is rejected. Since MNP with a general covariance matrix takes a prohibitively long time to converge, we assume that all the covariances between type i residuals and type j residuals, except for diagonal elements, are identical. 11. See Stern (1997) for details of the procedure to work with MNP model. 12. For more details on a workers’ joint-stock company, see Iwasaki (2007a). 13. Another aspect to be noticed is its response rate. Because our survey was interview-based, the response rate was not expected to be high. The rate was approximately one third; i.e., one of three company executives refused to participate in the survey (Dolgopyatova & Iwasaki 2006). 14. Although the survey evaluates current board composition, it did not ask the composition before the managerial turnover event. We could have included the board composition in our explanatory variables, but we did not do so because (a) turnover of top executives is likely to precede changes in board composition and the endogeneity issue is thus serious; (b) in many cases, when we included information on the outside board member ratio, our likelihood functions failed to converge; and (c) for some cases in which we could obtain the maximum, the outside board member ratio was not statistically significant. 15. There are two types of stock corporations in Russia – open and closed companies. The stock of a closed company cannot be traded without permission of all other stockholders. To be a closed company, several criteria, such as the number of shareholders and the amount of capital, should be met. For more details on this matter, see Iwasaki (2007a). 16. The marginal effects in the logit model are calculated as wY wxi ( xi )[1 ( xi )] , where Y is a dichotomous dependent variable, x is a vector of independent variables including a constant term, E is a parameter vector, and / (.) indicates the logistic cumulative distribution function. In the multinomial probit models, / (.) is substituted as the standard normal distribution function. 17. See page 52 in Dolgopyatova & Iwasaki (2006). 18. The sample size is smaller in Table 5.6 because some companies refused to answer the question about the occurrence of internal conflict.

Bibliography Abe, N. & Jung, T. (2004) Cross-shareholdings, outside directors, and managerial turnover: The case of Japan. Hi-Stat discussion paper No. 38, Tokyo: Institute of Economic Research, Hitotsubashi University. Abe, N. & Oguro, Y. (2004) Shacho koutai to gaibushusinsha torisimariyaku: Semiparametric suitei niyoru bunseki, Keizai Kenkyu, 55/1: 72–84. Barberis, N., Boycko, M., Shleifer, A., & Tsukanova, N. (1996) How does privatization work? Evidence from the Russian shops, Journal of Political Economy, 104: 764–790.

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Basargin, V. & Perevalov, Yu. (2000) Analiz zakonomernostei formirovaniya korporativnogo kontrolya na privatizirovannykh predpriyatiyak, Problemy Prognozirovaniya, 5: 120–138. Bevan, A. A., Estrin, S., Kuznetsov, B., Schaffer, M. E., Angelucci, M., Fennema, J., & Mangiarotti, G. (2001) The determinants of privatized enterprise performance in Russia. Working paper No. 452, Ann Arbor: William Davidson Institute, University of Michigan Business School. Coughlan, A. T. & Schmidt, R. M. (1985) Executive compensation, management turnover, and firm performance: An empirical investigation, Journal of Accounting and Economics, 7: 43–66. Denis, D. J., Denis, D. K., & Sarin, A. (1997) Ownership structure and top executive turnover, Journal of Financial Economics, 45: 193–221. Dolgopyatova, T. (2003) Ownership and corporate control structures as viewed by statistics and surveys, Russian Economic Barometer, 12: 12–20. Dolgopyatova, T. (2004) Sobstvennost’ i korporativnyi kontrol’ v rossiiskikh kompaniyakh v usloviyakh aktivizatsii integratsionnykh protsessov, Rossiiskii Zhurnal Menedzhenta, 2: 3–26. Dolgopyatova, T. & Iwasaki, I. (2006) Exploring Russian corporations: Interim report on the Japan–Russia joint research project on corporate governance and integration processes in the Russian economy. Discussion paper No. B35, Tokyo: Institute of Economic Research, Hitotsubashi University. Dolgopyatova, T. & Kuznetsov, B. (2004) Faktory adaptatsii promyshlennykh predpriyatii. In: E. Yasin (ed.), Modernizatsiya Ekonomiki Rossii: Sotsial’nyi Kontekst, Vol. 2 (Moscow: Gosudarstvennyi Universitet – Vysshaya Shkola Ekonomiki). Elenkov, D. S. (1997) Differences and similarities in management values between U.S. and Russian managers, International Studies of Management and Organization, 27: 85–106. Elenkov, D. S. (1998) Can American management concepts work in Russia? A crosscultural comparative study, California Management Review, 40: 133–156. Filatotchev, I., Wright, M., & Bleaney, M. (1999a) Privatization, insider control, and managerial entrenchment in Russia, Economics of Transition, 7: 481–504. Filatotchev, I., Wright, M., Buck, T., & Dyomina, N. (1999b) Exporting and restructuring in privatized firms from Russia, Ukraine, and Belarus, World Economy, 22: 1013–1037. Frydman, R., Pistor, K., & Rapaczynski, A. (1996) Exit and voice after mass privatization, European Economic Review, 40: 581–588. Goltsman, M. (2000) Empirical analysis of managerial turnover in Russian firms. Working paper No. BSP/00/035, Moscow: New Economic School. Goyal, V. K. & Park, C. W. (2002) Board leadership structure and CEO turnover, Journal of Corporate Finance, 8: 49–66. Gurkov, I. (2002) Raspredelenie rabochego vremeni rukovoditelei rossiiskikh promyshlennykh predpriyatii, EKO, 8: 69–79. Holt, D. H., Ralston, D. A., & Terpstra, R. H. (1994) Constraints on capitalism in Russia: The managerial psyche, social inflastructure, and ideology, Calfornia Management Review, 36: 124–141. Hunter, J. E. & Schmidt, F. L. (2004) Method of Meta-Analysis: Correcting Error and Bias in Research Findings (Thousand Oaks: Sage Publications). Huson, M. R., Malatesta, P. H., & Parrino, R. (2004) Managerial succession and firm performance, Journal of Financial Economics, 74: 237–275. Iwasaki, I. (2007a) Corporate law and governance mechanism in Russia. In: Dallago, B. & Iwasaki, I. (eds), Corporate Restructuring and Governance in Transition Economies (Basingstoke: Palgrave Macmillan).

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Corporate Governance and Managerial Turnover 147 Iwasaki, I. (2007b) Enterprise reform and corporate governance in Russia: A quantitative survey, Journal of Economic Surveys, 21: 849–902. Kang, J. & Shivdasani, A. (1995) Firm performance, corporate governance, and top executive turnover in Japan, Journal of Financial Economics, 38: 29–58. Kapelyushnikov, R. (2001) Sobstvennost’ i kontrol’ v rossiiskoi promyshlennosti, Voprosy Ekonomiki, 12: 103–124. Kapelyushnikov, R. & Demina, N. (2005) Concentrated ownership and management turnover: The case of Russia, Russian Economic Barometer, 14/1: 10–21; 14/2: 29–35. Klepach, A., Kuznetsov, P., & Kryuchkova, P. (1996) Korporativnoe upravlenie v Rossii v 1995–1996 gg., Voprosy Ekonomiki, 12: 73–87. Kornai, J. (2006) The great transformation of Central Eastern Europe: Success and disappointment, Economics of Transition, 14: 207–244. Krueger, G. (2004) Enterprise Restructuring and the Role of Managers in Russia: Case Studies of Firms in Transition (New York: M. E. Sharpe). Linz, S. J. (1996) Red executives in Russia’s transition economy, Post-Soviet Geography and Economics, 37: 633–651. Martin, K. & McConnell, J. (1991) Corporate performance, corporate takeovers, and management turnover, Journal of Finance, 46: 671–687. Muravyev, A. (2001) Turnover of top executives in Russian companies, Russian Economic Trends, 10: 20–24. Muravyev, A. (2003a) Turnover of senior managers in Russian privatized firms, Comparative Economic Studies, 45: 148–172. Muravyev, A. (2003b) Obnovlenie direktorskogo korpusa na rossiiskikh privatizirovannykh predpriyatiyakh, Rossiiskii Zhurnal Menedzhenta, 1: 77–90. Peng, M. W., Buck, T., & Filatotchev, I. (2003) Do outside directors and new managers help improve firm performance? An exploratory study in Russian privatization, Journal of World Business, 38: 348–360. Puffer, S. M. & McCarthy, D. J. (1995) Finding the common ground in Russian and American business ethics, California Management Review, 37: 29–46. Rachinsky, A. (2001) Managerial turnover and firm performance in Russia. Working paper No. BSP/2001/044E, Moscow: New Economic School. Rachinsky, A. (2002) Self-enforced mechanism of corporate governance: Evidence from managerial turnover in Russia. Working paper, Moscow: Center for Economic and Financial Research. Radygin, A. & Arkhipov, S. (2000) Sobstvennosti, korporativnye konflikty i effektivnosti: Nekotorye empiricheskie otsenki, Voprosy Ekonomiki, 11: 114–133. Ralston, D. A., Holt, D. H., Terpstra R. H., & Kai-Cheng, Y. (1997) The impact of national culture and economic ideology on managerial work values: A study of the United States, Russia, Japan, and China, Journal of International Business Studies, 28: 177–207. Stern, S. (1997) Simulation based estimation, Journal of Economic Literature, 35: 2006– 2039. Weisbach, M. (1988) Outside directors and CEO turnover, Journal of Financial Economics, 20: 431–460. Wright, M., Filatotchev, I., Buck, T., & Bishop, K. (2003) Is stakeholder corporate governance appropriate in Russia? Journal of Management and Governance, 7: 263–290. Yasin, E. (ed.) (2004) Strukturnye Izmeneniya v Rossiiskoi Promyshlennosti (Moscow: Izdatel’skii dom GU VSHE).

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6 Management Team and Firm Restructuring Victoria V. Golikova

Introduction The privatization of state-owned enterprises in Russia and the subsequent redistribution of property rights made up a large cohort of manager- owners. This group, according to surveys of the Russian Economic Barometer, became the major category of owners for the first time in 2003, with a 25% share in ownership structure, and maintained their leading position into 2007 with a 35% share (Aukutsionek et al. 2007). Therefore, a considerable number of management teams of Russian JSCs are headed by (or include) manager-owners. On the other hand, in the last decade, a tendency toward the separation of ownership and management has become more and more noticeable, and the old Soviet-style managerial teams are being substituted by a new generation of professionally trained hired managers. They are expected to be more effective at improving company performance by facilitating the large-scale market-oriented restructuring needed by the majority of privatized enterprises. However, the results of empirical surveys provide evidence that the privatization of initially state-owned manufacturing firms in Russia did not result in significant increases in productivity (Brown et al. 2004). Bhaumik and Estrin (2005) discovered that Russian industrial firms were unresponsive to almost all the normal economic drivers. In an attempt to explain the difference between two transitional countries, China and Russia, they discussed the managerial quality in the economies in transition and its influence on company performance. Due to methodological constraints and lack of information available for analysis, the composition of management teams and the role of CEO characteristics in enterprise restructuring do not very often become a subject of empirical research. For example, even public companies, which were obliged by law to disclose information about their activities, were not ready to present the information regarding the work of the general directors. S&P showed that, in 2006, the terms and conditions of the agreement with the general director were disclosed by only 1% of the companies, the remuneration of 148

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Management Team and Firm Restructuring

149

senior managers, by 16%, and information about the manner in which management remuneration depended on company performance, by only 17% (Standard & Poor’s 2006, p. 13). Information arrays, available for experts, are related to specific groups of companies, such as, for example, a study of Rachinsky (2002) based on a sampling of 110 large Russian enterprises, which are members of the Russian Trading System Stock Exchange (RTS), or a study by Roschin and Solntsev (2006) containing information about job dismissals and appointments of CEOs, published in 1999–2004 by the Vedomosti newspaper.1 Little is known regarding how and to what extent new company owners respond to changes in the composition of management teams in a situation of broadly recognized shortages of professionals, especially in the regions of Russia. Furthermore, the same could be said for the poor level of trust between owners and managers. By 2005, the cohort of general directors of Russian industrial enterprises consisted of former “red executives” and a new generation of managers who came from business or from government bureaucracy (so-called politically connected CEOs). It is not clear which of the two is really driving the restructuring of enterprises. Neither is it clear whether the status of the general director, that is, owner or hired manager, is correlated with the intensity of a company’s modernization and restructuring. The main trends for the formation of a cohort of CEOs and managerial teams are discovered on the basis of a comparative analysis of independent companies and enterprises, included in the holding company groups (HCG).2 The analysis is based on the results of a Japan–Russia large-scale survey of Russian joint-stock companies (JSCs) conducted in 2005.3 The remainder of this chapter is organized as follows: The first section is a comparative analysis of the basic characteristics of Russian JSC general directors and an exploration of common features and differences from the top managers in countries with developed market economies. The second section is an exploration of how the composition of the management team depends on the arrival of new company owners. The third section contains the main hypothesis regarding the influence of the composition of the management teams, changes of principal owners, and business environment on the intensity of enterprise restructuring and a discussion of the results of their empirical testing. The fourth section includes a summary of the results and the conclusion.

General directors of Russian JSCs: “Red executives,” politically connected CEOs, and new professional managers Our survey data make it possible to present a portrait of recent general directors of JSCs and to compare the findings with those of other empirical studies. First, we discover that the average age of a JSC general director is 49.4 years.4 This is very close to the recent results received by the Center

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of Labor Studies of SU-HSE based on the information of Rosstat statistical data (49 years old)5 and is compared to the earlier estimations of Rachinsky (2002) (50 years of age) related to 2001. Second, the directors in independent JSCs and group-member companies have essential qualitative differences: directors at independent enterprises, on the average, are considerably older; among them, the share of directors under 40 years old is lower, and the share of directors above retirement age is higher. One explanation for this is the fact that a considerable percentage of CEOs had already become shareholders in the course of privatization. Both in independent JSCs and in holding members, the director’s age is essentially related to whether he is a hired manager or a large business owner. For example, the average age of directors who are large shareholders exceeds that of hired top managers without stake in company stock ownership by four to six years. Among them, the share of directors younger than 40 is twice as low, and for managers/heads of holding companies, it is three times as low. Furthermore, directors who are large shareholders at groupmember companies are younger than those at independent JSCs: for example, if only 33% of them are older than 50 in the first group, more than 59% of them are above that age in independent businesses. There are differences, although not very significant, regarding the level of education of the chief executive officers. In group-member companies, in contrast with independent JSCs, the share of professional managers having education in economics or management or an MBA (28.4% in the entire sample) is higher (by almost 7 and 3 percentage points, respectively). The most prominent trend is the employment of professional managers in HCGs. At present, almost 15% of Russian JSCs have managers with job experience at a Western company, but, in the group-member companies, the share of managers with such job experience is two times higher (20.1% and 11.3%, respectively) than in independent JSCs. As far as hired managers is concerned, the share of directors having job experience at a Western company is practically the same, but, among the directors-large owners in group-member companies, the share of managers with such experience is significantly larger (20.0% and 7.8%, respectively). According to survey results, 35.6% of general directors were hired managers without a share in company stock ownership. In new appointments of 2005, their share was 50%, which is evidence of the tendency for the separation of ownership and control in stable economic growth.6 “Red executives” who became large owners in the course of privatization are gradually leaving CEO positions. By the time of our survey in 2005, only 39% of general directors-large owners in the entire sample had more than 10 years of job experience as company CEOs. We found that, in Russian companies, the turnover of hired managers is rather high: one-third of directors in the whole sample and as many in independent JSCs were appointed within one year of the time when the survey

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151

was conducted. The average number of years in the position of a Russian JSC general director, according to our survey results, is 8.4 years. This number is not much higher than it is in other countries, where, according to Booz Allen Hamilton’s study of CEO turnover in the world’s 2,500 largest public companies defined by their market capitalization, it is 7.8 years (Lucier et al. 2007). However, in our case, the average number of years in a CEO position in the entire sample of general directors masked essential differences between directors-large owners and directors that do not own shares. For example, in the first case, it is more than twice as high, 9.6 years vs. 4.5. In all categories of top managers analyzed in the survey conducted in the first half of 2005, the average time in one position was 6.5 years. At the same time, it was 5.3 years when large owners did not take a direct part in the enterprise management and 4.0 years when the managerial team was headed by a hired general director and large owners were not involved in the management. Let us briefly overview the recruiting sources of general directors, that is, the prior job occupation of the current general director. On the whole, according to our data, incumbents, , that is, those who previously worked at the same enterprise in another position, made up the larger part, 61%, of the general directors. This is typical for JSCs situated in different settlements (Moscow, regional capitals, noncapital cities, urban settlements, and villages). We found no differences in the share of directors-incumbents in terms of industry affiliation, except for chemistry and petrochemistry.7 Recruiting sources have essential differences depending on the status of the general director (Table 6.1). Therefore, in independent enterprises and in group-member companies, three-quarters of the directors, who are large shareholders of the JSC, are incumbents.8 With regard to hired directors without company shares, at independent enterprises, almost half of them (47.7%) are incumbents as well. The share of incumbents among hired managers in group-member companies is much smaller (30.2%). The modest share of the incumbents within group-member companies corresponds with the fact that the main source of the general directors’ recruitment within group-member companies is the rotation of the CEOs within the group. The appointment of successful CEOs from one group-member firm to another contributes to the rapid transfer of management knowledge and skills and, therefore, is a prerequisite for the dissemination of common management standards within the group and of faster adaptation of new group entrants. At independent JSCs, outside owners quite frequently appoint successful top managers without job experience in a particular industry (in 28.4% of cases). In contrast, in groupmember companies, such practices occur at one half that rate. One in four directors has work experience in government bodies in the postprivatization period; meanwhile, directors in group-member companies have such experience even more frequently, one in three. On the whole, the share of general directors with job experience at the state bodies is by 11 percentage points larger at JSCs with more than 1,000 employees, since the administrative

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67.5

Total group

Large owner Hired manager Total group

Large owner Hired manager Total group

4.0 20.7 11.0

76.6 37.9 60.3

12.7 36.8 28.6

2.0

1.9 2.3

This HCG, group of companies, business partners


15.6

11.5 21.2

5.5 19.8 14.9

15.3

12.6 21.6

Another company from the same industry

13.1

7.9 20.2

1.8 13.2 9.3

15.3

9.7 28.4

Company from another industry

Previous job of general directora

Notes: a A small category that came to business directly from the state bodies was excluded. b 2 test.

Significance of differences 0.000 b

Whole sample, including management or parent company of HCG


HCG member

80.0 30.2 47.2

75.8 47.7

This enterprise

Large owner Hired manager


Independent (autonomous) enterprise

Status of the JSC general director % by line

100

100 100

100 100 100

100

100 100

Total

481

278 203

55 106 161

295

207 88

Number of JSC

Table 6.1 Recruiting sources of general directors at independent enterprises and in HCGs (percentage of respondents who answered)

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17.2

12.5

Share of companies with top managers who have job experience in a foreign company

Share of companies with top managers with job experience in governmental bodies


a 2

test.

25.0

Share of companies with directors with higher education in economics and management

Note:

25.0

Share of companies with directors under 40 years of age

Moscow

8.8

15.0

25.4

16.5

Capital of the region

6.6

12.5

27.6

13.7

Noncapital city

Company location

2.8

18.8

33.3

19.4

Urban type settlement/ village

8.2

14.7

26.2

16.3

Total sample

0.374

0.730

0.653

0.239

Significance of differencesa

Table 6.2 Characteristics of managerial skills and experience by different status of company location (percentage of respondents who answered)

154


resources of the state bureaucracy in the 1990s–2000s made it easier for the officials to acquire the most attractive (and as a rule, larger) enterprises. On the other hand, the survey results prove evidence that, among CEOs in the past elite of functionaries, the share of directors-large shareholders and directors-hired managers is equal. This demonstrates that, in an unstable institutional environment and with an increased involvement of the state in the economy, business owners are interested in developing necessary relationships with state officials by appointing managers with appropriate experience and personal contacts. The question of whether or not there are any qualitative differences in the top managers in the capital and provinces will be examined. We compare the key indicators of age, education, and job experience by status of location (Table 6.2).9 A comparison of the main qualitative characteristics of CEOs by status of location has shown the absence of significant differences, which proves a trend toward the formation of a national market of top managers. The leading recruitment companies report that two–three years is the average amount of time spent in a management position. More and more often, middle-level managers of large companies receive a promotion in other regions of Russia and change location (Pal’shin & Goverdovskaya 2007). Many companies with their units in other regions of Russia prefer to send managers from the central office or from smooth-running large regional offices to improve the quality of management in the provinces (Goncharova 2008).

The composition of management teams as the decision of main shareholders In 2001–2004, as proved by the survey data, general directors were changed at more than one-third of joint-stock companies (almost 39%). The intensity of the turnover was the same in different types of settlements (Moscow, regional capitals, noncapital cities, urban settlements, and villages). It is evident that changing the controlling owner, with a high likelihood ratio, entails not only changing the general directors (Table 6.3) but also subsequently renewing managers at economic departments in order to provide control over financial flows.10 This trend has become common for independent enterprises and for group-member companies. According to the results of our survey, at least in one half of the cases, changing owners is accompanied by changing general directors. The scale of such a change of general directors following the arrival of new controlling owners in Russia is considerably higher (more than twice) than it is in countries with a stable market economy. For example, Booz Allen Hamilton’s survey provides evidence that the share of CEOs who left their company after the controlling owner changed was 18% in 2005 and 22% in 2006 (Lucier et al. 2007). For group-member companies, the frequency of the appearance of a new general director is still higher due to the fact that entering HCGs introduces

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155

Table 6.3 Change of general director/board chairman at independent enterprises and HCGs depending on changes of main company shareholders in 2001–2004 (percentage of respondents who answered) Change of main shareholder in 2001–2004. % by line.

Change of general director/ board chairman in 2001–2004 No

Yes

Total

Number of JSCs



Yes No

50.0 73.4

50.0 26.6

100 100

126 357

0.000

HCG member

Yes No

38.3 52.2

61.7 47.8

100 100

94 178

0.028

Management or parent company of HCG

Yes No

52.9 88.5

47.1 11.5

100 100

17 26

0.009

Whole sample

Yes No

45.6 67.3

54.4 32.7

100 100

237 562

0.000

Note: a 2 test. Source: Author’s calculations based on survey data.

significant changes in the ownership and corporate control structures (Avdasheva 2007). The turnover of general directors on the shareholders’ initiative, as evidenced by numerous studies, is determined by the achieved and expected results of JSCs (efficiency and growth of market capitalization) and lack of trust on behalf of the shareholders (an agent problem). Recent results presented by Jenter and Kanaan (2008) suggest that the standard CEO turnover model should be extended by capturing bad industry or market performance. They show that a decline in the industry component of firm performance from its 75th to its 25th percentile increases the probability of forced CEO turnover by approximately 50%. In Russian joint-stock companies, a considerable percentage of general directors (exceeding 59%) are forced to leave their positions on the shareholders’ initiative. This percentage is much higher than that in other countries, where, according to Booz Allen Hamilton’s research of 2006, approximately one in three CEOs was dismissed due to a decision of shareholders who were unsatisfied with the results of the past activity of the director or concerned about the current situation and the company prospects (the last reason has become a more and more noticeable trend in the recent years) (Lucier et al. 2007). In the opinion of Shekshnya (2006), based on the results of a survey and interviews with general directors, shareholders, and company personnel,11 a hired Russian general director has not yet become a CEO in the Western sense. He “plays a restricted number of parts, consciously excluding others from the field of his responsibility; he is concentrated on himself, the

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156


shareholders and the important officials to the prejudice of paying attention to the customers, employees and partners; he considers his work to be a means for achievement of more important life objectives not related to it, he plans his actions, predominantly bearing in mind a short-term planning horizon” (p. 30, translated from Russian). Such an assessment seems reasonable. Shekshnya explains this situation in several ways: the higher social status of the entrepreneur as compared to that of a comparably or highly paid employee and the orientation of the most capable potential CEOs to entrepreneurship; the presence of a redundantly high part of the owners in the operational management, which prevents managers from realizing their potentials; and, most importantly, the absence of professional training of the business leaders in the companies, which should be a priority task for its first executive. The additional characteristics completing the portrait of a Russian CEO derived from our survey came from the survey of 300 firms in 26 regions and 39 Russian cities (Radaev 2008). The evidence is clear that managers of new firms established after privatization tend to be more authoritarian than managers appointed under the socialist regime. An ideal top manager, as clearly shown by Adizes (2006), does not exist because the roles the individual is required to play are too large; therefore, the task of the general director should be to build a team, in which a synergetic effect is achieved from using certain capabilities and strong competencies of team members. Therefore, there are only a few such managers in the Russian market. A usually effective trend in Russia is for owners to keep in mind that the most difficult questions of operative management are to be resolved at the moment and, therefore, to appoint those CEOs who could do such tasks quickly using strict and authoritarian methods. When a company is in a new business and institutional environment, the owners find it necessary to replace the general director and redefine his/her key objective for a limited period of time. For these reasons, the median term of a hired general direction in a Russian JSC is only three years. Such a term might permit an individual to fulfill one or two relatively important responsibilities but would be absolutely inadequate for the implementation of a developed strategy. The survey results show that, differently from turnover of the general director, managerial turnover at the middle level is not significantly related to the arrival of new enterprise owners. Developing a management team is mainly a prerogative of the first executive officer. The arrival of a new CEO, as evidenced by the work practice of Russian companies, has grave consequences for the entire managerial team and the personnel (Figure 6.1). In the case of a director’s dismissal on the shareholders’ initiative, the economic departments were considerably renovated at almost half of the independent enterprises and group-member companies. At the same time, the management staff of manufacturing departments was subject to a lesser degree of personnel reshuffling. Such practice was mentioned by 22% of the

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157

50 40 30 %

20 10

Economic departments

Manufacturing departments


Change of general director by shareholders’ decision

No change of general director





0

R&D services HCG member

Figure 6.1 Change of managers in the departments following a new general director appointment by shareholders’ decision (percentage of respondents who answered) Source: Survey data.

Table 6.4 Change of middle-level managers in JSCs in which the general director was changed by the status of the current director (percentage of respondents who answered) Change among managers of departments in 2001–2004. % by line. Economic departments

Director-large owner Director-hired manager

Minimum Many changes Total or several or almost all changes members changed

Number of JSCs

40.6

59.4

100

286

22.5

77.5

100

187

Significance of differences 0.000 a Manufacturing Director-large departments owner Director-hired manager Significance of differences 0.001 a

37.4

62.6

100

289

26.6

73.4

100

203

R&D services

49.7

50.3

100

193

41.5

58.5

100

130

Director-large owner Director-hired manager Significance of differences 0.044 a Note: a 2 test.


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respondents at independent enterprises and 33% in HCGs. The managers of R&D services experienced even less reshuffling. Regarding the managerial turnover of manufacturing and R&D departments, considerable changes were more frequent in group-member companies than they were in independent enterprises. The most active managerial turnover takes place when a general director who is not a company shareholder is appointed at an enterprise. In this case, considerable changes of managers in the economic and manufacturing departments take place 1.5 times more often due to the two following circumstances (Table 6.4). First, hired directors pursue, as a rule, more radical policies on personnel renovation, and second, they provoke, to a higher extent, the voluntary leave of those managers who do not adjust to the new style and methods of management.

Propensity of proactive restructuring of joint-stock companies:12 The role of business environment, ownership changes, and reorganized management teams Theoretically, property rights should be transferred from an inefficient owner to a more effective one without considering cases involving raider attacks at successful enterprises or Russian variants of de facto nationalization. In this sense, it can be assumed that the owners of new JSCs and, correspondingly, new managers appointed by shareholders should also be more active in enterprise modernization and proactive restructuring in order to gain better performance results and efficiency growth. It would be extremely interesting to determine whether there is empirical evidence that the new generation of hired managers who obtained their knowledge and skills in the transitional economy were more active in restructuring in 2001–2004. Our survey data, unfortunately, does not allow us to clearly determine the exact time when the main enterprise owners and managerial teams changed. In the survey questionnaire, the questions concerning the changes in owners and general directors and firm restructuring activities refer to the same period of time. In this chapter, we assume that the turnover of key owners and managers took place at least no later than the restructuring measures. Hypotheses and empirical methodology Taking the above discussions into consideration, we examine the following five hypotheses: Hypothesis H1: First, in Russia, where the institutional environment is characterized by weak protection of property rights, the transfer of a JSC under control of new owners places a high-priority task on them to create mechanisms of property protection. One of the mechanisms is the radical change in the

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159

managerial team, which includes the general director and the managers of the economic departments. With the current managerial personnel shortage, time is required to replace individuals, and it is likely that qualified individuals for the positions are not available. The difficulties of building-up a new managerial team that is loyal to the owner for the protection of assets necessarily shift the proper tasks of enhancing the business efficiency and extend the restructuring terms thereof. In the context of this reasoning, we intended to check a hypothesis according to which activity in modernizing those JSCs which changed their main owners in 2001–2004 was unlikely to have been higher than that of the enterprises with stable ownership structure. Hypothesis H2: Second, we argue that the characteristics of ownership and patterns of ownership and management separation are significant modernization factors. Many directors who are large shareholders are successful at developing their businesses when relieved of the necessity to solve the agency problem and usurp power. We expect that their efforts to modernize will be, at least, on par with those of the firms headed by hired managers. Along with it, it is logical to assume that, with concentrated ownership characterized by the availability of large owners, making decisions on launching modernization programs and requesting large-scale and long-term investments are easier and faster, since there are no longer outdated procedures for obtaining approvals from numerous minority shareholders, whose interests could be related to the current profits and thus undermine any long-term business development plans. Therefore, we expect that the presence of large owners will be positively correlated with enterprise restructuring measures. Hypothesis H3: Third, we argue that management team characteristics are significant factors correlating with enterprise restructuring. As far as the education of a general director is concerned, theoretically, the education of a CEO in economics and management should positively correlate with more active and sophisticated restructuring. Unfortunately, the formal professional education in economics and management obtained by the CEOs in the Soviet era or at the beginning of the transition period was inadequate. Therefore, it was impossible to quickly introduce new content that was appropriate for a market economy in new institutional environment. Therefore, we do not anticipate the discovery of any significant positive correlations with restructuring efforts. Prior job experience and skills could be more significant than formal education. Considering the information above, Western managerial experience facilitates the transformation, since this cohort of managers is more sophisticated at conducting business in a globally competitive market environment. In contrast, prior government job experience does not have a direct effect upon the modernization scale, although it is important for the provision of the predictability of the development trajectory and facilitation of different bureaucratic procedures. On the other hand, keeping network ties as an additional resource might reduce the incentives of politically connected CEOs for market restructuring.13 Therefore,

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160


we assume that firms with CEOs who first worked in bureaucracies will be less likely to implement modernization measures. Changes of middle-level managers are more likely to have a positive impact. This is especially so for privatized companies due to the necessity of breaking the routines and introducing new standards of everyday operational management.14 Hypothesis H4: Fourth, we hypothesize that the availability of a long-term planning horizon, providing evidence of strategic goals of business development, will have a positive correlation with the scale of work in firm restructuring. Hypothesis H5: Finally, the self-sufficiency of the majority of Russian enterprises in the local markets, still beyond the boundaries of the sphere of the interests of the strong players (Kuznetsov 2005, 2007; Avdasheva et al. 2006), allows putting forward a hypothesis about the relatively weak influence of competition on the modernization efforts of JSCs, that is, we expect that the competition has not already become a serious driver in stimulating large-scale restructuring.15 Econometric model To provide a comprehensive analysis of determinants that could predict the probability of a company to implement modernization and proactive restructuring and test the abovementioned hypotheses, we estimate a binary logistic regression model with dependent variables that are assigned a value of “1” if the firm has demonstrated restructuring efforts in introducing new products, technologies, production facilities, ISO certification, and marketing and “0” otherwise. To estimate improvements in marketing, the value “1” indicates the same level or an increase in marketing budgets, and “0” indicates their decrease. Independent variables show the characteristics of stock ownership: dummies for the presence of large owners (with more than blocking stock), state and foreign owners, and change of key owners in 2001–2004; the patterns of separation of ownership from management (with a general director being a hired manager as a basic category). The characteristics of management teams include a long planning horizon in excess of three years and the following indicators of human capital: the presence of sufficient changes in economic and manufacturing departments (dummy); the change of the general director by a shareholders’ decision (dummy); CEOs’ previous job experience at governmental bodies (dummy, a 10-year period is considered). Other variables are included as categorical: the age of the general director (basic category: less than 40 years old); education of the general director (basic category: lack of profile high education in economics and management); and prior job occupation of the current general director (incumbent as a basic category). The level of competition with specific competitors (Russian companies, foreign companies in Russia, firms from CIS, developed countries, Turkey, China, and Baltic countries) was included as a dummy

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161

variable with “0” as a respondent’s estimation of the absence of competitive pressure and “1” indicating a sufficient level of competition. Control variables characterize industry affiliation (communications as a basic category), company size measured as a logarithm of employees, dummies for being a new company established after 1992, membership in a business group, location in capital cities (Moscow or oblast capitals), legal status (open vs. closed JSCs), and availability of exports. Results The estimation results are shown in Table 6.5. Of the basic company characteristics, size increases the chance for the implementation of restructuring, whereas the significance of membership in a business group and history is limited to certification. Marketing budgets increase for those firms located in capitals because this strategy rewards potentially larger markets. Legal status is not significant in the majority of models except for the probability of the introduction of new production facilities. In this case, being a closed JSC multiplies the chances. Export activities were found to be significantly correlated with ISO certification. The certification contributes to firm reputation, which provides evidence of well-organized business processes and, therefore, multiplies the chances to enter new foreign markets. In addition, exporting is correlated with the introduction of new production facilities, although the causality of this correlation should be investigated. Change of key owners and shareholder decisions to change the general director have no impact on measures of proactive restructuring in the time period analyzed. Moreover, for the introduction of new production facilities, there is a strong negative correlation with new director appointments that is significant at the 5% level. One possible interpretation of this puzzle could be connected with the lag needed before new owners change the organizational structure, develop a new business model, form a new appropriate management team, and start modernization. As far as the correlation with the changes of managers at the middle level is concerned, we revealed a significant positive correlation of managerial turnover in manufacturing departments, which multiplies the chances to introduce new products, technologies, and production facilities. This may indicate that CEOs are giving more attention to their production units, including investing in more advanced human capital capable of working with modern equipment and technologies. As far as changes in the economic departments are concerned, we found no correlation with most restructuring measures except a significant negative correlation in the case of the introduction of new technologies. One possible interpretation of this puzzle is connected with the abundance of managerial turnover in economic departments. Furthermore, for appointments in these departments, trust might be more important for owners than the professional skills of the invited managers.16

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0.813 (1.054) 0.220** (0.098)

Constant Company size (log of number of total workers) New enterprise (= 1) Legal status (open JSC = 1) HCG member (= 1) Planning horizon of more than 3 years (= 1) Location in capitals (= 1) Export (= 1) Sufficient level of competition with Russian companies (= 1) with foreign companies in Russia (= 1) with firms from CIS countries (= 1) with firms from developed countries (= 1) with Turkey, China, and Baltic countries (= 1) Large owners (with more than blocking stock) (= 1)

ISO certification

General director-large owner (=1)


Same level or increase of marketing budgets

0.536** (0.229)

0.613** (0.239)

1.116*** (0.234)

0.771*** (0.242)

0.734** (0.312)

0.775*** (0.240)

0.675*** (0.243)

0.542** (0.235)

1.450*** (0.398)

0.831** (0.406)

1.310*** (0.390)

1.057*** (0.324)

0.280*** (0.594) 4.065*** (0.845) 0.944 (1.035) 2.941** (1.292) 0.294*** (0.090) 0.411*** (0.102) 0.392*** (0.107) 0.427*** (0.147)

Introduction of new technology

Separation of ownership and management (general director-hired manager as a basic category)

0.989*** (0.319)

Development of new products

Dependent variable

Table 6.5 Logistic regression analysis of the propensity of proactive restructuring

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1.525*** (0.412)

0.819*** (0.245)

Level of education of general director (lack of higher education in economics and management as a basic category) Higher education in economics and management (=1) MBA in economics and management (=1) Change of general director in 2001–2004 (= 1) Sufficient changes of managers in 0.620*** (0.221) economic departments (=1) Sufficient changes of managers in 0.776*** (0.275) 0.978*** (0.273) manufacturing departments (= 1)

Age of general director (less than 40 years as a basic category) 41–50 years (=1) 51–60 years (=1) 0.174 More than 60 years (=1) Job experience of general director 0.510** (0.218) or board chairman at governmental bodies in previous 10-year period (= 1) Job experience of top managers in 0.948*** (0.283) Western companies (= 1)

Large owners are managers, general director is not a shareholder (=1) Large shareholders are not managers, general director is a shareholder (=1) Change of key owners in 2001–2004 (= 1) Change of general director by shareholders’ decision (= 1)

Continued

1.151* (0.671)

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522 555.61 0.218 87.786

Yes


521 304.15 0.322 99.486

Yes

Same level or increase of marketing budgets

Source: Author’s estimation based on survey data.

