i4 4o c * STUDIES OF ECONOMIES IN TRANSFORMATION Russia Creating Private Enterprises and Efficient Markets Edited by Ira W. Lieberman and John Nellis with Enna Karlova, Joyita Mukherjee, and Suhail Rahuja 15 THE WORLD BANK RECENT STUDIES OF ECONOMIES IN TRANSFORMATION No. I Country Department 111, Europe and Central Asia Region, Food and Agriculural Policy Reforms in the Former USSR: An Agenda for the Transition No. 2 Michalopoulos and Tarr, Trade and Payments Arrangements for States of dhe Fanner USSR No. 3 Country Department 111, Europe and Central Asia Region, Statistical Handbook: States of the Fanmer USSR No. 4 Barr, Income Transfers and the Social Safety Net in Russia No. 5 Country Department ImI, Europe and Central Asia Region, Foreign Direct Investment in the States of the Former USSR No. 6 Wallich, Fiscal Decentraization: Intergovemmenual Relatons in Russia No. 7 Michalopoulos, Trade Issues in the New Independent States No. 8 The World Bank, Statistical Handbook 1993: States of the Fonurm USSR No. 9 Holt, Transport Sirategies for the Russian Federaton No. 10 Fong, The Role of Women in Rebuilding the Rusnian Economy No. 11 de Melo and Ofer, Private Service Firns in a Transitional Economy: Findings of a Swrvey in Sr. Petersburg No. 12 Chu and Grais, Macroeconomic Consequences of Energy Supply Shocks in Ukraine No. 13 Michalopoulos and Tarr, Trade in the New Independent States No. 14 The World Bank, Stistical Handbook 1994: Stares of the Former USSR STUDIES OF ECONOMIES IN TRANSFORMATION Russia Creating Private Enterprises and Efficient Markets Edited by Ira W. Liebermar, and John Nellis with Enna Karlova, Joyita Mukherjee, and Suhail Rahuja 15 The World Bank Washington, D.C. Copyright © 1995 The International Bank for Reconstruction and Development/THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433, USA. All rights reserved Manufactured in the United States of America First printing April 1995 Papers in the Studies of Economies in Transormation series present the results of policy analysis and research on the states of the former USSR The papers have been prepared by World Bank staff and consultants and issued by the World Banles Europe and Central Asia Department III under the supervision of Constantine Michalopoulos. In light of the worldwide interest in the problen'4 and prspects of these countries, dissemination of these findings is encouraged for discussion and comment. The findings, interpretations, and conclusions expressed in this paper are entirely those of the author(s) and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent. The World Bank does not guarantee the accuracy of the data included in this publication and accepts no resporsibility whatsoever for any consequence of their use. The boundaries, colors, denominations, and other information shown on any map in this volume do not imply on the part of the World Banlk Group any judgrment on the legal status of any territory or the endorsement or accep- tance of such boundaries. The material in this publication is copyrighted. Requests for permission to reproduce portions of it should be sent to the Office of the Publisher at the address shown in the copyright notice above. The World Bank encour- ages dissemination of its work and will normally give permission prompty and, when the reproduction is for non- commercial purposes, without asking a fee. Permission to copy portions for classroom use is granted through the Copyright Clearance Center, Inc., Suite 910,222 Rosewood Drive, Danvers, Massachusetts 01923, U.S.A The complete backdist of publications from the World Bank is shown in the annual Index of Pubcado, which contains an alphabetical title list (with full ordering information) and indexes of subjects, authors, and countries and regions. The latest edition is available free of charge from the Distribution Unit, Office of the Publisher, The World Bank, 1818 1 Street, N.W., Washington, D.C. 20433, U.S.A., or from Publications, The World Banrk, 66, avenue d'I6na, 75116 Paris, France. AU the editors of this volume work in the Private Sector Development Department of the World Bank. Ira W Lieberman and Johr. Nellis are manager Enna Karlova, Joyita Mukhelree, and Suhail Rahuja are consultants. ISSN: 0114-997X Library of Congress Cataloging-in-Publication Data Russia: creating private enterprises and efficient markets J edited by Ira W. Liebernan ... [et aLl. p- cn - (Studies of economies in transformation, ISSN 1014-997X; paper no. 15) Indudes bibliographical references. ISBN 0-8213-3187-6 1. Privatization-Russia (Federation)-Congresses. 2. Capitalism- Russia (Federation)-Congresses. 3. Free enterprise-Russia (Federation)-Congresses. 4. Russia (Federation)-Economic policy-1991- -Congresses. 5. Russia (Federation)-Economic conditions-1991- -Congresses- L. Lieberman, Ira W., 1942- I1 International Bank for Reconstruction and Development. III. Series. HD4215.15.R87 1995 338.947-dc2O 9449067 CAP Contents Foreword v Abstract vii Aknowledgments ix 1 Introduction 1 John Nelis Part 1 Privatization 5 2 An Overview of Privatization in Russia 7 Ira VWLiebennan and Suhail Rhja 3 Privatization in the Regions: Prinorsky Krsi 35 Alexandr Vaaoux 4 Investment Funds and Pivatization 45 Mark St Giles and Sally Bv-on 5 VoucherInvestmentFund. 55 Andrei Volt and Ywi Milner 6 Techniques of Mass Privatization: Implentin the Voucher Auction Progm October 1992 to June 1994 63 JefSfey L Schwar and Zoanne L Nelson 7 Next Steps in Privatization: Six Major Challenges 75 Maxim Boycko and Andrei Shlifera Part 2 Capital Market Development 87 8 Capital Markets Development and Fiancing Russia's Trnsformaion 89 ClauiUa Morgens:emn 9 Securities Market Development and Priatization III Roger Leedr and Michael Harman Part 3 Corporate Governance and Restruc 123 10 Ownership, Governmanee, and Retructuig 125 Joseph BL ith asitacefiom Darya Hmia and Kterna Girachoxw 11 Corporate Governance during the Transition to Private Ownership 141 Leroy P Jone and Nataliakanova ComN~M 12 Restructuing Large Enterprises in Preparation for Privatization: A Case Study 159 HJkanJ. Wilson 13 Newly-Privatized Enterprises: A Survey 171 Leila Webster with Junxen Franz, IgorArtemiev, and Harold Wackman Part 4 The Emerging Private Sector: Constraints and Regulations 185 14 Constraints to Private Enterprise in the FSU: Approach and Application to Russia 187 Marie Sheprd 15 Private Sector Manufacturing in St. Petersburg 203 Leila Webster and Josrhua Charap 16 Competition Law and Policy 221 R Sbyam Kbemani Synopsis of Conference Proceedings 229 Grace Lao and John Nelis Glossuar 245 En2 Kalova Contributors 251 Russzk CnREG PB1VAE ENTmun Am EmFFcmNr MA S Foreword The role of private sector in the economic traordinary achievements by a small but tal- development of an econorny is well-estab- ented and dedicated group of reformers fished. In Russia, the task of creating a pri- who against difficult odds have managed to vate sector where none had existed for the implement the Russian Privatization Pro- better part of this century was a daunting gram. It brought together leading decision- one. The Russian pnvatizaton programmin- makers and advisors in the Russian tiated at the end of 1991 hasbeen success- privatization process to discuss issles ful in transferring ownership to private related to privatizaion, capital market de- hands and creating a critical core of private velopment, corporate govenance snd re- enterpises. By July 1994, between 12,000 structuring, and the constraints and to 14,000 enterprises large and medium- reglations affecting the private sector. sized enterprises had been privatized, and This publication is based upon papers pre- 40 mdion Russian had become sarehold- sented at thar conference ers in private enterprises. This provided the This book was prepared by the World basis for a rapidly emerging Russia capital Bank's Private Sector Development De- market partment with contributions from leading Moreover, rougly 85,000 small busi- Russian reformers, and advisors to the nesses, mosdy service establishments, were Russian govemment from the World Bank also prvatzedi This achievement was cnti- Group, academia, and the private sector. It calto demonstrate to the Russian population is intended for policymakers, development that private ownership matters significantly, institutons, researchers, and academics. and that the quality of goods and services Non-govenmental organizations may also avzilable to the ordinary consumer can be find it usefuil to learn and understand the inproved upon. It is also important because extent of reform in Russia, and she issues it begins to open the retal and service sec- that it faces in the coming years. tors o private sector entry. Moreover, it pro- vides employment opportunities as tde vast downsizing and restructuring of newly pri- vaized enterpises takes shape over the next svrl years. Russell Cheetbam The World Bank held a conference on Director privatization and the private sector in Country Departmnt LIT Russia injune 1994 to acknowledge the ex- Europe and Cenftl Asia Region FORanwORD v Abstract Thisbookcontuinsacollecionofpaperspre- Although the Russian privatization pro- pared at a World Bank confemnce held in gram has achieved impressive results, the June 1994 on privatization and private sect uansfer of ownership (mainly to insiders) is development in Russia. It reviews the priva- only a first step. This must be followed by ti2ation achevements of Rusian reformers equally essential second steps to facilitate over the past dtree years, dismcsses emerging ownership of privatized firms to external, second-tier privaization and post-privauza- coreinvestorswhowillbringinmmuchneed- tion issue, and sumaruze the key themes ed capital, managerial know-how, and ac- iD the papers presented at the conference. cess to global markets. Between November 1991 and June The sixteen chapters in this book are di- 1994, vided into four sections: Privatization, * between 12,000 and 14,000 medium- Capital Market Development, Corporate size and large enterprses had been Governance and Restucturing, and the transferred to prvate ownership; Emerging Private Secwr: Constraints and * this set of firms employed more than Regulations. The artidcles concentrate not fourtecill mfion people, or about half of only on what has been done, and why, but those employed in Russia's industial also on what remains to be done, and how sector-, to address the critical ioes that inpede * about forty milion Rusin citizns firther refornm owned shares in privaized firms or in- ves-tment funds. ABsrntAa vi Acknowledgments 'Me editors wish to acknowledge the sup- World Bank's Private Sector Devdopment port and assistnce of the many officials- Department, encouraged the idea of the particularly from the Russian State conference and the production ofthe book. Comniittee for the Management of State The editors are also grateful to Peter Fidler, Property (GEI) and the Wodd Bank's BmceRoss-Lason, and Vimce McCulough Eastem Europe and Central Asia Region, for editorial assistnce, and to Heather