Western Capital vs. the Russian State: Towards an Explanation of Recent Trends in Russia's Corporate Governance (PCEE 63) Stanislav Markus

The literature on corporate governance in Russia stresses the abuse of shareholder rights in the face of various asset-diversion tactics by the management. Attributing this fiasco to a number of structural obstacles and the privatization legacy, the orthodox account fails to incorporate - let alone explain - the recent data demonstrating a qualitative improvement of corporate governance in crucial segments of the Russian economy. This paper disaggregates corporate governance into specific institutions and examines their quality at the firm level as well as by sector. The data supporting the analysis is drawn from recent studies by the OECD, UBS Warburg, CEFIR, and other organizations. The causal inference presented in this paper critically evaluates the impact of foreign capital on the improved corporate governance in Russia's blue-chip firms. The paper presents two alternative state-centered scenarios to explain the implementation of internationally accepted standards of corporate governance by Russia's big business.
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   Center for European Studies Central and Eastern Europe Working Paper No. 63  Western Capital versus the Russian State: Towards an Explanation of Recent Trendsin Russia’s Corporate Governance by Stanislav Markus Ph.D. Candidate, Department of Government,Harvard University Email: smarkus@fas.harvard.edu  Abstract  The literature on corporate governance in Russia stresses the abuse of shareholder rights in the face of various asset-diversion tactics by the management. Attributing this fiasco to a number of structural obstacles and the privatizationlegacy, the orthodox account fails to incorporate–let alone explain–the recent data demonstrating a qualitative improve-ment of corporate governance in crucial segments of the Russian economy. This paper disaggregates “corporate govern-ance” into specific institutions and examines their quality at the firm level as well as by sector. The data supporting theanalysis is drawn from recent studies by the OECD , UBS Warburg, CEFIR  , and other organizations. The causal inferencepresented in this paper critically evaluates the impact of foreign capital on the improved corporate governance in Russia’sblue-chip firms. The paper presents two alternative state-centered scenarios to explain the implementation of interna-tionally accepted standards of corporate governance by Russia’s big business.    1 Introduction Scholars, policymakers, and investors alike increasingly view corporate governance 1 as thenew benchmark of competitiveness. The focus on corporate decision making and control pertainsespecially to transition economies (Guy et al., 2000). Corporations as fundamental economic unitspooling capital and maximizing profits were absent in the socialist economies, and the ensuing cog-nitive shift on the part of all stakeholders should not be underestimated. Domestic shareholders– having received their shares virtually for free during mass privatization–need to recognize their rolesas owners and “principals,” while managers–having engaged in asset diversion during privatizationand accustomed to running the corporations as their personal fiefdoms–need to realize their respon-sibilities as “agents” of the shareholders. Today’s transition economies are often caught in a viciouscircle of absent rule of law, ineffective government, and mismanaged opaque corporations. Hence,more accountable and transparent corporations can be expected to have spill-over effects on society.Good corporate governance is also imperative for the development of equity markets and the effi-cient allocation of scarce domestic savings: the value of shares depends in part on the investor pro-tection, and unless the shares are expected to generate adequate returns, equity markets are likely toremain rudimentary. Finally, sound corporate governance is associated with larger foreign investmentthat, in addition to the badly needed capital inflow, can assure technology transfer via FDI and theeffective monitoring of management via institutional investors’ participation in portfolio acquisitions. This paper examines corporate governance in Russia since the end of the 1990s. Ample lit-erature has been generated on the  failure  to establish effective mechanisms of corporate governancein Russia due to botched privatization, the inadequacy of the legal framework and enforcement, andthe insiders’ hostility towards corporate control by firm outsiders. Using the recent data from OECD , CEFIR  and other studies, I provide a more nuanced account which disaggregates “corporate govern-ance” into specific institutions, and outlines their prevalence in various economic sectors and com-pany types. The crucial puzzle emerging from the paper concerns the adoption of international cor-porate governance measures by the managers of blue-chip corporations that provide the bulk of Rus-sia’s GDP . My argument is that the conventional attribution of this phenomenon to the firms’ needfor investment is insufficient. Instead, this paper offers a political state-centered explanation whichlinks the corporate governance ‘fashion’ among Russia’s top firms to Kremlin’s assumption of amore active role in the economy. 