Notes: ***: significant at the 1% level, **: at the 5% level, *: at the 10% level. Standard errors are reported in parentheses. The forward stepwise method was used; blank cells, coefficients were not included into the final equation.

522 650.99 0.156 64.789

522 581 0.318 142.03

522 610.69 0.200 83.238

0.865** (0.382)

ISO certification

Number of observations 2Log likelihood Pseudo R 2 Wald test (2 )

Introduction of new technology

0.714** (0.333) Yes

Development of new products

Sources of recruitment of general director (incumbent as a basic category) Holding or business partners (=1) Governmental bodies (=1) From the same industry (=1) From another industry (=1) Industry dummies Yes Yes

Dependent variable

Table 6.5 Continued


165

The patterns of separation of ownership and management have basically turned out to be essential for all considered directions of restructuring. We found empirical evidence that directors-large owners are not worse in modernization efforts than hired managers. In contrast, they are much better at introducing relatively new technologies and increasing marketing budgets. This finding raises the question of whether Russian manager-owners have “insufficient incentives to restructure firms and maximize their value over the long run,” as explained by Desai and Goldberg (2000). Our understanding is that the era of stripping assets is already over and the current generation of manager-owners has strategic goals in regard to their business. It is surprising that the availability of a long-term planning horizon in excess of three years is only significant for introducing basically new technologies; in other words, the hypotheses on the role of strategic planning have been only partially confirmed. This correlation is positive with a 5% level of significance. Interesting results have been received regarding the role of a top manager’s job experience in a Western company on the scale of restructuring. These results clearly point out to a significant positive correlation with the introduction of basically new technologies (the correlation is significant at the 1% level). This finding proves that the invitation of foreign professionals17 and Russian managers with Western experience has significant rewards in speeding up the technological updating of the firms. In contrast, the state service experience of CEOs and the introduction of new technologies are negatively correlated. In fact, these results agree with the conclusions presented by Kramarz and Thesmar (2006), who also found that former state officials performed worse than the CEOs without such experience. The researchers showed that French companies headed by former bureaucrats more often produced less profit for the shareholders. However, inefficient top CEOs are more likely to retain their positions in cases of poor performance. Corresponding results were obtained by Chen et al. (2004) for privatized companies in China. A comparison of general directors-outsiders with directors-incumbents did not reveal any more significant incentives for restructuring. Moreover, regarding the introduction of new facilities, the former, that is, general directors-outsiders, were less active. Therefore, training potential team leaders among incumbents appears to be a rational strategy for the owners of Russian JSCs. For general directors, having an education in economics and management, even an MBA, is an insignificant factor for all analyzed restructuring measures. As we expected, in the mid-2000s, skills obtained in practical experience in an unfriendly institutional environment tend to be more essential than formal training which, in the opinion of many entrepreneurs, does not meet their requirements. Practically, in all models, the age of the director is insignificant. Older general directors are as active in restructuring as their younger colleagues. The only exception is the negative correlation

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166


with the introduction of new products for directors who are 51–60 years old; however, it is significant only at a 10% level. The results were predictable concerning the influence of competition on the modernization scale and efforts that are in compliance with the findings of other studies (Golikova et al. 2007). A significant positive effect has been revealed in relation to the influence of competition with the Russian producers for the development of new products and increase of marketing budgets. This result confirms information from the business press on the growth of marketing expenses for companies in which strong large domestic players have appeared, as in, for example, the food industry. Strong competitive pressure from developed countries stimulates ISO certification and more efforts in marketing. For the introduction of new production facilities and technologies, respondents’ estimations of competition are insignificant. In general, competitive pressure is still not a very strong determinant of enterprise restructuring.

Concluding remarks The majority of the tested hypotheses regarding factors correlated with restructuring efforts have a positive proof, except for the less than impressive role of a strategic planning horizon, which is weakly significant only for the introduction of new technologies. Former state officials have been proven to be worse managers than other categories of CEOs in terms of their efforts to modernize business. It is quite likely that the performance of Russian companies with CEOs from state bodies will be less effective than those with managers with other backgrounds. This is certainly an interesting topic for future research regarding social networks and their roles in providing effective firm performance. We found that changes of major owners do not correlate with the restructuring scale on the considered time horizon. The role of such changes is neutral, as is that of general directors’ turnover in the most analyzed directions. However, directors-large owners have proved to be no worse than hired managers, as we anticipated, even though they are significantly stronger in important areas of modernization, such as the introduction of new technologies and the formation of marketing budgets. Hired managers, as we know from the practice of Russian JSCs, often turn out to be severely restricted by the owner, who formally does not participate in operative management but is the final decision-maker regarding the distribution of resources and influences operating decisions (perhaps not always effectively). Such interactions between owners and hired CEOs are typical of the actual level of separation of ownership from management in a transitional period. The consequences of such interactions for enterprise performance are also interesting for future studies.

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167

We found that, currently, the Russian market for CEOs has more differences than commonalities with Western ones. The results of the analysis show that neither changes of key owners nor CEO and manager turnover in economic departments had a significantly positive influence on the scale of restructuring in the period analyzed. This might be due to the limited market for professional managers and, second, to the weak enforcement of property rights that influence the choice of attracting managers who are loyal to the owner but less effective. More promising positive trends are revealed in the manufacturing units, in which changes of managers are correlated with the development of new products and technologies. Due to the globalization process, more managers with experience in Western companies and leading Russian companies appear among the members of management teams not only in the capitals of Russia but also in the provinces, providing opportunity to improve the managerial quality in Russia. On the other hand, the existing shortage of qualified management personnel in the regions limits the potential of growth of Russian firms. The separation of ownership and management has a significant correlation with the scale of enterprise restructuring; on the other hand, directors-large owners are, as a general rule, not losers in comparison to other categories of managers. A considerable part of this group consists of former “red directors,” who, by our estimates, make up approximately 39% of the JSC managers (45% in autonomous business). Their exit from operative management is expected to increase considering that they are generally four–five years older than hired managers. Time will tell who will inherit the helm, the heirs or hired managers. As foreign experience shows, in the case of transforming Russian JSCs on the model of family businesses, there is some risk that these companies could lose their footing.

Acknowledgments This research was conducted with financial support of SU-HSE (funds from the Program for Fundamental Studies granted by the Ministry of Economic Development and Trade of the Russian Federation in 2007–2008). I would like to thank Andrei Yakovlev and Yurii Simachyev for their useful comments and suggestions. Special thanks are given to Olga Uvarova for her assistance with data processing and manuscript preparation.

Notes 1. The newspaper monitors job dismissals and appointments at large companies from a limited number of regions. Therefore, this source of information inevitably suffers from bias of estimations. Nevertheless, we considered it useful to compare the assessments received by various authors with the related references to the information sources and their limitations.

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168 Organization and Development of Russian Business 2. A differentiated approach is necessary here, since these two types of legal entities have principally different centers of decision-making concerning the managerial team and the extent of consideration given to the interests of a particular enterprise. 3. For a detailed description of the data and sampling procedure, see the Appendix of this book. 4. The question was asked on the interval scale with a spacing of 10 years; for the calculations, the medians of the of the intervals have been taken. 5. These estimations are related to all chief executive officers without selection of a cohort of general directors (Belokonnaya et al. 2007). 6. Significant events in the corporate history of Russian JSCs (such as IPO companies) or a rapidly changing financial and economic situation in the framework of a crisis quite often forces owners to once again become CEOs. 7. According to the data of Kapelyushnikov & Dyomina (2005), 67% of the general directors in the Russian Economic Barometer (REB) sample were incumbents. The assessments of Roschin & Solntsev (2006) also correspond with ours at 51%, but they are related not only to general directors but to all categories of CEOs. 8. According to a Booz Allen Hamilton survey (Lucier et al. 2007) conducted in 2006, the number of outsiders among the CEOs of the 2,500 largest public companies by market capitalization was 14% in 1995; it rose to 30% in 2003 and then dropped to 18% in 2006. This reflects the preferences of the Board of Directors regarding the training of leaders within the company. 9. According to expert opinion, location is a better indicator of the territory than population (Zubarevitch 2006). 10. As demonstrated in practice, for effective transformation in a company, new owners quite often prefer to import a practically full poll of the experienced managerial team from successful companies rather than changing specific specialists. 11. The sample multitude structure is unknown. The author has summarized the results of polling 73 general directors, the shareholders of 57 companies, and the employees of 25 companies, as well as 34 nonformalized interviews with representatives of the abovementioned groups of the respondents. 12. We follow the definition of propensity to restructure as expressed by Krueger (2004), who stressed the significance of proactive measures. 13. Chen et al. (2004) discovered that, in China, the underperformance of firms run by politically connected CEOs exceeds that of those without politically connected CEOs by 37%. The first are more likely to include other bureaucrats on the management teams, paying less attention to relevant professional background or prior business experience. 14. On the other hand, the presence of sufficient changes of managers in economic departments who are responsible for company cash flow might be evidence for the lack of owner trust in key personnel (principal–agent problem); i.e., we could not ignore that these changes are caused by the necessity for more loyal but less professional staff members. 15. Nevertheless, the subjectivity of the respondents’ estimates of the competition level should not be forgotten, either. 16. We support this explanation, which is in line with the findings of Landier et al. (2005). 17. According to the survey of 50 large international companies working in Russia implemented by Kelley Services in August, 2008, the average share of foreign

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managers in total employment is 1–5%. In 68% of companies, they occupy top-managerial positions, and in 26%, middle-level positions (Malykhin 2008).

Bibliography Adizes, I. (2006) Kak Preodolet’ Krizisy Menedzhmenta (St. Petersburg: Stockholm School of Economics in Russia). Aukutsionek, S., Dyomina, N., & Kapelyushnikov, R. (2007) Ownership structure of Russian industrial enterprises in 2007, Russian Economic Barometer, 3: 3–13. Avdasheva, S., Shastitko, A., & Kuznetsov, B. (2006) Konkurentsiya i struktura rynkov: chto my mozhem uznat’ iz empiricheskih Issledovanij o Rossii, Rossijskiy Zhournal Menedzmenta, 4/4: 3–22. Avdasheva, S. (2007) Holding company groups and model of corporate governance in Russia. In: Avdasheva, S., Golikova, V., Sugiura, F., & Yakovlev, A., External relationship of Russian corporations. Discussion paper No. B37: 1–28, Tokyo: Institute of Economic Research, Hitotsubashi University. Belokonnaya, L., Gimpelson, V., Gorbacheva, T., Zhikhareva, O., & Lukianova, A. (2007) Formirovanie zarabotnoj platy: Vzgliad cherez prizmu professij. Preprint WP/3/2007/05, Moscow: Vysshaya Shkola Ekonomiki. Bhaumik, S. & Estrin, S. (2005) How transition paths differ: Enterprise performance in Russia and China. Working paper No. 744, Ann Arbor: William Davidson Institute, University of Michigan. Brown, D., Earle, J., & Telegdy, A. (2004) Does privatization raise productivity? Evidence from comprehensive panel data on manufacturing firms in Hungary, Romania, Russia, and Ukraine. Staff working paper No. 04–107, Kalamazoo: Upjohn Institute. Chen, D.-H., Fan, J. P. H., & Wong, T. J. (2004) Politically-connected CEOs, corporate governance and post-IPO performance of China’s partially privatized firms. Working paper No. 2004–5, Tokyo: Center for Economic Institutions, Institute of Economic Research, Hitotsubashi University. Desai, R. & Goldberg, I. (2000) Stakeholders, governance and Russian enterprise dilemma, Finance and Development, 37. (available at: http://www.imf.org/external/ pubs/ft/fandd/2000/06/desai.htm) Golikova, V., Gonchar, K., Kuznetsov, B., & Yakovlev, A. (2007) Russian Industry on the Crossroads: What Prevents Our Firms from being Competitive? (Moscow: Higher School of Economics). Goncharova, O. (2008) Upravlyates’ sami, Vedomosti, September 9: A07. Jenter, D. & Kanaan, F. (2008) CEO turnover and relative performance evaluation, Stanford Graduate School of Business Research paper No 1992, May 2008, 74 pp. Kabalina, V. (ed.) (2005) Praktiki Upravlenia Personalom na Sovremennyh Rossijskih Predpriyatiyach (Moscow: Institute of Comparative Labor Studies). Kapelyushnikov, R. & Dyomina, N. (2005) Obnovlenije vysshego menedzhmenta rossijskih promyshlennykh predprijatij, Rossiiskii Ekonomicheskii Barometr, 1: 8–16; 2: 23–29. Kramarz, F. & Thesmar, D. (2006) Social networks in the boardroom. Discussion paper No. 1940, Bonn: Institute for the Study of Labor (IZA). Krueger, G. (2004) Enterprise Restructuring and the Role of Managers in Russia (New York and London: Sharpe).

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170 Organization and Development of Russian Business Kuznetsov, B. (2005) Vliyaniye konkurencii na process modernizatsii i reformirovaniya promyshlennykh predriyatiy. In: Vliyaniye Konkurencii i Antimonopolnogo Regulirovaniya na Processy Ekonomicheskoy Modernizatsii v Rossii (Moscow: TEIS). Kuznetsov, B. (2007) Vliyaniye konkurencii i struktury rynkov na razvitie i povedenie promyshlennykh predriyatiy: Empiricheskij analiz. Paper presented for the VII International Conference of SU-HSE “Modernization of the Economy and State,” April, 2007. Landier, A., Sraer, D., & Thesmar, D. (2005) Bottom-up corporate governance. Paper presented for the AFA 2006 Boston Meeting. (available at: http://ssrn.com/ abstract=687542) Lucier, C., Wheeler, S., & Habbel, R. (2007) The era of the inclusive leader, Strategy and Business, June. Malykhin, M. (2008) Sudba inostrantsa, Vedomosti, September 4: A07. Muravyev, A. (2003) Obnovlenie direktorskogo korpusa na rossiiskikh privatizirovannykh predpriyatiyakh, Rossiiskii Zhurnnal Menedzmenta, 1: 77–90. Pal’shin, K. & Goverdovskaya, O. (2007) Raskadrovka, Kompaniya, 21: 21–29. Rachinsky, A. (2002) Self-enforced mechanism of corporate governance: Evidence from managerial turnover in Russia. Working paper, Moscow: Center for Economic and Financial Research. Radaev, V. (2008) How managers establish their authority at the Russian industrial enterprise: A typology and empirical evidence. Paper presented at the 10th EACES conference “Patterns of Transition and New Approaches to Comparative Economics”(Moscow, State University-Higher School of Economics, August 28–30, 2008). Roschin, S. & Solntsev, S. (2006) Rynok Truda Top-Menedzherov v Rossii (Moscow: Higher School of Economics). Shekshnya, S. (2006) Ot plokhogo k velikomu, Expert, 29: 26–32. Standard & Poor’s (S&P), (2006) Issledovanije Informaciornoj Prozrachnosti Rossijskih Kompanij v 2006 g.: Skromnye Uspechi na Fone Vseobschego Stremlenija k IPO (Moscow: Standard & Poor’s). Zubarevitch, N. (2006) Rossijskiye goroda kak centry rosta, Rossijskoye ekspertnoyeobozreniye, 2/16.

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Part II Business Integration and Its Impacts on Corporate Governance

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7 Organizational Patterns of Corporate Control and Business Integration Tatiana G. Dolgopyatova

Introduction Conjecturing about the evolution of the Russian system of corporate governance continues; however, it would be interesting to answer the question of which model of governance dominant shareholders choose and whether or not they consent to the separation of executive management from company ownership. Reliance on hired management prompts owners to seek other methods of control over a business entity, and they sometimes resort to the use of internal corporate mechanisms. The issue of the gradual separation of executive management from ownership was discussed on the basis of records of 20 in-depth interviews with senior managers of jointstock companies (JSCs) (Dolgopyatova 2004). In formal terms, separation was recognized when a general director did not own shares and other company managers held little interest. It was demonstrated that as Russian business underwent an intense integration, the ways and means of corporate control also saw extensive change. Some examples are as follows: 1. The separation of the ownership and management functions was primarily characteristic of subsidiaries companies within company groups. 2. Formal separation resulted in real changes in the distribution of competencies, gradual delegation of some managerial issues to hired managers, and, in particular, production and operational issues and some strategic issues related to logistics and marketing. 3. Separation contributed to a more active use of internal mechanisms of corporate governance (boards of directors) by dominating owners to exercise control over hired managers. In academic studies (Yakovlev et al. 2006, for instance), it had been predicted that owners would tend to depart from business management, 173

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and this practice has received the attention of industry experts and the business community (Korporativnoe Upravleniye 2007). The separation of ownership from management and the delegation of authority to hired managers are the products of two opposing trends. The institutionally underdeveloped economy promotes the combination of both functions to protect the rights of large shareholders. At the same time, specific skills and competences still remain in demand under the current conditions as well as in the long-term perspectives for the development of Russian companies in the framework of a market embedded in the global economy; therefore, the requirements for management quality are likely to become exclusive. In many companies, owners have been withdrawing from executive management. The representatives of the reform-period managerial corps are also affected by the time factor. They gradually retire from the businesses, often by voluntarily selling consolidated blocks of share to new owners. Our main objective in this chapter is to identify, on the basis of a representative sample, a set of factors underlying the preference of dominating shareholders for top managers who do not hold shares of a given company. We will empirically test two core assumptions regarding the role of corporate integration in the choice of the form of control. The first hypothesis is that integration is a tool that replaces direct control by the shareholder and suggests a preference for a form of control with the separation of management and ownership. Our survey makes it possible to identify two types of companies, one, independent businesses, which are stand-alone entities and parent companies of holdings, and the second, business divisions, which are the rankand-file entities of a company group. The second hypothesis is that two types of companies will respond differently to demands of property rights protection and quality of management. For divisions of larger businesses, factors of preference for hired managers are linked to the state of corporate management, which includes that at the level of business groups. For standalone companies, the main determinants for the departure of shareholders from management are linked to the protection of property rights and the nature of markets. The chapter is organized as follows. The second section is a comparison of internal tools of corporate control in which management and ownership functions are either separate or combined. Based on the findings in the survey, the third section contains the driving factors of choice of the form of control with separate functions and measurement indicators, while the fourth section is a comprehensive analysis of their possible impact on the choice using a binary logistic regression. The final section is a summary of the outcome of the analysis and contains a qualitative forecast of the evolution of corporate control within companies.

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Corporate Control and Business Integration

175

Internal corporate governance tools at different types of corporate control Corporate integration and separation of ownership from management The survey data demonstrate that the patterns of a combination of ownership and control are different in JSCs that represent a business or a part of a business (Figure 7.1).1 The separation of ownership from management is typical (twice as often) of the enterprises that are rank-and-file members of holding company groups, but independent firms and parent companies are mostly operated on the basis of the inseparability of these functions. The stakes owned by a CEO are practically the same in all types of surveyed companies, but the few cases in which large shareholders participate in management when they are not CEOs are typical of parent companies. Patterns of control in rank-and-file members of company groups were correlated with their features. The separation of management is typical of large-scale business groups with complicated management: massive groups with large numbers of its entities, or holding company groups that are more widely dispersed geographically and diversified by industry (Table 7.1). Exceeding the boundaries of a single region gives the companies with separate ownership and management an advantage of nearly 10 percentage points. Separation of functions is evident in 55% of conglomerates; at 13 percentage points, there are fewer vertically integrated groups; and, at 20 percentage points, there are horizontally integrated company groups.

Independent joint stock companies Affiliated companies (subsidiaries) Parent companies of company groups 0 M&D_S

20 M_S

D_S

40

%

60

80

100

Separation of ownership and management

Figure 7.1 Links between ownership and management in integrated and independent companies Notes: M&D_S stands for JSCs where large shareholders are managers and the CEO is a shareholder, M_S, for JSCs where large shareholders are managers but the CEO is not a shareholder, D_S, for JSCs where large shareholders are not managers but the CEO is a shareholder. Source: Author’s illustration based on survey data.

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0.002

21.7 8.5 26.4 43.4

Two or more regions of Russia 15.2 6.1 33.3 45.5

Russia and abroad 31.7 5.5 27.4 35.4

A single industry

0.006

27.0 10.8 20.3 41.9

Technologically related industries 8.9 14.3 21.4 55.4

Technologically unrelated industries

Diversification of company group by industry, %:

0.000/0.003

9.1/6.0 27.9/6.0 33.4/9.0 31.4/10.0

Size of company group by number of legal entitiesa


Notes: a Numerator: means, denominator: medians. b Comparison of frequencies by 2 test; comparison o f means by Kruskal Wallis test in the numerator and median test in the denominator. M&D_S stands for JScs where large shareholders are managers and the CEO is a shareholder, M_S, for JSCs where large shareholders are managers but the CEO is not a shareholder, D_S, for JSCs where large shareholders are not managers but the CEO is a shareholder.

Significance of differences b

41.1 10.5 14.7 33.7

A single region of Russia

Diversification of company group by location, %:

Ownership and management configuration at affiliated companies of holding company groups

M&D_S M_S D_S Separation

Types of control

Table 7.1


177

Intra-corporate relations Separation of the executive management function and use of hired managers affect the state of corporate governance of companies that select this model of control. On the one hand, aggravation of corporate conflict could be anticipated as a result of agency problems, while, on the other hand, more focus by the board of directors and other corporate bodies on executive management activities would be expected. To test these assumptions, we used the indicators describing the state of corporate control, which included assessments by respondents of the role of main bodies in corporate decision-making, composition of the board of directors, relations between actors of corporate governance (Table 7.2), and intensity of rotation of corporate governance bodies (Table 7.3). The first assumption did not hold true. Despite the expected aggravation of the agency problem in the wake of the separation of ownership and management, an intra-corporate dispute was observed in a quarter of the companies as compared to 29% in other JSCs, the difference being negligible. This can be explained in two ways. The first explanation relates to the nature of the survey, in which respondents were managers normally reluctant to disclose conflicts with the owners. In addition, conflicts included not only those between managers and shareholders but also those between large and small shareholders. It is possible that, in this case, hired managers acted as arbitrators who took into consideration the sustainability of the company as a whole, unlike “managing owners,” who would often ignore the claims of minority shareholders. The second explanation is that, in formal separation, large owners would have at their disposal a variety of tools for tight control over the management. For example, Shekshnya and Kets de Vries (2007) demonstrated, on the basis of case studies, that where owners relinquished the management function, they typically gave up the responsibility but retained opportunities to intervene into business operations. The lead Russian experts in corporate governance were unanimous that owners would strongly contain the independence of top managers, largely because of the problem of trust rather than that of proper qualifications (Korporativnoe Upravleniye 2007). The second assumption was confirmed by various findings. Where ownership and management were separate, the internal control system demonstrated the following features: 1. The decision-making role of the board turned out to be considerably larger, although no difference in the assessment of influence of the general meeting of shareholders was observed (the significance of the difference by forms of control being 0.635). Interestingly, in the subgroup in which the CEO was one of the shareholders, a strong influence of the board was noted by most respondents (three-quarters). 2. Large outside shareholders, on the average, had more than half of the votes (almost 60%, together with independent directors) on the board,

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178 Organization and Development of Russian Business Table 7.2

Characteristics of intra-corporate control

Indicators

M&D_S M_S D_S Separation Significance of differencesa

Representatives in the board of directors, % of total membership Company managers Rank-and-file workers, trade union Federal administration Regional and/or local administration Large outside shareholders Minority outside shareholders Independent directors

67.0 5.3 1.3 1.8 16.7

53.6 33.6 8.6 4.8 1.8 3.9

26.3 3.5 2.4

0.000 0.020 0.013

4.3

3.4

0.041

22.7 40.3

3.2

50.7

0.000

3.4

4.9

6.3

3.8

0.067

4.2

2.7

6.7

8.8

0.011

Influence of board of directors on corporate decision-making, % of the number of JSCs Strong influence Moderate influence Practically no influence

58.9 29.8 11.3

62.1 74.7 27.6 21.1 10.3 4.2

71.5 25.0 3.5

0.002

Corporate control indicators, % of the number of JSCs JSCs included independent directors in board of directors JSCs passed through intracorporate disputes in 2001–2004 JSCs used outside auditing firm from the company’s base region JSCs used non-auditing service of their auditors regularly or occasionally

15.1

7.3 22.4

22.6

0.014

29.5

35.7 25.0

25.0

0.305

80.1

71.2 58.5

60.4

0.000

75.8

59.7 78.8

68.7

0.044

Note: a Comparison of frequencies by 2 test, means by Kruskal Wallis test. M&D_S stands for JScs where large shareholders are managers and the CEO is a shareholder, M_S, for JSCs where large shareholders are managers but the CEO is not a shareholder, D_S, for JSCs where large shareholders are not managers but the CEO is a shareholder. Source: Author’s calculations based on survey data.

which enabled them to monitor the activities of the executive management. Both the percentage of independent directors and frequency of their membership turned out to be significantly higher. On the contrary, where top managers and CEOs were among the shareholders, managers had two-thirds of the votes. 3. We observed the most intensive board turnover: in half of the companies, the board of directors was completely or considerably replaced, while the most conservative policies in respect of the board were maintained; when managers and CEO were shareholders, on the other hand, less than 18% of companies had a new or largely renewed board.2

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Table 7.3 Turnover of CEOs, boards of directors, and its chairs in 2001–2004, % of the number of respondents Indicators of changes CEO was never changed CEO was changed once CEO was changed several times CEO was changed by shareholders’ decision Chairman was never changed Chairman was changed once Chairman was changed several times Board practically unchanged Board slightly renewed Board largely renewed Board completely renewed

M&D_S

M_S

D_S

Separation


75.5 21.1 3.4

50.0 33.3 16.7

71.4 24.6 4.0

35.3 35.8 28.9

0.000

40.6

60.0

45.2

71.0

0.000

60.1 32.1 7.8

42.6 47.5 9.8

51.7 30.8 17.4

44.0 31.1 24.9

0.000

72.2 55.2 14.8 2.8

22.0 45.8 15.3 16.9

16.5 48.8 30.0 4.7

17.3 30.2 31.2 21.3

0.000

Note: a 2 test. M&D_S stands for JScs where large shareholders are managers and the CEO is a shareholder, M_S, for JSCs where large shareholders are managers but the CEO is not a shareholder, D_S, for JSCs where large shareholders are not managers but the CEO is a shareholder. Source: Author’s c.alculations based on survey data.

4. The CEO changed more frequently, sometimes repeatedly, with the change being increasingly initiated by shareholders. It appeared that the director would be “entrenched” in office if he were a large or small shareholder. On the one hand, separation could result from the replacement of a director, normally following a change of owners. On the other hand, separation undermined the position of the CEO, as confirmed by a considerable number of rotations over several years, and contributed to enlisting new managers from the outside. For companies with separate functions, the director was an employee of the same company in 36% of cases versus 68% for the other JSCs. 5. These companies took the lead in the rotation of the board chairman (along with companies in which managers held a large interest) and were significantly ahead of the rest as regards multiple changes. Moreover, the current board chairman was a company employee at 28% of the companies with separate functions, as compared to 52% in other companies. 6. Relatively often, these JSCs retained an auditor from elsewhere or a large international firm. In terms of this indicator, companies in which the director was one of the shareholders performed no worse, but they were more likely to raise suspicions of deviating from the principle of independent audit.

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Factors for the choice of corporate control forms Various methods of corporate control provide the dominating owner with choice options. For example, he or she must decide which type of operational environment of companies is in favor of the selection of hired management and the separation of ownership and management. In our empirical analysis, we include four sets of factors influencing owners’ choices. Furthermore, we define the indicators of the factors to be introduced and the specific hypotheses to be formulated for subsequent testing. Corporate governance and ownership Direct participation of the owner in management under a formal contract is a tool of property rights protection from the opportunistic behavior of managers when institutions are weak. There are other tools of control that substitute or complement a combination of management and ownership. Not all of them can be reflected in a formalized questionnaire. The basic tool is the integration of enterprises into company groups bringing other instruments of control and making it possible to enlist hired management among the rank-and-file members of business groups. In this case, parent companies and stand-alone enterprises will be less likely to separate ownership from management. Another tool is a very high concentration of capital, which makes it legally possible to take control of company boards. It can also be used as a substitute for a combination of ownership and management. With a lower concentration, a combination provides for strengthening of controlling positions of shareholders, thereby complementing the ownership. Another mechanism of protection (substitute) is property nontransparency or ultimate owner (beneficiary) concealment, which, in Russia, can be reflected by an interest owned by different legal entities or foreign investors (offshore).3 The existence of special owners, such as the government and real foreign investors, multiplies the chances of selection in favor of the division of the functions.4 The degree of a company’s publicity should follow the same direction. Open JSCs and, particularly, companies whose securities are traded in stock markets must be more inclined to engage hired managers because it may be a positive signal for retail investors. We believe that the peculiarities of internal corporate governance mechanisms as tools for protection of property rights, which are important for the monitoring of executives (for example, the composition and activities of the board), result from the use of hired managers. For this reason, we did not include these characteristics into the explanatory variables despite observing the link. Path-dependency Voucher privatization provided employees at enterprises with shares and created preconditions for the redistribution of ownership. The managerial

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181

corps had strong informational and organizational advantages over other potential owners in terms of the purchase of shares of the company, in which case the former used their own assets, which had previously accumulated in the shadow turnover (Dolgopyatova 2001). The scheme with a shareholder being in the capacity of manager is more likely to be used at JSCs established during privatization than at new (start-up) businesses or reorganized companies. At the same time, the effect of privatization might have lessened after such a long period of intensive redistribution of ownership upon its completion. Corporate management and markets A complex operational environment often requires professional managerial skills and expertise. The size and industrial classification of a company are indirect indicators of managerial complexity. The bigger the number of employees, the bigger the number of special competences required for its management. With regard to production particularities and industrial markets, the only existing aggregated industrial classification fails to allow such industries to be clearly identified. The communications sector and machinery-building industry can, to a certain degree of conventionality, be considered more complex in terms of their organization and production. Management complexity can be characterized by the particularities of the organizational structure and management techniques, in particular, the methods of strategic planning required due to the extension of the decision-making horizon in the 2000s (Yakovlev 2003). The strategic planning indicator of a company is the duration of the company’s decisionmaking horizon beyond 3 years, during which their chances of engaging hired managers should multiply.5 Restructuring plays a special role in the area of corporate management. There is much truth in the literature on management (Shekshnya & Kets de Vries 2007) in that restructuring is much easier to perform with a single center for decision making when a single person is acting in the capacity of owner and top manager.6 To measure the level of restructuring, the survey gives the following indicators describing the development of enterprises in the period between 2001 and 2004: introduction of new technologies, new production capacities, essentially new products or services, and R&D activities. As evidenced by many previous studies (Yasin 2004), the indicator of production promotion is not valid for restructuring, since respondents will often consider small improvements of the existing product range as new products. This measure is normally used by a vast majority of companies (from two-thirds to three-quarters). At the same time, some companies might not need new products due to the nature of their industry. Since new production capacities and new technologies are two strongly correlated variables, our analysis will be based only on the latter, as it provides a comprehensive measure of restructuring.

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R&D holds a special place. On the one hand, it relates to the industry association of the business and could partially suggest higher complexity of its nature (and, therefore, a positive influence on the preference for the separation of functions). On the other hand, in the weak innovative economic environment and production decline of the 1990s, R&D may suggest the intensification of production and technology restructuring and, thus, negatively affect the choice of hired managers. In our opinion, the second assumption is closer to the truth, and we consider R&D expenditures as an indicator of restructuring. Management complexity and peculiarities are also associated with market conditions, namely competition including global markets as well as enterprise engagement in the foreign trade. The survey provides respondent assessment of the existence of competition with Russian and foreign manufacturers of similar products.7 In many empirical studies, it is competition with manufacturers of developed market countries, rather than competition with Russian manufacturers or CIS enterprises that are mostly based on the prevailing stereotypes of operation and interaction in the market (mainly price competition and administrative leverage), that becomes the indicator of a truly competitive environment that has an impact on enterprise behavior and forces the Russian manufacturers to resort to modern market methods of competition (Kuznetsov 2005). With regard to competition with Russian companies, estimates of this type of competition are often of subjective nature, failing to be associated with the modernization behavior of enterprises and reflecting low demand, poor competitiveness, and, thus, incomplete restructuring as Avdasheva (2006) wrote. Incidentally, according to the findings of our survey, strong competition with Russian companies correlated positively with primary restructuring measures, such as the promotion of new products and new capacities. Competition with companies from developed economies was linked not only to new products but also to R&D expenditures, new technologies, and certification of production in line with international standards, which are measures of a more profound reform of the business. Therefore, we used the existence of (both severe and moderate) competition with companies from developed foreign countries as the key indicator of competition, assuming that it should multiply the chances of appointment of hired top management. With regard to competition (strong) with Russian enterprises, it is difficult to forecast any sign of correlation. Enterprise engagement in foreign economic activity can be assessed by using an indicator describing the existence of the export of products. Exports may require a more complex setup for production; however, this is true only for enterprises of manufacturing industries. We will not include this indicator in our model, as an antistimulus is available as well: owners are very unlikely to entrust their heavy export-based cash flows to the care of outsiders. In-depth interviews provided evidence of a positive correlation

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183

between export activities and a combination of ownership and management (Dolgopyatova 2004). Managerial labor market Operational conditions govern the demand for hired managers; in addition, their engagement is also encouraged by the management labor market’s development and the growth in the supply of qualified managers. Unfortunately, it is very difficult to provide an adequate assessment of it as part of a survey on a micro-level. 8 The Russian labor market’s development, taking into account its well-known regional dimension and low labor force mobility, can be assessed by using indicators based on regional official statistics.9 As a proxy for the labor market supply, we will use the assessment of the average wages in the regions with the data of a sample survey on wages of CEOs of enterprises and organizations conducted by the Federal Service of State Statistics (Rosstat 2006). We expect that the higher the wages are, the faster the division of functions that may be chosen. The wage level shows not only the market development because managers-shareholders may use other channels of remuneration (they may prefer informal methods of shadow income extraction or dividend payout).