CounttryDepartmentM. Thanks are due to Imboden for desktopping. Gloria Ornca- Russell Cheetham, Yilkon Huang, Michael Tettel prepared the manuscrpts, and Gould, and Constanine Michalopoulos for Susan ,Marcus with Suzanne Smith provid- their support in the publication of this ed advice on producdon. book. Magdi Iskander, Director of the AcowLMENIS ix CHAPTER 1 Introduction John Nellis Stuning accomplisments About 40 million Russian citizens had becomle owners of shares in privatized Privatization is the one bright spot in the firms. ... by the end of generally bleak Russian economic land- These achievements border on the June 1994, between scape. Staring from less than zero' in miraculous, having taken place xm the a- 12000 and 14,000 November 1991, a small, determined, and sence of consensus on the desirabllha often beleaguered group of Russian scope, and pace of lberalizing reform in medium-size and reformers-with some important external general, and privatization in partcular, and large enterprises suppor2-has been able to: in the absence of what would nomally be had been trans- * Devise and implement, in the fwce of considerd the requisite administratie andc strong resistance, a 'corporatizationm financial resources to implement, monitor, ferred to private program that turned cbout hif of and enforce a privatiation progrm of this ownership... Russian state-owned enterprises into magimde. Y fit was done. The only joint stock companies; potentially comparable privatization expe- * Persuade the most important insider riences are those of the former East skeholders who might have opposed Germany and the former Czechoslovakia privatization-workers and man- agers-to take part in the process by Comparisons to Germny and the for. offering them shares in the fims in mer Czechoslovalia which they work for free or at a low pnce; In Germany the Treu&lanswtlt succeded * Conceive and implement a voucher in putting more than 10,000 enterprises in program, giving 144 million pariipat- private hands between 1991 and 1994. This ingRussians a cance to become, along achievement anot and should not be with insiders, owners of enterprises; minimizd. Nonetheless, German privati- * Create a nationDal voucher auction sys- zation was a case of integration of a for- tern in more than 85 regions, with 750 merly socialist economy into a Lumctioning bid reception centers; and indeed flouishin& maet economy, an ex- * Facilitate the creation of some 650 pri- ercise that differs sharply from the totl vate investment funds that compete for transition that Russia confronted. In vouchers and convert them to diversi- Germanu an irreplicable combination of fled shareholdings in newly privatized West German lgal and administrative in- enterprises. stiturions, West German managers, and The result is that by the end of June West Geman money eased many of the 1994, problems of the itegrtion. * Between 12,000 and 14,000 maedium- The mass privatization program of the size and large enterprises had been former Czechoslovakia, which transferred tanferred to private ownership; 1,491 firms into private ownership in 1992 * These firms employed more than 14 and 1993, with a 'second wave coming in million people, or about half of those both successor states that ill touch an ad- employed in Russia's industrial sec- ditional 1,300 firms, is the best and per- tor;,and haps anly comparator to the Russin frnoDucnDN prvatizarion program. The Czech and different initial conditions, the period of Slovak privatizadon programs arc remark- "extraordinary polidcs"4 was both shorter able achievements. Indeed, a few Czechs lived and less intense than in other have suggested that their privatization economies in transition. This point must method is superior to Russia's since no spe- be grasped, both to comprehend how tm- cial inducements have been given to insid- ly impressive Russian privatization results ers. Outsiders, in the forn of external have been, and to understand why the investors and investment funds, have Russian process has unfolded as it has, played a major ownership and governance with the defining characteristic being the role from the outset, and some Czech prac- provision of financial rewards or equity titioners and extemal observers now riti- stakes to all the various actors and agen- cize Russia for not having followed the cies involved-meaning that the approach Transfer of same course. was thoroughly decentralized.' Had the ownership to Without disputing the impressive Russian reformers attempted to follow the im.ders was a Czechoslovakian achievements, it has to be Czechoslovak route of centralized admin- insiders was a stressed tbat Russia embarked on privatiza- istration of the process, and had they tried striking step.... tion in circumstances very different from to treat enterprise insiders as one poten- External investor those of the former Czechoslovakia. First, tial purchaser like any other, it is likely that wilcomplete the pr-communist Russia in 1917 was marked- little privatization would have occurred. ly different from pre-comumunist Czech- restructuring of oslovakia in 1948; it was less industrialized flat happens next firms begun by the and less capitaliste Second, the lengh of the communist period in Russia was almost The Russian privatization team thus opted transfer of double that in Czechoslovakia, meaning for the method that they judged would ownership. that in Russia collectivist approaches and yield results--and they got them. But as a habits had more time to take root and be- consequence, the results were tentative cme decply ingrained. Third, and par- and partial. Tansfer of ownership to in- doicaly, Czechoslovakia benefitted from siders was a striling step, but only a first an abscnce of refonn communism. Unlike step. It must now be followed by equally Hungary, Poland, and to some extent essential second steps opening ownership Russia, Czechoslovalda basicaly main- of privatized finms to external investors tained the central planning system until the and owners. These, in turn, will bring very end. The successor governments thus needed capital, market access, managerial have not had to debate the scope and pace know-how, and a bottom-line mentality to of liberalizing reform with entrenched, de- privatized companies. External investors cenralzed stakeholders such as the will complete the restucturing of firms Solidarity movement in Poland, the work- begun by the transfer of ownership. A sig ers' councils in Hungary, or the relatively nificant percentage of restructured firns empowerd enterprise managers, members will become profitable as well as national- of cooperatives, and leaseholders created in ly and internationally competitive, and perestrica Russia. The inheriting regime in Russia will be well launched on the process Czehosl ia in 1990 was less con- of growhi and integration into the global strained by decentralizing forces than al- economy. Such is the hope. most other successor regimes in Eastem and Central Europe--cirumstances of Issues to be resolved which Valav Klaus and his reform team have made the most.3 To put it mildly, much stands in the way of All in all, the obstes to Russian priva- the achievement of this grand aspiration. tization were more numerous and more Ignoring the evident macroeconomic and daunting than those encountered in Ger- macropolitical deficiencies of present-day many and Czechoslovakia, or indeed in any Russia, and concentrating solely on the other country that has serously embarked privatization process, one encounters a on the process. In Russia, because of these number of critical issues and questions: 2 RussLL CREATING PvAnE ENTsRmrs ND ErrxmENT MAr= * Insiders fear that the restructuring sate into businesss? Who willftnd and brought about by extemal investors will provide these resouwres? And what pdral- cost them their jobs, thus they do their let refbrms are required in tshe financial best to prevent or minimize sales of sector and capital market development to large blocks of shares to external in- support these actions? vestors. What are ';e mechanisms by Important as privatization is, it is only which secondary trding, leading to a part of the transition process, along. rafuctcaring, will be ampified and side new entrants and greenfields in- entrenched? vestments. What does Ab nonprivadzed * The voucher scheme expired on June private sector look like, and how, ifetalt, 30, 1994. The currcnt political con- do its activities differ fmm theprivatied figuration will apparently not tolerate sector? a second voucher issue. However, Small-scale 12,000-14,000 enterprises remain un- Approach of the stuuy privatization corporatized, unprivatized, and lackin, the voucher mechanism to spur their These are the many complex themes ad- schools both new divestiture. What will happen to this dressed in detail in the chapters of this owne and important set of firms? book. The authors are, without exception, cosumers in * Small-scale privatization in Russia is actors in the privatization process, either impressive in absolute terms (with as officials of the Russian Government, marketeconomic some 85,000 small business units di- advisors to the Russian privatization body and has proven vested), but lags relative to sirmilar pro- (the State Committee on Property Man- citical in job grams in, Poland, Hungary, Estonia, agement or GIN, as it is known from its and the Czech Republic, where a much Russian initials), officials of international cr"Mon.