1. Corporate governance in Russia – orthodox pessimism  Two models of corporate governance have figured prominently in the literature (Aguileraand Jackson, 2003), neither of which has taken root in Russia. The “outsider” model prevalent in Anglo-Saxon countries with dispersed ownership stresses liquid capital markets  as the disciplinary mechanism for managers: owners can easily sell their shares which could prompt a hostile takeoverand replacement of the incumbent management. 2 For Russia, the outsider model is rendered irrele- vant by the illiquidity of capital markets, unenforced property rights, prohibitions against transfers of assets such as land, as well as the discretionary enforcement of bankruptcy legislature (Sprenger 2002,19-20). Conversely, the “insider” model typical of continental Europe and Japan where share owner-ship is more concentrated emphasizes relational monitoring via company-internal mechanisms  , e.g. via thepresence of large stakeholders on corporate boards, such as banks that rely on private information 1 Corporate governance is usually defined as mechanisms for “actual repatriation of profits to the providers of finance” (Shleifer and Vishny, 1997). I adopt a slightly broader definition: corporate governance reflects theability to control decisions and cash flows through formal or informal channels in a given corporation. 2  This ideal-typical definition is qualified empirically by the rise of institutional investors in Anglo-Saxon coun-tries which pool capital from dispersed owners and exert considerable control over management, especially inthe case of private equity firms.    2 and “voice” rather than the arms-length transactions and “exit” in the outsider model. In Russia, theapplication of the insider model is thwarted by the opportunistic approach to asset management by Russia’s corporate stakeholders, who generally do not take a long-term interest in the firm as a com-munity, undermining trust on which relational monitoring is based (Buck, 2003). A long list of causes has been suggested for the fiasco of Russia’s corporate governance, with privatization as top culprit. The engineers of the 1992-94 voucher privatization of circa 15,800enterprises (Boycko et al. 1995, 106) coopted the insiders, i.e., managers and workers, by allowing them to purchase 51 percent of shares in their respective companies (Shleifer and Treisman, 2000). This option, chosen by 73 percent of privatized firms, pitted managers against workers in the internal voucher auctions, undermining trust among firm stakeholders (Woodruff, 2004), and led to the own-ership of 22 percent by senior management in addition to 44 percent owned by other employees in1994 (Buck et al. 1998, 93). In the process, managers used their discretion to consolidate both de jureownership and de facto control: they determined the book value of assets, diverted enterprise andstate funds for buying up shares from employees while usurping the voting power of workers’ sharesby pooling them in manager-controlled trusts or by instituting proxy voting schemes (Blasi andShleifer 1996, 101; Black et al. 2000, 1740-1). Given massive systemic uncertainty, managers usedtheir control to expropriate shareholders through transfer pricing, asset stripping, and other tech-niques. 3 The 1995-96 “shares for loans” privatization that handed over a dozen of leading oil andmetals companies to Moscow-based banks was similarly problematic: the right to manage the auc-tions for government shares was allocated among well-connected financial powerhouses such asOneximbank or Menatep, which colluded to win the auctions at infinitesimal prices. Instead of being converted into relational blockholders à la Germany or Japan, these Russian banks constituted theresult of an adverse selection mechanism in which any company adopting “good” corporate govern-ance in the overall dishonest corporate sector is driven out of the market (Guy et al. 2000, 3-4;Gaddy and Ickes 2001, 107).In 2000, 62 percent of joint-stock companies did not have a single shareholder with a stakelarger than 25 percent, while only 13 percent had a shareholder with a 50+ percent stake (  OECD  2002, 80). Such fragmented ownership