Empirical analysis of the determinants of hired management choice Basic models and results Holding of an enterprise’s shares by its general director could give the director solid advantages in decision-making, particularly because a JSC with a small director’s interest is distinguished by a lower concentration of ownership and a higher share of state in equity. This suggests that a comprehensive analysis of factors could be made by using the binary logistic regression and excluding from the sample a group of enterprises in which the director has an interest (D_S). The dependant variable CONTRL was therefore expressed by the probability of choosing a form of control with separation of ownership from management, which adopts a value of “1” in the case of separation and one of “0” in the case of inseparability (that principal shareholders are top managers of the companies). Table 7.4 shows a comparison of JSCs according to the value of basic indicators (descriptive statistics), which we assume have an effect on the choice of the control configuration. The names of variables used in regression analysis are presented in parentheses. In the analysis of binary dependencies, we obtained the expected results, although the correlations were not always significant. It is the communication sector in which separation occurs more often. With regard to branches of industry, separation occurred significantly more often in the fuel and energy and chemical and petrochemical

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3.0 26.3 11.4 11.0 77.6 49.5 49.5 55.3 30.7 33.5 16.627

1.4 11.0 9.0 20.6 70.3 61.0 58.2 67.5 26.6 22.8 16.041

0.061* 0.007*** 0.042** 0.004*** 0.303 0.005*** 0.121

0.000*** 0.356 0.003***

0.743

0.129 0.035** 0.048** 0.040** 0.039** 0.000*** 0.367 0.000*** 0.620 0.792


Note: a Comparison of frequencies by 2 test, comparison between means by Kruskal Wallis test: ***: significant at the 1% level, **: at the 5% level, *: at the 10% level. Source: Author’s calculations based on survey data.

2154 9.2 68.3 61.7 13.3 49.1 4.1 7.6 7.0 4.1

Separation

1096 4.7 60.2 70.0 7.9 77.4 5.8 2.4 3.7 2.2

Combination

Comparison of JSCs with separation or combination of ownership and management

Average number of employees in a JSC, persons (COMSIZ) JSCs in communications, % Open JSCs, % (OPECOM) Privatized enterprises, % (PRICOM) JSCs with securities traded on stock markets, % (STOCKM) Independent JSC or parent company in a group of companies, % (BUSINES) Parent company of a group of companies, % (HOLCOM) Average percent of shares owned by foreign investors, % (OWNFOR) Average percent of shares owned by authorities, % (OWNSTA) Including average percent of shares owned by federal administrations, % (OWNFED) Average percent of shares owned by regional and local administrations, % (OWNREG) Average percent of shares owned by all legal entities, % (OWNENT) The largest shareholder owns less than 25% of shares (CONLOW) The largest shareholder owns less than 50% but more than 25% of shares (CONMED) The largest shareholder owns more than 50% of shares JSCs invested in R&D, % (R&DEXP) JSCs introduced new technologies, % (NEWTEC) JSCs faced intense competition with Russian enterprises, % (COMPRU) JSCs faced competition with enterprises of developed countries, % (COMPFO) JSCs with horizon of strategic planning of 3 years and more, % (STRPLA) Average wages of enterprises top managers by regional statistics data, thousand roubles (SALCEO )

Table 7.4


185

industries. The negative correlation found between the separation of functions and severe competition with Russian companies is probably explained by the aforementioned peculiarity of its subjective assessments. Competition with developed countries played the expected role, although it was insignificant at a 10% level. The logistic regression model of choice was assessed for all JSCs (sample I) and for JSCs with the exclusion of enterprises of the communication and fuel and energy sectors due to their features (sample II). Large holding company groups organized and controlled by the federal state operate in these two sectors. They are distinguished by a high public interest and developed market regulation. Based on the principle that choice is an exclusive right of the controlling owner, we also considered only those JSCs with a clearly defined controlling owner (sample III represents all sectors, while sample IV excludes the fuel and energy and communication sectors). Indeed, if it is necessary to look for compromises or take into account the interests of different shareholders, there may be factors in place which are not included into our model and defy formalization. Two models, each with a different definition of the value of the public block of shares, were made: in model A, this block is calculated as the sum of interests held by the federal and regional/local governments, while, in model B, these types of holdings are separated. Table 7.5 shows calculation results including the previously introduced indicators. The models include mostly dummy variables. All 9 industries (7 for samples II and IV) were used for industry classification (INDDUM), with the communication sector (construction materials industry) being the basic category. JSC, with a high level of concentration, was considered as the basic category for ownership concentration. The logarithm was taken from the quantitative variable of the number of employees in a company. Close estimates of selection options of the form of control were obtained with different samples. A steady significant effect is typical of ownership characteristics and corporate management: the chances of selection in favor of separation multiplied at open JSCs, with an increase in the interest held by legal entities, foreign investors, and government bodies at all levels; on the other hand, the chances were reduced with a medium level of equity concentration in comparison with a high level (only for industries outside of the fuel and energy, and communication sectors). Furthermore, a positive effect was demonstrated by the existing competition with companies of developed market economies. Fewer chances for using hired management were observed in companies under restructuring or severe competition with Russian companies as well as in those related to privatized enterprises. In addition, integration had a stable and strong influence at all specifications and samples: the chances of engaging hired managers were considerably reduced for enterprises classified as independent businesses. With a

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[A]

0.719* (0.396) 1.187*** (0.250) X

Modela, b

Constant

CONMED

OWNREG OWNFOR

OWNFED

OWNSTA

0.020*** (0.007)

0.015** (0.007)

X

STOCKM CONLOW

PRICOM

X 0.670** (0.264) 0.594** (0.255) X X

COMSIZ OPECOM

HOLCOM

BUSINES

I

0.018* (0.010) X 0.020*** (0.007)

X

X 0.711*** (0.261) 0.594** (0.255) X X

0.741* (0.394) 1.161*** (0.250) X

[B]

I

0.029*** (0.009)

X 0.739** (0.299) 0.660** (0.288) X 0.719 (0.444) 0.719* (0.375) 0.020** (0.009)

1.106** (0.468) 1.410*** (0.291) X

[A]

II

0.022* (0.013) X 0.029*** (0.008)

X 0.778*** (0.297) 0.653** (0.289) X 0.666 (0.443) 0.756** (0.377)

1.129** (0.468) 1.397*** (0.291) X

[B]

II

0.024*** (0.007)

0.021*** (0.008)

X

X 0.784*** (0.292) 0.504* (0.281) X X

0.773* (0.413) 1.396*** (0.266) X

[A]

III [B]

III

X 0.024*** (0.007)

X

X

X X

X 0.766*** (0.287) X

1.444** (0.637) 1.279*** (0.276) X

Logistic regressions for shareholder choice of separated ownership and management

Sample

Table 7.5

0.030*** (0.008)

0.875* (0.509) 1.580*** (0.320) 1.108* (0.568) X 0.917*** (0.341) 0.528* (0.320) X 0.209 (0.662) 0.927** (0.431) 0.020** (0.010)

[A]

IV

X 0.029*** (0.008)

X

X 0.149 (0.661) 0.959** (0.432)

0.902* (0.509) 1.558*** (0.320) 1.060* (0.566) X 0.970*** (0.338) X

[B]

IV

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456 477.567

0.324 123.698***

456 476.680

0.326 124.585***

0.357 117.278***

0.354 115.979***

394 385.513

1.261*** (0.283) 0.627** (0.260) X X

1.263*** (0.284) 0.626** (0.261) X X 394 385.214

0.013*** (0.005) 0.781*** (0.267) 0.825*** (0.278) X

0.013*** (0.005) 0.776*** (0.268) 0.859*** (0.279) X

0.350 117.759***

401 402.293

0.943*** (0.268) 0.685*** (0.256) X X

0.017*** (0.004) 0.776*** (0.256) 0.653*** (0.282) X

0.372 126.446***

401 393.606

0.987*** (0.294) 0.775*** (0.266) X Yes*

0.016*** (0.004) 0.709*** (0.269) 0.590** (0.300) X


Notes: a Standard errors are reported in parentheses. ***: significant at the 1% level, **: at the 5% level, *: at the 10% level. b Forward stepwise method was used: X: variables dropped from the final regression equation.

SALCEO INDDUM

NEWTEC

R&DEXP

STRPLA

COMPFO

COMPRU

N 2Log likelihood Pseudo R 2 Test of the model 2

0.015*** (0.004) 0.621*** (0.236) 0.670*** (0.258) 0.540** (0.264) 1.137*** (0.250) 0.540** (0.233) X X

0.015*** (0.004) 0.599** (0.236) 0.700*** (0.260) 0.490* (0.264) 1.117*** (0.250) 0.528** (0.234) X X

OWNLENT

0.386 112.721***

352 322.944

1.047*** (0.309) 0.911*** (0.295) X X

0.014*** (0.005) 0.814*** (0.294) 0.899*** (0.308) X

0.381 110.843***

352 324.812

1.047*** (0.309) 0.910*** (0.294) X X

0.014*** (0.005) 0.820*** (0.293) 853*** (0.307) X

188


total of 456 of surveyed JSCs, 38% of companies had separate ownership and management compared to less than 28% of independent businesses and almost 58% of JSCs, which were previously integrated into a holding company. Corporate integration and the choice of separated ownership and management Model A was tested separately at companies representing independent businesses (subsample 1) or a division of them (subsample 2) with a view to assessing the possible effect of the same factors on companies of different types. Similar specifications for these subsamples (including an indicator identifying the enterprise as the parent company) allowed us to see an appreciable difference in the effect of tested independent variables (Table 7.6). The history of a company ceased to have an effect when the sample was broken down into two types. While the choice of a form of control for businesses remained heavily influenced by factors of ownership and corporate governance, enterprises integrated into holding company groups remained under a positive effect of the interest held by legal entities and (exclusive of the energy and communication sectors) foreign investors. The interests of legal entities as well as, to some extent, those of foreign investors were previously interpreted as a means to reduce ownership transparency used by ultimate owners as a tool to protect their property rights. Restructuring had an effect on independent businesses and rank-andfile members of the holding company groups. With regard to the latter, both indicators manifested themselves with an added effect from the use of strategic planning. Competition with foreign manufacturers always had a positive effect on independent businesses as well as on rank-and-file members of company groups in industry (exclusive of the fuel and energy sector). Competition with Russian manufacturers always was significant for independent businesses and, in some cases, divisions of the holding company groups. It is only the rank-and-file members of the company group that experienced a positive effect from the labor market, mostly due to the existence of enterprises of the energy and communication sectors. Naturally, all-Russian holding companies of these sectors have to take into account the situation in the regional labor market when hiring new employers. In addition, two other models were estimated for rank-and-file members of business groups, which took into account the scale and structure of the entire group of companies. The management complexity in the group was assessed by including an industry diversification indicator into model C (affiliation to a vertically integrated holding company INTVER or conglomerate INTCON, while affiliation to a horizontal type of association became the basic category), and the D specification was added with a variable for the size of group of companies (SIZHOL, the logarithm of the number of legal

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X

COMSIZ

OPECOM

STRPLA

COMPFO

COMPRU

OWNENT

OWNFOR

OWNSTA

CONMED

X X 0.710* (0.427) 0.566 (0.424) 0.036*** (0.010) 0.032*** (0.012) 0.016*** (0.006) 0.680** (0.292) 0.700** (0.320) X

X

HOLCOM

PRICOM STOCKM CONLOW

1.315 (0.805) X

0.658** (0.311) X

Constant

1.273*** (0.445)

X

0.018*** (0.006) X

X

X

X

X X X

X

X

[A]

[A]

Modela, b

I -2

I-1

Sample

1.485*** (0.470)

X

0.018*** (0.006) X

X

X

X

X X X

X

X

1.044 (0.826) X

[C]

I -2

1.360*** (0.496)

X

0.016** (0.006) X

X

X

X

X X X

X

X

2.007** (1.001) X

[D]

I -2

X

0.893* (0.449) 0.723** (0.356) X X 0.865* (0.457) 0.580 (0.457) 0.030*** (0.010) 0.039*** (0.014) 0.014** (0.007) 0.741** (0.317) 0.770** (0.339) X 1.030** (0.487) X

0.023** (0.010) 0.017** (0.007) X

X

X

X X X

X

1.132 (0.884) X

[A]

II-2

1.043 (1.163) X

[A]

II-1

0.020* (0.012) 0.021*** (0.008) 0.975* (0.589) 1.173** (0.569) 1.343** (0.627)

X

X

X X X

X

X

1.031 (0.733) X

[C]

II-2

0.032** (0.015) 0.021** (0.009) 2.088*** (0.809) 1.144* (0.687) X

X

X

X X X

X

X

2.939** (1.376) X

[D]

II-2 [A]

III-2

X

X X X

X

0.031*** X (0.010) 0.032*** X (0.012) 0.016** 0.016** (0.007) (0.007) 0.671* 0.938* (0.325) (0.487) 0.733** X (0.354) X 1.754*** (0.519)

X

0.678* (0.370) X X X

1.210*** 0.222 (0.422) (0.919) 0.900* X (0.510) X X

[A]

III-1 [C]

III-2

1.885*** (0.547)

0.019*** (0.007) 1.000* (0.520) X

X

X

X

X X X

X

X

0.140 (0.988) X

Table 7.6 Logistic regressions for shareholder choice of separated ownership and management and corporate integration

Continued

1.516*** (0.597)

0.018** (0.008) 1.133* (0.581) X

X

X

X

X X X

0.956* (0.522) X

2.283 (1.702) X

[D]

III-2

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X

X

SALCEO

INDDUM SIZHOL

I -2

I -2 [D]

1.332*** 1.453*** 1.356*** (0.443) (0.468) (0.496) 0.125*** 0.110** 0.090* (0.047) (0.049) (0.051) X X X 1.382*** (0.531) 0.126 0.286 (0.450) (0.466) 1.940*** 1.864*** (0.663) (0.698)

1.199*** 1.170*** (0.449) (0.462)

[C]

X

X

X

1.258*** (0.340)

[A]

II-1

1.503*** (0.496) 0.083* (0.051) X

X

[A]

II-2

0.008 (0.579) 2.374*** (0.775)

X

1.778*** (0.589) X

1.689*** (0.645)

[C]

II-2

0.628 62.923***

100 73.135

X 5.699*** (1.473) 0.413 (0.681) 1.924** (0.881)

1.463** (0.674) X

1.430** (0.687)

[D]

II-2


a

[A]

III-1 [A]

III-2

128 133.697

1.636*** (0.503) 0.125** (0.050) X

0.253 0.361 50.627*** 39.949***

273 251.365

X

0.645** (0.328) X

0.887*** 1.314*** (0.340) (0.486)

Notes: Standard errors are reported in parentheses. ***: significant at the 1% level, **: at the 5% level, *: at the 10% level. b Forward stepwise method was used: X: variables dropped from the final regression equation.

N 313 143 143 139 291 103 103 2Log 307.773 159.491 150.291 138.480 270.919 116.397 97.636 likelihood 0.247 0.288 0.354 0.401 0.263 0.281 0.458 Pseudo R 2 Test of the 58.318*** 34.356*** 43.556*** 48.937*** 56.908*** 24.200*** 42.960*** model 2

INTCON

INTVER

X

1.047** (0.429)

1.232*** (0.308)

R&DEXP

NEWTEC

[A]

I -2

I-1

[A]

Modela, b

Continued

Sample

Table 7.6

0.446 51.436***

128 122.209

0.270 (0.513) 2.051*** (0.744)

1.810*** (0.543) 0.120** (0.054) X

1.625*** (0.529)

[C]

III-2

0.526 61.556***

125 106.697

X 2.045*** (0.681) 0.624 (0.559) 2.275*** (0.877)

1.634*** (0.567) X

2.283*** (0.669)

[D]

III-2


191

entities integrated into the holding company). The use of these indicators in the model has a positive effect on the choice and increases its explanatory function with retained stability of basic dependences.

Conclusions Business integration encourages a gradual separation of ownership from management, and shareholding relations among the members of a company group allow abandoning a combination of ownership and control through direct managerial control by principal shareholders. Hiring of top managers contributes to changes in the development of internal corporate norms. The role of the board of directors becomes stronger; it evolves into an agency working in the interests of large shareholders, and it is able to monitor the executive management. As the mechanisms for control over executive management are more widely used, managers have fewer entrenchment opportunities. At the same time, the use of hired managers did not aggravate the agency problem, which suggests that large owners still maintained tight control. Summing up the results of a statistical analysis of the factors affecting the choice of the form of control, two basic hypotheses and most of the special assumptions with regard to the effect of suggested factors were confirmed with different samples and specifications. Indeed, factors of ownership and corporate governance, which are “responsible” for property rights protection, made a considerable contribution to multiplying the chances of engagement of hired managers at Russian JSCs. Evident were differences in owners’ choice at JSCs representing independent businesses against rankand-file members of company groups. Another and more important result is that integration became a significant feature that predetermined differences in the role of other factors of choice for different types of companies. Direct participation of shareholders in management is preferred by stand-alone enterprises and parent companies, while engagement of hired managers is encouraged by both competition with companies of the developed countries increasing demands to management and the peculiarities of capital structure. Factors of corporate management and restructuring play an important role at rank-and-file members of company groups, in which case the management complexity of the entire group is important as well. Holding company groups retain their nontransparency as an additional element of protection for principal shareholders. At the same time, no evidence was obtained on a possible effect of company openness. While identification as an open JSC showed the previously positive effect (for all enterprises as well as those that represented independent businesses), free floating of company securities in stock markets had no significant effect on the selection of the form of control. The role of stock markets was not evident.

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In general, a number of characteristics regarding the peculiarities of corporate management were relevant and significant. Irrespective of the JSC involvement in integration, we observed an adverse effect of restructuring on the chances of selection in favor of hired managers. Globalization (existence of competition with foreign manufacturers that aggravates operating conditions for companies) encouraged the engagement of hired managers. No steady effect of the size of enterprise on the setup of corporate control was revealed.10 Severe competition with Russian manufacturers remains a mystery. The adverse effect on selection in favor of hired management is typical of all companies and JSCs classified as independent businesses. The existence of such competition may reflect restructuring in progress at enterprises, but it also demonstrates operation in relatively competitive markets requiring no special competences. Privatization promoted a combination of functions, but its influence is not stable. As for the management labor market, its limited role may be defined by the quality of a selected proxy variable. The question of how Russian companies will advance is worthy of consideration. Whether owners will remain as managers or rely on the labor market for hiring top managers will be of interest. It is safe to predict that restructuring of the legacy of the state-planning economy will be up for completion and competition in globalizing markets will improve against the smoothing of the effect of privatization and the inevitable resignation of the “red directors” generation, thereby enhancing the intention to hire professional management and search for better candidates. It remains to be seen whether costs from “self-administration” will outweigh company benefits from minimizing the risks of managers’ opportunistic behavior. From all appearances, the existence of an alternative mechanism of control through integration has already made these values comparable. The risks of the violation of shareholders’ rights and poor corporate governance are as important for independent businesses as they were before. It is far more difficult to forecast the situation with property rights protection. However, a certain improvement in corporate governance in the 2000s was evident (Korporativnoe Upravleniye 2007, Natsional’nyi Doklad 2008), and this tendency is expected to remain in perspective. Incentives for improving intra-corporate practice are derived from the growing demand for investments under increasing competition, and the transition to the engagement of hired managers pushes companies to arrange for standard intra-corporate procedures promoting corporate governance development.

Acknowledgments This research was conducted with financial support of SU-HSE (individual academic grant of the Scientific Foundation No.06-01-0050 and funds from

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193

the Program for Fundamental Studies granted by the Ministry of Economic Development and Trade of the Russian Federation in 2007–2008). I would like to thank Heiko Pleines, Andrei Shastitko, and Yurii Simachyev for their useful comments and suggestions. Special thanks are given to Olga Uvarova for her assistance in data processing.

Notes 1. The explanations of abbreviations reflecting configurations of ownership and management used in tables and graphs of this chapter were made in Chapter 2. 2. Records of in-depth interviews show that board activities are often a tribute paid to formal legal regulations and that their titular nature tends to correlate with both the fusion of the board with executive management and the stability of its membership (Dolgopyatova 2004). 3. Although such ownership indicates, to some degree, an enterprise’s participation in the holding company group, it may have an individual value as a signal of nontransparency. 4. The existence of a foreign or quasi-foreign investor will have no effect on the formulation of a quantitative hypothesis. 5. Management turnover is certainly encouraged by inefficient management, but a single survey is insufficient to offer adequate indicators of its measurement. 6. Restructuring was required for the overwhelming majority of Russian companies, both privatized ones whose assets were collected under the state-planned economy and new ones, because they emerged in the real sector from what was left from old Soviet enterprises by accumulating their assets. Corporate integration became one of the main forms of business restructuring (Radygin 2004). 7. It should be emphasized that, although the point is the company’s external factor of competition in the market of its products, we in fact have only a subjective respondent assessment of the level of competition that can be developed though a set of conditions. 8. A series of signals is available in the survey, namely, the educational background of the CEO as well as his/her “history” (external manager or incumbent, i.e., staff member of a given enterprise) and management experience at foreign businesses or government bodies. However, such characteristics are unlikely to be independent factors of choice; thus, they may be useful at the stage of looking for a suitable candidate (or be its effect) rather than for a shareholder’s critical decision with regard to withdrawal from management. 9. Labor market supply can also differ depending on the size and the status of populated areas (capital city, town, and village). However, the situation is not exactly straightforward. On the one hand, a more important status and population will offer a wider choice of labor, while, on the other hand, small villages are unattractive to business owners as a place of principal residence. When a business includes divisions located elsewhere, especially in small towns and villages, shareholders will be more inclined to look for local candidates for managerial positions, while they themselves could manage companies located in Moscow or other large cities. 10. The number of employees is closely correlated with the company’s form of incorporation, and the last indicator includes the effect of size.

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Bibliography Avdasheva, S. (2006) Stimuly i rezul’taty integratsionnykh protsessov ili pochemu predpriyatiya prisoedinyayutsya k biznes-gruppam. In: Dolgopyatova, T. (ed.), Integratsionnye Protsessy, Korporativnoe Upravleniye i Menedzhment v Rossiiskikh Kompaniyakh. Seriya “Nauchnye Doklady: Nezavisimyi Ekonomicheskii Analiz,” No. 180 (Moscow: Moskovskii obshchestvennyi nauchnyi fond & “Proekty dlya budushchego”) (available at: http://www.mpsf.org/lib.html). Dolgopyatova, T. (2001) Modeli i mekhanizmy korporativnogo kontrolya v rossiiskoi promyshlennosti, Voprosy Economiki, 5: 46–60. Dolgopyatova, T. (2004) Sobstvennost’ i korporativnyi kontrol’ v rossiiskikh kompaniyakh v usloviyakh aktivizatsii integratsionnykh protsessov, Rossiiskii Zhurnal Menedzhmenta, 2/2: 3–26. Korporativnoe Upravleniye v Rossii: Opyt i Perspektivy (2007) (Moscow: Natsional’nyi sovet po korporativnomu upravleniyu). Kuznetsov, B. (2005) Vliyanie konkurentsii na protsessy modernizatsii i reformirovaniya rossiiskikh promyshlennykh predpriyatii (opyt empiricheskogo analiza). In: Avdasheva, S. & Tambovtsev, V. (eds), Vliyanie Konkurentsii i Antimonopol’nogo Regulirovaniya na Protsessy Ekonomicheskoi Modernizatsii (Moscow: TEIS). Natsional’nyi Doklad po Korporativnomu Upravleniyu. (2008) Pervyi Vypusk (Moscow: Natsional’nyi sovet po korporativnomu upravleniyu). Radygin, A. (2004) Evolutsiya form integratsii i upravlencheskikh modelei: opyt krupnykh rossiiskikh korporatsii i grupp, Rossiiski Zhurnal Menedzhmenta, 2/4: 35–58. Rosstat (2006) Zarabotnaya plata rabotnikov v Rossiiskoi Federatsii, Statisticheskii Bulleten, 9/130: 112–114. Shekshnya, S. & Kets de Vries, M. (2007) Mnimyi ukhod. Ekspert, 5: 34–41. Yakovlev, A. (2003) Spros na pravo v sfere korporativnogo upravleniya: evolutsiya strategii ekonomicheskikh agentov, Voprosy Ekonimiki, 4: 37–50. Yakovlev, A., et al. (2006) Corporate governance in transition: New trends and challenges. In: Sell, A. & Krylov, A. (eds), Corporate Governance (Frankfurt am Main: Peter Lang GmbH). Yasin, E. (ed.) (2004) Structural Changes in the Russian Industry (Moscow: SU-HSE Publishing House).

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8 Corporate Governance and Decision-Making in Business Groups Svetlana B. Avdasheva

Introduction This chapter and the following one are devoted to independent legal entities that constitute united companies and are known as business groups (BGs) or holding company groups. In modern economic literature, BGs are defined as “a set of firms which, though legally independent, are bound together by a constellation of formal and informal ties and are accustomed to taking coordinated action” (Khanna & Rivkin 2001: 47–48). Russian law defines a parent company and its subsidiary, which together constitute a holding company group, as a pair of agents, one of which, namely, the parent company, has sufficient authority to determine the decisions of another based on ownership rights or any other type of control rights.1 In this respect, both terms, BGs and holding company groups, are synonymous. In Russia, the term “business group” usually applies to legally independent entities under the same control that were historically independent businesses and have experience acting independently. BGs are sometimes considered to be newly established integrations that occurred after privatization. In this book, a business group is defined as a set of legally independent entities joined by ownership rights. The set of entities (enterprises) is under control of the ultimate owner (or small groups of interrelated ultimate owners) or parent company. No distinction is generally made between BGs founded during the Soviet times and those established in mergers during the economic upturn that started in 1999 after the completion of a mass movement of privatization.

Competing hypotheses of corporate governance in Russian business groups In contemporary studies, considerable attention is given to Russian BGs as a form of concentration of capital and assets and, at the same time, as a way to restructure privatized enterprises. Mergers are also among the most 195

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important events changing the organization of markets in Russia. During the economic upturn, the ratio of merger value to GDP increased from 4% in 2001 to about 8% in 2005–2007.2 The largest groups control almost onehalf of the relevant industrial markets in Russia (Guriev & Rachinsky 2005) and the great majority of companies listed on stock exchanges (Boone & Rodionov 2002). After the acquisition of undervalued assets or their takeover via the use of various informal instruments during the 1990s, BGs have been making substantial efforts to restructure their constituent companies. “Oligarchs” are not only the largest shareholders but also more efficient owners in comparison to the owners of nonaffiliated enterprises (Guriev & Rachinsky 2005). However, the rapid development of BGs contradicts common knowledge about the prominent features of the Russian national model of corporate governance (see Chapters 1 and 7 for details). BGs are supposed to be based on the separation of ownership and management. However, in recent surveys, it has been demonstrated that, in most Russian companies, ownership and management converge. Given a weak institutional environment, the most successful way to resolve agency problems in a typical Russian company is the “do-it-yourself” option. That is the reason that many executive managers of privatized firms became the controlling owners, and new owners of companies (both privatized and newly established) became executive managers (in reality, if not formally) or hired managers that were so closely affiliated that the agency problem could be considered to be nonexistent. Therefore, an important problem in the study of transition in Russia is explaining the model of corporate governance in Russian BGs. Thus, it is necessary to understand which specific tools are used to prevent losses from the agency problem in Russian BGs. It is worthwhile to discuss five hypotheses regarding the instruments of corporate governance in BGs: Hypothesis H1: There is no agency problem in Russian BGs, since they are not companies. The formation of BGs is a completely artificial process motivated by political considerations. From this point of view, the support provided by the Russian government to large company alliances thoroughly explains the incentives for typical privatized enterprises to join BGs. If the JSCs in the group are integrated in the company, that is, if they are organized into a hierarchical system, then four hypotheses are possible: Hypothesis H2: The principal-agent problem is solved by the convergence of ownership and management, as is traditional in Russia. BGs have the same system of corporate control as do independent or autonomous enterprises. This means that management is not separated from ownership and ultimate owners manage the enterprises in the BGs.

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Corporate Governance and Decision-Making

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If the BGs are organized as hierarchies but management is separated from ownership, then, Hypothesis H3: The principal-agent problem is solved by the development of internal corporate governance tools, which include boards, independent directors, and internal audit units. This should be extremely important in the Russian context of weak external instruments to uphold the discipline of executive management. Hypothesis H4: The principal-agent problem is solved by the owner having additional bargaining power. One example is the state as a dominant owner. Hypothesis H5: The executive management in BGs is disciplined by the benefits of joining the group. For instance, BGs can be supported by relational-type contracts (Goldberg 1980) between an owner who is an outsider not participating in management and an executive manager. In this case, the outside owner does not need to spend resources to control executive management. Discipline within the group of enterprises is upheld by mutual interests. Not all of the hypotheses are mutually exclusive. This is especially true for H3–H5. Improvement of subsidiary performance can complement the impact of corporate governance bodies as a disciplinary device. The potential opportunism of executive management can be prevented by direct supervision of a parent company and by increasing the performance of the enterprise within a BG. The objective in this chapter is to examine the hypotheses, from H1 to H4, using the results of the Japan–Russia joint survey conducted in 2005. The next chapter is devoted to the impact of BG membership on the performance of subsidiaries, and the analysis will provide evidence in favor of H5.

Organization of Russian business groups The ratio of enterprises that are members of BGs and their share in the overall employment in the relevant industry are presented in Figure 8.1. Communications, fuel and energy, and metallurgy lead in the percentage of industry employment in the BGs, while light industry and construction materials are comparative outsiders. The larger companies are involved in group membership. Of 323 enterprises that identified themselves as affiliated to a BG, 44 respondents declared themselves to be parent companies; the others are subsidiaries. Almost one-third of the subsidiary companies in the sample are in regulated industries that include the generation and transmission of electric power and regional telecommunication companies. The share of JSCs affiliated with BGs is very close to the alternative estimates of the share of BGs in economic activity in Russia (see, for instance, Guriev & Rachinsky 2005).

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Fuel and energy Metallurgy Machine building and metal working Chemicals and petrochemicals Wood, paper, and wood products Light industry Food industry Construction materials Communications Total 0

10

20

30

40 50 (%)

60

70

80

90

Percent of enterprises affiliated to BGs by industry Percent of workers employed in BGs by industry Figure 8.1 Share of business groups (BGs) in number of companies and in employment (%) Source: Author’s illustration based on survey data.

Although BGs are primarily of interest as a form of ownership reallocation following privatization, not all the enterprises in the sample joined the groups after privatization and liberalization. In the fuel and power industries, the largest groups emerged before 1992. In all other industries, most of the groups were founded after privatization. Mergers intensified during the economic recovery after 1999; most of the deals for the sample took place in 2002. During this year, 50 enterprises, or slightly less than one-sixth of the whole subsample of affiliated companies, joined their groups. About half of the BGs are horizontal; they include enterprises in the same industry. Slightly more than a quarter are vertical; they contain producers along the same technological chain. The rest are conglomerate. Most groups include numerous auxiliary units as separate legal entities in addition to the basic production facilities; half of the groups include trade enterprises, and about one-fifth include banks and/or financial/insurance companies. Therefore, the firms in the groups represented in the survey are very heterogeneous by the origin, industry, and experience of being autonomous as a business unit. However, by considering such diverse companies, we can collect evidence to support several of the hypotheses presented in this study on the nature of corporate governance in the subsidiaries. Before discussing the various alternative hypotheses, it is necessary to analyze the allocation of responsibilities and the decision-making

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process within the BGs. The goal here is to make sure that coordination and decision-making within the groups comply with a hierarchical system, which gives rise to the agency problem. If, according to the classification of the new institutional economics (Williamson 1985), coordination within BGs is more of a hybrid-type coordination between legally and economically independent units, then the stability of these companies should be analyzed solely in the framework of relational contracting and not in the framework of corporate governance and corporate control. If subsidiaries are part of companies but not independent businesses and the disciplinary devices within the groups are to be considered it is necessary to evaluate corporate governance as disciplinary device. In order to do that it is necessary to compare the corporate governance, including the convergence of ownership and management in companies that are either affiliated or nonaffiliated with a BG, as well as the role of internal corporate governance instruments, such as the board of directors and shareholder meetings. In Chapter 7, it was demonstrated that corporate governance in subsidiaries in holding company groups differs substantially from corporate governance in JSCs representing autonomous business. In this chapter, the different types of subsidiaries are investigated. Special attention is given to the comparison of corporate governance in companies in regulated industries, such as energy and telecommunications, and nonregulated industries. In regulated industries, the agency problem can be prevented, since the state can uphold the discipline of executive management with a broad range of supplementary instruments. Correspondingly, we can expect more effective internal corporate governance in the holding company groups in regulated industries. The remainder of the chapter is organized as follows. The second section is devoted to decision-making in BGs. The scope of centralization and the involvement of stakeholders in strategic planning are under analysis in order to support or reject H1. The third section is a comparison of the internal instruments of corporate governance in the JSCs in regulated and nonregulated industries in order to discuss H2–H4. The fourth section is an attempt to quantify the role of different instruments used to discipline executive management in Russian BGs.