*. larger percentage of the entire small- financial institutions working with the scale base has been divested. Small- GKI (half of the authors in this volume are scale privatization schools both new staff of the World Bank or the Inter- owners and consumers in market eco- national Finance Corporation), university nonics, and has proven critical in job professors on contract to the GIG, or staff creation, essential to the absorption of of private sector consuting firmns em- surplus labor flowing out of the large ployed by the GKL One author-who enterprise sector. /by has Ruia exbib- heads an investment fund in Moscow- ited this comparatively poor perfoenmnce comes directly from the emerging Russian regarding small-scale privatization, and private sector. what does it meanforthe economicfuture Given the active roles of the authors, ofth. counry? the volume is as prescripdve as it is analyt- * Twelve to fourteen thousand medium ical; that is, chapters concentrate not sim- and large firms aie now in private ply onwhat was done and why but on what hands. But there are few who believe remains to be done, on the questions listed that their future operations will be left above that have not been answered, and on entirely to determination by pure mar- how they may be resolved In addition, the ket forces, since the current Russian volume contains a detailed summation of variant of the market deviates so the proceedings of a conference held in sharply from the textbook modeL Pdi- Washington, D.C., onJune21-22, 1994, in vatizedfirmsurgentlyrequiretechnical which the draft versions of the chapters assistance (to help in the preparation were presented and disussed and in which of business plans and in restructuring), presentations on the accomplishments and creit to finance working capital, remaing problems of the Russian privati- trade, and investments, and equity in- zation program were made by Anatoly jections to provide both long-term Chubais, Russian Deputy Prime Minister, money and active governance. How by Maim Boycko, President of the Russian can thse needs be met in a manner that Privatization Center, and several resident does not reinroducetbe heavy hand ofthe advisers to the GKL bIn7ODUCIZON 3 Thc thrustoftlhese presentations bythe need for reform in all these areas is direct pracutioners was threefold: acute, and considerable actmty is under Russia's voucher-led mass privatization way. However, a recuning theme in the program, without precedent in terms of conference, on which there was umrver- size and speed, is a major success. Why? sal agreement, was that the priority mat- Because the links between the enter- ter was the development of capital and prises and the state have been severely securities markets. This is seen as critical frayed, if not yet totally cut, and a mass to assist investors in acquiring property of property owners-who, presmnably, and protecting savings and to address will support further reform-has been theproblem of improved corporate gov- created. The first and overarching goal enance in the privati7ed firms. of the procss, to make reform irre- Privatized firms veible, seems to have been achieved. urgently require Iitial inquiries into the behavior of Not firms after sale reveal that rescutumnng tecbnica fis after sle reviea ta rroduct 1. Less tan zero in dLe sense that the reforders ts.under way as evidenced by product rie not id simply with the privatization of a assistance..., diversification, labor shedding, ani mass of state-ow entexprises, but also had to credit, . ..and changes in top management. deal with the quasi-pvate entities liat had been * The nxt stage of pivatization will eai craeddingthelatep oM aperiod SeeJohn equity injections... seling the remaining shares and the re- Nelis, 1991,. inproving the Fbrfonrance of Soviet muining thousands of enterprises for Enterpuises", Word Bank Discssion Papers 118, cash, tugh auctions nd der The Vsbing D.C goverment proposes that a subsantial 2. From the G-7 countries through biateral pro- amount of the generated cash remain in g! and lfom the Eurpean Bank for Remn- st"uc"on and Development, the World Bank the firm to finance needed restructur- Group, and EuSanCommu Equaly un- ing. To increase the attrctveness of porut, the Russin pvan aon zen knew how firms to investors, the real estate on to put these exernal resources to effctive use. which the company sits must be clearly 3. One potentilly massve set of decentralizing tradable and clealyindudedinthe deal ficts that std m 1990-the federal nature of This approach will address essen!ial the state and the tensions betwem the Czech and needs of newly privatized im, but wi Slak triries-s, of aco been resohled by ncoessatly be a slower process thm the dissolution of the federation. mnecessarily be a slowerekrocessthan 4. The phrase IS born Leze Balcerwicz and transfer through voucher auctions. And 4Tpas is om in onLe aselret it has already provoked vehement op- Econumy. A Three 1ar Nrspectie, paper pre- poson from regional govnments and seted t the IWord Bank's Annual Bank Con- municipalities, who see the new ap- ference an Devlopment Economics, Wx(shingom, proach as a threat tothi lucrative con- D._C Apri 19949 The audhs ague xt a perod trol over local real estate In mid-Jl of oexnldina ps occurred in a number of 1994, the Russian Pamament reected Eastern and Central Eurpea cuntries when the old commuus ektes were discrdited, but deve- the proposed second phase program, apeingroupswcre few fragmented, anddis- bUt it was promptly promulgated by a pre.,& mis T aowed e ng rhcbc to presidmential decree trake command, greody raising the -pr ity A fidmental contc ution of the mass difficult, normalmy contovs, ecoom policy pNvatization progam has been its ca- muse wiibe accepted (p. 11).The periodlas, pacity to reveal thc need for and spur re- sy the authors, for one ortw years, and then pol- form in other aspects of the enomy. itics as usu tend to rein their supremacy form i othe, laspe of the econrom 5. Given the complex of the progmam and the Lglreforms, land privtzation, pro-. , , , ,, , ,,P lackofpoRtcalconsenustwasirnperativethatthe tection of sharehokler and creditor . be d ired; pivatiation coul not rights, social safety net reforms, and the Lmemac mi.predwio&ntheaciveinvov- closely relatedisse ofhow to dispose of ment of the regnal and local autoities and the ancllary or social assets of finms-the rqional voucher auctons. 4 RussH: CREATING PuAnE mnERmsEs AND EFrICENT MAmrr Part One PRIVATIZATION CHAPTER 2 An Overview of Privatization in Russia Ira W Lieberman and Suhail Rahuja Russia's size makes its privatization pro- enterprises in this industy has proceedd gram probably the larg sale of assets ever slowly and infornnly, away from the publc conductae From December 1992 to glare. An analysis of the privatizarion of In Russia, large- February 1994, nearly 9,500 large-scale en- these enterprises-which, in any event, has scale enterprises terprises, employing 11 miflion people, been limited-is no within the scope of have been privatized were pnvatized, creating 40 million new this paper. shareholders. The speed with which the As the fist counatry to embrace com- essentuilly by a program has been enacted is ipressive munsm, Russia has an industial and com- closed subscripton given Russia's recent political turbulence meral base that is more eavily distorted to the employees and its dire macroeconomic pformane. by communist planning than most. This Indeed, these numbers wil rise even high- section of the chapter begins by highlight- followed by an er by the end of the voucher auction pro- ing some of the most salient points of the open voucher gram in June 1994. environment in which the Russian piva- ation. Thi chapter describes the design, iu- zationprogranhasbeencamedoutktdis- plementation, and progress of the Russian cusses the degree of state ownership and large-scale privatization program. The pro- indusial concentration that existed in the gram is the centerpiece of Russia's formal Soviet Union (and by proxy in Russia) pri- privatizaion process. In contrast to other or to the collapse of communism. formerly communist countries, which have Puivatization is always an intensely po- used a variety of methods to achieve their litical process and nowhere was this more privatization goals, Russia's reliance on a true than in Russia. To understand why large-scale mass privatization program has managers and workers were able to influ- imposed a high degree of conformity on the ence the privatization program in Russia to privatization prcess. In Russia, large-scale the degree that they did, it is necessay to enterprises have been privatzed essentially understand the poliical forces unleashed by a closed subscription to the employees by the Gorbachev reforms. Thus, this sec- followed by an open voucher auction. In tion includes a brt.:f introduction to this respecr, it differs from the Czech and Gorbachev's economic reforms.' It also Slovak Republics and Poland, where a provides ahighlyabbreviatedchronologyof menu of privatization techniques (such as the majorRussian privatizationlaws, aswl IPOs, tade sales, muuala fund schemes) as a description of the major institutions re- was part of the overall privatization pro- sponsible for enacting privatization- gram. The uniformity in the method of pri- The second section covers the basic aim, vatization not only captures most of the scope, and structure of the privatization ways that large enterprises in Russia have program and compares and contrasts the been privatized, but also explains the speed Russian program with the Czech, Slovak, of privatization. and Polish schemes. It then describes each Not all Russian enterprises, however, of the programds major elements: corporati- have followed the prescribed privatization zation, vouhers, open subscription, vouch- route. Russia's significant defense indusu, er funds, voucher auctions, and the public for example, has been excluded from the information campaign. The next section privatizauion program The pnvatization of provides the latest data on the progress of AN C0EI OFPRWAtrZAm[oN Ix RusSA 7 the program, as well as recent evidence on matically increased the scope and complex- the low values currendy being placed on ity of the privatization program, as wel as shares sold thmugh voucher auctions. It al- the need for an effective post-privatization so summarizes preliminary research on ini- corporate govemance system. ial trends in share ownership after voucher auctions. The last sections highlight devel- Gorbachev's reforms opments in Russia's capital markets and provide brief remarks on foreign invest- Gorbachev's reforms of 1985-90 were the ment in Russia. first systematic attempt to dismande the central planning apparatus. The reforms The industrial legac had considerable impact on the privatiza- tion program. The broad aims of the re- Privatization is Until the Gorbachev reforms of 1985, the forms were to transfer decisionmaking always an intensely USSR followed a dassic central-planning power from the bmnch ministries and the political proces systm. The state played an overwhelmdng central agencies to enterprise managers, potwcas process mrole in the econorny In all Eastern bloc and to allow (and encourage the formation and nowhere was countnies, the scte was the dominant eco- of) nonstate forms of enterprises. this more true than nomnic player, but there was a notable van- Enterprise managers' new ights were ation between the USSR and Eastern bloc laid out in the 1988 Law on State Enter- in Russta. countres. In the Soviet Union it has been prises. Managers were given leeway to re- estimated that in 1985, 96 percent of the tainand allocate internallygenerated funds net material product (NNP) was produced (partcularly for wages and bonuses), by the state sector (Milanovic 1989). In change product design, expand into foreign 1984 in China, the figure was 82 percent markets, seek foreign joint venture part- and in Hungary, 74 perceat. Only the for- ners, and borrow from outside the official mer Czechoslovalia and East Germany funding sources. Most important, manda- had higher figures-97 percent (1986) and tory production targets were replaced with 965 percent (1982) respecively. It has "state orders." Enterprises were now free, been estimatedthattherewer 47,OODfstate after fiulfiBing state orders, to produce and enterprises in the USSR industrial sector? sell as much output as they could. Initially, If energy and large service firms are indud- this meant little, since state orders covered ed, the total rises to 55,000. 