structure effectively precludes the possibility of relationalmonitoring since small shareholders cannot be expected to surmount collective action problems andinformation asymmetries vis-à-vis management in a corporate environment lacking transparency. The inadequacy of the legal framework and its poor enforcement critically compounded theabove problems. Notably, until 1996 no legislation existed to regulate corporate affairs. Thereafter,the legal environment for corporate governance in Russia was largely shaped by three laws: “On Joint-Stock Companies,” effective since January 1996; “On the Securities Market,” effective since April 1996; and the law called “On Protection of Investor Rights,” effective since March 1999. Criti-cal loopholes present in this legislation (somewhat remedied by recent amendments) included theabsence of a clear definition of “interested party transactions,” the lack of personal managerial liabil-ity to prevent asset stripping, the opaque formula for net profit calculation allowing managers to uselower estimates which cost the investors $100 million per year in preferred dividends, the insufficientrequirements on disclosing ownership and formal agreements, the unduly narrow definition of stipu-lated “independence” with respect to board members thwarting effective monitoring by shareholdersand auditors, and many others (Sprenger 2002, 12-3; OECD 2002, 9-29; UBS 2002, 19).Finally, historically contingent cultural influences are cited as an impediment to effectivecorporate governance (McCarthy and Puffer, 2002). Buck (2003) argues that the traditional intrusive-   3  Transfer pricing involves purchasing inputs from management-controlled trading companies at inflated prices,or selling to these companies at below-market prices. Asset stripping is often done by transferring company as-sets to management-owned holdings and bankrupting the value-stripped firm. For more details, see Fox andHeller (1999).    3 ness of the Russian/Soviet state in the economy, its authoritarian management style, and the histori-cally speculative short-term approach of foreign investors to Russian business have generated defen-sive attitudes on the part of labor with respect to firm outsiders; such adversarial relations among stakeholders have allegedly entrenched opportunism as the operating principle of Russian firms. The verdict on corporate governance in Russia continues to be starkly negative. An EBRD working paper (Sprenger 2002, 1) contends that while the official stake owned by managers has been reducedto 15 percent, 4 “[m]anagers are the most powerful group of corporate owners in Russia.” As Figure 1shows, while corporate stakes owned by outsiders have steadily increased since 1994, the shareowned by the insiders (managers plus workers) and that owned by the state was still very con-siderable on average in year 2000. An OECD study (2002, 82) suggests that the decrease in managers’ nominal  stake reflects the transfer of shares to manager-affiliated companies and has been, in fact,accompanied by higher informal  managerial control. The figures on managerial turnover, an indicatorof market discipline on corporate governance, also seem worrisome; while the general manager hadbeen replaced in 26 percent of the larger non-agricultural firms during 1999-2001, only in 20 percentof the cases was this due to poor performance (Springer 2002, 7). Figure 1 : Ownership structure of Russian medium and large joint-stock companies 1994-2000 as % of the charter capital Source: OECD 2002, 81 While the flak of corporate governance in Russia continues unabated in the academic litera-ture (Black, et. al, 2000; La Porta, et al., 2000; Buck, 2003; Woodruff 2000; ibid, 2004), a new look atthe evidence is warranted by the need to transcend the theoretical focus on structural obstacles andlegacies, as well as the empirical necessity to disaggregate the ‘corporate governance’ phenomenon.  2. Corporate governance disaggregated – blue chips vs. “the rest” Given the radically disparate conditions facing Russia’s leading blue-chip firms in energy andtelecommunications sectors and the large mass of capital-starved manufacturing firms, aggregate in-dicators of corporate governance are often misleading. To examine the overall trend among the ‘bluechips’ in 2000-02, I use the UBS Warburg analysis, which covers twenty leading Russian corporations. The UBS rankings reflect the risk to investors present in eight categories of corporate governancesuch as transparency level, share dilution probability, transfer pricing risk, etc. Appendix 1 explains 4  According to other estimates, this stake is much lower at 7.2 percent; for an overview of data on Russian cor-porate ownership, see OECD (2002, 88).
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