Decision-making in the holding company groups: Centralization or networking with stakeholders? During the last decade, among Russian economists, there were a number of competing opinions about decision-making within BGs. Ten years ago, most experts considered BGs as completely artificial alliances without common group decisions and without a special system of decision-making. In the course of time, most researchers concluded that the nontransparency of the ownership structure and decision-making prevents identifying

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the type of coordination that occurs within a group and even the group boundaries. It spite of nontransparency, centralized decision-making takes place (Pappe 2000). The ownership structure within the groups, as well as the group boundaries, became more transparent over a 10-year period, and the same was true for the decision-making within the groups. However, the results of the comparison of the decision-making and management in the BGs with those in a large company are still debatable. In some studies, it was reported that both strategic and daily management decisions in the groups are extremely centralized (Dolgopyatova 2004). Others observed the centralization of only strategic management decisions, as daily management decisions are decentralized (Radygin 2004). However, in almost all studies, there was agreement that BGs are a specific type of firm with hierarchical governance of transactions and not a network of enterprises that are equal partners. Moreover, with the course of time, Russian BGs restructured the system of decision-making toward further separation of strategic and daily management decisions and the centralization of strategic decisions (Pappe & Galukhina 2006). According to the results of sample surveys of enterprises in the project Structural Changes in the Russian Industry (Yasin 2004), there is evidence that authority is divided between parent companies and subsidiaries in a rather irregular way: the parent company makes all financial, marketing, and investment decisions, which include not only strategic but also daily decisions, along the traditional lines of this division, and subsidiaries make production management decisions only. There were 30 respondents, representing both affiliated and nonaffiliated enterprises. All the respondents were top managers of their firms: 14 were general directors, and 11 were deputy directors. Most of the companies were established in the Soviet period and then privatized (60% were open JSCs, and 30% were closed JSCs); 37% of the respondents were in light industry, 30% were in the food industry, and 33% were in the machine-building industry. As reported above, interviews were conducted in medium-size companies: 13 of the companies had 100 to 500 employees, 12 had 501 to 1,000 employees, and only 5 had more than 1,000 employees. The typical firm in the sample had relatively stable financial performance, while there were some firms in bankruptcy, including those that were under external management at the moment of the interview. Firms interviewed had demonstrated a very large increase of output since 1998. Of the 30 firms included in the interview, 16 were part of various BGs, which are outside owners of the enterprises. Only one respondent said that his enterprise was part of a BG that did not participate in authorized capital and, in spite of that, performed the functions of executive management. In most cases, the responsibility for decision-making was allocated so that the parent company was the marketing center of the group and all marketing and financial decisions were centralized; the affiliated enterprise was a

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production facility only but enjoyed significant autonomy in production decisions and labor management. The following quotations from the interview are typical: “Key decisions are made at the enterprise level; the group was formed only for marketing.” This respondent was the general director of a machine-building enterprise with 300 employees. The strong opinion expressed by the respondent that marketing decisions were of secondary importance to him is crucial here. “The holding company (parent company in this context) controls all the finances, buys all the inputs for production, and provides us with the technologies, including all of the documentation ... We supply the final products in exchange for that.” This respondent was the general director of a machine-building firm with 1,800 employees. The director of the enterprise considers the management and decision-making within the group as internal markets but not as hierarchical coordination. “The enterprise is freed from unusual and unnecessary decisions. The parent company performs the functions of the Soviet Glavk (industrial planning body under socialism). We don’t care about what and how much to produce ... The holding (parent) company supplies the raw materials, sells our products, and takes care of all the accounting, taxes, and finances. The director shouldn’t think about taxes and wages ... The holding company (parent company) is a buffer that saves us from the market ...” This respondent was the general director of a machine-building enterprise with 1,100 employees. The notion of enterprise as a production unit of broader company is typical here. “(The parent company) deals with the marketing for the most part. I do not care any more to whom the product is sold or at what price it is sold.” The respondent was the general director of a food processing enterprise with 430 employees. The results of the interview lead us to the conclusion that, first, decisionmaking in the BGs has changed significantly from that in the period when enterprises functioned as independent entities; yet, secondly, the main trend of these changes is not to modify the decision-making process at the enterprise level but to strip the enterprises of all marketing decisions; the enterprises then become pure production facilities. It is symptomatic that the top managers of the enterprises stress the use of Soviet-type planning inside the BGs as the main advantage of this form of organization. The conclusion is that holding companies are a very Soviet form of capitalism, and this important explanation of the rise of this organizational form in Russian industries has been suggested by others, for example, Clarke (2004). The level of centralization of decision-making in BGs needs to be assessed to verify the hypotheses on the corporate governance of BGs given above. A

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high degree of centralization of decision-making would mean that ownership and management are not separated, and, thus, the agency problem is resolved (H2). If the parent company concentrates all important decisions at the level of headquarters, or, as is typical for Russian JSCs, at the level of a small group of ultimate owners, there is no specific agency problem in the BGs other than the typical agency problem faced by all big companies. However, if the top management of affiliated companies enjoys substantial autonomy, then the agency problem between parent and subsidiary intensifies, and specific instruments are needed to resolve it. Our survey results are ambiguous as to whether decision-making is centralized or decentralized. The degree of centralization does not seem to be very high if we look at the decisions made exclusively by the parent company without participation of the enterprise. Strategic decisions are made by the parent company alone in 40% of the groups, while daily management decisions are completely centralized in only 5%. However, in slightly more than half of the enterprises, parent companies participate or coordinate strategic and daily management decisions, although subsidiaries retain an influence on them. Important evidence is that the degree of centralization of daily management decisions significantly increases over time. From enterprises that became subsidiaries in the groups before 1995, the last year of mass privatization, 55% consider themselves as fully autonomous in daily management decisions. Among the enterprises that became subsidiaries after 1995, the ratio falls substantially to 37%. Therefore, recent BGs employ more centralized decision-making. This evidence is in favor of H2: even if ownership and management at the level of subsidiaries are formally separated and the ultimate owner does not own the shares of subsidiaries, the role of the parent company reflects the participation of the owner in management. By taking part in daily management decisions in subsidiaries, which is the case for more than half of the enterprises, parent companies and the ultimate owners correspondingly prevent the soundest manifestations of agency problems at the level of subsidiaries. The participation of stakeholders in the planning and management of the enterprises is important for both analyzing the process of decision-making in BGs and qualifying them as companies rather than as networks of companies. Networking and corresponding relational rents are traditionally seen as an important source of advantages for BGs, especially in Korea, Taiwan, India, and Malaysia (see Khanna & Yafeh 2005, for a survey). The high importance of networks, which may have been inherited from the Soviet period in some cases, is also often attributed to Russian enterprises. The influence of networks on decision-making, management, and performance in enterprises was evaluated by researchers of Russian enterprises either positively or very negatively. According to the first point of view, contacts with stakeholders suggest relational rents in the networks of traditional suppliers

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and customers (Moers 2000) and then improve the economic performance of the enterprise, while, according to the second point of view, supporting relationships in traditional networks is the alternative to a marketoriented restructuring that prevents upgrading of the enterprise (Gaddy & Ickes 1998). At the same time, both groups agree that Russian enterprises are active participants of networking, both formal and informal. However, our findings contradict this notion as far as members in BGs are concerned (Table 8.1). Although group member companies more often coordinate their strategic decisions with different types of stakeholders, this coordination is quite limited. A large part of the respondents, 69% of independent enterprises and 57% of group member companies, reported that they do not coordinate their strategic management decisions with any type of outside stakeholders. Horizontal coordination between firms is implemented by less than one-third of BG members. Even this modest difference between affiliated and nonaffiliated companies can be easily explained, both by the size of the companies and by the specifics of regulated industries. First, the importance of stakeholders and the scale of networking generally increase with the size of the company and the specificity of the deals, and BGs are substantially larger than nonaffiliated enterprises. Second, companies in regulated industries, where affiliated enterprises prevail, are involved in more intensive networking in order to bargain over regulated tariffs and investment plans that need to be approved by regulatory bodies and/or parliament. As is evident in Table 8.1, federal and regional administrations are important stakeholders for JSCs in regulated industries, both as regulators and as representatives of the state as shareholders. This evidence indirectly refutes H1. In conclusion, our survey results show that it is a hierarchical coordination rather than networking that prevails in Russian BGs. Group firms (first Table 8.1 Enterprises coordinating strategic decisions with outside stakeholders (%) Affiliated JSCs

Federal administrations Regional administrations Workers and trade unions Banks (not group members) Suppliers and customers (not group members) Members of a BG

In regulated industries (N = 79–82)

In nonregulated industries (N = 97–100)

Overall

Nonaffiliated JSCs

40.00 52.20 47.80 22.30

14.60 28.20 30.80 17.50

21.90 35.20 35.70 18.90

9.60 22.70 27.00 12.10

21.10

20.80

20.90

13.40

30.20

31.80

30.80

—


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of all, “old” group members) retain autonomy in daily management decisions at most. The specific tools for resolving the agency problem lie in the relations between the parent company and the subsidiaries.

Corporate governance in BGs: The state’s presence matters Group firms, particularly subsidiaries, differ from independent companies by their patterns of ownership and control (Table 8.2). Many group member JSCs are under unilateral influence of the dominant owner. Control in the groups is largely based on shareholding: two-thirds of independent enterprises reported that they had a shareholder or a group of shareholders with a controlling stake, but almost four-fifths of the group member companies already had such owners. The smaller number of firms in which there is an owner with a blocking package in addition to another owner with a controlling stake among subsidiaries is an additional indicator of the higher concentration of control in subsidiaries. In contrast, parent companies of BGs more often have an owner with a controlling stake along with an owner holding a blocking package.

Table 8.2 BGs (%)

Ownership and management in JSCs depending on their affiliation with

Indicators

Not affiliated (1)

Affiliated (2)

A controlling owner or a controlling group of owners is present

85.25 (461)

An owner (consolidated group of owners) of a controlling stake (50%+1 share) is present

In BGs Parent (3)

Subsidiaries (4)

Differences significant at the 5% level

90.68 (311)

90.70 (43)

90.68 (268)

Among (1) and (2)

66.30 (460)

78.11 (297)

66.67 (42)

79.22 (255)

Among (1) and (4)

Apart from the owner of a controlling stake, an owner of a blocking package is present

32.66 (294)

27.23 (224)

50.00 (28)

23.98 (196)

Among (1), (3) and (4)

Large shareholders act as enterprise managers

56.24 (473)

34.95 (309)

53.50 (43)

31.95 (266)

Among (1), (3) and (4)

The CEO (chairman of the board of directors) holds enterprise shares

70.23 (477)

50.66 (304)

68.29 (41)

47.91 (263)

Among (1), (3) and (4)

Notes: The number of respondents is given in brackets. The significance of the difference is estimated using the Tamhane T2 test. Source: Author’s calculations based on survey data.

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205

As reported in Chapter 7, affiliate companies of a BGs, especially subsidiaries, demonstrate a lower level of convergence of ownership and management than independent companies. This is especially true for the largest diversified groups with many subsidiaries and an all-Russian and/or international scope of activities. Under management separated from ownership, the ultimate owner should rely on the internal system of corporate governance in order to prevent the exertion of an agency problem. Therefore, in subsidiaries, as in other JSCs with management separated from ownership, the structure and role of corporate governance bodies are expected to reflect the increasing demand for disciplining executive management. Our survey data comply with these expectations. The average share of managers on the boards of directors in affiliated companies is 32%, which is notably lower than the 54% in nonaffiliated companies. The share of external owners on the boards is much higher in affiliated companies, especially in subsidiaries (47% of the board members in subsidiaries, 28% in parent companies, and 24% in nonaffiliated companies). Finally, the percentage of the boards of directors, which include independent directors, is twice higher among group firms than among independent JSCs (27% as opposed to 14%). Respondents representing group members more frequently report that shareholder meetings play an important role in decision-making (58% in subsidiaries in contrast to 45–46% in parent and nonaffiliated companies). The same is true for the board of directors: 71% of companies in BGs considered the board to be extremely important, in contrast to 63% of nonaffiliated companies. Corporate governance implies a strong reliance on both the market of control and the market of managers, which should be more important for group firms because of management separated from ownership. At the enterprise level, this reliance must be reflected in a higher frequency of change of owners, top managers, and members of the boards of directors. During 2001–2004, when the process of corporate integration was experiencing its most intensive period, every third enterprise belonging to a BG changed owners, while the percentage for nonaffiliated enterprises was only a quarter. The same is true for the change of general directors: 49% of the general directors in affiliated companies were replaced during the period under analysis, in contrast to 32% in nonaffiliated enterprises. As is clear, the results of our joint survey provide supporting evidence for H3. Instruments of corporate governance are more important in group firms. At the same time, we cannot fully refute H2, which states that the agency problem is solved in BGs in the same way as in nonaffiliated JSCs: by the convergence of management and ownership. Top managers own shares, and controlling shareholders act as managers in, at the very least, one-third of the BG subsidiaries. However, the data on corporate governance presented allow different interpretation. In many Russian companies, corporate bodies do not play an important role in decision-making in spite of the fact that, formally, corporate procedures comply with the standards

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of good corporate governance (Yakovlev 2004). Therefore, it is necessary to look closer at the subsidiaries in which corporate governance is relatively developed. It is possible that the functioning of corporate governance is supported by supplementary instruments. The range of these instruments is extremely broad: from relational contracting based on mutual interest of the parties involved to asymmetric position of the parties. The latter is a case in which, for instance, a parent company is the only or dominant supplier of important input for the subsidiary. Another example is when an ultimate owner is closely related with an influential political power or special interest group. Our survey, of course, does not provide evidence on all the possible advantages of parent companies that allow for effective control of decision-making in a subsidiary. One special case is when a state is an owner and/or regulator. The authority of the state as a regulator and/or owner can provide additional support for corporate governance (H4), especially in the modern Russian context, when the state, especially, federal authority, is of growing importance. If a state supports corporate governance in the subsidiaries, it will be more developed in the subgroup of subsidiaries in regulated industries and/or subsidiaries with state shareholding. The state at the level of the federal and/or regional authority is a shareholder (major or minor) in many JSCs in regulated industries. For comparison, in nonregulated industries, only every tenth JSC affiliated to a BG has shares belonging to the federal authorities, and every sixteenth has shares belonging to regional authorities or to municipalities. In regulated industries, federal authorities are a shareholder in about 40% of affiliated JSCs, and regional authorities or municipalities are shareholders in about 20% of affiliated JSCs. Our survey data show significant differences in the structure of the board of directors and its role in corporate governance in regulated and nonregulated industries. In group firms in regulated industries, the composition of the corporate board complies with good corporate governance standards better than in nonregulated industries (Table 8.3). While the executive management in regulated industries is represented in the same proportion of JSCs, the share of this group in the number of board seats is significantly lower in regulated industries. Worker representatives who are mostly passive on Russian boards are almost unrepresented in this group of companies. It is necessary to stress the significantly higher ratio of boards in regulated industries that include independent directors. Important conclusions on the ability of the board members to influence the managerial decisions can be drawn. Participants of the corporate board with no additional control rights, such as independent directors and small outside owners, are more often represented in regulated industries, but their shares are not always higher in comparison to those of nonregulated industries. In fact, they are lower for independent directors. Apparently, this can be considered to be evidence that the very presence of the state among shareholders protects

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7.20

26.50

15.19

74.91

20.49

9.89

80.92

42.97***

18.61***

60.12

31.43

29.06

42.87***

Nonregulated industries

28.55***

31.32***

57.38

41.14

18.84

31.30***

Regulated industries

35.65

25.65

59.27

37.26

27.96

39.48

Overall affiliated companies

Share of a given group in the board (only for boards in which a given group is represented), % a


Notes: a Comparison of frequencies by 2 test; comparison of means by F-test for number of board members and Kruskal Wallis test for the shares of the group in the board. ***: significant at the 1% level, **: at the 5% level, *: at the 10% level.

43.18***

18.97***

75.00

74.87 27.27***

32.95**

14.87**

9.74***

3.41**

76.14

8.00***

Regulated Overall affiliated industries (N = 88) companies (N = 283)

12.82**

83.08

6.80***

Nonregulated industries (N = 195)

Share of the boards in which a given group is represented, % of respondentsa

Boards of directors in subsidiaries of BGs in regulated and nonregulated industries

Number of board members Managers of JSC Workers and representatives of trade unions State Large outside shareholders Small outside shareholders Independent directors

Table 8.3


property rights for all the groups of owners and provide board members with the power in decision-making. The state serves as a guarantee for noncontrolling outside owners to influence corporate governance through their seats on the board. Again, the different board structure in regulated and nonregulated industries does not allow higher assessment of corporate governance in companies with state ownership. The difference itself could be explained by the fact that the standards of good corporate governance in regulated industries are applied under pressure of the state, and these standards are very often applied quite formally, without significant impact on decisionmaking (Yakovlev 2004). However, the respondents themselves were very appreciative of the influence of corporate governance instruments, including shareholder meetings and the board of directors, most of all in regulated industries. In fact, among the top managers of affiliated JSCs in regulated industries, 67% assessed the role of shareholder meetings as high in contrast to 56% of top managers in nonregulated industries and 46% in nonaffiliated enterprises. The same is true for the board of directors: 86% of respondents in affiliated JSCs in regulated industries agree that it has a strong influence on decision-making in the enterprise, in contrast to 65% in affiliated JSCs in nonregulated industries and 63% in nonaffiliated JSCs. Regular dividend payments are additional evidence that affiliated JSCs in regulated industries try to follow good standards of corporate governance. During the three years before the survey was conducted, even fewer affiliated JSCs in nonregulated industries (29%) than nonaffiliated JSCs (40%) paid dividends. In regulated industries, two-thirds of JSCs paid dividends during this period. The assumption that the state as a shareholder has a positive impact on the effectiveness of corporate governance is indirectly confirmed by the respondents’ assessment of the concentration of ownership. In nonregulated industries, 68% of respondents see the current ratio of concentration as optimal for the companies, 12% see an increase of concentration necessary, and only 8% believe that a lowering of concentration is possible. The opinions in regulated industries are different: about one-half of the respondents consider the concentration ratio to be optimal, but, at the same time, 30% of the respondents think a decrease of concentration could be useful. Nine percent believe that an increase of concentration is necessary. It seems that the respondents in affiliated enterprises in regulated industries do not consider the agency problem to be so acute. That is the reason that they do not seek further concentration of ownership, which is the main instrument to protect ownership’s rights in Russia (see Chapter 7). The evidence of more developed corporate governance in regulated industries contributes to an extremely important question about the role of the state in securing and protecting property rights in Russia. The impact of the state on ownership rights at the level of the economy as a whole and that of one given company is different. It is common knowledge that, in

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contemporary Russia, the state is the main threat to property rights and the owners of industrial assets are not exempt. At the same time, in a given company, the very presence of state shareholding can protect the property rights not only of the state as an owner but also of private shareholders. That is the reason that corporate governance in the companies under influence of the state as a shareholder and/or regulator is associated with lower cost and protects the interests of owners better than in private companies without state presence. Additional protection is important, in the first place, for companies with complicated internal organization and structure, such as BGs. In summary, the survey data are insufficient to refute H2–H4. About onethird of the BG members apply a model of corporate control in which management is not separated from ownership, and this fact supports H2. Affiliated JSCs evidently surpass the nonaffiliated enterprises in the development of corporate governance, and this does not allow us to refute H3. In their turn, JSCs in regulated industries outperformed those in nonregulated sectors in following good corporate governance standards. Protection of property rights by the state as a shareholder and/or regulator weakens the incentives for ownership concentration and for the owner participating in management. Therefore, H4, regarding the additional instruments that allow the owner to discipline executive management in affiliated enterprises, cannot be denied either.

Conclusions BGs represent a significant proportion of enterprises in Russian industries. Thus far, during the last decade, mergers and corporate integration have been among the most typical forms of business restructuring in Russia. The primary objective in this chapter was to explain the development of the organizational form apparently based on the separation of ownership and management, such as BG, in a country in which a national model of corporate governance is based on the convergence of ownership and management. In this context, the central issue is identifying the main instruments employed to solve the agency problem under separated management and ownership. Several explanations are likely, from the possibility that there is no additional agency problem because ownership and management in the Russian groups are in fact not separated to the possibility that the agency problem is resolved using the instruments of corporate governance, including monitoring and specific types of incentive contracts with executive management. Our survey results demonstrate that the agency problem should exist in Russian BGs, since a hierarchical type of coordination prevails in them. In spite of the heterogeneity of BGs, most of them are organized as companies and not as networks of independent businesses. There is no simple way to determine what the main instrument is for solving the agency problem in Russian BGs, as they are very heterogeneous. In some of them, ownership and management are not separated, and, in this case, the

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model of corporate governance does not differ much from that of a typical nonaffiliated company. Convergence of management and ownership prevents potential losses from the agency problem. At the same time, Russian BGs apply internal mechanisms of corporate governance, a board of directors in the first instance, as controlling devices more actively than nonaffiliated enterprises. However, the instruments of internal corporate governance seem to be most effective in companies in which the state has enough bargaining power against top managers (as regulator and/or owner) to protect property rights and to force subsidiaries to apply good corporate governance standards. Figure 8.2 gives a rough estimation of the role that various instruments discussed in this chapter play in solving the agency problem in the subsidiaries of BGs based on the data on subsidiaries in which respondents answered all the relevant questions on ownership, control, and decision-making. These tools are not mutually exclusive, as reported above. The ranking of possible instruments to support managerial discipline is arbitrary to a great extent. It is interesting, however, to assess the spread of different discipline devices in Russian BGs, at least approximately. The classification follows the common knowledge that to protect the interests of the ultimate owner in the very imperfect institutional environment, a do-it-yourself option is applied as the best one. A special form of this option is the participation of the parent company, rather than the ultimate owner by himself, in the daily management of the group firm.

Management separated from ownership, participation of parent company in daily management decisions 16%

Management separated from ownership, internal CG, regulated industries 12% Management separated from ownership, internal CG, nonregulated industries, no state ownership 17%

Management separated from ownership, state ownership or regulated industry 10%

Owners directly participate in management 32% Others 13%

Figure 8.2 Instruments to solve the agency problem in Russian BG subsidiaries (N = 258) Source: Author’s illustration based on survey data.

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The alternative to direct participation in decision-making is the development of a corporate governance system as a tool for owners to subordinate executive management. About 30% of the JSCs developed an internal system of corporate governance. The respondents consider shareholder meetings and the board of directors as “extremely important in decision-making.” Corporate governance bodies are especially important in the subsidiaries of BGs in regulated industries. This could be considered to be evidence that the state supports corporate governance and that the internal instruments of corporate governance could be most efficient under the protection of the state. Moreover, state ownership or regulation can discipline executive management even in the absence of internal corporate governance. Ten percent of the subsidiaries in the sample fall into this group. In conclusion, our survey data make the widespread existence of holding company groups in Russian industries less unexplainable. The discipline of executive management is not a mystery in about one-half of subsidiaries, since owners themselves or represented by parent companies directly participate in management. Neither is it mysterious in about one-fourth of the subsidiaries in regulated industries and/or those with state shareholding. A not very large but noticeable share of subsidiaries, 17%, supports the view that internal corporate governance itself, without any supplementary support, allows private owners of industrial assets in Russia to control executive management and to prevent the acute manifestation of the agency problem. Only a small part of subsidiaries, 13%, does not fit any of the explanations presented. By discussing various ways to prevent losses from agency problems, it has been demonstrated that there are no severe inconsistencies between the development of BGs and the Russian institutional environment as a source of serious agency problems under management separated from ownership. Ultimate owners and/or parent companies find specific devices to prevent losses from the agency problem in their groups.

Acknowledgments This research was prepared with financial support of SU-HSE (individual academic grant of Scientific Foundation No. 06-01-0063 and funds from the Program of Fundamental Studies granted by the Ministry of Economic Development and Trade of the Russian Federation in 2007–2008). I am grateful to Tatiana Dolgopyatova, Ichiro Iwasaki, Victoria Golikova, Konstantin Sonin, Fumikazu Sugiura, and Andrei Yakovlev, as well as to Bruno Dallago, John Litwack, and other participants in the ninth EACES conference in Brighton, UK, in September 2006, for their comments and suggestions.

Notes 1. See, for instance, article 105 of the Civil Code of the Russian Federation: “The economic company shall be recognized as subsidiary, if the other (the parent)

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economic company ... can exert a decisive impact on the decisions, adopted by such a company ... on account of its prevalent participation in its authorized capital, or in conformity with the agreement, signed between them, or in any other way.” 2. Data of Mergers & Acquisitions informational and analytical project (available at: www.merger.ru).

Bibliography Abegaz, B. (2005) The diversified business group as an innovative organisational model for large state-enterprise reform in China and Vietnam, International Journal of Entrepreneurship and Innovation Management, 5: 379–400. Boone, P. & Rodionov, D. (2002) Rent Seeking in Russia and the CIS (Moscow: Brunswick UBS Warburg). Clarke, S. (2004) A very Soviet form of capitalism? The management of holding companies in Russia, Post-Communist Economies, 16: 405–422. Dolgopyatova, T. (2004) Sobstvennost’ i korporativnyi kontrol’ v rossiiskikh kompaniyakh v usloviyakh aktivizatsii integratsionnykh protsessov, Rossiiskii Zhurnal Menedzhmenta, 2: 3–26. Dolgopyatova, T. (ed.) (2003) Russian Industry: Institutional Development (Moscow: SU-HSE Publishing House). Gaddy, C. & Ickes, B. (1998) To restructure or not to restructure: Informal activities and enterprise behavior in transition. Working paper No. 134, Ann Arbor: William Davidson Institute, University of Michigan. Goldberg, V. P. (1980) Relational exchange: economics and complex contracts, American Behavioral Scientist, 23: 337–352. Guriev, S. & Rachinsky, A. (2005) The role of oligarchs in Russian capitalism, Journal of Economic Perspectives, 19: 131–150. Khanna, T. & Rivkin, J. (2001) Estimating the performance effects of business groups in emerging markets, Strategic Management Journal, 22: 45–74. Khanna T. & Yafeh Y. (2005) Business groups in emerging markets: paragons or parasites? Finance Working paper No 92/2005, European Corporate Governance Institute. Moers, L. (2000) Determinants of enterprise restructuring in transition: Description of a survey in Russian industry, Post-Communist Economies, 12: 307–335. Pappe, Ya. (2000) Oligarkhi: Ekonomicheskaya khronika 1992–2000 (Moscow: SU-HSE Publishing House). Pappe, Ya. & Galukhina, Ya. (2006) Rossiiskiye korporatsii: Ot oligkhicheskih struktur do polnopravnih subjektov mirovogo rynka, Neprikosnovennyi Zapas, 4–5 (2006), 48–49: 16–29. Radygin, A. (2004) Evolutsiya form integratsii i upravlencheskih modelei: Opyt krupnih rossiiskih korporatsii i grupp, Rossiiskii Zhurnal Menedzhmenta, 2: 35–58. Williamson, O. E. (1985) The Economic Institutions of Capitalism: Firms, Markets, Relational Contracting (New York: The Free Press). Yakovlev, A. (2004) Evolution of corporate governance in Russia: Government policy vs. real incentives of economic agents, Post-Communist Economies, 16: 387–403. Yasin, E. (ed.) (2004) Structural Changes in the Russian Industry (Moscow: SU-HSE Publishing House).

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9 Impact of Business Integration on Corporate Restructuring and Performance Svetlana B. Avdasheva

Introduction The impact of business groups (BGs) on the restructuring and business performance of subsidiaries has been an important feature of studies of Russian companies. The characteristic of this impact provides answers to two questions. The first is why BGs formed during the past decade remain an important part of the Russian industry and why their share continues to grow. An effort should be made to explain the emergence of major diversified amalgamations in an unstable institutional environment, which should aggravate an agency problem and cause the group performance to deteriorate. The second question is threefold and involves the following: first, the role that BGs played in Russian corporate restructuring during the past decade; second, whether they contributed to the increase of competitiveness by corporate restructuring or enabled enterprises to survive without profound restructuring; and finally, in the case of the success of BG member enterprises, whether this success was due to enhanced competitiveness of the companies or support from the authorities.

Recent studies of the impact of mergers on the conduct and performance of enterprises Russian economic and business literature expresses various points of view on the impact of BGs on enterprise activity. In the literature devoted to the Russian transition, all forms of enterprise mergers, from voluntary affiliations to new companies controlled by a single owner, are often considered as a means of overcoming problems of disorganization within Russian industry (Blanchard & Kremer 1997) that are caused by privatization of enterprises within their legal boundaries formed under socialism. The role of the driving force of growth was consecutively claimed by officially registered 213

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financial-industrial groups (Dementiev 2000), by new “oligarchic” associations controlled by private owners (Dynkin & Sokolov 2002), and, recently (at least, in the official rhetoric), by integrations of state-owned enterprises (SOE) headed by state-developed institutions. In most Russian studies, BGs were evaluated on the basis of quantitative indicators, such as output, growth ratio, profit, and investments (Dynkin & Sokolov 2002; Dolgopyatova 2003). The possibility of making major investments was regarded as the main advantage of Russian BGs (Klepach & Yakovlev 2004). The focus of this analysis of the restructuring of BG member enterprises was primarily restricted to quantitative indicators. Most of the sampling surveys (Yasin 2004) showed that the share of enterprises undergoing restructuring efforts was higher among group members than among independent companies. The share of companies implementing investment projects in 1999–2001 was twice as high among BG members as among independent enterprises, and BG members have shown a ratio of investments to sales that is twice higher than that of independent firms (Dolgopyatova 2005). Membership in BGs increases an enterprise’s chances of successful implementation of various types of investment projects (Frye 2004, 2006). A comparison of the total factor productivity (TFP) of independent enterprises and members of “oligarchic integrations” (major BGs) made by Guriev and Rachinsky (2005) produced mixed results. Enterprises pooled into groups demonstrated higher ratios of total factor productivity growth during the reporting year, but, in static terms, the productivity of group participants was not significantly different from the productivity of independent enterprises. The question of whether oligarchs are more efficient owners remains open. Monographic research conducted by Pappe (2000, 2002a, 2002b) explains the origins of the BGs’ advantages. The formation of BGs controlled by private owners is equivalent to the transformation of a Soviet enterprise into a company adapted to a market. Therefore, entrepreneurship meets labor and capital. In this case, the creation of a marketing system within the frameworks of the amalgamation eliminates the need for the market adaptation of each given enterprise. This is the reason that the competitiveness of BGs can be combined with the preservation at the enterprise level of a management system maximally close to the old Soviet pattern (Clarke 2004). An additional factor stimulating restructuring inside a BG is the presence of additional property right protection tools (Frye 2004, 2006). The probability of an illegal raider capture of property is lower inside larger amalgamations. Equivalently, larger groups enjoy the positive scale effect of protecting property rights, which are extremely important in the Russian institutional environment. Consequently, the motives for restructuring group member enterprises are higher. There is a point of view according to which enterprises that are members of major BGs experience a lesser danger of capture

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Corporate Restructuring and Performance

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by the state, although Russia’s modern history shows that, even if this rule is true, frequent and significant exceptions to it are allowed. There are two alternative concepts of the BG impact on subsidiaries. One is that of the BG as a means of protection of a subsidiary against the external environment (Yakovlev & Danilov 2007), and the other is that of the BG as an initiator of active restructuring aimed at increasing competitiveness (Pappe & Galukhina 2006). The difference between these concepts lacks depth because the subsidiaries in both cases increase their competitiveness due to BG membership. Therefore, the two concepts provide a basis for different hypotheses concerning the comparative efficiency of BG members and nonmembers. In the former case, BG member enterprises may not display higher productivity than independent enterprises. The main role of amalgamations is to give independent enterprises a boost in reaching the level of comparable companies. The results of Guriev and Rachinsky confirm precisely this concept of BG impact on comparative productivity and competitiveness of enterprises incorporated in groups. In the latter case, a BG member can be expected to demonstrate higher productivity; the role of amalgamation is to enable members to gain leadership in relevant industries.

Testable hypotheses and data Our goal in this chapter is to examine the hypothesis that Russian BGs have a positive impact on subsidiary enterprises and to evaluate the correctness of the existing ideas about the impact of the Russian BGs on the conduct and performance of their member enterprises. According to these concepts, subsidiaries in BGs are relatively large enterprises1 that experience, possibly because of their size, greater difficulties in a market-oriented restructuring. Membership in groups promotes the sales of enterprises and more active restructuring. More active restructuring can compensate for a later start of transformations but does not guarantee that a merged enterprise achieves leadership in the market. This is the reason that subsidiaries within groups may not display higher productivity. The analysis of the impact of a BG on competitiveness is seriously complicated by the nonhomogeneity of the groups and group members. In the previous chapter, it was reported that participants of merger processes2 after privatization refer to themselves as BGs, as do enterprises that have belonged to major companies from the moment of their creation, for instance, powergenerating units and local communication networks. The impact of parent companies on the conduct and performance of these two types of subsidiaries can vary substantially. In the latter case, it is difficult to determine the impact because the BG is a natural form of the asset’s allocation, organization, and subordination. Our study compares the activity of group members and independent enterprises. Subsidiaries representing only part of the business rather than

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the business as a whole are selected for survey purposes from the entire sample of BG members. To show the impact of transactions concluded after an enterprise is privatized, group member subsidiaries are classified according to the time of the merger deals that occurred before or after 1995, which was the last year of mass privatization. In some cases, industries will be categorized as regulated and nonregulated in order to reflect the specifics of the impact of head companies on the conduct of subsidiaries in groups. The performance results are influenced by state tariffs and returns on investment regulations. On the whole, the impact of membership in holdings in regulated industries on the financial and operative performance of subsidiaries can be expected to be not as strong as it would be in nonregulated industries. We will verify the hypothesis that membership in BGs has a favorable impact on the activeness of enterprises in restructuring (H1) and on the financial and operative performance (H2) of enterprises. At the same time, members of holdings merged after privatization do not demonstrate sustainable resource productivity advantages over independent companies (H3). The chapter is organized as follows: the next paragraph is an assessment of the role of a BG by directors of the affiliated enterprises. In the following section, the impact of group membership on the restructuring activity of subsidiary enterprises is analyzed. The third paragraph is a consideration of the performance indicators of subsidiary companies vis-à-vis independent enterprises. Finally, the fourth paragraph introduces a comparison of the TFP in affiliated companies with independent ones. A summary of the results of the empirical analysis is presented in the Conclusion.

Managers of subsidiaries on the advantages of being members of BGs In our survey, the gains from an affiliation with a BG for the directors of the enterprises can be assessed by two indicators. The first is which party initiated the affiliation with the group, and the second is what advantages the enterprise obtained from operating as a member of the group. The key role in initiating the merger of an enterprise was played by the owners of the parent company by more than 40% of the respondents. However, in a third of all cases, the initiative came from the private owners of other companies as well. The answers give the impression that, in Russian industry, the role of friendly takeovers is comparable to that of hostile takeovers. The impact of state administrations on the federal or regional level as initiators of corporate integration is relatively modest and is negligible for mergers in nonregulated industries. It is important to emphasize that most BGs are the result of private and not state decisions. Responses to the question about the advantages gained by their companies by belonging to BGs confirm the notion that, for directors, competitiveness

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on the market on the whole is more important than relations with the state. In accordance with the two alternative concepts of the role of Russian BGs, that is, as a tool to protect against the external environment and as the driving force of restructuring, a subsidiary’s advantages can be classified as protective or active gains. Protective gains include the strengthening of bargaining positions in relationships with the state and protection against hostile takeover. Active gains involve the improvement of competitiveness in the market and the enhancement of investment availability. Protective gains are more important for group participants that merged before privatization and during initial property distribution (Figure 9.1). BG participants that merged after 1995, on the contrary, associate greater value with the gains connected with the companies’ market competitiveness, that is, stronger positions on the domestic and world market and access to investments and new technologies. Support in relationships with the state is more important for subsidiaries that lack independent experience in a market economy. On the whole, the evaluations of the gains from participation in BGs made by enterprise directors support the H1 and H2 hypotheses. An important source of additional advantages for subsidiaries from group membership is internal financing. This could be important, especially in view of Russia’s underdeveloped financial markets. Until now, evidence on internal financial markets in Russian BGs has been controversial. Earlier studies (Perotti & Gelfer 2001) confirmed the hypothesis about their existence,3 but later studies did not (Shumilov & Volchkova 2005). According to our survey, in companies affiliated with groups, the second and third most important financial sources of investment are shared by bank borrowings and group funds (15–20%). About one-third of the respondents reported that they do not use group funds for financing their investment. The size of

70 60 50 40 30 20 10 0 Strengthened marketing position

Received access to investments and new technologies

Protected from hostile takeover

Merged before 1995

Strengthened bargaining position in relation with state

No gains

Merged since 1996

Figure 9.1 Gains from joining business groups (BGs) according to directors of enterprises by time of merger (% of respondents) Source: Author’s illustration based on survey data.