90 percent of industrial output. State or- Soviet state enterrses were large and dens, however; were progressively curtailed monopoisdc Of the 7,664 product groups and managers were given real power over distributed by the former Soviet Gossnab output decisions. And from 1989 on, (Committee of Deliveries and Supplies), 77 branch ministries were reduced and reor- percent were produced by just one fimL ganized, considerably restricting their pow- The high degree of industrial concentration er over state enterprises. These ministries r-d the size of the Soviet market meant that have since sought to reassert themselves (as Lnc average Soviet enterprise was far larger holding companies, Joint stock companies, than its counterpart in either the Western or trade associations, and so on), forcing the Eastem bloc.3 The average number of erm- privatization program to require corporati- ployees for the largest 952 firms in manu- zation at the lowest institutional level. factring and energy was over 8,500; the Cooperatives and leaseholds were per- average for all 25,000 enterprises in these mitted from 1988, and small private com- sectors was 821, ten times the equivalent panies, limited-liability companies, and figure for a range of Westem counties. The joint stock companies were permitted from larget enterprises in the former USSR (AV- 1990. Cooperatives were frequently sub- TOVAZ, which produced cars, and KA- contractors or spin-offs from state enter- MAZ, which made trucks and tractors) each prises and were often set up to exploit employed 100,000 employees. This indus- privileged access to scarce goods. Likewise, trial legacy of a high degree of both state leasholdings were usually subunits of large ownership and industrial concentration dra- state enterprises. Groups or workers would 8 Russu: C(EATNG PirvmE Nmm'm ANm EncINir MAnS lease space and equipment from their state by Grgory Yavlinsky and Stanislav Shatalin enterprse. Leaseholders were free to accu- in mid-1990, had mentioned privatization mulate new assets through retained earn- but had never contained a detailed program. ings or bank loans, with these assets These packages were ultimately abandoned. becoming the property of the leaseholders. Although the 1991 law has since been Agreements to buy out the leased assets amended, it remains a blueprint for privati- were also common. A recent survey of pri- zadon. It lays down procedures, outlines the vate sector manufacturing activity in St. organizational infastmrurc for implemen- Petersburg shows how a cooperative or tation. and mandates a detailed annual pri- leasehold functions in practice.4 vatization progranm Even at this early stage, As intended, Gorbachev's refoms the law foresaw workers receiving discount- transferred power from planners to work- ed shares in the enterprise in which they ers, managers, and regional authorities. worked, state enterprises convertng into The first steps What was not antidpated was the manner joint stock companies, and vouchers being toward privatiation in which these groups began to exploit their disibuted. But given the poitical turbu- w the new-found freedoms. State enterprises be- lence and uncertainty generated by the coup were th gan rapidly increasing workers' wages, in August 1991, the breakup of the Soviet Gorbachev bonuses, andwdfare expenditures. This led federation, and ietsins tial focus on govenment in Jly to a sharp decline in after-tax profits remit- macroeconomic stabliyt litde was done to govenm ted to the state and a federal budget crisis. establihthenecessarylegalandcinstitutional 1991. Spontaneous privatization became pre- frmework required for privatization. Not valent as managers began to divert profis surprising1 byJanuary 1992 the number of and assets bodtlegally (through cooperatives enterpnses transferred to prvate and collec- and leaseholds) and ilega4y. The demise of tiveownershiphadreachedordy70and922, the Communist Party and its associated or- respectively (Chubais and Vxshevskaya gans of control made this possible. This 1993). process accelerated in 1991 as employees The pratization program as it unfold- usodthepurchaseoptioninleaseagreements ed in 1992 and 1993 was heavily influenced with a new right to set up joint stock compa- by the differences between the Yeltsin pres- nies, often buyng leased assets at book val- idency and the Russian parliament. The ues-a fraction of their true value Simllady, parliament acted as a remnant of the com- local authorities took control of ifatruc- munist past and an obstacle to smooth pas- ture in their area (water, electmcty, and so on) sage of the program. Quarrels over the anddemandedcontroloverenterpnseswith- form and speed of the 1992 privatization in theirurisdiction. Governments at aUllevels program erupted throughout the first haIf lost many of their ownership ights to enter- of the year Significant compromises were prses, which had been ceded to workers, made to the anti-reform camp m the pas- managers, and local authorities. Russias sage of prvatization legislation through mass privatization program, bynecessity, had Parliament. The 1992 annual privatization to recognize and incorporate these new and program itself was not passed until mid- competing ownership claims. 1992.5 A large number of other enabling decrees and laws covering details we is- Legislative and institutional framework sued from 1991 onward. Topics covered delineation of ownership between federal The first steps toward privatization were and local authorities, the corporatization taken by the Gorbachev govemment in July process, vouchers, investmnent funds, auc- 1991, when the former Soviet Union tions, tenders, and other sales procedures. Supreme Soviet passed a law on "he Basic Along with progress on the legisiative Foundations of Denationalization and Pri- front, an institutional infrastructure was al- vatizationofEnterpises."Anequivalentlaw so established. The State Committee for was passed by the Russian Supreme Soviet a the Management of State Property (known few days later Previous refim padkages, as the GKE) was reoriented to drive for- such as the "500 days" program put forward ward the privatization program. The Gla AN OVERIEw OF PKIvATinON iN RusSn& 9 is responsible for formulating and imple- 20,000 medium-sized enterpises the op- mentngpvatzatonpoiqmIthasalsobeen tion of joining the program. These figures responsible for preparing arnual prnvatiza- underestmate the true numbers. Data on tion programs, drafting privatzation laws the number of large and medium-size cn- and decrees, distibuting voudhers, licens- trprises prior to privatization are sketchy ing investment funds, and enforcing priva- and durng the course of the pnvaization tization legislation. The GK1 is supported program some enterprises split into smaler by regional (oblast) and municipal sub- independent units. Russia's privazation sidiries (KEs) attached to local or munic- programs dwarfs those in the Czech and pal administrations. The head of each oblast Slovak republics and in Poland. In the first is nominated by the govemor of the oblast wave of the Czech and Slovak mass privati- for approval by the central GKL The head zations, 2,776 enterprises wer sold, of The privaization of each municipalK[ is appointed by the lo- which 1,492 were pivatized in vucher auc- program as it cal mayor. Regional and muncipal propery tions. In the second wave, 900 enterprises unfolded in 1992 ancommittees ensure that each state enter- are to be pnvauzed m the Czech Republic. unjOiaea in 1992 prise sets up a pivatization commission, In Poland, 600 enteprises are to be priva- and 1993 was produces a privatization plan, and is later tized in the mass privatization scheme.6 heavily influenced colporatized. Only the privatization of more than 10,000 r the -rThe Russian Parliament, in an effort to firms by Germ anyys Treubandtak comes oy dneazfferences exercise greater contml over the pnvatza- near to Rusan totals. The admative between the Yeltsin tion pmgram, created a rival agency tothe complerity of the Russian program was fur- presidenCy and the GXI, the Federal Property Fund, which re- ther compounded by the inablty of the ported directly to the ParliammtL In addi- centertocontrol,forbothtecdhnologicaland Russran paruament. tion to the Fcderal Prperty Fund property political reasons, the oblasts (property com- funds were created at the local and munici- mittees and property funds). With eighty- pallevL The heads of oblast property fbnds eight oblasts, the program had to be were appomted by and reported to oblast decentralized, as opposed to the Czech, sovets until the latter were abolished in Polish, and Gemn schemes, which were October 1993, following the faled coup. tiWy administered on a national leveL In These property funds assume the stats comparison with the Czech or Polish pro- stae in an enterprise from the GCI or XE grams, the Russian mass privaiization pro- (as relevant) after corporatization of the en- gram has been a much more complex erprise. The local propery find exercses political and lgical operation. ownersip ights on behalf of the state and is responsible for the management and dis- Prinls persalof the state's remaining stake, such as publshig the legal notice announcing an In drafting the Russian program, reform- auction and distrbuting property tides. ers focused on a few key principles: TensionhasarsenbetweentheGMlandthe * Speed. As the power of the center re- FederalPropertyFund,compoundedbythe ceded, mnanagers and workers found overlap in administrative roles. Infighting, themselves in a governance vacuum. however, generally has not filtered down to On the one hand, the best assets were the local or municipal leveL Indeed, coop- be:ing systematically looted by sponta- eration between the local and municipal neous privatizations. On the other, the property committees and property funds is state was bailing out loss-making en- the norm, and this has ensured a measure of terprises (either direcdy through sub- continuity in the privatization procss. sidies or indirectly through financing by the state-owned banks) on such a Mass privatizaion pogm scale that macroeconomic stability was threatened. It was therefore es- usias privatization program is exmdy sential to establish a privatization pro- ambitious. It entails privatizing some 5,000 gram by which many firms could be large state enterprse and gives 16,000 to quickly privatized. 10 Russr cuairrGo PmnA EmmEusEs Anm EFpprnrMmrls * Transparency andfairness. Proper regu- * The creation of financial intermediaries lation and procedures were required to and institutions; and ensure that each privatization was ad- * Voucher auctions. equately reviewed, that a transparent Like the Czech and Slovak scheme, environment was created, and that the Russian scheme was "bottom-up."The bidding was as fair and competitive as state's privatization role is limited to possible. providing enterprises with a conceptual * Political feaibility. 