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this share differs significantly depending on the industry. The highest share of such enterprises is in electric power (about 60%) and construction materials (50%), with lower shares in the chemical and petrochemical industry (22%) and light industry (17%). At the same time, about one-quarter of affiliated firms consider internal financial markets to be important, with the share of group funding in overall investments being more than 20%.4 The use of an additional source of funding of restructuring should also support hypothesis H1. To sum up, top managers of group companies acknowledge the positive impact of affiliation with a BG on competitiveness and firm performance. However, their statements need to be verified. The question of whether enterprises use additional sources of financing for restructuring and not for compensation to make up for shortfalls will be answered. Another issue that will be examined is whether higher restructuring activity improved their financial and operative performance and led to higher productivity.

Impact of business integration on corporate restructuring A comparison of the intensity with which independent companies and group subsidiaries engaged in restructuring demonstrates that the latter applied measures aimed at the increase of competitiveness more often during 2001–2004 (Figure 9.2). The superiority of BG participants is particularly clear in the area of restructuring involving production expansion, namely, successfully introducing new technologies and making significant capital investments. However, a considerable number of respondents had joined Successful introduction of essentially new products and services 80 Introduction of new production Increasing volume of export 60 facilities 40 Long-term (over one year) credit

20

Increasing of expenditures on marketing and advertising

0

Successful introduction of new technologies

Increasing R&D expenditures Making of significant capital investments Independent enterprises

Successful certification according to international strandards Merged before 2000

Merged since 2001

Figure 9.2 Restructuring activity in subsidiaries of BG vis-à-vis independent companies Source: Author’s illustration based on survey data.

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groups in the same period when restructuring had become more active. It is noteworthy that new subsidiaries that merged after 2001 displayed the highest degree of activity aimed at the restructuring of all other groups of enterprises. In this case, we could not distinguish between the two competing hypotheses, that is, that group membership had a favorable impact on the restructuring intensity and that BGs were acquiring enterprises which were more active in restructuring. This is the reason that the analysis was conducted only for the old group participants that merged before 2000. To test the hypothesis that the intensity of restructuring displayed by subsidiaries is higher than that of independent companies, we used the index of intensity of restructuring (INDRES).5 This index is calculated as the total number of restructuring measures, including the successful introduction of essentially new products and services, the introduction of new production facilities, the increase of expenditures on marketing and advertising, the successful introduction of new technologies, successful certification according to international standards, significant capital investments, and an increase of R&D expenditures.6 Presumably, the intensity of restructuring in nonregulated industries is influenced by company size, corporate governance organization, and market competition as well as by membership in BGs. In regulated industries, competition as such is restricted by the model of regulation, and, in many cases, it is completely impossible. This is the reason that the set of explanatory variables is different for nonregulated and regulated industries: for both types of industries, the set includes attribution to subsidiaries merged before 2000, the GROAF1 variable, the company size COMSIZ variable measured by the logarithm of the number of employees, the property and management convergence indicator, MANSHA, which equals 1 if large owners participate in management of the firm and 0 otherwise, and variables for individual industries and types of settlement (capital city, regional center, town, urban settlement, or village). The comparison of the impact of BG membership and corporate governance organization on the scope of restructuring is connected with the problem raised in a previous chapter, namely, the reason for the widespread practice of the BG organizational form resorting to the separation of management from ownership in the Russian economy when it has been amply demonstrated that the opposite model, in which ownership converges with management, is much more advantageous. The investigation also examines the advantages of BGs compensating for a more acute agency problem caused by the separation of property from management. In addition, the explanatory competition variables COMPRU and COMPFO are used for nonregulated industries. The COMPRU variable equals 1 if the enterprise experiences tough competition and 0 in all other cases. The COMPFO variable equals 1 if the enterprise experiences competition with suppliers from developed Western countries and 0 in other cases. The introduction of two different competition indicators is justified by previous

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experience of an empirical analysis of Russian companies’ performance (Avdasheva et al. 2007). A positive response to the question of tough competition with Russian manufacturers may not necessarily reflect competition intensity proper. The choice of this answer often reflects not the market competition but the low competitiveness of the enterprise in comparison with other domestic suppliers. At the same time, a positive response to the question about the existence of competition with foreign suppliers usually means that the company’s production is indeed involved in competition in the global market. This is the reason that a number of empirical studies have failed to reveal a favorable impact of competition with domestic suppliers on the intensity of Russian companies’ restructuring, in contrast to the case of competition with foreign manufacturers. Our survey has demonstrated that the impact of competition with domestic and foreign manufacturers on the behavior of enterprises, e.g., on the choice of the company organizational model, is not just different but clearly opposite (see Chapter 7 for details). Judging by the results of our survey and contrary to the existing opinion about a considerable decline in competition within the framework of Russian groups, subsidiaries experience as much competition as independent firms. Considering nonregulated industries alone,7 every 20th enterprise among independent firms and subsidiaries experiences no competition with domestic or foreign suppliers; approximately one-quarter of the enterprises have to cope with tough competition with domestic and/or foreign suppliers; and the overwhelming majority of respondents evaluate the competition as moderate.8 A number of surveys of Russian enterprises have confirmed the favorable, although not always monotonic, impact of competition on restructuring (see Avdasheva et al. 2007 for survey). In our case, the impact of competition may amplify the effect of the enterprises’ affiliation with BGs. Regression analysis denies the null hypothesis that the intensity of restructuring of group subsidiaries did not differ statistically from the intensity of restructuring of independent companies (Table 9.1).9 This pattern is true for both regulated and nonregulated industries. As expected, for the reasons presented in Chapter 7, the convergence of ownership and management, which is demonstrated by the participation of large shareholders in company management, has a statistically significant favorable impact on the intensity of restructuring only in nonregulated industries. Among the two competition indicators, it is competition with foreign manufacturers that has a statistically significant favorable impact on the intensity of restructuring in nonregulated industries. The impact of the industry in most regression specifications was statistically significant. The impact of location is also significant with the expected sign: enterprises located in regional centers and the capital city took more restructuring measures in 2001–2004 than enterprises located in urban settlements and villages. In some specifications, enterprises located in towns

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Corporate Restructuring and Performance Table 9.1

221

Impact of membership in business groups on restructuring activity

Dependent variable Estimator

INDRES (intensity of firm restructuring) Ordinal logit

Ordinal logit

Poisson

Poisson

Sample

Ia

IIa

Ia

IIa

GROAF1

0.827* (2.900) 0.465*** (7.573) 0.119 (0.048) —

0.094** (3.956) 0.087*** (23.690) 0.100*** (7.177) 0.041 (1.232) 0.141*** (14.043) Yes */*** Yes */***

0.139* (2.925) 0.058*** (8.391) 0.048 (0.112) —

INDDUM CITDUM

0.503** (3.873) 0.469*** (23.809) 0.503*** (7.527) 0.168 (0.815) 0.729*** (14.200) Yes Yes */***

N 2Log likelihood Pseudo R 2 Test of the model 2

480 958.80 0.154 70.736***

COMSIZ MANSHA COMPRU COMPFO

— Yes */*** Yes */*** 86 141.389 0.435 42.004***

480 782.185 — 41.838*

— Yes * Yes */** 86 111.988 — 22.197*

Notes: a Sample I: enterprises in nonregulated industries; Sample II: enterprises in regulated industries. Wald statistics (Wald Chi-square for Poisson model) are reported in parentheses. Only subsidiaries merged before 2000 are included. ***: significant at the 1% level, **: at the 5% level, *: at the 10% level. Source: Author’s estimation.

also demonstrated advantages over companies located in urban settlements and villages. Therefore, hypothesis H1 is confirmed: group subsidiaries were more actively involved in restructuring in 2001–2004 than independent enterprises. Participation in competition and access to additional financial and business resources within the framework of a BG has a favorable impact on the quantity of enterprise restructuring measures. Additional resources available to enterprises inside a BG, in turn, substitute the solution of the agency problem by the use of the do-it-yourself option.

Impact of affiliation with a business group on financial and operative performance The second type of hypotheses tested in this chapter is that BG subsidiaries demonstrate better financial and operative performance indicators. The confirmation of this hypothesis would lead to two important conclusions. First,

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a wider program of subsidiary restructuring during the four previous years yields fruit. Second, we can once again confirm the assumption expressed in the previous chapter that better financial performance of group member enterprises may provide the basis for maintaining corporate discipline and preventing conflicts between ultimate owners and executive management. The common lack of reliability and distortion in financial data suggests that use of different financial and operational performance indicators would provide for greater accuracy. Survey results and annual reports together might be better sources of information. The first indicator is the response to the question about companies’ output increase during the four-year period preceding the survey. The INCOUT variable is based on responses from directors to the question about the change of output during the four years preceding the survey. The value of this variable is 1 if the enterprise reduced its output, 0 if the output has not changed, 1 if the output increased less then 50%, 3 if the output grew more than 50%, and 4 if the output more than doubled. The higher the INCOUT variable is, the more successful and competitive the enterprise is. The second indicator is the self-assessments of financial performance, both direct and in response to the question about the need to finance a shortfall in cash. The FINPER indicator reflects the sufficiency of cash inflows for the financing of current activity and equals 1 if the enterprise did not experience a serious shortfall in cash flow during 2001–2004 and 0 in other cases. The FINSELF indicator value ranges from 2 to 2 depending on respondents’ self-assessment of the company’s financial performance (including the responses bad/ likely bad/ satisfactory/ likely good/ good). The third indicator is the profitability (ratio of profit to sale) and returns on asset (ROA) indicators obtained on the basis of companies’ book reports from SKRIN and SPARK databases.10 The AVEPRO and ROAAVE indicators represent the average profitability and returns on asset values in the period of 2002–2005. According to the assessments of company directors, the share of enterprises that increased their output in 2001–2004 was higher among affiliated firms: 42% of subsidiaries more than doubled their output in comparison to 27% among autonomous enterprises. It is noteworthy that 40% of group members that increased their output simultaneously cut employment. A similar indicator for independent enterprises was less than 30%. Subsidiaries are not only stepping up output but also enhancing labor productivity. The superiority of subsidiaries in increasing output and simultaneously reducing employment is manifested both in the regulated and nonregulated industries. An employment reduction with a simultaneous increase in output is slightly more frequent among enterprises merged before 2000 and, even more often, among those merged before 1995. Group members also demonstrate better financial performance and experience difficulties with the financing of their current activities less frequently (Figure 9.3). However, the advantages of subsidiaries can be explained by a favorable impact of

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Subsidiaries

Subsidiaries

Parent companies

Parent companies

Independent enterprises

Independent enterprises 0

20

40

60

80

100

0

20

40

% Bad

Likely bad Likely good

80

100

% Satisfatory Good

Self-assessment of financial performance of the enterpriseat time of survey

Figure 9.3

60

223

Yes

No

Serious shortfall in cash flow between 2001 and 2004

Financial performance of different types of enterprises

Source: Author’s illustration based on survey data.

the parent companies and by the industrial structure of the groups. It was reported in the previous chapter that the distribution of the group enterprises gravitates, first, toward industries with higher profitability and, second, toward larger enterprises displaying better financial stability. This is the reason that the effect of membership in BGs should be distinguished from the effect of size and industry classification. Nevertheless, our regression analysis showed that this is not connected with the size and industry classification of the enterprises only (Table 9.2). In nonregulated industries,11 participants in BGs displayed higher probability of output increase, better financial performance self-assessment, lower probability to encounter shortfalls in cash flows, and significantly higher profitability and ROA indicators. Besides group membership, significant factors explaining all indicators were the enterprises’ industry classification and location. Enterprises located in the capital city, regional centers, and towns demonstrated better financial and operative performance than enterprises located in villages. Interestingly, although all group participants had better indicators, for example, higher financial performance self-assessment, this effect was higher and statistically more significant for old subsidiaries that had merged before 2000. At the same time, neither the competition characteristics that were measured by the COMPRU and COMPFO indicators nor corporate governance organizations represented by the indicator of large owner participation in management MANSHA had a noticeable impact on company financial performance results. Therefore, hypothesis H2 is also confirmed as true. The higher activity of enterprises in groups with better financial performance creates the image of Russian groups as quite normal companies and, at the same time, refutes the opinion that the development of connections between enterprises replaces corporate restructuring (Gaddy & Ickes 1998). Regardless of the

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0.575*** (7.177) —

GROAF1

480 119.899 0.041 22.028***

86 89.132 0.138 11.899*

Yes* Yes*

0.579 (1.785) —

—

663 747.755 0.083 39.160***

0.136 (2.293) Yes Yes*

1.538* (2.780) 0.531*** (7.471) —

Ia

Binary logistic

FINPER

557 617.379 0.090 35.550***

0.840*** (10.880) 0.151 (2.116) Yes* Yes*

2.096** (3.837) —

Ia

Binary logistic

FINPER

660 1098.664 0.066 37.984***

0.219*** (7.998) Yes Yes*

0.394** (5.212) —

—

Ia

Ordinal logit

FINSELF

0.433 29.712***

527

3.095* (1.904) 0.003*** (18.736) Yes*/*** Yes*

1.278 (0.481) —

IIIa

OLS

AVEPRO

— 0.016 1.653*

522

Yes*/*** Yes*/***

0.231** (2.172)

0.253 (1.532) —

IIIa

OLS

ROAAVE


Notes: Wald statistics are reported in parentheses for the models with INCOUT, FINPER, and FINSELF as the dependent variables. t-statistics – for the models with AVEPRO and ROAVVE. a Sample I: enterprises in non-regulated industries; Sample II: enterprises in regulated industries; Sample III: enterprises in both types of industries. b Pseudo R 2 is reported for the models with INCOUT, FINPER, and FINSELF as the dependent variable; Adjusted R 2, for the models with AVEPRO and ROAAVE. c 2 for INCOUT, FINPER, and FINSELF; F-statistics for AVEPRO and ROAAVE. ***: significant at the 1% level, **: at the 5% level, *: at the 10% level.

N 2Log likelihood R 2, b Test of the modelc

INDDUM CITDUM

Yes * Yes */***

—

GROAFF

COMSIZ

—

Constant

—

IIa

Ia

Sample

INCOUT

Ordinal logit

INCOUT

Ordinal logit

Estimator

Performance indicator

Table 9.2 Impact of membership in business groups on performance indicators


225

cause-and-effect relationship between corporate restructuring and financial performance (i.e., whether restructuring ensures an increase of profit or better financial performance allows for restructuring), both phenomena are observable in Russian BGs.

Impact of business integration on total factor productivity The data of enterprises’ annual balance sheets allow a comparison of the TFP on the basis of the Cobb–Douglas production function in independent enterprises on the one hand and subsidiaries of BGs on the other. The analysis is aimed at establishing the extent to which the advantages of subsidiaries, primarily, more stable financial performance and better financial indicators, are due to higher productivity. On the other hand, a comparative analysis of productivity will determine the gains of corporate restructuring within BGs. Higher resource productivity would provide an unambiguous favorable assessment of the impact of BGs on the development of Russian enterprises. On the basis of other results of TFP analysis (Guriev & Rachinsky 2005) of enterprises merged with major integrations, we assume that subsidiaries have higher productivity than independent firms. The TFP comparison is based on the Cobb–Douglas production function evaluation. Company proceeds are used as the output indicator, the average number of employed individuals (the LABOR variable), as the indicator of labor use, and the book value of fixed assets, CAPITA, as the indicator of capital use volume. The source of data on employment and the value of fixed assets for subsidiaries in industries, which includes all industries surveyed, except telecommunications, is the SPARK database. In addition to the industry and settlement-type variables characterizing the enterprise, the regression analysis was also based on the factor of retaining a state package of shares at the respondent enterprise. The value of the OWNSTA variable is 1 if the stake of the state on the federal or local level in the company equity capital exceeds 10% and 0 in other cases. Retaining a significant share in state property is expected to result in the lowering of company productivity. This can happen in the contemporary Russian economy for two reasons. The first is associated with the traditional disadvantage of the state as the principal in comparison with the private owner. Representatives of the state have fewer personal incentives toward raising the productivity of the assets administered by them and fewer opportunities to control the executive management as compared to private owners. The second is connected with the specific role of small state-owned stakes in Russian joint-stock companies. Retaining such stakes is an effective tool to prevent a change of owners. This is the reason that the managers and owners of enterprises with lower productivity and the worst corporate governance are interested in retaining a state-owned stake, usually in the form

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226


of minority packages. In the absence of a state stake, such enterprises are the prime target for takeover. In addition to industry and enterprise location indicators, the TFP analysis relied on the classification of enterprises by their time of merger. In addition to the classification of the group participants into subsidiaries merged before 2000 and after 2001, another classification criterion was used. In this case, the margin between the old and new participants lies in 1995 (the GROAF2 variable). This choice is not accidental. The year 1995 is when mass privatization was completed. Therefore, enterprises that merged before 1995 were either initially created as a component of a broader organizational structure or acquired in the course of privatization, which was generally possible due to special decisions of the state. If these particular enterprises demonstrate higher TFP, we will not be able to conclude that BGs turned out to be better owners for companies acquired after the completion of privatization. The results of the regression analysis are mixed (Table 9.3). On the one hand, the whole family of BG members (the GROAFF variable) is 13% more

Table 9.3 Total factor productivity in subsidiaries of BGs compared with independent enterprises (Cobb–Douglas production function, output in 2004) Model CONSTA LABOR CAPITA OWNSTA GROAFF GROAF1

[1] 7.874*** (21.689) 0.742*** (15.933) 0.340*** (13.309) 0.246** (2.092) 0.131* (1.757) —

GROAF2

—

INDDUM CITDUM N Adjusted R2 F-statistics

Yes */*** Yes */**

[2] 7.878*** (21.702) 0.742*** (15.945) 0.340*** (13.282) 0.254** (2.155) 0.051 (0.511) — 0.134 (1.670) Yes */*** Yes */**

[3] 7.914*** (21.805) 0.740*** (15.918) 0.339*** (13.289) 0.260** (2.209) 0.059 (0.609) 0.275* (1.839) — Yes */*** Yes */**

594 0.769

594 0.769

594 0.770

132.750***

124.557***

125.176***

Notes: We estimated all models by OLS. t-statistics are reported in parentheses. ***: significant at the 1% level, **: at the 5% level, *: at the 10% level. Source: Author’s estimation.

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productive than nonmember enterprises. On the other hand, this effect is mainly due to group members that merged before 1995 (the GROAF1 variable). These integrations are most likely the heritage of Soviet industrial organization but not the result of merger deals in the transition economy. Therefore, the higher TFP of these companies does not reflect the superiority of BGs as new owners over other types of owners of Russian enterprises. The results are very similar to those obtained by Guriev & Rachinsky (2005). Analyzing enterprises within the largest BGs in Russia, these authors found advantages in improving TFP, but they did not find a higher TFP of group members vis-à-vis independent companies in 2001. These results contribute to the characteristics of the impact of Russian BG on subsidiaries. New subsidiaries, those merged after 1995, were unable to complete marketoriented restructuring themselves as independent companies without the support of BGs. They are the last starters, which became potentially efficient during the period of economic upturn and were led by a parent company that had expertise in corporate restructuring and the enhancement of competitiveness. BGs can organize the efficient restructuring of these firms due to better management, that is, higher quality of entrepreneurial ability; in addition, BGs provide to subsidiaries access to group financing. As a result, enterprise directors are satisfied with group membership. New BG members up to the year of the survey had caught up with autonomous companies; however, they did not outperform them in terms of TFP. Thus, hypothesis H3 is only partially confirmed. Although subsidiaries demonstrate higher TFP than independent companies, this superiority is created by participants that merged with groups before the completion of privatization. Companies that merged with groups in the period of the merger boom, which started in 1999, in turn, use resources with the same productivity as independent companies.

Conclusions In this chapter, the impact of BGs on restructuring and performance was measured by economic and financial performance indicators and by TFP. According to the directors of the enterprises, BGs are important both in providing recourse for restructuring and in managing the restructuring processes. Subsidiaries in the groups took a broader set of corporate restructuring instruments in the four years before the survey. Group membership substitutes the participation of large shareholders in decision-making and daily management on the level of enterprises and, therefore, compensates for the higher agency cost in the subsidiaries. Membership in the groups also results in better financial and operative performance, especially, for the old members of BGs, and in higher probability to increase output in the four years preceding our survey. For the analysis of BGs as a phenomenon of corporate organization in Russia, these

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findings provide evidence in favor of the hypothesis that there is a potential for relational contracting between the parent and the subsidiaries based on the possibility for subsidiaries to achieve better economic performance inside the group. This evidence also supports the positive assessment of the impact of BGs on enterprises by enterprise directors. In conclusion, it is necessary to emphasize once again that BGs are exceptionally diverse. On the wave of mergers that followed after 1999, BGs acquired not only the enterprises that needed restructuring but also those in which such restructuring was already underway. The share of enterprises taking different corporate restructuring measures is the highest among the new participants of groups, and such enterprises are the ones that should be the first to benefit from the improvement of financial performance inside the group. At the same time, the resource productivity of the new participants did not exceed the resource productivity of independent companies at the moment of the survey. Presumably, active restructuring of these companies is not completed yet or, at any rate, has not yet yielded the expected results. Another watershed is the division between group participants in nonregulated and regulated industries. The advantages of subsidiaries in nonregulated industries, above all, better financial performance, are much more vivid. This is another confirmation of the assumption frequently expressed in Russian economic and business literature (Pappe 2002a, 2002b), in which the comparative advantages of the group participants are a result of better entrepreneurial skills and better management of the parent companies. Analysis produces an image of subsidiaries actively merging with groups in the period of economic upswing. It is most likely that they needed profound corporate restructuring at the moment of the merger and that better access to the financial market and entrepreneurial skills within the BGs made it possible. However, despite the measures taken, the more stable financial performance of the new participants of the groups is not a result of higher productivity. Until the final year of observation, 2004, new members of BGs that merged after mass privatization did not achieve higher TFP than autonomous enterprises. Almost all the positive impact of group membership on total factor productivity is due to the old members of BGs, which were included in holding company groups before privatization and liberalization. In contrast, new group members, who take a broader range of corporate restructuring measures, do not display higher productivity. Therefore, BGs definitely helped last starters to improve productivity during economic upturn, but there is no evidence that BGs already made them leaders in the relevant markets. Until now, the parent companies most probably performed the function of protecting the new participants from the market (Yakovlev & Danilov 2007); of course, they were not protected from the market themselves. A breakthrough to higher competitiveness (Pappe & Galukhina 2006) is demonstrated by the group participants that originated

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as a result of the allocation of ownership rights before the economic upheaval and even before privatization and liberalization.

Acknowledgments The research was prepared with financial support of SU-HSE (individual academic grant of the Scientific Foundation No. 06-01-0063 and funds from the Program of Fundamental Studies granted by the Ministry of Economic Development and Trade of the Russian Federation in 2007–2008). I am grateful to Naohito Abe, Tatiana Dolgopyatova, Victoria Golikova, Satoshi Mizobata, Heiko Pleines, Fumikazu Sugiura, and Andrei Yakovlev as well as participants of the Joint Workshop of Japan Association of Comparative Economic Studies and the European Association of Comparative Economic Studies in Tokyo, Japan, in October 2007. I am particularly grateful to Ichiro Iwasaki, who made the greatest contributions toward improving this research. Special thanks are due to Olga Uvarova and Leonid Levin for their valuable assistance in data processing.

Notes 1. In our survey, a typical member of a BG is also a larger participant in the relevant industry (see the previous chapter). 2. There were a number of different ways to form BGs in Russia’s transitional economy, including voluntary amalgamations of enterprisers, redistribution of controlling stakes of shares, special agreements on cooperation (for instance, officially registered financial-industrial groups), and redistribution of control under the same allocation of formal ownership rights. Companies in regulated industries also seen as business groups in our survey were created according to special decisions of the state as an owner. In this chapter, all the legal forms of amalgamation, including mergers, acquisitions, takeovers, both friendly and hostile, and all types of economic concentration deals will be referred to as mergers. 3. Perotti & Gelfer (2001) found the opposite directions of fund flows in bank-led and industry-led FIGs. Regardless of the impact of group membership on funds available, flows are sensitive to the group’s affiliation. 4. It is noteworthy that the share of subsidiaries using BG funds to finance their current activities is comparable to the share of enterprises using these funds for investment financing: 23% of subsidiaries that encountered financial difficulties in 2001–2004 contracted loans from trading partners, holding companies, or individuals to manage their problems. The share of independent firms that are using this source of compensating for the shortfall in cash flow is almost twice lower, only 12%. Subsidiaries that merged before 2000 financed the current shortfall from the holding company funds more often. Among group members experiencing a shortfall in cash flow, about 31% of enterprises merged before 2000 were using group funds, in contrast to 20% merged since 2001. 5. This index was used in this form in Chapter 2. 6. The basic value of the index was calculated similarly to that in Chapter 2, with the index value ranging from 0 to 7. However, as restructuring measures are interconnected, in order to avoid double-counting, in this chapter, we used the bounded

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7.

8.

9.

10.

version of the index, which is equal to 0 (low intensity of restructuring) if the INDRES value is from 0 to 2, 1 (moderate intensity of restructuring) if the INDRES value is 3 or 4, and 2 (high intensity of restructuring) if the INDRES value exceeds 5. As the intensity of competition in regulated industries is strongly industryspecific, it depends, first and foremost, on the model of tariff regulation, vertical organization of the industry, and market access rules for potential entrants. The subjective assessments of competition in our survey fully coincide with alternative competition evaluations obtained within the frameworks of various sampling surveys of Russian enterprises (see Avdasheva et al. 2007 for the survey). It should be reported that a favorable impact of business groups on corporate restructuring was established only for the index of the quantity of measures applied. A favorable impact of business group membership on individual measures was established (using the logit model) only for the probability of successful certification of output according to international standards for enterprises in nonregulated sectors. In other words, no special restructuring model was discovered in this case for group subsidiaries: they apply a greater quantity of the same measures that are applied by independent enterprises. Performance indices take industry-adjusted values using a method proposed by Eisenberg et al. (1998) and represent the distances from the median performance in each industry. The formula is: Performance adj

sign Performance u Performance,

where ΔPerformance is the value obtained by subtracting the median performance in the corresponding industry from the sample firm’s performance. 11. Relevant analysis of regulated industries revealed a lack of impact of membership in business groups on the output dynamics, self-assessment of financial performance, and probability of not encountering financial problems. Table 9.2 presents, as an example, only the results of the analysis of profit increase for the sample of enterprises in regulated industries. This result was not unexpected. A decisive impact on the output dynamics and financial performance in regulated industries is made by tariff and investment plan regulation and, to a lesser extent, in the allocation of consumers to suppliers. Moreover, enterprises of major amalgamations, OJSC Svyazinvest and RAO UES of Russia, in regulated industries fulfill a wide spectrum of obligations that restrict their profitability, including the servicing of privileged categories of consumers and providing compulsory (uninterruptible) services to special categories of clients.

Bibliography Avdasheva, S., Shastitko, A., & Kuznetsov, B. (2007) Competition and industrial organization in transition markets: What can we derive from empirical studies? Post-Communist Economies, 19: 17–33. Blanchard, O. & Kremer, M.(1997) Disorganization, Quarterly Journal of Economics, 112: 1091–1126. Brown, D. J., Earle, J. S., & Telegdy, A. (2006) The productivity effects of privatization: Longitudinal estimates from Hungary, Romania, Russia and Ukraine, Journal of Political Economy, 114: 61–99. Clarke, S. (2004) A very Soviet form of capitalism? The management of holding companies in Russia, Post-Communist Economies, 16: 405–422.

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Dementiev, V. E. (2000) Finansovo-promyshlennyie gruppy v strategiyi reformirovanoya rossiiskoy ekonomiki, Rossiyskii Ekonomicheskii Zhurnal, 11–12: 3–9. Dolgopyatova, T. (ed.) (2003) Russian Industry: Institutional Development (Moscow: SU-HSE Publishing House). Dolgopyatova, T. (2005) Stock ownership and corporate control as determinants of company modernization: The case of Russia. In: Proceedings of the 65th Anniversary Conference of the Institute of Economics, Zagreb (The Institute of Economics), pp. 533–564. Dynkin, A. & Sokolov, A. (2002) Integrirovannyie biznes-gruppy v rossiyskoi ekonomike, Voprosi Ekonomiki, 4: 78–95. Eisenberg, T., Sundgren, S., & Wells, M. T. (1998) Larger board size and decreasing firm value in small firms, Journal of Financial Economics, 48: 35–54. Frye, T. (2004) Credible commitment and property rights: Evidence from Russia, American Political Science Review, 98: 453–466. Frye, T. (2006) Original sin, good works, and property rights in Russia, World Politics, 58: 479–504. Gaddy, C. & Ickes, B. (1998) To restructure or not to restructure: Informal activities and enterprise behavior in transition. Working paper 134, Ann Arbor: William Davidson Institute, University of Michigan. Guriev, S. & Rachinsky, A. (2005) The role of oligarchs in Russian capitalism, Journal of Economic Perspectives, 19: 131–150. Klepach, A. & Yakovlev A. (2004) O roli krupnogo biznesa v sovremennoi rossiiskoi ekonomike (kommentariyi k dokladu Vsemirnogo banka), Voprosi Ekonomiki, 8: 36–45. Pappe, Ya. (2000) Oligarkhi: Ekonomicheskaya khronika 1992–2000 (Moscow: SU-HSE Publishing House). Pappe, Ya. (2002a) Rossiyskii krupnii biznes kak ekonomicheskii fenomen: Osobennosti stanovleniya i sovremennogo etapa razvitiya, Problemy Prognozirovaniya, 1: 29–46. Pappe, Ya. (2002b) Rossiyskii krupnii biznes kak ekonomicheskii fenomen: Spetsificheskiye cherty, modeli ego organizatsiyi, Problemy Prognozirovaniya, 2: 83–97. Pappe, Ya. & Galukhina, Ya. (2006) Rossiyskiye korporatsiyi: Ot oligarhicheskih struktur do polnopravnih subjektov mirovogo rynka, Neprikosnovennyi Zapas, 48–49: 16–29. Perotti, E. C. & Gelfer, S. (2001) Red barons or robber barons? Governance and financing in Russian financial-industrial groups, European Economic Review, 45: 1601–1617. Shumilov, A. V. & Volchkova, N. A. (2005) Russian business groups: Substitutes for missing institutions? In: Sbornik dokladov shestoy mezhdunarodnoy konferencii GY-VSHE “Modernizatsiya ekonomiki I vyratschivaniye institutov,” Vol. 2 (Moscow: SU-HSE Publishing House), pp. 183–194. Yakovlev, A. A. & Danilov Y. A. (2007) Rossiiskaya korporatsiya na 20-letnem gorizonte: struktura sobstvennosti, rol’ gosudarstva i korporativnoye finansirovaniye, Rossiyskii Zhurnal Menedzhmenta, 5: 3–34. Yasin, E. (ed.) (2004) Structural Changes in the Russian Industry (Moscow: SU-HSE Publishing House).

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Part III The Role of External Agents in Corporate Governance

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10 The Banking Sector and Corporate Finance Fumikazu Sugiura

Introduction A corporate financing mechanism plays a pivotal role in a market economy for growth. This chapter tries to clarify, both from a macro and a microeconomic viewpoint, what sort of mechanism is emerging in Russia. The country has been experiencing positive economic growth since 1999. Now that the effect of the drastic depreciation of the exchange rate in 1998 has faded, Russia is facing a test as to whether a sustainable economic growth is possible even in the event of adverse price movement of major export items, such as oil and gas, on international markets, or in other words, as to whether a sufficiently self-sustaining system has been developed to enable continued economic growth under market-economic principles. In the context of corporate finance, the enterprises, which used to rely completely on the state budget and the national bank (Gosbank) for their financing needs under the erstwhile command economy, can no longer hope to do so after the regime change. At the same time, they are now capable of making independent decisions regarding their financial needs. Their behavior is influenced not only by their needs but also by the efficiency of the financial sector as well as by various institutional frameworks surrounding it. Reforms to the latter were initiated from scratch after the regime change and have been evolving ever since. Hence, a study of enterprise behavior in the area of corporate finance would also clarify the extent to which the economic system has been transformed (Sugiura 2007). There is a potentially enormous demand for investment funds in Russia. The manufacturing sector, founded and expanded in the socialist command economy, is now extensively burdened with obsolete machinery and equipment. There is an acute need to enhance its competitiveness by replacing them with new technologies and equipment. The demand for funds is large, but the financial sector has not been able to cope with it due to its immaturity as well as to an inadequate legal environment, such as a weak creditor protection (Berglöf et al. 2003). The present economic growth may 235

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be attributed, to a large extent, to the continued use of the existing obsolete equipment. From the financial sector’s standpoint, on the other hand, there had been ample opportunities for a much safer mode of operation in the prevailing conditions of economic crises and political confusion, such as speculation in foreign currencies or in government bonds (Matovnikov 2000). Such opportunities permitted financial institutions to take a cautious or even negative attitude toward risky business-related investment (Egorova & Smulov 2002; Bonin & Wachtel 2003). According to statistical data on investment sources, neither the securities market nor the banking sector was the major provider of funds for that purpose.1 As a corollary, it may be said that the financial crisis of 1998, contrary to earlier apprehension, did not spread to the wider economy. Rather, it helped subsequent economic growth (Rabotsii Tsentr Ekonomicheskikh Reform 2002). 2 In examining corporate behaviors for investment finance under a market economy, one has to take a wider view, taking into account such factors as the institutional environment and the degree of maturity of the financial agents, not only of the countries concerned but also of others. An examination of corporate behavior involving investment finance under a market economy requires a broad view that considers such factors as institutional environment and the degree of maturity of the financial agents in the countries concerned. A study of such behavior would better enable an understanding of the basic growth mechanism of an economy, and, in this chapter, we explore a “Russian-style” from this viewpoint. A thorough understanding of the rapidly growing Russian economy requires the consideration of both macro and micro approaches. We, therefore, conducted the joint survey. The intentions were to clarify internal organizational changes that enterprises had undertaken and their responses to a new external environment. The latter relates to external relationships that regulate enterprise activities, such as their relationships with local governments and financial institutions. By comprehensively collating the survey results, we intended to clarify the enterprise behavior of contemporary Russia from various points of view. This research is the first step toward that objective. For organization, the first section is an overview of the current status of the Russian economy with an emphasis on the role of the financial sector. The second section deals with the largest bank, Sberbank, and examines its behavior in more detail. The third section, after a brief presentation of the survey results, is an analysis of the empirical data regarding enterprise behavior on finance, and the conclusion offers recommendations with policy implications.

The booming economy and corporate finance High level of investment and its sources The Russian economy has been maintaining strong growth. The GDP growth rates have been positive ever since 1999. While the industrial production is

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The Banking Sector and Corporate Finance

237

somewhat low, due in particular to the slowing of the oil and gas sector, the investment boom is continuing. Capital intensive infrastructure and resource exporting sectors take up about 60% of the total investment. Along with recently surging consumptions, investment constitutes a main engine of growth. Since the gross savings are high, the economy is considered capable, according to I = S macroanalysis, of supporting high levels of investment, provided there exist appropriate conditions (TsMAKP 2006). Let us now see what kind of financial sources have supported the booming investment. According to macrodata on investment sources of enterprises (excluding small firms), the share of internally generated funds declined markedly from 53.2% in 1998 to 42.1% in 2006 (Table 10.1). Among external sources, the budgetary and off-budgetary funds, which used to have a share of 29.8% in 1998, came down to 19.3% in 2006. In contrast, borrowings from banks and other enterprises increased nearly twice, from 4.8% to 9.6% for the former and 4.3% to 6.0% for the latter, during the same period. Considering that external resources are beginning to play an increasingly important role in private investment, a closer look at the development of the financial sector with an emphasis on banking is warranted. In the summer of 2004, several small banks were deprived of their licenses in an anti-money laundering campaign of the Central Bank, and there appeared a liquidity crisis in the interbank market. However, this did not affect the aggressive attitude of banks in general for increased lending to enterprises and organizations (Renaissance Capital 2005). The crisis, moreover, reinforced the status of both Sberbank and the Bank for Foreign Trade (VTB), whose deposits the citizens considered protected by the state, as well as of some foreign-owned banks considered more creditworthy. This tendency continued similarly in 2005 and thereafter (Lepetikov 2005).