'Tere had to be framework and common privatization do- enough incentives to ensure the sup- cuments and to reviewing and approving port of all directly-affected stakehold- the plans submitted to them. Moreover, as ers (workers and managers) and of with the Czechs and Slovaks, Russian in- those who irnplemented the process dividuals and firms are free to start up (oblast authorities), voucher finds that can accumulate vouch- Russia's * Poltical popul4ity and equity Market ers and bid for enterprises, subjecrt o min- privatitation reforms have led to a marked decline in imal criteria. living standards for most Russians. It There were, however, substantial differ- program... entails was important to offer incentives to the ences between the Russian and Czech and privatizing some general public. If pivatization were Slovak programs. Russian managers and 5,000 large state successful, it would be the first reform workers won substantial privfleges not avail- that would bring benefits to the gener- able to their Czech and Slovak counter- enterpnues and al public through short-term financial parts. They secured big (often majority) gives 16,000 to rewards and access to goods and ser- shareholdings in a "dosed subscription" be- 20,000 medium- vices. Reformers had to create a large fore equitywasputup forgeneralsale. They and powerfu constituency that would were also able to ensure that outsiders sized enterprises the have a vested interest in ensuring the played a far smaler role in Rusin mass pri- option of joining continuance of economic reforms. vatizatior. than they did in the Czech and the program. - Den The program had to stimulate Slovak Republics There was no scope in demand for assets as public savings are Russia for outsiders to submit altemative too low and foreign investment too un- privatization plans to the authorities as certain to ensure that more than a small there was in the former Czeciosovakia. fraction of the assets on offer can be Manydifferent and competingprivatization sold, even at book values unadjusted alternatives emerged out of the Czech and for inflation. Slovak mass privatization scheme, such as • Decen&azraion. The program had to voucher auctions, direct sales, competitive be 'bottom-up" in approach-that is, auctions and tenders, and combinations enterprises had to carry most responsi- thereof In Russia, the most common way bility for developing their privatization for outsiders to participate in privatization plans. Moreover, implementation and has been through a voucher auction, an ef- supervision of privatization had to be at fective way of dispersing outside share own- the local level. ership and, as a consequence, of limiting * Gouernance. Privatization had to inns- and Mduting their influence. Finail; in fer stae assets to economic agents with Russia there was no single grand Czech- both the incentives and the expertise to style auction in which the shares of a thou- undertake the restructuring required to sand or more enterprises were allocated at build a healthy and profitable economy. once and in which all voucherholders were free to bid. Russia's size, the number of en- Framewvork terprises up for sale, and the lack of a com- muniations network made such an auction To reconcile these objectves, the large- technically diffiulL Further, the autonomy scale privatization program was built on: each enterprise and oblast had over the * A mass privatization program; speed of the prvatization process meant * The distribution of privatization that a single grand auction was also politi- vouchers; cally difficult. An attempt to hold such an AN OvERVEw Or PRATON W RussIA 11 auction would have led to lengdty delays in rubles as of January 1, 1992. Medium-size the privatizaton process. In Russia, most enterprises were defined by exdusion. enteprises are auctioned a few at a time by Small enterprises follow a different privati- the local property fund to voucherholders zation procedure than large enterprises. who live in the region over a period of time Most small-scale enterprises are owned by determined by local players. In 1993, a municipal authorities who are responsible voucher depository network and a national for their privatization, whereas most auction center were established that helped large-scale properties are owned by the fed- mitigate the parochial nature of auctions. eral or oblast authorities. Further, although Russian policymakers rejected the federal authorities are responsible for the Ctop.down' approach of the Polish voucher privatization of federal properties, oblast scheme because of three main concerns. property committees and flmds carry out A series of laws First, the Polish scheme emphasizes allocat- thte tasks of prvatzing federal properdes, passed by ing a sdected group of enterprises to twen- getting the approval of the GKI or the tr or so government-sponsored investment Federal Property Fund before proceeding Parixnent ing funds. The finds in Russia codd easiy with the prnvattion. All enteprises, 1991-92 evolve into a powerful constituency arguing whether federal, local or municpal, large or categorized state for subsidies and cheap credits for the com- smalL were allocated to one of five broad panies they managed, effectvely hindering categories in the 1992 state pgramuL property as federal, the efficient and speedy restcuing of local (oblast), or these enterprises. Second, in the Polish Mandatory pnativzaio This includes municial and scheme enterpises essentially play a pas- firms in wholesale and retail trade, con- -r sive role in the privatization process. In struction and construction supply, food allocated Russia, the ifluence manger andworkers processg light industry, textiles, frni- responsibility for have made such an approac unfeasible, ture, agricultural prduce, road transport, and the privatization process has tocdirecty and all loss-making enterprises (except pwvatization to incorporate their intrests. FinalW the those that faU into one of the other cate- property Polish scheme requires a delay of eighteen gories). Most small-scale enterprises fell committees and months or so before vouchcrholders can into this category, togete with some property 4iuus at convert their vouchers into the shares of 5,000 large enterprises. By having a the appropriae .mutual funds, and an unspeifed time will mandatory categoy, the Russians created a the appropriate elapse before citizens can directly hold eq- pipeline of firms to be privatized. This put leuel. uiy m the privatized enterprises. Thus, the pressure on oblast authorities to begin pri- political benefits of involving the general vatization as quiddy as possible. public in the mass privatization scheme at the eariest opportunity would be IsL Priivatwtion with the approva of dhe fed- eral GKI (after cosaukation with sectoral itristps mini). This includes large firms that ei- ther dominate the market they operate in, A series of laws passed by Parliament in employ over 10,000 people, or have assets 1991-92 categorized statt property as fed- worth over 150 millionrubles onjanuary 1, eral, local (ob6st), or municipal and allo- 1992 (such as railroads, airlines, shipping cated responsibility for privatization to lines, alcohol, tobacco, pharmaceuticals, property committees and propey funds at and medical equipment). When these en- the appropriate leveL State enterprises terpises are privatized, the state can retain were also chaterzed as small or large for a controlling stake for up to three years. the purposes of tie privatization program A large state enterprise was defined as an Privatition pemitted with government enterprisewith more han 1,000 employees approval. These are firms in industries of or assets ovier 50 million rubles as of strategic importance (natural resources, Janmary 1, l992.7Asmall cnterprisewas de- steel, defense, information and wireless fined as an enterprise with fewer than 200 agencies, grain storage, and so on). Given employees or assets less than 1 million the opposition of anti-reformers in gov- 12 RussIw CRuE&TNG PRWAE ENm uE AND EFFICIEN M ernment, privatization of these industries vatization commission (which carries out has been slow. the practical tasks of the corporaization procedure) was determiined by the chief ex- Privattzaton forbidden in 1992. This ecutive of the enterprise. The only require- category included entities such as major ments were that the commission have nantral resource industries, the Central between three and live members, one of Bank, social infrastructure, television and whom had to be from the workers' coliec- radio stations, ports, and nuclear produc- tive. The oginal 1991 Privatizauon Law tion facilities. envisaged a much larger privatization com- mission, with representatives from local Local pnuvatAsion prognmzt This cate- state property committees, local citizens, gory indudes most social infrastructure un- officials of financial agencies, managers, der the auspices of local authoities (such and workers. To acceerate privarization Corporatization is as mass transit tems, health, education, and strengthen the role of managrs, the the process by and aultural and sports facilities). composition of commissions was curtailed in a presidential decree ofJly 1992 (Presi- which a state Corporatzadon dent's decree 721). enterprise becomes The Ia can do little to hinder the enter- a joint stock Corporatization is the process by which a pfises proposals on prvatization. For exam- stte enterprise becomes a joint stock om- pile, the Is had to approve asset valuations company with a panywith a legal identity It is no longer an pepared by the pivatization commission, legal identity. adjunct to a branch miniy It has its own but they hadtde infomaiion on which to charter (tghts and obligations of share assess or contest the validity of manage- holders), a board of directors that has the ment's valuation. anagement had a big in- right to appoint and dismiss management centive to underestmate the valuation since and operates under the same commercial the valuation was taken as the founding cap- law as the private sector. AL large-scale en- ital ofthe privatized firn and, hence, the ba- terprises, except those for which privatiza- sis on which manages and worcers bid for tion is forbidden, must be corporatized. shares in the closed subscription. Indeed, Subdivisions of large enterprses can also this methodoogy was modified by the July corporatize as a first step toward indepen- decree to favor speed (and, thus, insiders). dence. Medium-size enterprises can be pri- The original 1991 Privatizarion Law envis- vatized through eitier the smal (which aged that the valuation would be calculated does not require corporatization) or large on a market or discounted cash flaw basis. privatization program. Given the understandable difficulties of To be c&rporatized, an enterprise had to making projections under Russian condi- submit a privatization plan, a valuation of tons, the methodology was changed to one its assets (as of July 1, 1992), and a joint based on book values (as of July 1, 1992).10 stok charter to the locaL property commit- With inflation running at over 1,000 percent tee by October 1, 1992.9 Trght deadlincs in 1992, this was a huge transfer of wealth were set for the corporatization process, as from the state to insiders. well as for particular stages. In practce the timetable was untenable. Many enterprses Closedsubscrpidon filed late, and even a year afterthe original deadline the process was still far from com- One of the major decisions managers and plete. Insofr as the intention was to create workers make as part of corporatization a pipeline of firms ready for privatization, is over the closed equity subscription. however, the tight deadlines had the de- Employees have three choices: sired effecL Power over the privatization process Optsn 1. Managers and workers are was in the hands of enterprise insiders, with given 25 percent of the enteprise's equity the balance of power usually lying with in preferred, nonvoting shares.'1 They also managers. Thus, the composition of the pri- have the option to subscibe for another 10 AN OVEXUEw OF PRIvAnzON zN RussiA 13 percent of ordinary (voting) equity on fa- prise employees (including manages) are vorable terms These include: also given the right to acquire a firther 20 * A 30 percent discount from the book percent of thevotingcapitalata30 percent value (taken on July 1, 1992), discounttobookvalue.Option3hasrarely ' Payments are in equal quarterly install- been used. ments over imreeyears (considerably re- A vote on which option to choose is ducing the real value of the payment, made at a general meeting of the workers' given inflation), coUective. A two-thirds majority is required * An initial down payment (payable with- to choose option 2 or 3. If there is no such in 90 days) of not less than 15 percent majority, option 1 applies.'3 of the book value, and Employees also had two other impor- * Up to 100 percent of the amount owed tant subscription priviles-Personal Pri- can be paid for in vouchers. vatizationAccounts and the Share Fund for Acquisition of both the 2-5 prcent non- Employees of the Enterprise (FARP). Pdi- votingstockandthe l0percentvotingstock vatization accounts are part of an enter- are sject to nrble limits to prevent eces- prise's social fund. This is composed of sive gveaways in enterprises that have high such items as a housing fimd, wage find, asset values reative to total employment?lz bonus payments, and, more recenrl priva- In addition, enterprise managers (di- tizainon accounts. Each year part of the en- rector; deputy director, chief engineer. and terprise's net income is alocated to the chief accountant) have the option of ac- social fund. Employees can use these pri- quimng up to 5 percent of voting equity at vatization accounts to finance their share book value (for which they can pay with purchases in the dosed subscription vouchers and cash). Managers and workers (though inflation has reduced their value in can sell their stock to whomever they real terms). FARPs allow certain groups of choose, but sale of the nonvoting preferred employees to subscribe for up to 5 percent stock does not change its status. of the enterprise's capital after the dosed subscription and the voucher auction. C)paion 2 Employeescanbuy5i percnt FARPs apply to those who could not par- of the ordinary shares of the enterpise for ticipate in the closed subscription, such as 1.7 times the bookvalue (as ofJuly 1, 1992). former or retired employees. There are no discounts or deferred payment Significant resrctions were placed on terms and no sales of nonvoting shares. the use of shares m the hands of the local Vouchers and cash can be used to pay forthe property fund after the dosed subscription. shares (no less than 50 percent must be in Thefundmaynotvotemorethan2opercent vouchers). The entire payment must be of the equity Any stock held by the fund in made in 90 days. The 70 percent madup on ess of this (40 pecent in the case of op- the book value was an inadequate attempt tion 1 or 29 percent in the case of option 2) by the GKE to compensate for inflation. has the status of nonvoting, preferred shares with a minimum dividend equal to the bank Option 3. This is open only to enter- discount rate. OnDy on sale to a private in- prises with more than 200 employees and vestor wl these shares become common assets of between 1 million and 50 mIlion stock. These restrictions were imposed to rubles as of Januayr 1, 1992. Managers as- thwart local poperty funds from tying to sume responsibility for running the enter- maintain direct control over enterprises. prise under a contract with the local Because substantial equity ended up in the propFrty committee. They agree to main- hands ofinsiders, howcvei these resctions tam both the compettiveness of the enter- had unintended consequences. Under op- prise and a certain number of jobs for at tion 1, for example, insiders who took up least two years. If the terms of the contract teir ful subscription received 15 prcent of are fulfilled, managers can acquire 20 per- the equity but because of the resticton on cent of the voting capital at book value property fi nds' votng rights, had 47 percent with payment over three years. All enter- of the voting rights, they do not need to buy 14 RussUi CzmNaG Pnt ERnPss AND EFFKCET M.ZwIS many more shares in open subscription to Voucaers gain voting controL Under option 2 insiders can subscnbe for majonty control, but even Vouchers were put on sale a month ahead of when they fail to subsabe for their full al- schedule (from October 1, 1992) at Sber- lotnent or subscnbe for their fullallotment bank, the state savings bank, to demon- and thenselitheirshares, the20percentvot- strate that privatizadion had started in a ing limit on the funds prvides insiders with meaningful way and to build support for the considerable leeway before they lose voung prograwm The main characteristics of the controL14 voucher scheme were: The scale of equity transfer offered *For a fee of 25 rubles, each Russian through dosed subscription is enormous- would receive one voucher with a de- a reflection of the strength of implicit own- nomination of 10,000 rubles.AII citizens ership claims spawned by the Gorbachev would receive a voucher regardless of .. .by the end of enterprise reforms. Managers and work- age, residence, workplace. or income. January 1993, es, trough their de facto control of enter- V Vuchers could be accepted by a prnva- prises and ther vocal representation in PtonagencyanywhereintheRussian four months after Parliament, were able to mold privatiza- Federation for the sale of state assets. the first sale, tion legislation. Enterprise workers have Oncereceivedbytheagencryhevouch- 9S perCent of rmceved more generous concessions th er would expire. in any other privatizadon program in the * Vouchers were bearer documents and Russians had world (Boycko, Shleifer, andVishny 1993). could be used to buy shares of the en- collected their Not only did they receive 35 percent of the terprise in which the voucher holder vouchers (some equity on generous terns under option 1 works or to purchase shares at the auc- or 51 percent under option 2 (with an op- tion of any other enterprise in the 146 mllion). portunity to increase their shares in open Russian Federation, traded in a com- subscription), they also had a voice, mercialorinestmentender, exhianged through the workers' council, on the for shares of a voucher investment fund, choice of option. More iinporantly, they sold for cash, or used to pay for housing were able to prevent the immediate dolmi- and small-scale property nance of strong powerful outside share- * Vbuchers were originally to be valid holders. In acquiring stakes, managers and from December 1, 1992, to December workers invested little of their own money 31, 1993, but the deadline was extcnd- but were usuallyable to subscribe for the ed to July 1, 1994 because of delays in full amount open to them. After taking in- the privatization programm to account the effects of inflation (1,000 * Only the Russian Federation could is- percent) and the use of discounts, vouch- sue vouchers and only federation ers, payback periods, and privatization ac- vouchers could be accepted by privati-. counts, the actual contribution made by zation agncies. No local vouchers were workers and managers has been negligible. permitted Closed subscrption has represented a sig- The Russian privatization voucher dif- nificant transfer of wealth frm the state to fered i important aspects from the Czech workers and managers. and Slovak vouchen It was less expensive. The orignal privatizaion plan envis- The Czech and Slovak voucher cost about aged only option 1, which did not offer $35 (mughlythe avergeweeklywage) and immediate majonty control, inhibited out- the program was self-financing. The sider involvement, and represented a de Russian voucher first went on sale at facto veto on future restuctring. Option around 5 cents. This led to 'both a higher 2 offered both substantial equity and in- take-up rate and rapid disbursement. The mediate controL Not surprisingly more GKE estimates that by the end of January than 70 percent of corporatized state en- 1993, four months after the first sale, 95 terprises chose option 2. The rest chose op- percent of Russians had collected their tion 1 and onLy a handful of enterpses vouchers (some 146 million). Four months chose option 3. into the Czech and Slovak sale, only 2 miL- AN OVEREW OF PINOATZoN IN Russ& 15 lion of an eligible 10.5 million participants backed by valuable assets. ThWrd, in the had bought voucher booklets.5 The event of an illiquid voucher market, an in- Russian voucher had a nominal denomina- sistence on using only vouchers would delay tion of 10,000 rubles (unlike the Czech and the privatization process unti investors and Slovak vouchers, which were denominated employees had bought the required vouch- in points, not currency units), and Russians ers. Finally assigning a nominal value to could sell theirvouchers for cash, unlike the vouchers had ramifications for the payment Czechs and Slovaks. decision. If the voucher's market value fails Russian reformers had several reasons below its nominal value and if there are no for allowis g voucher trading (Boycko limitations on how many vouchers can be 1993). First, any restrictions on trading subscribed, then no investor (either in the would limit an individual's portfolio closed or open subscrption) wl use cash to choices. Second, some people, especially pay for privatized assets. the poor, could sell their vouchers to in- crease their consumption. Third, given that QOen sbso*ron many people would want to sell their vouchers even if it were illega to do so, a The privatization commission has to lay out black market was bound to emerge-an of- a proposal for the sale of the equity remain- ficial market could be somewhat regulated. ing after the dosed subscription. The thre Fourth, tradability would allow large and choices for the enterprise are a voucher auc- powerful shareholders to emerge. It would tion, a voucer auction combined with permit individuals, firms, and voucher commercial tender, or a voucher auction funds to