Table 10.1

Financing sources of fixed investment (%)

Year

1998

2000

2002

2003

2004

2005

2006

Total fixed investment Internal sources Borrowings of which From banks From other organizations Federal budget Local govt. budgets Off-budget sources Others

100.0 53.2 46.8 4.8 4.3 6.5 12.6 10.7 7.8

100.0 100.0 47.5 45.0 52.5 55.0 2.9 5.9 7.2 6.5 6.0 6.1 14.3 12.2 4.8 2.4 17.3 21.9

100.0 45.2 54.8 6.4 6.8 6.7 12.1 0.9 21.9

100.0 45.4 54.6 7.9 7.3 5.3 11.6 0.8 21.7

100.0 100.0 44.5 42.1 55.5 57.9 8.1 9.6 5.9 6.0 7.0 7.0 12.3 11.8 0.5 0.5 21.7 23.0

Source: The figures for 1998 from Rosstat (2003) and the figures for 2000 and later from Rosstat (2007).

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Some changes in financial statements of enterprises Let us look at this tendency from the viewpoint of enterprises’ financial statements. Since macroeconomically compiled data do not delineate any differences in firm size, there are certain limitations in interpreting the analyses based thereon. With that proviso in mind, the asset and liability structure of enterprises were analyzed (Figure 10.1). On the liability side, borrowings from banks increased continuously from 4.1% of the total assets in 1998 to 15.8% in 2005.3 This trend is also confirmed in the manufacturing and mining sectors, where the share moved from 7.0% to 17.3% from 1998 to 2003. Generally speaking, borrowings from banks are difficult to obtain during unstable transition periods, and, therefore, firms are more likely to resort to inter-enterprise debts. The peak of the accounts payable was 22.6% of the total liabilities in 2001, but the percentage has been declining since then, reaching the level of 17.4% in 2005. Confining it to the manufacturing and mining sectors, the ratio came down from the peak of 30.6% in 2000 to 23.6% in 2003. Unpaid debts are, in general, only a short-term measure and are unsuitable for complementing medium-to-long-term funding needs. On the asset side, long-term investments increased from 2.9% in

25

20

15 % 10

5

0 1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Year Bank credits & borrowings Inventories Long-term Investment Short-term investment Monetary assets Accounts receivable Accounts payable

Figure 10.1

Trend of major asset and liability items of Russian enterprises

Source: Rosstat, Finance Rossii, various issues.

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239

1998 to 16.3% in 2005, showing a corresponding trend to that of bank borrowings. Due to the nature of the basic data reported previously, however, this represents only an overall macroeconomic picture without discriminating for firm sizes or industrial sectors. Microlevel analysis is required to obtain more detailed information based on firm sizes. New trend in Russia’s financial sector As is well known, since the 1998 crisis, several large banks have been intensifying their efforts to expand their lending operations to the real sectors, supported by strong economic expansion. Especially noteworthy in this regard is the behavior of the five largest banks in terms of assets. Sberbank, the largest bank, is a typical example in this regard. This bank had often been criticized as an obstacle to financial sector reform on account of its enormous size, monopolistic position in the deposit market, oblique ownership structure, antiquated management, and majority ownership by the government. On the other hand, there is no denying that the bank was, to a fair degree, instrumental in ameliorating the devastating impact of the 1998 crisis.4 Established as a specialized deposit taking bank during the Soviet era,5 Sberbank had been trying to transform itself into a “universal bank” during the 1990s (Sberbank RF 1996). The fact that it had been supporting, on the strength of its enormous deposit base, several large enterprises in the face of their operational crises has an important bearing when analyzing the relationships subsequently emerging between banks and enterprises (Table 10.2 for Sberbank’s financial exposure to large enterprises). In line with, and supported by, the Central Bank’s policy direction for streamlining the banking sector, Sberbank has also been absorbing a number of under-capitalized banks since the 1998 crisis, as a result of which it has now grown to take a predominant position. In recent years, two conspicuous tendencies have been observed in the financial sector. One is the increase in consumer loans, and the other is the buoyancy of the corporate bond market. The former is attested by entry into the consumer loan market of VTB-24 (formerly the Guta Bank, bought and reorganized by VTB6) and by a significant increase in the number of credit cards issued by banks (Central Bank of Russian Federation 2005). As for the latter, although it is still at a nascent stage, the environment seems gradually improving for firms to raise capital more cost-effectively than by resorting to bank borrowings. For instance, the tax rate was reduced for bond issuance (Lepetikov 2005).7 It is assumed that Russian enterprises, which are generally averse to disclosing corporate information in fear of being taken over, might prefer this mode of fund raising. Another tendency observed was that some large industries in the oil and gas sector and communications sector, in particular, were eager to raise funds abroad (Rybin 2001). These industries being considered most creditworthy

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Clients

Rusagro Group

ZAO Delta Telecom Comos Communications Ilyusin Finance (Leasing)

Sukhoi

OAO Russia Telecom Net OAO TAIF, OAO Kazanorg sindes

OAO Russia Railway OOO Terna Polimer

AFK Systema ZAO Delta Telecom Vympelcom Vnukovo Airport

OAO FSK UES FGUP Fulnichev State Cosmic Science Production Center OAO Sayansk Khimplast OAO Sezensky TsBK OAO AK Transnefti Forestry Complex OOO Commi-Vermi

Sviaji Invest thru OAO RTK Lease

Date

7/21/2005

7/8/2005 6/27/2005 6/7/2005

3/25/2005

11/3/2004 10/12/2004

7/12/2004 6/9/2004

6/4/2004 6/3/2004 5/21/2004 2/4/2004

1/22/2004 1/21/2004

11/28/2003 11/3/2003 10/16/2003 9/26/2003

9/5/2003

Table 10.2 Recent Sberbank financial undertakings

7 credit lines

Credit line

Credit line Credit line

Credit line

Euro 40 million Euro 40.4 million Rbl. 10 billion $15 million

8 years 7 years 3 years

Euro 228.1 million

$6 million

3 years

5 years

$60 million $130 million Euro 24 million

Rbl. 455 million

$20.9 billion

5 years fixed 5 years 7 years

5 years

5 years

up to $21.3 million Euro 500 million

5 years fixed

Long-term financial cooperation program Credit line Cooperation agreement

Rbl. 1 billion

3 years

Debenture underwriting Credit line

Amount

Duration

Financing mode

Ecology project Paper mfg Baltic pipeline Construction of new complex

Skylink network 4th Credit line New passenger terminal

New factory for mfg. const. material

Purchase of rockets for delivery of TU-204–300

Coupon rate 11.66% p.a.

Purpose and other notes

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OAO Energomash Corp.

Transtelecom ZAO OAO Vympelcom Region Rusal Aeroflot Sayansk Alminium Factory FGUP Moscow Endclini Factory Megaphone OAO

Rusal

Magnitgorsk Metallurgy Combinat Rosnefti

FGUP Cosmos Communications ditto Sviaji Invest

7/30/2003 7/25/2003 6/23/2003 6/19/2003 6/3/2003 4/28/2003 2/28/2003

2/19/2003

2/17/2003 1/14/2003 1/13/2003 12/10/2002 12/3/2002 11/22/2002 9/16/2002

8/8/2002

7/19/2002 6/18/2002

6/17/2002

Long-term credit Credit line

Long-term financial credit Long-term credit

Credit line

Credit line

Credit line

Lease project Credit line

Credit line Credit line Credit line Credit line Credit agreement

Source: Compiled by the author, based on press releases of Sberbank.

5/27/2002

Rusagrolease OAO Siberia Coal Engergy OAO Moscow Mobile Telecom MSS Megaphone OAO ditto Ilkt Scientific Production Enterprise Northernflot Rusagro Baltic Factory OAO OAO AK Transnefti MNKTrans OOO Doc. Genny Technology

8/27/2003 8/26/2003 8/8/2003 8/1/2003

5 years

5 years 5 years 1.5 years 5 years 3 years 4 years fixed

4.5 years 5 years

Till Sept. 2005

3 years 3 years 5 years 5 years

over $125 million $239 million Rbl. 4 billion

over $700 million

$49 million

$70 million $70 million $27 million $27.3 million $143.2 million $30.3 million

$419 million Rbl. 10 billion $11 million Rbl. 66 million

Rbl. 100 million Rbl. 3.05 billion $48.2 million $300 million $185 million equiv. $193 million

since 2001

Reconst. Comsomol Petro-chemical

Investment project Network in the northwest Factory renovation

Seeds & nursery warehouse Gas-turbine power station

A new Flugel ship

Skylink network


and therefore preferred customers for domestic banks, Russian banks are to that extent exposed to international competition against foreign institutions. Such competition is considered accountable, to a certain extent, for domestic banks’ eagerness to expand credit to the consumers (Figure 10.2). Bank loans are playing a substantive role, through mortgage loans, in the housing market boom in big cities and in increased expenditure on (mainly imported) consumer durables. There is even apprehension that such a consumption boom, if excessive, as it seems to be the case, might encourage imports of expensive luxuries and impair the competitiveness of domestic industries in the long run. In any case, it is noteworthy that the banks, having been deprived of opportunities for speculation in foreign currencies and purchase of government bonds, are becoming more assertive in extending loans to enterprises and that the two government-owned giants, Sberbank and VTB, are leaders in that direction. As is evident above, it seems that waves of monetization have been steadily spreading in the Russian economy since 1998. Our next task is to look at the relationships between enterprises and financial agents, in particular 9000 8000 7000

Trillion rubles

6000 5000 4000 3000 2000 1000 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 To individuals Figure 10.2

To banks

To enterprises and corporations

Composition of bank credits in Russia

Note: Sum of credits both denominated in rubles and in foreign currencies. Sources: CBR, Bulletin of Banking Statistics, various issues.

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243

banks, at the microeconomic level. This exercise would help clarify the financing activities of enterprises.

Sberbank – “the Ministry of Cash” for the Russian economy Tompson, who called Sberbank the “Ministry of Cash,” argued in a 1998 paper that it was a cash machine for the Russian economy (Tompson 1998). At that time, the bank was a big purchaser of federal government bonds on the basis of its abundant deposit base from the citizens, thus functioning as a de facto financier of state budget deficits. At the same time, the bank had also been extending corporate loans in a move toward “universal banking,” as reported earlier. This maneuver resulted in a very high ratio of delinquent loans (Sugiura 2005).8 It was, however, the crisis of 1998 that triggered a rapid increase in its corporate lending resulting in its current prominence (Renaissance Capital 2003). The bank had started lending aggressively to big enterprises such as Gazprom, Transaero, UES of Russia, and MPS and had also begun relationships with Rostelecom, Baltika, LUKOIL, Vimpelcom, and Rosvoordgenie. The number of large enterprises thus assisted exceeds 20, extensively covering various sectors, such as energy (including oil and gas), metallurgy, communication, and transportation (Renaissance Capital 2002). The major borrowers in recent times, compiled on the basis of the press release, are shown in Table 10.2. The upheaval reported above was closely linked to the banking sector reorganization, occasioned by the proliferation of crises in many large institutions in the aftermath of the 1998 financial crisis. The Promstroibank, created during the Soviet regime as a specialized agency for financing the needs of heavy industry and a major provider of credits to the sector even after the regime change, had its banking license revoked in July 1997. The SBS Agro bank, a successor to the Agroprombank, specializing in the agriculture and food-processing sectors, was also closed. Several big banks belonging to “Financial Industry Groups,” likewise, underwent crises, although some were rehabilitated by so-called “bridge banks.” In short, the major players in the banking sector had undergone substantial changes. Such changes provided Sberbank with ample opportunities to expand its activities. As if to fill the gaps left by defunct banks, it expanded the loan portfolios with major enterprises within a short period of time. In parallel, the bank undertook internal organizational changes with the objective of enhancing the management efficiency. For instance, the branch offices, which used to be grouped in such a way as to correspond to the local administrative units of the government, were consolidated into 17 regional headquarters with a view to facilitating internal resource transfer.9 By curtailing interbank market operations, it aimed to use the resources for longer-term portfolio instead. The bank started to show higher interest in long-term project finance.10

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These expanded activities, however, need to be viewed with a certain proviso. From the viewpoint that the bank had had little experience in extending corporate credits and, consequently, inadequate institutional capability for risk assessment, it was likely that the decisions on credit extension were mainly made on the basis of the sheer size of the enterprises concerned and/ or their connections with the government. The asset structure of the bank is shown in Table 10.3. The aggressive posture of Sberbank was a reflection of the fact that it was supported by a very large deposit base of more than one half of the citizens’ savings. Behind it laid an implicit guarantee of the state on the deposits. With the introduction of a new deposit insurance scheme in 2005, however, the privileged status of the bank was lost. In contrast to its lending operations, its position in the deposit market started to decline, from 59.1% of the market in early 2005 to 53.8% a year later.11 Another factor influencing its operations is the active use of foreign funds by major nonfinancial enterprises, which has become more pronounced lately. Some of the large customers of the bank have been successful in a Eurobond issue. Aided by BRIC’s boom, major Russian firms have been actively exploiting direct relationships with European and North American financial institutions. Such development does not allow Sberbank to be complacent with the former business model of confining its loan operations to large firms. The bank has been trying to extend credits to individuals as well as to medium/small industries (Korzhov 2005). Although owned by the government and, therefore, influenced by the state authorities for decisionmaking, the bank is trying to survive, along with private banks, in an ever competitive environment on the strength of its unique character. Needless to say, it has an immeasurable importance in corporate finance in Russia.

Table 10.3 Asset structure of Sberbank (%) Year Cash and balance with Central Bank Federal Government bond Portfolio investment Outstanding loans Physical assets Other assets Total

1998

1999

2000

2001

2002

2003

2004

2005

10.7

9.8

10.1

14.1

9.9

6.8

5.6

6.9

53.7

54.6

38.9

31.7

27.4

0.8 20.6 8.8 4.2 100.0

0.5 0.3 20.0 40.0 7.4 5.3 2.0 1.7 100.0 100.0

0.5 0.3 47.6 52.1 3.9 7.7 0.8 1.5 100.0 100.0

NA

NA

NA

14.0 52.2 6.1 0.5 100.0

19.0 55.9 5.1 1.4 100.0

14.4 69.6 4.5 0.4 100.0

Source: Compiled and calculated by the author based on the accounting data submitted by Sberbank to and published by the Central Bank of Russian Federation.

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245

Findings from the joint survey Our first point of interest was to find out the relationships between firms and banks, which, although still far from maturity, have been steadily developing. The first question asked was whether or not enterprises had designated main banks, and, if so, we wanted to know when such relationships had started (Q. 44, Figure 10.3). The result endorsed what we have been describing in the foregoing sections. The majority (53%) replied that the relationship had started after the 1998 crisis. Ten percent of the firms replied that such relationships had existed before the collapse of the Soviet regime and had been maintained thereafter, and 17% said they had no main banks. The former shows that the relationship established during the Soviet era between state firms and specialized banks lingers. The latter suggests that they have been unable to build solid relationships with banks despite the general economic boom. The next question referred to borrowings obtained from banks during 2001–2004 and their maturity structures (Q.45, Figure 10.4). The maturities between 6 months and one year showed the highest share at 38%, followed by those between 1 and 3 years at 19%. Because investment-related loans normally carry maturities in excess of one year, the survey results testify that the bank finances are in a transitional stage. A follow-up question ascertained which bank was the largest lender in respect to the 2004 loans (Q. 48, Figure 10.5). Excluding those firms that had no borrowings in that year (1/3 of valid respondents), Sberbank turned out to be the largest lender (27% of respondents), followed by local banks (22%) and by major banks located in Moscow and St. Petersburg (except Sberbank) (11%). In sum, onethird of the firms had no external borrowings, one-third borrowed from Sberbank, and the remainder, just under one-third, borrowed from local 4.2 17.1

No such bank Before 1992 1992–1995 Autumn 10.1

37.9

7.9

1995 Autumn–1998 Financial crisis 1998 Financial crisis–Beginning of 2000 After 2000

8.2

Impossible to answer

14.7 Figure 10.3

Existence of a main bank relationship (Q44)


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246


4.6

3.7 16.8

No credit borrowed Up to 3 months

19.1 6.3

3 months–6 months 6 months–12 months

11.0

1 year–3 years Longer than 3 years Impossible to answer

38.5 Figure 10.4 (Q 45)

Maturity structure (the longest) of borrowings made during 2001–2004


0.6 2.6 0.7 1.1

2.4

No external fund raised Saving banks (Sberbank)

32.9

22.0

Metropolitan banks, except saving banks Local banks National finances or extra-budgetary funds Investment funds or nongovernmental pension funds Nonfinancial group companies Other nonfinancial companies

10.6

Others

27.1

Figure 10.5

External funds raised in 2004 and banks that offered the most (Q48)


and large metropolitan banks. This pattern agrees with what was reported earlier. An effort was made to determine which enterprises used bank credits, which did not, and how they differed. We determined whether firms with a potential for growth, and, thus, with a high demand for funds, had their

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247

demands met by the banking sector. A determination was made regarding any possibility for further improvements. These issues are examined in the following section. Empirical analysis In this section we develop our testable hypotheses and empirically verify them using the results of the joint survey. Enterprises with no external borrowing One-third of the firms surveyed had no record of external borrowing. The purpose of the following analysis was to clarify whether this was due to low growth potential of these firms (thus, not much demand for resources) or to inadequacy of the financial sector to meet the demand. Before doing so, certain peculiarities regarding corporate finance in Russia at this stage of development should be noted. Generally speaking, the size of enterprises tends to correspond proportionally to their perceived creditworthiness. Large employees, even when inefficiently managed, are more likely to be bailed out in times of crises by government intervention to forestall any social instability resulting from mass unemployment. Financial institutions, in passing judgment on credit extension, tend to place higher value on the size and the political clout of firms than on the purpose of demand for funds or their repayment capacity (Kumo & Sugiura 2006). Another important point relates to management attitude on information disclosure. Access to external finance requires a fair degree of information disclosure. The more receptive a firm is to disclosure, the easier the access to finance is, and vice versa. As reported in Chapter 3 of this book, in Russia, the overwhelming majority of firms have chosen a closed-type corporate structure, a clear deviation from the basic concept of a joint-stock company, which is the precise mechanism for wide democratic mobilization of capital among the masses in modern times. The closed nature is considered an important reason for having no access to external finance. These firms tend to be owned by insiders with a small number of employees, and, even if they happen to be performing efficiently, they tend to have little external finance from financial institutions due, presumably, to immaturity of the latter. Thus, a hypothesis to be examined can be stated as follows: Hypothesis H1: Companies with no external borrowing tend to be small and to have unfilled demand for investment resources, even if well managed. They tend to be joint-stock companies of closed-type ownership, and the managers, in fear of losing control, are averse to information disclosure. To examine the hypothesis, the survey data were analyzed as follows. The variable to be explained (NEXFIN for no external financing) would be shown by a discrete quantity, where 1 corresponds to no external borrowings

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248


and 0, to external borrowings. The explaining factors were the size of the company (COMSIZ), the corporate performance (CORPER), the corporate form (CORFOR), and the share of outside ownership (OWNOUT). As for the constraining factor for obtaining external financing, a probit estimation on a qualitative selection model was carried out to serve as a proxy, taking as the explaining variable the natural logarithm of corporate loans by all financial institutions located in the area where the enterprises concerned are located (LCREFI). For corporate performance (CORPER), the following variables were taken as proxies: per employee sales in 2004 (in natural logarithm), growth rates of sales between 2000 and 2004, rates of wage increase during the same period, rates of increase in the number of employees between 2001 and 2005, and the prevailing economic and financial conditions extracted and analyzed from major indicators. The communication sector was taken as a dummy for representing a different sector. Details on the variables can be found in Table 10.4. The results of this regression analysis are shown in Table 10.5 (Model [1]). The analysis endorsed the hypothesis, namely that firms without external finance had little outside ownership and a small number of employees, and were located where the financial sector was underdeveloped. As to their corporate performance and the type of share ownership, the numbers were too small to be statistically significant, although the signs in front of the numbers were in line with the hypothesis. Accordingly, assuming that these firms were good performers, active in investment but not able to approach external financing, two more variables were added: one (INVACT) to show investment activities, and the other (EQPINV) to show investment on equipment (Models [2] and [3]). The result showed that these firms, while exhibiting good corporate performance, were not active in investment. Overall, it was shown that small firms tended to face difficulties in obtaining external finance, probably due to the underdeveloped status of the financial sector. Enterprises with external borrowings Enterprises with external finance are analyzed next. About two-thirds of the surveyed firms had borrowings from Sberbank, metropolitan banks, or local banks. We tried to determine if there were any discernible differences in the characteristics of firms, depending on the largest source of their external finance (Table 10.6). First, on the sector distributions, firms with Sberbank as the largest creditor tended to be in the wood/paper/wood-processing and communication sectors. Those with metropolitan banks as the main creditors occupied a relatively high share in the fuel, energy, and communication sectors, and those with local banks did so in the food-processing and construction materials sectors. Geographically, metropolitan banks lent more in the urban areas, and local banks in the rural areas, with Sberbank in the middle, as expected. In terms of number of employees, metropolitan banks had the highest share in large enterprises with more than 1,000 workers,

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249

Table 10.4 Definitions, descriptive statistics, and sources of variables used in the empirical analysis Variable name

NEXFIN EXFIN SBER MBNK LOBNK CORFOR OWNOUT a LCREFI

COMD CORPERb INVACT c EQPINV c

CMPDOMd EXPORT COMSIZ

Definition

Enterprise dummny with no external resources Enterprise dummy with external resources Enterprise dummy with Sberbank resources Enterprise dummy with metropolitan bank resources Enterprise dummy with local bank resources Dummy for closed-type joint-stock company Share of outside shareholders Total corporate lending by financial agencies located in an area (in natural logarithm) Communication sector dummy (sector dummy) Business performance indicator Investment activity dummy Enterprise dummy that introduced new equipment during 2001–2004 Competition in domestic market Export record dummy Total employees (in natural logarithm)

Descriptive statistics Mean

Standard deviation

0.33

0.47

0

1

0.67

0.47

0

1

0.27

0.44

0

1

0.11

0.31

0

1

0.22

0.41

0

1

0.33

0.47

0

1

1.87 13.16

2.14 0.51

0.09

0.28

0.00 1.15 0.67

1.43 0.79 0.47

1.50 0.51 6.43

0.69 0.50 1.22

Min.

0 11.12

0 4.56 0 0

Max.

5 14.38

1 3.81 2 1

0 2 0 1 4.66 11.21

Notes: a Classified to 6 categories; value 0 for no external share holders, 1 for up to 10%, 2 for 10.1–20%, 3 for 20.1–30%, 4 for 30.1–50%, 5 for 50.1–75%, and 6 for the highest. b The first principal component of the following five corporate performance indices: 2004 sales for an employee in rubles (in natural logarithm); growth rates of sales between 2000–2004 (1 for negative, 0 for unchanged, 1 for less than 1.5 times, 2 for 1.5 to less than 2 times, and 3 for over 2 times); Rate of increase of employees between 2001–2005 (2 for decrease over 20%, 1 for decrease of 1–19%, 0 for no change, 1 for increase of 1–19%, and 2 for increase of 20% and above); Growth rate average wages (1 for negative growth, 0 for no change, 1 for increase of 1.5 times or less, 2 for 1.5–2 times, and 3 for over 3 times); Financial and economic conditions (2 for worse, 1 for slightly worse, 0 for normal, 1 for slightly better, and 2 for better). The ratio of contribution is 40.76%. c Value 0 for no investment, 1 for small investment, and 2 for large investment. d Domestic competition; 0 for no competition, 1 for moderate competition, and 2 for fierce competition. Source: The joint enterprise survey.

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250 Organization and Development of Russian Business Table 10.5 Results of regression analysis on enterprises with no external borrowings Model Estimator Dependent variable CORFOR OWNOUT COMSIZ COMD CORPER LCREFI INVACT EQPINV Const. N LR 2 Pseudo R 2

[1]

[2]

[3]

Probit

Probit

Probit

NEXFIN

NEXFIN

NEXFIN

0.172 (1.39) 0.084*** (2.91) 0.270*** (4.77) 0.280 (1.29) 0.055 (1.43) 0.279*** (2.61) —

0.165 (1.31) 0.066** (2.26) 0.245*** (4.23) 0.349 (1.58) 0.104** (2.52) 2.664** (2.45) 0.288*** (3.63) —

0.207 (1.63) 0.082*** (2.78) 0.268*** (4.53) 0.272 (1.20) 0.090** (2.22) 3.196*** (2.91) —

— 4.925*** (3.44) 602 66.68*** 0.09

4.890*** (3.36) 597 79.92*** 0.11

0.342*** (2.72) 5.654*** (3.83) 590 76.54*** 0.10

Notes: The figures in parentheses are t values. ***: significant at the 1% level, **: significant at the 5% level. See Table 10.4 for definitions, descriptive statistics, and sources of variables used in regressions. Source: Author’s estimation.

followed by Sberbank, although the latter was also strong in firms with 300–499 employees. Local banks tended to lend to smaller firms. With regard to the main-bank relationships and the time of their commencement, Sberbank had a relatively high share among firms with whom it had had dealings before the collapse of the Soviet regime, while metropolitan banks figured high for the period between the 1998 crisis and early 2000, and local banks, after 2000. Among those firms having no designated main banks, Sberbank was also involved in a relatively high proportion. Bearing these general qualitative characteristics in mind, we will take a closer look at Sberbank’s lending operations using a quantitative method. As reported earlier, the bank embarked on corporate finance after the Soviet regime collapsed, in keeping with the intention of going into “universal

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251

Table 10.6 Certain characteristics of enterprises depending on main source(s) of external finance (a) Sectoral distribution

Share in total

EXFIN

SBER

MBNK

LOBNK

Other EXFIN

Fuel and energy Metallurgy Machinery and metal processing Chamical and medicinal drugs Wood, paper, and wood processing Light industries Food processing Construction materials Communication

8.0 4.4 31.0

6.9 5.1 31.1

4.1 4.1 32.4

10.3 4.6 32.2

6.7 6.1 31.1

13.1 6.6 24.6

4.0

4.2

3.6

2.3

4.4

8.2

7.7

6.9

11.3

5.7

3.3

3.3

6.2 20.6 9.5 8.6

5.5 24.5 7.3 8.5

6.8 21.6 6.3 9.9

4.6 26.4 4.6 9.2

4.4 28.9 10.0 5.0

4.9 19.7 6.6 13.1

100.0

100.0

100.0

100.0

100.0

100.0

4.0 2.8

4.5 2.5

1.4 3.2

14.9 6.9

0.6 0.6

13.1 0.0

4.5 0.1

4.7 0.0

5.0 0.0

4.6 0.0

3.9 0.0

6.6 0.0

88.6

88.2

90.5

73.6

95.0

80.3

32.2

34.2

26.6

44.8

40.0

29.5

11.8

11.3

14.4

11.5

7.8

9.8

8.6

7.8

8.6

10.3

6.1

6.6

24.0

24.0

29.3

13.8

21.7

26.2

10.1 10.3

10.5 9.6

9.5 9.5

4.6 11.5

14.4 8.9

11.5 9.8

2.9

2.5

2.3

3.4

1.1

6.6

100.0

100.0

100.0

100.0

100.0

100.0

30.2 21.9 19.0 29.0 100.0

24.2 20.2 20.7 34.9 100.0

22.1 23.4 15.8 38.7 100.0

25.3 12.6 20.7 41.4 100.0

26.7 21.7 23.3 28.3 100.0

23.0 14.8 13.1 13.1 100.0

Total (b) Geographical location City of Moscow Moscow Province (excl. the City) St. Petersburg Leningrad Prov. (excl. S.Ptsbg) Others Central Federal Adminstrative District North Western Fed. Admn. District Southern Fed. Admn. District The Volga Riparian Fed. Admn. District Ural Fed. Admn. District Siberia Fed. Admn. District Far Ease Fed. Admn. District Total (c) Number of employees 100–299 300–499 500–999 1000 and above Total

Continued

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252


Table 10.6

Continued

(d) Borrowing relationship Share in commencing in total Not applicable Before 1992 1992–autumn 1995 Autumn 1995–1998 fiancial crisis 1998 Financial crisis-early 2000 2000 and later Total

EXFIN

SBER

MBNK

LOBNK

Other EXFIN

17.8 10.6 8.3 8.5

11.1 11.1 8.3 8.9

11.6 15.3 8.3 9.3

9.6 4.8 13.3 12.0

7.4 9.1 5.1 6.9

22.8 10.5 10.5 8.8

15.3

17.9

18.5

24.1

16.6

10.5

39.5 100.0

42.7 100.0

37.0 100.0

36.1 100.0

54.9 100.0

36.8 100.0

Note: See Table 10.4 for definitions, descriptive statistics, and sources of variables. Source: Prepared by the author.

banking.” The tendency was more pronounced after the 1998 crisis, when the government bond market collapsed, thus making available for that purpose a huge amount of resources that had, up to that time, been tied up with the bond purchase. The main clients for increased corporate finance were those that belonged to the sectors considered important to the national economy. This implies that the bank’s credit extension was influenced by government’s intentions, or conversely, that it was a reflection of some kind of strong connections that the client firms wielded with the government. Considering that the bank, because of its still inadequate risk-screening capacity, was not considered particularly strong in identifying promising clients in an increasingly competitive market, as compared, for instance, with metropolitan banks, the hypothesis to be examined next would be as follows: Hypothesis H2: Enterprises whose principal source of credits is Sberbank tend to have special connections with the government or its agents. They tend to be large influential ones with export capability, active in investment but not necessarily efficiently managed. To examine the hypothesis, a similar analysis to that in the previous section was conducted. A probit estimation on a qualitative selection model (twostep Heckman probit estimation) was used. For explained variables, discrete quantities were used, with 1 corresponding to firms where Sberbank was the main lender and 0 to others. The explaining variables were enterprise representation(s) in advisory committees of any state organs (ADVCOM) as a surrogate for special connections, exposure to domestic competition (CMPDOM) as an indication of competitiveness, export sales (EXPORT),

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253

and investment records (EQPINV). Furthermore, a communication sector dummy (COMD) and a closed-type incorporation dummy (CORFOR) were added. To consider eventualities as to whether or not an enterprise had a choice in seeking outside finance in the first stage, and, in the former case, as to whether it had a choice in selecting Sberbank or another bank as the source of finance in the second stage, a two-step estimation approach along the Heckman model was adopted. The results of the analysis are shown in Table 10.7. It is evident here that the firms with whom Sberbank acted as the largest lender tended to be an open-type ownership with export records, active in investment, and exposed to domestic competition. As to their relationships with the government, they were well represented in the advisory committees, indicating, with high likelihood, the existence of special connections to the government. Table 10.7 Results of regression analysis on enterprises with borrowings from Sberbank Model

[1]

[2]

Heckman

Heckman

SBER

SBER

0.304*** (2.70) 0.232 (1.18) 0.186** (2.39) 0.251** (2.25) 0.278*** (2.61) 0.179** (2.54) —

0.352*** (3.12) 0.318 (1.62) 0.195*** (2.43) 0.259** (2.30) 0.275** (2.34) —

Estimator Dependent variable CORFOR COMD CMPDOC ADVCOM EXPORT INVACT EQPINV Const.

1.273*** (7.69)

0.279** (2.33) 1.259*** (7.32)

N Wald 2

745 39.76***

746 39.91***

Notes: The figures in parentheses are t values. ***: significant at the 1% level, **: significant at the 5% level. See Table 10.4 for definitions, descriptive statistics, and sources of variables used in regressions. Source: Author’s estimation.

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Concluding remarks The above analysis clarifies certain aspects of the corporate financing mechanism now evolving in Russia. Since 2000, the financial institutions, in particular, banks, have been playing an ever-increasing role in corporate finance from both macroeconomic and microeconomic points of view. In that sense, the process of transition to a market economy seems to be taking a normal course in Russia. On the other hand, there are still many large/ medium-sized firms, as much as one-third of the surveyed ones that have no external borrowings. There is still room for the banking sector to improve its loan operations. If such operations could be extended further to small but competitive firms, it would contribute a great deal to the government policy objectives of economic diversification as well as promotion of small/ medium industries. Sberbank, the largest among the major banks, has been increasing in importance. It has been successful in meeting growing investment demand by enterprises since the 1998 crisis by departing from earlier emphasis on portfolio investment in government bonds. In the light of the fact that the clients with whom the bank is the leading lender tend to be influential ones with export capabilities and special connections to the state, the bank’s corporate finance model has been formed, more likely, as a product of collaboration between the state and enterprises. Now that the bank has lost its privileged position for attracting individual savings through revocation of implicit state guarantee on deposits, the share in the deposit market has been declining. These factors would require that the bank pursue further efficiency in its lending operations. In recent times, the bank has vigorously embarked on the extension of finance to small/medium industries as well as the retail sector. The bank’s effort in the former area suggests the future course of Russia’s economic development. In view of its weight in the finance sector, it would greatly facilitate the country’s progress to a market economy if the bank could also enhance its risk-assessment capacity in such a way as to provide guidance to the clients for promoting their management efficiency.

Acknowledgments This chapter is the result of a study with financial assistance from the Ministry of Education and Science of Japan (Nos. 16530149, 17203019, and 17730157) and from the Foundation of Japan Legislation Society. This paper benefited greatly from various comments offered on the author’s draft by the members of the Institute of Economic Research at regular meetings as well as by the participants in a meeting at the Slavic Research Center of Hokkaido University. I would like to offer my special appreciation to Naohito Abe, Ichiro Iwasaki, Kazuhiro Kumo, Yoshiaki Nishimura, Manabu Shimizu,

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255

Shin-ichiro Tabata, and Tsuyoshi Tsuru for their valuable comments. My thanks are also due to Eiichi Watanabe for his assistance in translation and Tomiko Noguchi for her assistance in collecting and sorting data.

Notes 1. The financial sector is one of the priority areas for development in Russia (World Bank 2002). Recognizing a need for developing a mechanism whereby citizens’ savings are mobilized more through higher confidence in the system and channeled to industrial investment, the government set targets for the banking assets to reach 56–60% and its assets in nonfinancial sectors to reach 26–28% of GDP by 2009 (Zaiavlenie 2005). 2. The low level of monetization is also indicative of the underdeveloped nature of the financial system. 3. Overdue debts to banks also decreased from 15.2% in 1998 to 1.3% in 2005. 4. Sberbank had received 440,000 deposit accounts from six defunct commercial banks. It also intensified lending to enterprises suffering from liquidity shortage. 5. According to the bank’s report, it was founded in 1842 during the Czarist times. 6. The expansion of VTB in recent times, along with that of Sberbank, is worthy of strong interest. It acquired control of 4 of 5 subsidiaries (except the EastWest United Bank in Luxembourg) of Zagranbank (a commercial bank remaining from Soviet times with subsidiary banks located overseas). It also bought Promstroibank (St. Petersburg), with whom VTB had had a share-holding relationship earlier. The consolidated assets of this group increased from 6.6% of the total banking sector assets in 2004 to 8.2% in 2005, while those of Sberbank decreased slightly from 30% to 29% (Ivanter 2006). 7. According to Lepetikov, the real cost of a bond issue was equivalent to 10–12% p. a. on average and 7–9% for large prime issuers as of the end of 2004. This compares with the 10–14% rate of interest on bank loans in rubles. With the reduction in the tax rate from 0.8% of the total value of the bond issue to 0.2%, the cost advantage is obvious. 8. According to the Interfax-100 index, the overdue accounts were 18% of the total credits, as of October 1, 1998. 9. This was also considered effective in avoiding local government pressure for loans (interview with Prof. Smulov). 10. These moves were in line with the “Strategic Development Program till 2005” adopted by the shareholder meeting of 2001 (Sberbank RF 2001). 11. The implementation of this scheme would commence from 2008. The real impact on Sberbank’s deposits will likely be observable after that year.

Bibliography Berglöf, E., Kunov, A., Shvets, J., & Yudaeva, K. (2003) The New Political Economy of Russia (Cambridge, MA: MIT Press). Bonin, J. & Wachtel, P. (2003) Financial sector development in transition economies: Lessons from the first decade, Financial Markets, Institutions and Instruments, 12: 15–16.

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256 Organization and Development of Russian Business Central Bank of Russian Federation (CBR) (2005) Financial Stability Review 2004 (Moscow: Central Bank of Russian Federation). Central Bank of Russian Federation (CBR) Bulletin of Banking Statistics (Moscow: CBR) (various issues). Dolgopyatova, T. & Iwasaki, I. (2006) Exploring Russian corporations: Interim report on the Japan–Russia joint research project on corporate governance and integration processes in the Russian Economy. Discussion paper No. B35, Tokyo: Institute of Economic Research, Hitotsubashi University. Egorova, N. & Smulov, A. (2002) Predpriiatiia i Banki: Vzaimodeistvie, Ekonomicheskii Analiz, Modelirovanie (Moscow: Delo). Federal State Statistical Service (Rosstat) Finansy Rossii (Moscow: Rosstat) (various issues). Federal State Statistical Service (Rosstat) (2003) Investitsii v Rossii 2003 (Moscow: Rosstat). Federal State Statistical Service (Rosstat) (2007) Investitsii v Rossii 2007 (Moscow: Rosstat). Ivanter, A. (2006) My tam, Oni zdec, Ekspert, 1–2: Jan. 16. Korzhov, V. (2005) Sberbank pomozhet, AiF na Donu, August 24. Kumo, K. & Sugiura, F. (eds) (2006) The new generation of Russian economic studies. Discussion paper No. B34, Tokyo: Institute of Economic Research, Hitotsubashi University. Lepetikov, D. (2005) Bankovskaia Sistema v 2004 g.: Rost Kreditovaniia na Fone Krizisa, Moscow: Tsentr Razvitiia. Matovnikov, M. (2000) Funktsionirovanie Bankovskoi Sistemy Rossii v Usloviiakh Makroekonomicheskoi Nestabil’nosti, Nauchnye Trudy No. 23R (Moscow: Institut ekonomiki perekhodnogo perioda). Rabotsii Tsentr Ekonomicheskikh Reform pri Pravitel’stve Rossiiskoi Federatsii (2002) Finansy Otraslei Promyshlennosti Rossii do i posle Krizisa 1998 goda, Moscow: Author. Renaissance Capital (2002) Sberbank: Saving the best for the future, Moscow: Renaissance Sector Update. Renaissance Capital (2003) Sberbank: Banking on the economy, Moscow: Renaissance Sector Update. Renaissance Capital (2005), Sberbank: Retail rewards, Moscow: Renaissance Sector Update. Rybin, I. (2001) Na fondovom rynke poiavliaiutcia novye pravila, Izvestiia, 26 June. Sberbank RF (1996) Strategiia Razvitiia Sberegaterinogo Banka do 2000 (Moscow: Sberbank RF). Sberbank RF (2001) Strategiia Razvitiia Sberegaterinogo Banka do 2005 (Moscow: Sberbank RF). Sugiura, F. (2005) Rosia no mibarai mondai to ginkou sistemu: Kigyo kara ginkou heno kigenchoukasinyou wo chuushin ni, Bulletin of the Japan Association for Comparative Economic Studies, 42: 27–41. Sugiura, F. (2007) Economic transformation and corporate finance in the postcommunist world. In: Dallago, B. & Iwasaki, I. (eds), Corporate Restructuring and Governance in Transition Economies (Basingstoke: Palgrave Macmillan). Tompson, W. (1998) Russia’s “ministry of Cash”: Sberbank in transition, Communist Economies and Economic Transformation, 10: 133–155.

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Tsentr Makroekonomicheskogo Analiza i Kratkosrochnogo Prognozirovaniia (TsMAKP) (2006) Ekonomicheskie Itogi 2005 Goda, Obzor Makroekonomicheskikh Tendentsii,63. World Bank (2002) Building Trust: Developing the Russian Financial Sector (Washington, DC: World Bank). Zaiavlenie Pravitel’stva Rossiiskoi Federatsii i Tsentral’nogo Banka Rossiiskoi Federatsii o Strategii Razvitiia Bankovskogo Sektora Rossiiskoi Federatsii na Period do 2008 Goda, Moscow, 2005.

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11 Business Associations: Incentives and Benefits from the Viewpoint of Corporate Governance Victoria V. Golikova

Introduction The results of our studies in 2002–2004 demonstrate that the business community was placing a greater emphasis on the demand for law and that preferences were being expressed to conduct business in a legal and civilized manner (Razvitie Sprosa 2003; Yakovlev et al. 2006). One indicator of this demand is membership of entrepreneurs in a number of nongovernment organizations, such as guilds, unions, and organizations that are provided for in Article 121 of the Civil Code of the Russian Federation (RF) for the purposes of coordination of their entrepreneurial activity as well as representation and defense of common property interests. Before the start and at the very first stage of market-oriented reforms in Russia, the prevailing type of associations included those that were not and could not be equal partners in a dialogue with the state authorities. Their role in the economy and direction of their activities were defined by government policies. As a rule, they were initiated “top-down” by former ministerial officers of the Soviet Union and Russia, who competed for leadership in the post-Soviet space. As such, they were narrow “personoriented” groups of business people who gathered around individuals striving to broaden their personal and political influence (Kubicek 1996; Zudin 2006). At least one half of the associations were headed by former officials of a ministry of the USSR or Russia (Recanatini & Ryterman 2001). Some of them developed these associations as individual projects (Pachenkov & Olimpieva 2005). The majority of existing Russian Business Associations (BAs) were established after the crisis of 1998. While some of them, mostly the national and regional ones, were initiated by the authorities, most industrial associations were started by business enterprises that had expanded their planning horizons by that time and gained an understanding of the need 258

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Business Associations: Incentives and Benefits 259

to consolidate their activities in order to champion their interests. The transformation of the BAs into institutions of a civil society in Russia was not a straightforward process. Empirical studies have shown that, at the initial stage, seizure of power, dependence on authorities, favoritism to their “closest circle” of members, and discrimination against rank-and-file participants were typical of leaders of newly established unions and associations (Golikova et al. 2003). For these reasons, many of the institutions in question in the 1990s had not established any reputational capital that would serve them well. We will now examine the nature of Russian BAs. Duvanova (2007b) described them as “one of the most highly developed institutions of the post-communist civil society;” however, as Pachenkov and Olimpieva (2005) and Lehmbruch (2003) maintained, it is too early to draw such a conclusion because of interest group weakness in Russia. The analysis of the incentives to join associations and benefits from the membership based on our representative survey of medium-size and large Russian JSCs has the potential to clarify this issue. The decision to join an association and to retain or curtail membership afterwards is made by an owner or CEO. For this reason, our analysis is focused on the incentives of owners and CEOs to participate in associations, the factors behind their choices, and the benefits they gain for their businesses within an institutional environment. A brief review of empirical studies of BAs is presented in the first section of this chapter as a part of the evolution of state business relations in modern Russia. The second section contains the main hypothesis regarding the incentives to join an association as a result of costs-benefits calculus and a review of their preliminary testing. The third section is a discussion of the determinants of membership in associations. The fourth section is an evaluation of the benefits from being a member of an association(s) and demonstrates the reputational capital of different types of associations from the viewpoint of their members. The fifth section is a summary of the results. The empirical analysis in this chapter is mainly based on the results of various enterprise surveys conducted by the SU-HSE in 2002–2008, which was centered on top managers of 822 large and medium-size joint-stock companies (JSCs) implemented in 2005. For our comparative study, we also use the results of a survey of 304 JSCs, which covered only open JSCs in the industrial and other sectors of the real economy as well as in the financial sector, implemented in 2002 in three regions of Russia (Golikova et al. 2003), and the results of a survey of 147 firms of different legal forms conducted in two Russian regions in 2005 (Tikhomirov 2005).1 In addition, we incorporate the results of in-depth interviews with business association officials, company CEOs, and representatives of regional and local authorities.2

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Who joins and why: Main findings from the empirical studies of BAs in Russia Researchers started to explore the institute of business associations (BAs) in the mid-1990s. One of the first empirical surveys involving BAs was a World Bank survey implemented in five Russian cities in 1992–1994 with a modest sample of 157 firms (Recanatini & Ryterman 2001). These researchers stressed the spontaneous emergence of business associations as a firm’s rational attempt to mitigate the initial decline in output. An incentive to join an association was analyzed in the context of the means to reduce transaction costs in the interactions with potential trading partners.3 Several studies on BAs in transition economies were based on EBRD–World Bank Business Environment and Enterprise Performance Survey (BEEPS)4 data (Raiser et al. 2003; Campos & Giovannoni 2006; Duvanova 2006, 2007a, 2007b). They concentrate on the determinants of a firm’s membership in BAs and the role of the institutional environment. Using BEEPS-2002 data, Raiser et al. (2003) examined the role of business networks in building trust between firms.5 The researchers obtained contradictory results with respect to the role of BAs: membership in associations tends to increase prepayments at the firm level, which is used as a measure of trust, and to decrease them at the country level, with the country-level effect being much larger than that at the firm level. On the basis of BEEPS-1999 data, Campos & Giovannoni (2006) examined the interdependence of lobbying and corruption. They show that, in the economies in transition, lobbying, channeled, among other things, through membership of entrepreneurs in business associations, appears as a substitute for corruption and is a more effective instrument of political influence. Company size, age, ownership type, political stability, and level of per capita GDP in a country all contribute to the active involvement of firms in lobbying activities. Duvanova (2007a), using the same data, found that low-level bureaucratic corruption and excessive state regulations facilitate the formation of business associations, that is, a decision to join an association is a rational defensive strategy of firms in the situation of bureaucratic predation. Several empirical surveys were implemented exclusively on the basis of Russian data (Frye 2002; Pyle 2006a, 2006b, 2007). Limiting his study to the relationships between business enterprises and the state, Frye (2002) focused on the problems of sources, methods, and scales of lobbying activities.6 His study contains several important results. In the context of incentives to join an association, he revealed that (a) successful lobbying depends on the characteristics of a company and on the level of government, while relations among firms and regional authorities are a special and yet unexplored type of interaction; (b) most successful lobbyists use the ground of business associations to seek more favorable

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conditions for their businesses. In this context, a question is brought up about the extent to which business associations supplement or replace personal connections; (c) in Russia, an elite exchange is more typical of relations among business enterprises and authorities than capture, but the methods and consequences of this kind of exchange for firms as well as for representatives of government require further examination. On the basis of the results of a series of surveys conducted in 2003–2004,7 Pyle (2006a, 2006b) found that, contrary to common belief, business associations are not a weak and ineffective institution of the Russian economy, which is proved by large-scale membership in associations and, recently, by a growing influx of new members. He also found that membership in business associations correlates with more active market behavior and enterprise restructuring. In a later study, Pyle (2007) showed that regional associations are growing faster in regions with higher levels of democratic institutions, but the effect of membership, measured in this case as the possibility to defend ownership rights, is higher in the less democratic regions. Similarly, the results of a survey based on BEEPS-2005 data also provide evidence that membership in associations is more typical of dynamic, relatively large enterprises, and exporters. BA members outperform nonmembers in terms of their innovative activities (Desai & Goldberg 2007). A number of interesting results were obtained in qualitative surveys based on in-depth interviews with business associations. For instance, Lehmbruch (2003) explored the phenomena of multiple memberships in forest sector associations in Russia and provided strong evidence that, in the case of fragmentation of rights and responsibilities among numerous agencies, competing associations within one sector could apply to different parts of the state apparatus and mobilize different sources of rent for their members. Multiple membership, thus, provides better access to patronage. 8 Another study by Pachenkov and Olimpieva (2005) provided evidence from in-depth interviews with the heads of BAs in St. Petersburg that the main condition for a BA to be successful is to maintain close connections with state authorities using social networks for lobbying. These authors stress the necessity to treat separately those BAs created by the businessmen and the so-called supporting structures initiated from higher authorities. Such supporting structures are often subordinate to agencies of local authorities, and their leaders often appear to be bureaucrats within those organizations.9 In summary, the empirical results on membership of Russian firms in BAs provide no clear explanation of the main incentives motivating firms to join BAs. The kinds of incentives that prevail among medium-size and large industrial enterprises are important, and the need for collective action stems from market pressure. In other words, whether the level of competition and the globalization of company operations are the major determinants of membership or whether rent-seeking and the desire to establish personal relationships with authorities are the most important drivers of a

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firm’s decisions must be determined. In the next section, we present a testable hypothesis that will clarify these issues.

Consolidation of interests of Russian JSCs: Costs-benefits calculus and main hypotheses about incentives to medium-size and large JSCs to join BAs According to our survey results, the membership rate of Russian mediumsize and large JSCs in BAs (54.7%) sufficiently exceeds the membership rate determined for Russian companies in the BEEPS-2005 survey (20%). The high participation rate indicates that the results of costs-benefits calculus are more favorable for larger companies. An obvious explanation would be that large firms are less tentative regarding the cost side of calculus than small ones, which usually experience financial constraints.10 On the basis of a univariate comparison between member and nonmember firms (Table 11.1), we hypothesize that there is no significant difference in the participation rate between privatized and new firms regardless of whether there is a state share in the stock ownership. All other corporate governance characteristics might be correlated with membership in BAs. It is reasonable to propose that good and bad performers have different incentives to become a member of a BA. Empirical surveys have proved that successful businesses are more demanding of the quality of the institutional environment (Golikova et al. 2008). As reported by Auzan (2006), “The condition for the establishment of nonprofit business organizations was the appearance, in the course of an emerging market economy, of companies that understood that they would remain in existence in their industries and markets even in the subsequent five years. This was the time when interests beyond current business and premise for collective identification came into being” (translated from Russian). Therefore, we hypothesize that, among members of BAs, significantly more successful businesses could be found, including exporters and firms with a long planning horizon. Under the increasing competition and globalization of the economy, member firms will strive for active participation in associations in order to defend and promote their collective interests in external and domestic markets. A preliminary statistical analysis of survey data on Russian JSCs in 2005 on the basis of cross-tabulation of the level of competition, export activities, and membership in BAs supports this consideration. In the 2002 survey, the correlation between membership in BAs and the financial condition of enterprises was hard to trace. In 2005, successful Russian companies were clearly interested in BAs. In general, the better the financial standing of an enterprise was according to the subjective estimates of the respondent, the more likely it was that the enterprise was a member of an association. Objective indicators also confirm that BA members are significantly better off than those outside unions and associations (Table 11.2). Members

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Note: a 2 test.

Total sample, including: Autonomous enterprises Members of the business groups Number of employees: 100–299 300–499 500–999 More than 1,000 Privatized New firms With foreign owners Without foreign owners With a stake of state in the stock ownership Without a stake of state in the stock ownership With large owners Without large owners Separation of ownership and management: General director – large owner General director – hired manger Listing (preparation) on the Russian stock exchange No listing (preparation) Listing (preparation) on the foreign stock exchange No listing (preparation)

45.3 47.4 41.8 58.3 46.8 44.4 31.0 43.9 51.2 28.9 48.2 40.7 45.4 42.8 56.6 37.9 52.1 35.2 47.9 26.3 47.9

41.7 52.3 55.6 69.0 56.1 48.8 71.1 51.8 59.3 54.6 57.2 43.4 62.1 47.9 64.8 52.1 73.7 52.7

Nonmember

54.7 52.6 58.2

Member

100 100 100 100

100 100 100 100 100 100 100 100 100 100 100 100 100 100

100 100 100

Total

128 541 57 715

242 171 151 229 665 121 121 672 135 568 650 99 290 215

793 487 306

N

0.002

0.008

0.004

0. 010

0. 325

0.000

0.136

0.000

0.123


Table 11.1 Characteristics of companies: Members and nonmembers of business associations (percentage of respondents who answered)

264 Organization and Development of Russian Business Table 11.2 Indicators of financial standing of joint-stock companies and membership in business associations (percentage of respondents who answered) Indicator

Share of respondents having reported their membership % in lines Type of association

Members

Nonmembers

Share of companies which doubled and more than doubled sales volume at current prices in 2000–2004

Any National Industrial Regional

36.4 36.4 36.3 43.7

28.6 31.6 31.6 30.3

Share of companies which doubled and more than doubled wages in 2000–2004

Any National Industrial Regional

42.5 46.2 40.3 43.7

31.5 34.3 36.4 36.0

Share of exporters

Any National Industrial Regional Any National Industrial Regional Any National Industrial Regional

55.0 60.3 53.7 52.0 48.1 46.9 53.3 51.0 49.5 51.8 50.0 50.0

41.5 44.8 47.0 47.4 29.5 37.1 34.6 37.0 34.6 40.1 40.7 40.7

Large-scale investment

Share of own resources in investment is more than 60%


0.026 No (0.585) 0.005 0.016 0.001 0.002 0.061 0.023 0.000 0.000 0.095 No (0.301) 0.000 0.013 0.000 0.002 0.001 0.049 0.031 No (0.505)


of associations have a much higher share of exporters and of fast-growing financially well-off companies, which made substantial capital investments in 2000–2004 from their own funds and generously raised (doubled and more than doubled) compensation to their employees. As already reported, this tendency corresponds to the results of previous studies. An incentive to join an association is to hedge the risks of doing business in a fragile institutional environment with unsecured property rights and lack of state long-term policy predictability.11 According to worldwide governance indicators (Kaufmann et al. 2008), the institutional environment in Russia is still unfavorable for doing business and developing a civil society. Except for progress attained in the perceptions of political stability and regulatory quality, other indicators in Russia, such as voice and accountability, government effectiveness, rule of law, and control of corruption, remain on a very low level or even demonstrate negative dynamics. In an

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imperfect institutional environment, an owner/top manager is dependent on the availability of his/her personal contacts with state officials, who might assist in resolving problems in the interactions with different parts of the state bureaucratic apparatus. We argue that participation in BAs is one of the most convenient means to attain personal access to state officials via membership in the association. One of our respondents explained the situation during the interview: “To solve problems nowadays when we go up to the authorities and ask: ‘When will this end?’ It shouldn’t be done this way. Well, those problems are being taken care of behind closed doors. A man stays behind after the meeting, goes up to the official, and says: ‘Come on, give me a break, please. I am dying here.’ ” (excerpt from an interview with the head of an association in the Moscow oblast, December 2007, translated from Russian). Thus, participation in BAs should be treated not only as a mechanism that supplements or replaces personal contacts but as one of the best options to establish and maintain useful personal contacts with the bureaucrats that could reduce the administrative burden or provide financial or organizational assistance (Table 11.3). Therefore, we expect that the dichotomy of member and nonmember matters in the context of benefits Table 11.3 Types of support rendered to authorities and aid through various channels depending on membership in business associations (percentage of respondents who answered) Rendering support % in column

Rendering support to local authorities by firms

Membership in BAs

Total sample

Yes

No

Yes No Total N

88.8 11.2 100 430

74.5 25.5 100 353

82.4 17.6 100 783

Yes No Total N

27.0 73.0 100 430

18.1 81.9 100 354

23.0 77.0 100 784

Yes No Total N

36.1 63.9 100 421

19.7 80.3 100 351

28.6 71.4 100 772

Significance of differencesa 0.000 Receiving financial support from the authorities by firms

Significance of differencesa 0.003 Receiving organizational support from the authorities by firms

Significance of differencesa 0.000 Note: a 2 test. Source: Author’s calculations based on survey data.

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266


obtained from the authorities, but the strategy of multiple choice in this case is more beneficial, as it increases the probability to obtain assistance from different sources. Such assistance, undoubtedly, is of extreme importance, first of all, for weak market players. This consideration supports Lehmbruch’s (2003) statement that “the actual role of many Russian business associations lay in the intermediation of individual interests, rather than aggregation and representation of collective interests” (p. 14).12 The results of our survey show that the members of BAs who wish to maintain steady relationships with authorities and are successful at maintaining them derive substantial benefits from these relationships (Table 11.4). They are much more likely to obtain financial and nonfinancial support using administrative facilities for the consolidation of their market positions. Insecure property rights and more active state pressure on large business in the 2000s caused the reincarnation of the Soviet-era paradigm of the behavior of general directors, which is an incentive to demonstrate loyalty to the authorities. In the context of membership in BAs, it means that the general directors, who are large owners, usually accept an invitation from

Table 11.4 Benefits for members of associations from the establishment of steady contacts with authorities (share of joint-stock companies having obtained support from authorities, %) Establishment of steady contacts with authorities in the framework of associations

Organizational support Financial support from regional or local authorities Assistance in contacts with federal agencies Assistance in contacts with Russian partner enterprises Assistance in contacts with foreign partner enterprises Lending on favorable terms Budget subsidies Help in search of Russian investors Assistance in contacts with banks and financial institutions Help in search of foreign investors


Yes

No

52.8 38.6

32.9 24.8

0.000 0.003

29.9 21.3

13.0 11.8

0.000 0.010

11.0

2.7

0.000

10.2 10.2 7.9 7.9

3.9 5.7 1.8 3.9

0.009 0.091 0.002 0.083

3.1

0.9

0.080


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the authorities to join an association initiated from the top, even in a situation in which the potential benefits from participation remain unclear: “Basically, many of our associations were created artificially, that is, they did not grow from below. They said there in the oblast: ‘Guys, we should support the Chamber of Commerce and Industry. It is such an expert institution. It is recognized all over the world, and we need its stamp of approval.’ Some of the firms think: ‘Well, the membership dues are chicken-feed for me. The authorities want this for some reason, and it comes from the regional center. I may later get some support from them, some extra natural gas or something else.’ In reality, they join just because of the potential payoff.” (excerpt from an interview with the head of an association in the Moscow oblast, December 2007, translated from Russian). The information quoted above suggests that, in this case, the low costs of joining an association plus the incentive to obtain potential support outweigh the objections of joining the association that are put forth by the authorities. These relationships have the quality of an informal bargain and make it easier for the authorities to perform their public functions and for the firms to work in a certain area. In the context of these considerations, we speculated that (a) the presence of large owners in a stock ownership structure and (b) a pattern that occurs when a general manager is a large shareholder13 should correlate positively with membership in associations. Those directors who became large owners during the privatization and after-privatization redistribution of property rights for their benefit take a much more personal interest in seeking additional channels and chances to keep in contact and maintain relationships with the authorities, including the “brokerage” of associations in order to secure property; this is unlike the new generation of hired managers, who often prefer to distance themselves from them, as their job expectations are usually not connected with a certain industry or location. Correspondingly, we expect that the personal characteristics of the general director, such as age and prior job experience, should also matter. The last hypothesis establishes links between the level of concentration of the business community and the probability of becoming a member of an association. Wherever the concentration of the business community is higher, which is typical of the location of companies in larger and, correspondingly, higher-status settlements, informal social networks are more likely to transform into an institution of bottom-up associations (Figure 11.1). We expect the type of location to be a significant determinant of JSC membership in associations. The level of market competition, according to our survey results, has a rather weak correlation with membership in associations. Only among companies whose officials reported strong or not very strong competition with the Baltic countries, China, and Turkey were there significantly more participants in associations (62.9%) than among firms that lacked this

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268

Organization and Development of Russian Business 60 50 40 30 20 10 Moscow

Capital of oblast (republic)

Nonmember of BA Member of industrial association

Figure 11.1

Noncapital city

Urban communities, villages

Member of national association Member of regional association

Membership in associations by type of settlement

Source: Survey data.

competition (51.9%; significance of difference, 0.009). These results support the idea that the level of competition can hardly be considered to be among the major determinants of membership in BAs. As we reported in the first section, on the basis of a study conducted in 2004, Pyle (2007) revealed a positive correlation between membership in associations and level of democratization in a region. In our study, using an aggregate rating of the level of democracy in Russian regions in 2000–2004,14 we could not demonstrate this correlation for membership in regional or in any other type of associations. However, if we turn our attention from the aggregate evaluation to its individual components, we can see that some of these components, such as expert assessments of openness and political pluralism, have weak positive correlations with membership of joint-stock companies in unions or industrial associations. The development of a civil society and local self-government has little to do with membership in regional associations. Contradicting the results of Duvanova (2007a, 2007b) obtained using BEEPS data for 25 post-communist countries, including Russia, we did not find any correlations between membership in associations and corruption. In addition, membership in national associations is unrelated to any of the particular indexes describing the levels of democracy in the regions.

Empirical analysis of factors correlating with membership of JSCs in associations To provide a comprehensive analysis of determinants that could predict the probability of a company to be a member of an association and test the hypotheses characterizing the incentives to join associations developed in the previous section, we estimate a binary logistic regression model with

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a dependent variable that takes a value of 1 for firms with a membership in any type of association and 0 otherwise. The independent variables characterize: ●

●

●

●

●

The patterns of separation of ownership from management with a general director who is a hired manager without company shares, which is a basic category. The personal characteristics of CEOs, who decide whether to participate in the associations, include the age of the general director or Chairman of the Board of Directors and a dummy for his/her previous job experience within governmental bodies; The characteristics of stock ownership: dummy variables, which take a value of 1 for those firms with large shareholders with more than blocking stock and presence of state and foreign owners; The financial standing of the enterprise measured by dummies, which take a value of 1 for the presence of large capital investment in 2001– 2003; the presence of exports and a long planning horizon (more than 3 years); and listing (or preparation for listing) on the foreign and Russian stock exchange; The level of competition with the Baltic countries, Turkey, and China, which was found to be significant at the preliminary stage of analysis, was included as a categorical variable with no competition as a basic category; The control variables include industry affiliation (communications as a basic category); company size, measured as a logarithm of employees; dummies, which take a value of 1 for the case of a new company established after 1992; membership in a business group; and location in capital cities (Moscow or oblast capitals).

To identify the influence of the institutional components of the business climate and check the robustness of the model, we first constructed a model without factors characterizing the quality of the regional institutional environment. For the second step, we included aggregated assessments of a regional investment climate derived from the journal EXPERT15 with “insignificant potential and moderate risk” as a basic category. For the third step, instead of assessment from the journal EXPERT, we used individual components of the aggregate rating of the level of democracy in Russian regions in 2000–2004 reported above. The better the situation in a region, the higher its rating relative to this component. Table 11.5 shows our estimation results. Close estimates of factors correlating with participation in associations were obtained in all three models. A steady significant effect is typical of ownership, corporate management patterns, and the personal characteristics of general directors: the chances of being a member of an association multiplied for companies headed by general directors who were large owners. The age of a director had a positive

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270


Table 11.5 Logistic regression analysis of the determinants of participation in business associations Model Constant Company size (log of number of total workers) New enterprise (= 1) With state owners (= 1) With foreign owners (= 1) Listing on foreign stock exchange (= 1) Listing on Russian stock exchange (= 1) Large owners (with more than blocking stock) (= 1) Large capital investment (= 1)

[A]

[B]

[C]

4.258*** (0.790) 0.376*** (0.092)

4.077*** (0.798) 0.351*** (0.094)

4.968*** (0.934) 0.397*** (0.094)

0.731*** (0.209)

0.772*** (0.211)

0.683*** (0.212)

Planning horizon of more than 3 years (= 1) Export (= 1)

0.526** 0.524*** 0.584*** (0.220) (0.219) (0.223) Level of competition with Baltic countries, Turkey, and China (no competition as a basic category) High level of competition (= 1)

0.680** (0.295)

0.677** (0.297)

0.711** (0.297)

Medium level of competition (= 1) Separation of ownership and management (general director-hired manager as a basic category) General director – large owner (= 1)

0.473** (0.239)

0.438* (0.240)

0.478** (0.242)

Large owners are managers, general director is not a shareholder (= 1) Large shareholders are not managers, general director is a shareholder (= 1) Age of general director

0.291*** 0.282*** 0.275** (0.110) (0.112) (0.113) Job experience of general director or board chairman at governmental bodies in previous 10-year period Components of aggregate rating of democratization: Openness X Electoral democracy Political pluralism Independent mass media Economic liberalization Civil society Political system

X X X X X X

X X X X X X X

0.530*** (0.164)

20.398** (0.182) Continued

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Table 11.5 Continued Model

[A]

[B]

[C]

Elites Corruption Local self-government Location in capital cities

X X X X X X 0.496** 0.424** 0.535** (0.217) (0.217) (0.219) EXPERT Regional investment climate estimation (insignificant potential and moderate risk as a basic category) High potential and moderate risk (= 1) Medium potential and moderate risk (= 1) Reduced potential and moderate risk (= 1) Industry dummies N 2Log likelihood Pseudo R 2 Wald test (2 )

X X X yes

yes

573 550 674.975 658.458 0.230 0.211 107.883*** 94.017***

X X X yes 573 664.191 0.251 118.667***

Notes: ***: significant at the 1% level, **: at the 5% level, *: at the 10% level. Standard errors are reported in parentheses. X: The variable was not included in the model. Forward stepwise method was used; free cells: coefficients were not included in the final equation. Source: Author’s estimation based on survey data.

significant influence in all three models. We found no influence of state and foreign owners of the company or of the availability of large owners with more than a blocking stake. Of the basic characteristics of a company, firm size increases the chances that a company will be a member of any BA (the larger a firm, the more chances to participate in the association), while being a member of business groups and history (whether it is a privatized or a new entity) have no significance. In all three models, the location of a company in the country or an oblast capital increases the likelihood that it will be a member of a BA. Among the indicators of a firm’s performance, large capital investment and exports have a positive effect on the likelihood that it will be a member of an association, while a long planning horizon and its presence on the Russian or a foreign stock exchange do not matter at all. The introduction of evaluations from the journal EXPERT of the regional institutional environment reduced the sample to 550 observations and slightly worsened the fitness of the model. However, the revealed correlations, excluding location in capitals, did not lose in significance. Location in capitals was significant at the 1% level, and, in the second model, it became significant at the 5% level. This model demonstrates that none of the evaluations of the regional investment potential (all the surveyed regions were of moderate investment risk) has an influence on membership

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of a joint-stock company in a BA, as such evaluations were not included in the final equations. Using individual components of an aggregate rating of the level of democracy in Russian regions in 2000–2004 instead of the journal EXPERT assessments provides better estimation results. In addition to the major factors correlated with participation in BAs revealed earlier, two institutional components of the democracy rating have a significant influence on membership in BAs. One is a positive correlation in the case of openness (i.e., transparency and integration into the national political life), and the other is a negative correlation in the case of a political system component, which characterizes real political balance, independence from court and law enforcement bodies, and civil rights violations. The interpretation of the last result might include two options: availability of a defensive strategy in the case of bottom-up associations or orientation on the personal links with the authorities in the case of top-down institutions.

Membership: Single or multiple choices An examination of medium-size and large member firms of industrial associations as a whole (Figure 11.2) indicates that the majority (three-quarters) prefer to be a member of only one of three types of associations, choosing a nationwide or industry-wide type slightly more frequently than a regional type. A quarter of BA members are in different associations at the same time. On average, one of 10 BA members chooses a strategy of simultaneous membership in all three types of associations. To check the hypothesis regarding benefits from obtaining multiple membership in different associations, we reorganized and recoded our survey data with the introduction of a new variable, which takes a value of 0 for nonmembership in any type of association (default category), 1 for National associations 30% 3%

7% 9%

18% Regional associations Figure 11.2

6%

28% Industrial associations

Strategies of membership in associations (% of number of members)

Source: Survey data.

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membership exclusively in one (any) type, 2 for participation in two types of BAs, and 3 for participation in the three analyzed types. As the local and regional authorities are strongly dependent on the sustainable development of businesses in the territory (the individual profit income tax is one of the major sources of local budgets), it is reasonable to propose that, first of all, they will support larger firms with a long planning horizon and high investment potential. All the respondents from the state bodies interviewed in 2008 in the Karelia and Moscow oblast stressed their strong interest in creating new jobs within their territories. In the context of possibilities to manage the routine relationships with company management, we argue that (a) companies with a state stake in ownership, (b) open JSCs, and (c) autonomous enterprises with CEOs located in a particular territory have more opportunities to be the recipients of state financial and organizational support. In consideration of these points, we ran a binary logistic regression to determine how multiple choice correlates with the propensity to obtain financial and organizational aid from the authorities. We controlled for industrial affiliation using communications as a basic category, size of the company measured as a logarithm of employees, history of organization or whether it was privatized or new (organized after 1992), legal status (open or closed JSC), and affiliation with the business groups. In addition, we used dummy variables, which take a value of 1 for location in capitals and the presence of state or foreign owners in stock ownership. We also took into account the performance of the firm. To separate good and bad performers, a wide range of indicators were used. They included subjective estimations of respondents with good standing as a basic category and dummy variables, which take a value of 1 for the availability of a long planning horizon in excess of three years, large capital investment in 2000–2003, and exports. An institutional environment of the region should be taken into consideration as well. We argue that the better the conditions for doing business for the whole business community are, the fewer opportunities there will be for particular businesses to obtain direct financial and organizational support from state authorities. In our models, the institutional environment of the region is controlled by the aggregate rating of the level of democracy described in the previous section. To estimate the path dependency and role of networks, we include a dummy variable, which takes a value of 1 for those firms with a general director or chairman of the board of directors with previous job experience in governmental bodies. We also use a variable that provides the information of the general director’s age. Finally, we evaluated the linkages between a company and authorities by including a dummy variable informing whether there were initiatives from the firm to render support to the state bodies. It is natural to assume that

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274 Organization and Development of Russian Business Table 11.6 Logistic regression analysis of probability to obtain financial and organizational support from the state authorities Dependent variable

Financial support from the authorities

Organizational support from the authorities

Constant 1.530** (0.601) 1.273*** (0.358) Company size (log of number of total workers) HCG member (= 1) Legal status (open JSC = 1) 0.593*** (0.224) New enterprise (= 1) 0.620** (0.265) With state owners (= 1) 0.918*** (0.227) 0.711*** (0.226) With foreign owners (= 1) 0.560 ** (0.283) Large capital investment (= 1) Planning horizon of more than 0.562** (0.216) 0.555*** (0.200) 3 years (= 1) Export (= 1) 0.414** (0.190) Aggregate rating of level of democracy 0.042** (0.017) Age of general director Subjective estimation of performance (“good” as a basic category) “Satisfactory” (= 1) “Bad” (= 1) Job experience of general director or board chairman at governmental bodies in previous 10-year period Rendering support to the state bodies (= 1) Location in capitals (= 1)

1.091*** (0.367)

Membership in associations (non-member as a basic category) Membership in 1 type of associations (= 1) Membership in 2 types of associations (= 1) Membership in 3 types of associations (= 1) Industry dummies N -2Log likelihood Pseudo R 2 Wald test (x2)

0.508** (0.225)

0.700*** (0.209) 1.124*** (0.309)

1.240*** (0.412) yes 650 626.193 0.128 56.247

1.323*** (0.403) yes 641 698.797 0.151 71.561

Notes: ***: significant at the 1% level, **: at the 5% level, *: at the 10% level. Standard errors are reported in parentheses. Forward stepwise method was used; free sells: coefficients were not included in the final equation. Source: Author’s estimation based on survey data.