acquire as many vouchers as they combined with investment tender. Each of wished, which is precisely what happened. these options could also be followed by a One argument against voucher tradabil- sale of shares for cash A minimum of 29 ity is its possible effect on inflation-vouch- percent of the totl equity had to be sold in ers, functioning as high-denmination bills, a voucher auction.17 would add to the moneystoc In addition, Under a commercial tendet, the enter- distributing vouchers leads to an increase in pniseis sold (in an auction room orby sealed the wealth of all tizens which, in turn, bid) to the highest bidder accepng specific would increase their consumption and thus conditions. An inestment tender is a much inflationary pressure; boowing against onger process, suitable for large entetpris- vouchers for current consumption would es* The evaluation criteria are not resmcted only result in an incase in the relative price solely to price, but may also include invest- of goods consumed by the poor (food, ment, employment guarantees, and so on- clothes, and so on). Resticting the use of Commercial and investment tenders are vouchers so that they are not redeem le for rare. In Februay 1994 a presidential decree goods and services mitigated their inflation- was issued in anticipation of the increase in ary consequences, but the most potent tenders likely to occur after the end of method was to ensure that there was a rapid voucher auctions in July 1994. The decree supply of enterpnse shares, thereby rein- simplified the procedures required for in- forcing the equity-linked basis of vouchers.' vestment and commercial tenders. A related issue was allowing vouches Given the absence of control firm the and cash to be used as altemate forms of center, the nature and speed of the sale of payment The decision on payment de- the rreaining equity has been negotiated pended on satisfying a number of policy ob- between the enterprise, locd politicans, the jectives and consraints. First, it was Ka and the cal property fund. This has left important to ensure that local authoities re- a lare amount of discretion over the form ceived cash from share sales and thus had of the open subscription in the hands of the the incentive to sel the shares in the first insiders. Insiders may try to delay the sale place. Second, it was important that a direct either to keep equity in the hands of the link was made betwecn vouchers and assets property fund, which is likely to be more re on sale, therebyensuringthatvouchers were sponsive to their interests and to share their 16 RUssmL CQEAnNG PmvAiE ENT5m AND EFFICENTrMASn concern over outsider control, or to allow Voucberfunds time to accumulate enough capital to buy some or all of the remaining equity In Russian investment funds are all privately voucher auctions, local property funds and sponsored. The state is limited to providing enterprses have often tried to evade the 29 and ensuring compliance with a prudential percent minimum by selling a smaller per- regulatory framework. Legislation, includ- centage through a series of auctions in which ing a presidential decree issued in October small stakes are sold. The situation deterio- 1992, followed by an Investment Company rated so much that another decree was is- Law in 1993, allowed for the creation of sued after the April 1993 presidential both voucher and nonvoucher investment referendum reiterating the 29 percent target funds. The voucher funds are licensed and and threatening disciplinary measures for regulated by the GK[ and the nonvoucher failure to comply with the target (presiden- fimds by the Miistry of Finance. . . .by May 1994, tial decree of Ma 8, 1993). Compliance has Investment funds were slow to emerge. there were 624 improved considerably since this decree. The first investment fimd licenseswere not During 1993 it was common to find lo- issued until December 1992, three months licensed investment cal property finds retaining 20 percent of after vouchers first went on sale. There fieds (mostly the equity in privatized enterprises, beiev- were logistical hurdles w the formation of vucher fnds), ing that once 80 percent of the equity had funds. such as raising finance, registering, been sold (most commonly in an enterprsr- and so on. There was also a lack of public with 550 choosing option 2, with 51 percent sold w - '' -tanding of investment funds, due in investment fund the employees and a miniimum of29 percent I, r -r poor marketing Even so, the num- managers and 21 sold hirough a voucher auction) they were ber of funds has grown rapidly. It is esu- under no obligation to sell more. The "80 mated that by May 1994, there were 624 million percent" rule, however, required that 80 licensed investment fumds (mosdy voucher shareholders percent of enterprise equity had to be sold funds),vAth550investnentfundmanagers controlling 45 for vouchers. If the proceeds of the closed and 21 mfllion shareholders controlliing 45vo . .s. subscription were not entirely in the form of million vouchers-about 30 percent ofthe mllion vouchers vouchers, then the property fund (having total number issued (Price Waterhouse sold 29 percent through the voucher auc- 1994). By May 1994 voucher funds had in- don) has to sell from the remaining 20 per- vested 27.6 million vouchers. Moscow city cent to comply with federal legislation. The has the highest concentration of fiuds with GEl has used this rule to push the property more than 120 (the Moscow oblast has funds to sell more equity for vouchers be- about 150), while the St. Petersburg oblast fore the voucher expiration date. has about 35. The largest fund has more Local property funds have also reduced than two million shareholders and four mil- their stakes by using the option of seling up lion vouchers. Voucher and nonvoucher to 5 percent of the share capital offered in funds can subscribe for cash, though this the voucher auction for cash (that is, up to has notyetbeenapriority and littlecash bas 5 percent of the minimum 29 percent). been raised. This will change after the ex- Property funds are reluctant to sell further piration of vouchers in mid-1994. shares forvouchers, andmost arewaitingfor Investment funds and managers are reg- the expiration ofvouchers at the end ofJune ulated in a number ofways, such as the form 1994, when they hope to sell shares for casih and nature of invesunent funds, licensingre- In contraSt to the 5 percent cash sales, the quirements, the relationship between funds proceeds from these cash sales wi not and fund managers, portfolio investment re- accue solely to the local property fund. strictions, valuation procedures, repordng They will be split with the federal property requirements, the rights of sarholders, fund, the local 1K4 the central GIlC, and the and so ao Legislation saw voucher funds federal and oblast authorities. Local proper- acting as passive portfdlio investors, playing ty funds will retain the option of selling muchithesamesortofroleastheirWestem shares throughan investment orcommercial mutual fund countrparts. (The Invstment tender beyond the June voucher deadlne. Company Law was based on the 1940 U.S. AN OvaEDwoF PIvATgZATnION IN RussiA 17 Investment Company Act.) In particular, latter are used in voucher auctions, the for- various restrictions were placed on voucher mer for speculation. funds'portfolios. Fundswerc not allowed to As the pacc of voucher auctions in. invest more than 5 percent of their assets in creased, funds focused on acquiring blocks one enterprise, to own more than 15 per- of equity in specific enterprises and indus- cent of the debt instruments of an enter- tries. There seem to be two broad explana- prise, or to invest outside of Russia. One tions for this behavior. The first is that, like important rcstriction was that a fund could Czech funds, Russian funds see more prof- not own more than 10 percent of the stock it in acting as proactive restructurers of of an enterprise. This rule (later changed) corporate assets rather than as portfolio in- initially placed voucher funds at a disadvan- vestors. Singly or in concert, Russian funds tage not only to insiders, but also to other have challenged management at sharehold- The licensing private investors who faced no such restric- ers meetings and have sought to remove conditions that tions, and severely lmited the corporate them or otherwise promote restrucuring. governance role they could play. In compar- To gain control, many funds have ignored funds and fund ison, in the Czech Republic, the limit is set the 10 percent restriction. Because of the managers have to at 20 percent. Thus in the Czech Republic widespread disregard for the rule and be- comply with have it would require three voucher finds voting cause it was felt that funds were being un- twgether to control an enterprise, whereas in fairly penalized, the limit was raised to 25 been kept to a Russia it initially required six. percent in the 1994 privatization program. minimum both to The funds' behavior has been quite dif- The second reason for acquiring blocks of encourage the ferent from that originally envisaged. There equity is the exact opposite of the first. seem to have been two stages of develop- Many managers have sought to expand formaton of funds ment. At first the funds were active partici- their shareholdings beyond the level grant- and to leave little pants in the voucher market. In addition to ed to them in the closed subscription. discretionary power trading vouchers for capital gains, funds Funds often acquire shares in voucher auc- the of r rwere selling vouchers to raise cash to meet tions orin the secondary market with the in- in t be bands ot their current expenses, since they found tention of selling thembackto management oblast KIs.... themselves in a position with little or no in- at a markup. This practice has proven to be terest or dividend income and an illiquid a lucrative source of profits with which to share portfolio. Their only cash reserves pay dividends, though in doing so funds are were their founders' capital. The voucher forsaking a long-term investment role and market was the only avenue by which funds instead fulfilling the role of a broker. could be obtained for current expenses. To The licensing conditions that funds and the extent that cash proceeds from vouch- fund managers have to comply with have er sales did not come out of trading gains, been kept to a minimum both to encourage the fund was paying expenses out of prn- the formation of funds and to leave little cipaL The govenment took the view that discretionary power in the hands of oblast the resulting sell-off of vouchers by the Els, on whorn most of the regulatory bur- funds wasunderniining voucher prices and, den falls. Two points are worth noting: in a May 1993 presidential decree, forbade foreign fund managers are treated no dif- funds from trading in vouchers. This belief ferently from domestc and state enterpris- seens unfounded-fluctuations in the es are forbidden from setting up voucher voucher market are more