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a company in which CEOs cooperatively support the needs of the territory will have more opportunities to obtain rewards. The results of calculations are presented in Table 11.6. Logistic models demonstrated that a multiple choice of membership was rewarded in both cases. The chances to obtain financial and organizational aid from authorities were sufficiently higher in the case of participation in three types of BAs. The performance of the firms did not have an influence, or, in other words, state assistance was not provided to weak market players and, thus, was not a cause of distortion. Both models clearly demonstrate that state bodies preferred to provide assistance to enterprises with a state stake in ownership and a long planning horizon. On the other hand, chances for obtaining financial aid were reduced for enterprises with a foreign ownership stake. The sign of the coefficient with a variable characterizing the level of democratization in the region (negative and significant at the 5% level) demonstrates that, in more democratic settings with higher ratings, the chances to obtain financial assistance are lower. Contrary to our expectations, network relations based on former CEO job experience with governmental bodies do not increase the chances for any kind of aid. The opportunities to obtain organizational support from state officials are higher for new enterprises with a legal status of open JSC. A better strategy to obtain financial assistance from state bodies, all else being equal, is to be cooperative and meet the needs of providers.

Practical value of enterprise unions: Reputation of associations from a membership viewpoint In the 2002 survey, a pessimistic assessment of associations prevailed among their participants. For instance, only 29% of the respondents answered the following question affirmatively: “Have nongovernment organizations of entrepreneurs improved their protection of interests of the business community in the last three years?” Twenty-six percent of the respondents believed that membership in associations brought no benefits to their enterprises (Golikova et al. 2003). To evaluate the changes that have occurred within three years, we compared the assessments given by our respondents in the 2002 and 2005 surveys in a commeasurable range of enterprises (open JSCs with more than 100 employees in industry) using only the identical wording of answers to this question (Table 11.7). Our analysis shows that the general assessment of associations in the compared subsamples remains practically unchanged. Their activities were considered useless by less than 13% of the respondents in 2002 and by 16% in 2005. The negative opinion of BAs is unrelated to the organizational and legal forms of enterprises, their industrial affiliation, and their integration or nonintegration into business groups. Many more negative views were given by enterprises not involved in active interaction with authorities, that

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276 Organization and Development of Russian Business Table 11.7 Utility of business associations and their contribution to the establishment of standards and rules of conduct of business, evaluated by respondents in 2002 and 2005 (percentage of respondents who answered) Answers to the question: “What benefits does your enterprise obtain from membership in nongovernment enterprise associations?”

2002*

2005

None Participation in preparing legislation Establishment of steady contacts with government administration Support with conflict resolution Defining new standards of conduct of business Number of observations

12.3 9.9 18.5 13.6 7.4 127

17.2 20.2 30.6 6.1 16.5 297

Source: Survey of 304 open JSCs conducted by the Autonomous Non-profit Organization “Projects for the Future: Scientific and Educational Technologies” in three regions of Russia; survey of 822 JSCs.

is, those which render no help to local governments and receive no organizational and financial aid from them. Finally, more negative assessments have come from individual enterprises that have not yet completed the separation of ownership and management, in other words, those in which the CEO was a hired manager but large shareholders held key managerial positions. Although dissatisfaction with the activities of associations is unchanged, demand for law is showing impressive positive changes. For instance, the share of respondents who report an advantage of associations in the preparation of legislation and in defining new standards of conduct of business has more than doubled.16 Among such respondents, the share of larger enterprises is significantly higher. The share of open JSCs is higher than that of closed ones, and that of integrated businesses is larger than that of autonomous ones. Furthermore, among the respondents who indicated a growth in the demand for law, the percentage of enterprises that have listed their shares on Russian or foreign stock exchanges is significantly higher as well. At the same time, the share of respondents pointing at the role of associations in conflict resolution has been reduced by half. In our opinion, this is evidence that the number of internal conflicts in the business community in the last three years is on the decline and emerging conflicts are more often resolved in a pretrial mode in negotiations between parties. In addition, in the case of failure, the instruments of formal law are being used. In the past, the share of respondents who indicated that associations helped them to establish steady contacts with authorities almost doubled, increasing from 18% to 31%. The question of whether this increase indicates that the dialogue between business and the authorities is progressing satisfactorily remains to be answered. We believe that it is too early to

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make such a conclusion. Since the Yukos affair, a demonstration of loyalty to the authorities has become a rational strategy of conducting business for large and medium-size companies, which can, if only partially, protect them from excessive interest on the part of the government. The results of the empirical survey of 147 enterprises in two Russian regions conducted in 2005 show that all enterprises, whether they are association members or not, are equally keen on establishing personal relations with people

Table 11.8 Evaluation of contribution of NGBOs to the solution of important problems of the business community by the respondent joint stock companies (percentage of respondents who answered) Answers to the question: In Members “What benefits does total of national your enterprise obtain sample associationsa from membership in nongovernment enterprise associations?”

Members of Members industrial of regional associationsa associationsa

None

17.8

20.3

12.6

28.9

Participation in preparing federal and local legislation

19.6

18.0

24.4

11.8

Establishment of steady contacts with government administration

27.9

27.3

19.3

32.9

Informational support

53.4

57.8

52.1

46.1

Strengthening of positions in the Russian market

20.0

18.8

27.7

11.8

Strengthening of positions in foreign markets

5.1

4.7

5.9

5.3

Support with conflict resolution

6.2

1.6

6.7

10.5

Protection from unfair competition and unscrupulous bureaucrats

9.0

10.9

10.1

7.9

Chance to take part in establishment of new standards of conducting business

14.5

12.5

18.5

10.5

Participation in preparation and supervision of industrial quality standards

12.1

8.6

24.4

6.6

Number of observations

455

128

119

76

Note: a Nonmembers of other associations. Source: Survey data.

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278


from the government. The platforms of associations may possibly serve as one of the channels for such communication in an underdeveloped civil society. Assessments by the respondents of benefits from their membership in BAs across all 822 joint-stock companies of the sample are given in Table 11.8. As in 2002, for most of them, this benefit is related to informational support that they obtain from the associations, as reported by about one half of the respondents who are members of BAs; every fourth respondent has a positive opinion regarding the establishment of steady contacts with authorities; every fifth reports the success of associations in making their position in the Russian market stronger. However, efforts of all types of Russian BAs for the promotion of Russian enterprises in foreign markets are barely noticed by the overwhelming majority of the respondents, which means that these efforts are insufficient. From the answers, it is evident that our respondents are more satisfied with the activities of industrial associations, which received fewer negative appraisals in general and were also positively viewed by every fourth or fifth respondent in six of nine assessed directions. At present, the least developed institution is regional associations, the activities of which, excluding informational support and establishment of contacts with authorities, are little appreciated by the survey participants. We conjecture that this lack of appreciation may be due to the fact that, in most cases, these regional associations were not organized by the business community but initiated by regional authorities and most probably reflect the interests of regional governments rather than those of entrepreneurs.

Concluding remarks Our survey results show that about one half of medium-size and large Russian JSCs are members of various national, industrial, and regional unions and associations. At the same time, according to many studies, associations of small businesses so far include few potential members, which is a sign of their institutional weakness. In the last three years, the share of medium-size and large companies that joined BAs has increased, which is a sign that economic agents have a positive interest in an institution of a civil society. Overall, our testable hypotheses were confirmed. In other words, the larger and better-performing enterprises, which are active in restructuring and operate in a competitive environment, are more interested in using a platform of associations. The institution of associations is developing in the territorial dimension with great irregularity. The status of the settlement in which an enterprise is located is one of the most influential factors in its joining a BA. The diffusion is centrifugal, moving from the center to the provinces, where this institution of a civil society is, so far, underdeveloped.

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The hypothesis regarding the role of the patterns of separation of ownership from management in making decisions to join associations has been proven for membership in any type of association. The status of a director who is also a large owner of the company is a significant determinant of membership in associations. One of five member firms in associations and one of four among members of industrial associations are involved in lobbying. Significantly more enterprises that support local authorities and receive organizational support from them were found among members of associations, which is a confirmation of the hypothesis involving an exchange of elites and a proof of the conclusions reached by Frye (2002). Regional and local authorities give assistance to members of BAs twice as frequently as they do to nonmembers with regard to the establishment of contacts with federal agencies, the search for Russian partners, and efforts to obtain external financing. Interactions with state authorities are of great importance for the members of associations. Most probably, the opportunity to establish closer ties to the authorities and personal relationships that comes with membership in associations is a strong incentive for joining BAs. We have revealed that multiple memberships in different types of associations provide more rewards to the participants and increase the probability to obtain financial and organizational assistance from the state. Involvement of a firm in corporate integration has no influence on its membership in BAs. In other words, autonomous enterprises and members of business groups are equally likely to be members of BAs. This means that the surveyed enterprises do not use the associations as an institution to replace or supplement business integration. We found no evidence that, in the last three years, members of associations had changed their opinion regarding the benefits of membership. In general, approximately one of six member enterprises believes that the membership is useless for them. Many more negative judgments are expressed by enterprises that are not involved in active interaction with the authorities. This results in no help to local agencies and eliminates the possibility of receiving organizational and financial assistance from them. More critical assessments are typical for the enterprises that have not yet completed separation of ownership and management. Although satisfaction with the activities of associations is unchanged, the realization of a rising demand for law has achieved substantial progress. The share of respondents who report that the platform of associations has been useful for improvements in federal and local legislation and in defining new standards of conduct for business has more than doubled. The larger enterprises are more deeply involved in these activities and include open joint-stock companies rather than closed ones, integrated businesses rather than independent ones, and enterprises that have placed their securities on Russian and foreign stock exchanges.

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According to our survey results, at present, the most advanced and efficient institutions representing the interests of medium-size and large JSCs are industrial associations, which were initiated by businesses, worked a difficult way of self-organization, and successfully gained respect in the business community. At the opposite pole are regional associations, created and often even imposed from the top-down, which are being used mainly as a channel for communication with authorities.

Acknowledgments This research was conducted with financial support of SU-HSE, which included funds from the Program for Fundamental Studies granted by the Ministry of Economic Development and Trade of the Russian Federation in 2007–2008. Qualitative data from in-depth interviews were collected and transcribed within the framework of a joint project of the State University – Higher School of Economics and Helsinki School of Economics “New business strategies of foreign and Russian companies: Interactions with stakeholders” (in 2007–2009, this project was funded in Russia by the Russian Fund for the Humanities, project N 07-02-93203a/F). I would like to thank Andrei Yakovlev and Yurii Simachyev for their useful comments and suggestions. Special thanks are given to Olga Uvarova for her assistance in preparation of the manuscript and Dina Yakupova for transcribing the interviews.

Notes 1. Both surveys were conducted by the Autonomous Non-profit Organization “Projects for the Future: Scientific and Educational Technologies.” 2. The data were obtained within the framework of a joint project of the State University – Higher School of Economics and Helsinki School of Economics “New Business Strategies of Foreign and Russian Companies: Interactions with Stakeholders.” In 2007–2009, this project was funded in Russia by the Russian Fund for the Humanities (project N 07-02-93203a/F). 3. This is extremely important, but, in our opinion, such motivation being focused on market behavior of the firms does not cover the whole range of incentives to join a BA – a well-known phenomenon of rent-seeking in the interactions with state authorities. The conclusion concerning the “spontaneous” emergence of BA does not fully correspond to Russia’s history of the formation of associations via direct or indirect incentives of state officials. Lack of data on the exact time for joining the association gives no opportunity to solve the causality problem. There is a lack of strong arguments of whether joining the BAs improves firm performance or, on the contrary, better performers more often prefer to become the participants of interest groups in order to obtain assistance for the implementation of more ambitious development trajectories. W. Pyle stressed this point in his research of membership in BAs and enterprise restructuring.

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Business Associations: Incentives and Benefits 281 4. The survey is implemented in 25 economies in transition, including Russia. The data for Russia are available for 1999, 2002, and 2005. The BEEPS sample is heavily weighted toward small enterprises and private firms with a strong representation of services (Raiser et al. 2003), and, thus, general estimations could not be directly compared with our survey results. 5. They suggested measuring trust by the level of prepayment required by the firm. 6. The survey covered 500 companies of various sizes and forms of ownership in 8 Russian cities. The sample has some limitations regarding the representation of regions. Companies in Siberia, the Far East, and Southern Russia are not included. The limitations include types of settlement because companies outside the federal and republican capitals are not included and the rate of refusal to answer is high at 44%, which may result in biased assessments. 7. Initially, to make the most general assessment of membership of Russian companies in BAs, 1,353 companies were surveyed in 48 regions of Russia. Later, 606 companies were surveyed in order to make a more detailed comparison of the characteristics and mode of behavior of the firms that are members and nonmembers of the associations; the latter, in line with the a priori construction of the sample, were presented in equal proportions. 8. Intuitively, this conclusion is relevant not only to the multiple choice of membership within one sector, but, in a much broader context, to multiple membership in general. 9. This population of BAs could hardly be treated as institutions of a civil society, as they represent the interests of the founders. Usually, the heads of such associations limit membership by loyal firms with a long history of personal relationships. 10. Our calculations, based on the results of a survey of 147 firms of various legal forms conducted in two Russian regions in 2005, prove that only two small firms mentioned high dues as an obstacle to membership in BAs. 11. Forty percent of respondents from the sample of 1,002 industrial enterprises in the World Bank – HSE survey reported that uncertain government policies are to be serious or very serious obstacles for doing business. 12. This is not a one-way road: members of associations also more frequently provide support to the authorities. 13. The identification procedure is described in detail in Chapter 2. 14. Offered in Petrov & Titkov (2005). The suggested assessment of the level of democracy in a region is based on a moving average. The regions were evaluated on a five-point scale for each of nine individual components. For instance, when evaluating corruption, an assessment of joining economic and political elites and corruption scandals was made; when evaluating an open/closed type of political life, transparency and the degree of involvement in national political affairs were taken into account; when evaluating local self-government, the researchers took into account whether there were elected local authorities and, if so, whether they were active and influential. Information on the levels of individual indexes and the aggregated expert assessment in the regions in 2000–2004 was derived from the book (Rossija regionov, 2005, p. 269). 15. Based on the evaluation of investment risk and potential. Details could be found in http://www.raexpert.ru/rating/regions/2004. 16. Frye (2002) shows, by using empirical survey data of 2000, that members of associations are, in general, better lobbyists at all levels of state and municipal government than nonmembers.

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Bibliography Auzan, A. (2006) Grazhdanskoye obschestvo ne chram, a alternativny sposob proizvodstva obshestvennogo blaga (interview recorded on the website: www.opec.ru) (available at: http://www.opec.ru/point_doc.asp?d_no=47179). Campos, N. F. & Giovannoni, F. (2006) Lobbying, corruption and political influence. Discussion paper No. 06–14, CEDI (Centre for Economic Development and Institutions) Brunel University Working Paper N 06-14, September 2006. Desai, R. M. & Goldberg, I. (eds) (2007) Enhancing Russia’s Competitiveness and Innovative Capacity (Washington, DC: World Bank). Duvanova, D. (2006) Business associations in post-communist Russia: Explaining sectoral variation. Paper prepared for the Midwest Political Science Association Conference, Chicago, April 2–23. Duvanova, D. (2007a) Bureaucratic corruption and collective action: Business associations in the post-communist transition, Comparative Politics, 39: 441–461. Duvanova, D. (2007b) Business associations in post-communist countries: A comparative analysis of business and employer associations. Ph.D. Dissertation, Ohio State University. Frye, T. (2002) Capture or exchange? Business lobbying in Russia, Europe–Asia Studies, 54: 1017–1036. Golikova, V., Dolgopyatova, T., Kuznetsov, B., & Simachev, Y. (2003) Spros na pravo v oblasti korporativnogo upravleniya: Empiricheskie svidetel’stva. In: Razvitie Sprosa na Pravovoe Regulirovanie Korporativnogo Upravleniya v Chastnom Sectore, Seriya Nauchnye Doklady: Nezavisimyi Ekonomicheskij Analiz, No. 148 (Moscow: Moskovskii obschestvennyi nauchnyi fond). Golikova, V., Gonchar, K., Kuznetsov, B. & Yakovlev, A. (2008) Russian manufacturing at the crossroads: What prevents firms from becoming competitive (Moscow: Publishing House of SU-HSE). Kaufmann, D., Kraay, A., & Mastruzzi, M. (2008) Governance matters VII: Aggregate and individual governance indicators 1996–2007. Policy research working paper No. 4654, World Bank. Kubicek, P. (1996) Variations on corporatist theme: Interest associations in postSoviet Ukraine and Russia, Europe–Asia Studies, 48: 27–47. Lehmbruch, B. (2003) Collective action and its limits: Business associations, state fragmentation, and the politics of multiple membership in Russia. Paper presented at the American Political Science Association Annual Meeting, Philadelphia, Pennsylvania, August 28–31. Pachenkov, O. & Olimpieva, I. (2005) Grazhdanskie ob’edineniya predprinimateley v sfere malogo I srednego biznesa (na primere Sankt-Peterburga), Otechestvennye Zapiski, 6: 5–17. Petrov, N. V. & Titkov, A. S. (2005) Index demokratichnosti regionov. In: Rossiya Regionov: V Kakom Socialnom Prostranstve My Zhyvem? (Moscow: Nezavisimyj institut socialnoy politiki). Pyle, W. (2006a) Russia’s business associations: Who joins and why? Paper presented for the Center for International Private Enterprise Economic Reform, July 17, Washington, DC. Pyle, W. (2006b) Collective action and post-communist enterprise: The economic logic of Russia’s business associations, Europe–Asia Studies, 58: 491–521. Pyle, W. (2007) Organized business, political regimes and property rights across the Russian Federation. Discussion paper No.18, Bank of Finland Institute for Economies in Transition.

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Business Associations: Incentives and Benefits 283 Raiser, M., Rousso, A., & Steves, F. (2003) Trust in Transition. – European Bank of Reconstruction and Development Working Paper No. 82, October 2003. Recanatini, F. & Ryterman, R. (2001) Disorganization or Self-Organization: The Emergence of Business Associations in a Transition Economy. – in The World Bank Policy Research Working Paper Series, No 2539. Rossiya Regionov: V Kakom Socialnom Prostranstve My Zhyvem? (2005) (Moscow: Nezavisimyj institut socialnoy politiki). Tikhomirov, Y. (ed.) (2005) Vlast, Zakon, Biznes, Series “Nauchnye Doklady. Nezavisimyj Ekonomicheskij Analiz”, No 168. (Moscow, Moscow Public Science Foundation, Projects for Future: Scientific and Educational Technologies, Department of Law of SU-HSE). Yakovlev, A., Golikova, V., Dolgopyatova T., & Simachyev, Yu. (2006) Corporate Governance in Transition: New Trends and Challenges, In: Sell, A. & Krylov, A. (eds), Corporate Governance (Francfurt am Main: Peter Lang GmbH). Zudin, A. (2006) Biznes, Assotsiatsii i Gosudarstvo: Sravnitelnyj Analiz Razvitiya Otnoshenij na Zapade i v Postsocialisticheskikh Stranakh: K 15-letiyu Centra Politicheskikh Technologij (Moscow: Centr politicheskikh technologiy).

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12 State–Business Relations and Improvement of Corporate Governance Andrei A. Yakovlev

Introduction The corporate behavior of Russian firms has changed drastically in the last decade. In the beginning of this period, many experts reported the failure of institutional reforms (Stiglitz 1999), and many empirical studies confirmed this viewpoint. Therefore, a detailed study by Brown et al. (2006) based on data from 24,000 enterprises over the 1992–2002 period established that, while the Ukraine, Romania, and Hungary enjoyed increases in productivity, on the average, within a year of privatization, the effect of privatization in Russia was indeterminate even after five years. Russian companies systematically treated foreign investors with hostility and grossly violated shareholders’ rights, and the Russian government could not protect abused investors and shareholders by law (Kraakman et al. 2000). In comparison with Central and Eastern Europe, the inhabitants of Russia were more critical of the outcome of privatization and were widely supportive of the revision of its results (Denisova et al. 2007). The negative experience in Russia led to new conclusions about the importance of the institutional environment and the inefficiency of privatization under a weak government exposed to group interests (Perotti 2004). Contrary to this very poor starting point, two parallel trends became apparent in Russia during the 2000s: corporate governance obviously improved, and the government gained strength and significantly increased its presence in the economy. The first trend was expressed in terms of a broad introduction of international accounting standards, in the initial public offering (IPO) of Russian companies on international stock exchanges, and in the more widespread practice of invitation of independent directors to the boards (Puffer & McCarthy 2003; Yakovlev 2004). This was followed by substantial growth in capitalization of the Russian stock market and, since 2006, by a strong inflow of foreign investment. 284

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State–Business Relations and Corporate Governance 285

State-owned enterprises (SOEs) as well as mixed enterprises played important roles in this process. Since the beginning of the 2000s, the government streamlined the activities of SOEs as well as made general improvements in the institutions of corporate governance. In particular, a new version of the joint-stock company law was passed, the bankruptcy law was revised, a code of corporate behavior was designed, the dissemination of best practices of corporate governance was promoted, a reform of the judicial system was launched, and the system of law enforcement was upgraded. At the same time, the monitoring of SOE performance was introduced, the corporatization of federal state enterprises (FGUP) accelerated, standard instructions for state representatives in SOE boards with government stakes were developed, competitive procedures for the appointment of SOE managers were introduced, and contracts with them were formalized (HSE 2003). In the course of upgrading corporate governance in the public sector, the government launched IPOs of large state-owned companies in order to increase their capitalization and to obtain financial market appraisals of their performance. As a result, two leading Russian state-controlled banks, Sberbank and VTB-Bank, as well as the state-owned Rosneft Oil Company, acquired the main assets of Yukos Company had large IPOs in 2006–2007 and managed to raise more than $27 billion in the market. The second trend had different dimensions as well. On the one hand, macroeconomic and monetary policies significantly improved. The Russian government secured a budget surplus for a long time, which could reduce inflation by up to 10% per annum and accumulate a large amount of international currency reserves. As a consequence, Alexei Kudrin was recognized in March 2005 by the international business-magazine, The Banker, as the Finance Minister of The Year. On the other hand, strengthening of the Russian state was expressed in the direct and indirect nationalization of a number of large companies either by filing tax claims against them or by the government or an SOE acquiring controlling stakes in private companies (see OECD (2006, section 1) for the entire economy and Vernikov (2007) for the banking sector). At the same time, the government was keen on exerting informal pressure on business enterprises. In addition to the Yukos affair in 2003–2004, which is discussed in detail by Yakovlev (2006), the Russian government conducted a sort of corporate takeover in the cases of the Russneft Oil Company in 2006–2007 and the conflict surrounding the TNK-BP in the spring of 2008. The years 2006–2007 were also marked by the establishment of state corporations, which were endowed with several billion dollars from the federal budget and acquired a number of private and mixed companies (the first case is that of the former FGUP “Rosoboronexport,” which was reorganized in November 2007 into the state corporation “Rostechnologii”). In July 2008, Prime Minister Vladimir Putin charged one of Russia’s leading mining and metals companies, Mechel, with tax evasion via transfer pricing.

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This led to a 40% decrease in company market capitalization on the NYSE and was considered by some observers as a reiteration of the Yukos affair (Shokhina & Shevtsova 2008). These contradictory trends raise the question of whether or not the connection to the state has a statistically significant impact on the quality of corporate governance in the firms concerned. In this chapter, we are going to answer this question by relying on the results of a survey of 822 joint-stock companies, which was conducted by SU-HSE and Hitotsubashi University in 2005 (see the Appendix of this book for more details). The rest of the chapter is organized as follows. The second section contains a short description of relevant studies and a formulation of a testable hypothesis. The third section contains a description of the methodology. The fourth section contains empirical results and discussion. The last section is a presentation of the main findings and the conclusion.

Literature review and testable hypothesis Government intervention in the economy by the establishment of SOEs has been generally met with criticism in the mainstream economic literature. Based on a review of empirical studies, Megginson and Netter (2001) concluded that SOEs, as a rule, are inferior to private firms in terms of efficiency. As noted by Perotti (2004), this is related to a lack of sufficient accountability of SOEs or to “soft budget constraints,” as termed by Janos Kornai. In effect, SOE managers and employees lose incentives to upgrade their efficiency. SOEs are used for political objectives, and the responsible government agencies become more and more corrupt. In addition, even disregarding the corruption, the inefficiency of an SOE can arise from a conflict between public interests and the interests of state officials who, following the standard bureaucratic logic, try to maximize the budgets under their control rather than to improve efficiency. SOEs may also restrict the activities of private firms and, therefore, undermine competitive environment (Vining & Boardman 1992). Logically responding to such a skeptical view of SOEs by economists, governments focused on the improvement of enterprise efficiency and economic performance in general by means of privatization policy. According to the estimates cited by Megginson and Netter (2001), the SOE share of the “global GDP” declined from more than 10% in 1979 to 6% by 1996. To a great extent, this was a result of mass privatization in former socialist countries. However, the experience of economies in transition in this context is far from unambiguous (Nellis 1999). In Central and Eastern Europe, privatization has usually improved the performance of firms (Pohl et al. 1997). However, Poland in the early 1990s and especially China in the 1980s and early 1990s gave empirical evidence that SOEs can perform much better without any privatization. Pinto et al. (1993) and Li (1997) explained this

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effect by the results of such measures as toughening of budget constraints and bank lending policies, stronger competition of imports, and introduction of a system of incentives for SOE managers. Explaining similar results for Singapore public companies in 1990–2000, Ang and Ding (2006) noted that, when the venture capital industry is not yet developed and institutional investors have not reached the critical threshold of share ownership, the government can lead in providing risk capital and may serve as a large monitoring shareholder. In another institutional context of the developed US economy, Kwoka (2005) shows that public enterprises may be superior when output has important nonspecifiable attributes. Private providers in this case will have incentives to undersupply this hard specifiable quality. Public enterprises, by contrast, may have weaker overall incentives and, hence, higher costs, but those incentives do not favor price over quality. Summarizing the general discussion about comparative efficiency of state-owned, mixed, and private firms, Kwoka (2005) concludes that even careful control for external factors has not eliminated divergent findings and there is a space for new empirical research. Privatization in transition economies and the developing world clearly showed another problem, namely, that one firm could be private but, under conditions of a weak and corrupted state, it could extract rents from close connections to the government at the expense of society and other private firms. Hence, Hellman et al. (2003), using the World Bank and an EBRD firm-level survey on obstacles in the business environment, defined state capture as one of two key corrupt strategies of interaction between a firm and the state in transition countries. Following this line of analysis, a number of researchers studied more broadly the phenomenon of “politically connected firms,” in which top officials or politicians act as shareholders or members of the board or good friends of main owners (Faccio 2006). Analyzing a very large sample of 16,000 public companies in 47 countries for 1997, Mara Faccio concludes that, even though political connections provide significant benefits, connected firms under-perform their peers on an ex-ante basis. Recent relevant studies for France (Bertrand et al. 2006) and China (Choi & Thum 2007) support these findings. Thus, most of the previous theoretical research stresses the efficiency advantage of private enterprise, comparing it to public or “politically connected” firms. However, the results of empirical studies are not so unambiguous, especially in the case of privatization in transition countries. This effect is usually explained by the weakness of government institutions in a transition environment. Therefore, on the basis of detailed analysis of development in the former socialist countries in 1980–1990, Grzegorz Kolodko, a well-known Polish economist and a key government official in Poland in 1994–1997, concludes that the depth of the “transitional” crisis and further

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economic development was conditioned by the retention of capable institutions in some countries and the catastrophic incapability of the government in others (Kolodko 2002). If such institutions are inherited from a preceding regime, such as in China, they can be supportive of economic development. Therefore, we can assume that, under the conditions of the Russian economy of the early 2000s, the improvement of state capacities could have a positive influence on the quality of market institutions, including corporate governance. This hypothesis corresponds to the arguments of Ang and Ding (2006) on the higher efficiency of Singapore public companies in 1990–2000 and to the broader approach of “second-best institutions” proposed by Rodrik (2008). The hypothesis about the positive influence of the state on formal indicators of corporate governance in state-owned and mixed enterprises was formulated in some policy advice and analytical papers (Avdasheva et al. 2007; NCCG 2008: 132–135). However, until 2008, this hypothesis was never tested by formal econometric methods.

Methodology To test if our hypothesis regarding the connection of a firm to the government can be positive for the quality of corporate governance in the Russian situation of the early 2000s, we used a set of ordinary probit regressions. For the dependent variable, we took the CG_IDX, the integral indicator of the quality of corporate governance, which was built on the basis of a number of variables directly or indirectly describing relationships between joint-stock companies and their shareholders, first of all, minority ones. In this aspect, our approach differs from that of most previous studies, which relied on various financial indicators of enterprise performance as dependent variables (Li 1997; Tian & Estrin 2008). The explanation for our choice is that Russia has developed a very high concentration of ownership and control under a narrow equity market and imperfect institutions of corporate governance. In this situation, if a company is showing strong financial performance, this by no means implies that minority shareholders of the company will actually be able to receive a share of the “corporate pie” that they are formally due. In the case of Russia in the 2000s, the improvement of financial performance indicators can be explained in the short-term period by the influence of external factors, such as the devaluation of rubles for domestically oriented firms or an increase of world market prices for exporters of raw materials. Under such contextual changes, the quality of corporate governance (considered as a system of incentives) can be more important for investors and minority shareholders. Indeed, good corporate

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governance is quite costly for firms, and return on such types of “investment” can be expected only from a midterm perspective. Therefore, CG improvement on the firm level can be a signal of real changes in a firm’s strategies. There are also some differences between our approach and that in relevant studies of corporate governance. Traditionally, such studies used a variety of ratings for the assessment of the quality of corporate governance. For instance, Doidge et al. (2007) included in their analysis the data of S&P transparency and disclosure rating, based on the information disclosed by the companies, and the FTSE/ISS scorecard, based on evaluations of financial analysts. However, such ratings and scorecards are generally applicable to public companies that are traded on stock exchanges and disclose considerable volumes of information about their business. For current Russia, this is a very restrictive approach because only a small number of joint-stock companies can meet such criteria of the stock market. For example, in 2007 Standard & Poors rated informational transparency in only 80 companies in Russia (S&P 2007). However, there are about 170,000 joint-stock companies in Russia, and most of them have minority shareholders. Our sample consists of such joint-stock companies to a large degree, and we tried to detect how their relationships with shareholders are changing. To this effect, using a number of questions about the corporate behavior of firms surveyed in our questionnaire, we constructed the CG_IDX for our sample, which covered listed and nonlisted companies. The list of these 13 questions and the answers of our respondents are shown in Table 12.1. By interpreting the answers in terms of better / worse corporate behavior, we followed conventional principles of corporate governance (OECD 2006). The distribution of companies depending on this new variable CG_IDX is shown in Table 12.2. To avoid overestimating the quality of corporate governance due to the interrelation between some variables, we divided the sample firms into 5 categories (i.e., 20, 40, 60, and 80 percentiles) depending on the total initial score of the CG_IDX and created a transformed CG_IDX that ranges from one (firms with the lowest CG quality) to five (firms with the highest CG quality). To measure the influence that the government can possibly exert on the quality of corporate performance in the surveyed joint-stock companies, we used two variables. First, our questionnaire provided information about government shares in the capital of the surveyed firms. This enabled us to form the ST_OWN variable, dividing our sample into three subcategories: state-controlled firms, firms with the minority stake held by the government, and private firms. There were about 20% of firms with a governmental stake in our sample (Table 12.3). Second, we had data on different forms of support that enterprises obtained from the government as well as on other formal and informal relationships

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290 Organization and Development of Russian Business Table 12.1

Construction of the CG_IDX

Questions on corporate behavior

Firm received 1 point in the CG_IDX if answer was

Share in the sample (%)

Company’s securities (shares, bonds) are listed on stock exchanges in Russia (q5)

yes

12.8

Company’s securities (shares, ADR, bonds, Eurobonds) are listed on stock exchanges abroad (q7)

yes

4.1

Long planning horizon – 3 years or more (q21)

yes

27.9

Bank credits for 1 year or more (q45)

yes

23.7

Company paid annual common share dividends all three years in 2002–2004 (q45_50)

yes

25.6

Corporate conflicts between shareholders / shareholders and managers in 2001–2004 (q66)

no

73.2

Independent directors and/or representatives of minority outside shareholders not working at the company are members of the board of directors (q67_6+7)

yes

27.3

Domination of outsiders in a corporate board (q67)

yes

45.9

Presence of experts, layers, and professional auditors in an audit committee (q70)

yes

26.4

Engagement of an international audit firm in company’s internal control (q72)

yes

8.3

Adoption of a collective executive organ in accordance with the law on JSCs (q75)

yes

34.1

Influence of shareholders meeting on key corporate decisions (q82A)

high

48.0

Influence of board of directors on key corporate decisions (q82B)

high

63.8

Source: The enterprise survey.

Table 12.2

Distribution of firms depending on the value of the CG_IDX

Value of the CG_IDX

0

1

2

3

4

5

6

7

Frequency

4

60

129

158

171

141

60 41 23

Share in the 0.5 7.3 sample (%)

15.8

19.3

20.9

17.2

7.3

5

8

2.8

9

10

11 Total

15

12

4

1.8

1.5 0.5 100

818

Source: The enterprise survey.

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State–Business Relations and Corporate Governance 291 Table 12.3 State-controlled companies and firms with a minority stake held by the government Subcategories of the ST_OWN variable

Frequency

Share in the sample (%)

42 99

5.8 13.7

Firms under state control Firms with a minority stake held by the government Private firms

583

80.5

Total*

724

100.0

Note: * There is a lack of data on the ownership structure for 98 firms Source: The enterprise survey.

between the government and the enterprises in question. Relying on this questionnaire data, we built a variable expressing the proximity of enterprises to the government POLCON (from this viewpoint, our approach is close to that of Faccio (2006) and other studies of “politically connected firms”). Table 12.4 includes nine questions on relationships with the government and obtained state support, and Table 12.5 presents the distribution of firms depending on their score on this new variable. To avoid the overestimation of political connection, we divided the sample in the three categories depending on the total score of the POLCON Index. Both variables are highly correlated with our dependent variable CG_IDX (Table 12.6). There is also a high correlation between ST_OWN and POLCON (Pearson Chi-Square, p

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