a reflection of the funds. The latter condition was imposed vagaries of Russian politics on the because it was feared that state enterprises prospects for privatization-though con- might create funds to buy stakes in priva- cern about funds eating into their capitl tized companies, thus defeating the pur- bases seems reasonable. It appears that pose of privatization." some funds are evading this rule by ex- By decree, Russian voucher finds hve ploiting ambiguities in the legislation. They to be closed-ended-that is, they have a purchase vouchers for cash in the market fixed number of shares in issue. An investor but keep them separate from vouchers they subscnres capital during specific offer pe- receive in exchange for their shares. The riods, and once the find is set up, the in- 18 Rusm& CaENmG PRIVATE ENmEwasz AND FmcIENr MAC vestor recoups investment by selling vouch- ers, particulady on television. Many have er fund shares on the secondary market. made exaggerated claims about future div- Unlike investors in open-ended funds, in- idends, causing concem among policy- vestors in a dosed-ended fund cannot sub- makers. Thus there is a regulation scribe more capital or ask the fund to forbidding Russian voucher funds from redeem shares. making guarantees on future performance. Though voucher funds are closed- This rule was instituted because of the ex- ended, many have developed a lopsided na- perience of the Czech and Slovak authori- ture in that they have semi-continuous sub- ties. In the former Czechoslovakia, several scription periods (in contrast to the limited investment funds guaranteed tenfold re- offer period of a Western dosed-ended turns or more on a citizen's coupon book a fund). These funds fall halfray between a year aftershares began tading.Authorities closed-ended fund and an open-ended feared that if enough people cashed in fund in that they subscribe for vouchers on their fund shares at the same time, these a semicontinuous basis without being ob- funds might have to liquidate a substantial ligated to redeem their shares. This has portion of their portfolios to make good on caused a number of problems, induding their promises, leading to a steep fall in the the rate at which funds are exchanging their stock marker and seriously undermining shares for vouchers. Most funds are issuing the credbility of the nascent capital mar- their own shares for a fixed number of kets in the eyes of the general population. vouchers (normally ten shares for each To prevent this kind of scenario in Russia, voucher), with little or no attempt to up- Russian voucher funds were forbidden date the price of their shares on any net as- from maling guarantees. set valuation basis. Thus, one group of Stil, there are many examples of mis- shareholders is being short-changed at the leading caims. Indeed, a large number of expense of another. IF a fimd's assets are unlicensed funds are operating. There have worth more than the price at which that been a number of scandals in which fund fimd's shares are being sold, shareholders' shareholders have been defrauded. investments are being continLiously dilut- Recently the GKr has made strides m im- ed, whereas if the fund's assets are worth proving good practice in the indusryt. A less than the price at which fund shares are Funds Monitoring Unit was set up in being sold, then futue shareholders are be- Moscow to collect information on develop- ing short-changed. Funds have claimed ments in the industry from oblast Kls, ana- that they are prevented from changing their lyze funds' financial statements, and prices because of a Ministry of Finance reg- initiate action against unlicensed fimds and ulation that prevents shares of the same is- other illegal behavior. Two trade associa- sue being sold for different prices. If they tions have been formed, the Association of did not engage in these semicontinuous Investment Funds and the League of subscriptions, this problem would not oc- Investment Managers. The latter has ssdf- cur The situation is further complicated by regulatory stms with the GICI and the the fact that no attempt is made to recalcu- Ministry of Finance and was modeled after late share prices (the ratio at which fund the ASD in the U.S. and the CIDA in shares are exchanged for vouchers) with Canada. the voucher market price. Thus there is lit- The connections between banks and dle relationship between fumd share prices the voucher funds are looserin Russia than (to the extent that they exist) on the pd- in the Czech Republic. In the Czech maryorsecondarymarker andnetassetval- Republic, a smal number of privatized for- ucs. Indeed, so long as funds engage in mer state banks dominate the banldng sec- semi-continuous subscriptions, they have tor. All major investment management little intere,t in seeing a secondary market companies are owned by the big banks. in their shares emerge. Thus, though teir direct credit re]ation- Like their Czech and Slovak counter- ships and their influence over inve, meat parts, fimds have been aggressive advertis- fimds, Czech baiks have emerged with a AN Ovmorw OF PIvATIAON IN RussI 19 large amount of control over enterprises. In in other oblasts. At that auction, autiiorities Russia the banking sector is fragmented. verify the receipt and confirm it has not There arc over 2,000 banks, most of which been used in another auction. On verifi- are privately established. Although Russian cation, the voucherholder's account is banks have established funds, they do not debited. This depository system relieved the dominate the fund industry. voucherholder of the rneed to carry large numbers of vouchers around the cuntry. Voucber auctions In addition, an 'All Russia Auction Center" has been in place since March Most state enterprises are sold locally, 1993. Alhough the center is based in though a national and inrer-oblast auction Moscow, auctioned enterprises can come scheme has been created In a typical re- from anywhere in Russia and can be sold Russian interest gional auction, the shares of between five concurrendy through a large number of groups or stake- and twenty enterpriscs are sold. Bidders oblasts. Twelve regions participated in the must report to the voucher auction center first aucton of Z, the car manufacre, holders (workers, orto a satellite bid center within a specified and the national auction scheme has grown managers, bureau- period-normally two to six weeks. In the since to include 72 regions. Thecenteris re- crats, politicians, voucher auction, voucherholders have two served almost exclusively for the largest en- choices. They can submit any number of terpnses, almost all of which are or investors) have vouchers, not specify the number of shares federally-owned properties. Initially, the a keen interest in tLey expec, and accept the strikr price that choice of wheder to go througi the nation- clears the auction (type 1 bid). Or they can al auction center was voluntary, but since Prwvatization, submit any number of vouchers with a spe- October 1993 ithasbeen mandatoryforen- given the possible cific maximum price, that is, the maxirmum terprisesvwith capital over250 milion rubles rewards. number of shares per voucher (ype 2 bid). as ofJanuary 1,1992. Almostall ofthese en- Those who bid at or above the strike price terprises are outside the mandatory privati- are then allocated shares. Those who bid zation category beLause of their size, and below the strike price do not receive any instead fall in the category requiring federal shares and have their vouchers returned for GIC[ approval. Because of the political dout use in a future auction- the sheer size of the enterprise gives them, There is a large variation in the speed at managers of these enterprises have con- which regions hold auctions. Determined siderable discretion over their passage opponents can stUll privatization, prevent through the privatization and nationd auc- shares from being sold to voucherholdes tion process. In many cases they are able to from outside the region, or both. By Ma,1rch negotiate special terms not available to 1994, some regions had sold shares in over firms privatized on a local basis. In addition 370 state enterprises, whie others had sold to the national auction center, a more limit- shares in less than 20. ed inter-oblast voucher auction has been As auctions took place, the government created in which the shares of an enteprise became concerned that the intra-oblast na- in one oblast are offered to voucherholders ture of the auctionswas helpingthose forces in at least three regions. There are no re- seeldngtofragmenttheRussianFederation. quirements regarding whether a property It was thought that if inter-oblast holdings has to go through this limited inter-oblast could be encouraged, the unity of the auction, but it appears that most have capi- Federation would be strengthened. Thus a tal of about 100 million rubles. voucher depository scheme and a national aucuon network were introduced during Public i mfortion campazgn 1993 to facilitate inter-oblast holdings. The voucher depository scheme consists of 30 Privatization is an intensely pofitical process centers around the country, it allows vouch- evewhere, includig in Rusa. Russian in- cr holders to deposit voudhers at one of the terestgroups orstakeholders (workers, man- centers in echange for a receipt The re- agers, bureaucrats, politicians, or investors) ceiptisused obidatavoucherauctionheIld have a keen interest in privatization, given 2D Russi& CREmATNG PIvATE ENriEmSEs AND EFFICENT MAm the possible rewards. Policymakers felt that privatization as a defensive measure; it there was a need for an information cam- served to ensure that outsiders did not gain paign to mold the public into a constituency controL The fact that many medium-scale with a dear interest in pushing forward the enterprses chose the large privatization programL scheme is indicative of the certnty that it The campaign had to overcome mdif- provides against outsiders gaining control ference and hostility to both economic re- of the enterprse. Of the dosed-subscrip- form and privatizaton. Various media were tions options. option 2, which gives insiders used in the campaign-advertising on na- inunediate majorty control, is the most tional television, on the radio, in print, and popular; 78 percent of medium-sized en- in prime-time weekly programming devot- terprises took this route. Option 1 was ed specifically to privatization issues. chosen by 18 percent of medium-size Regional information offices were set up enterprses. This option was usually chosen By March 1994, and regional training semiinars held. An when the company was too capital-inten- ove 8,700 educational brochure, riPvatization in sive to buy outright (which is presumblyv Your Pocket," was produced, and mass why the percentage is higher for large en- medium-size -bhlicity privatmation days' were orga- terprises) or when managers feared giving enterprises had nized. The campaign was split into phases. workers voting shares. been privatized The first was an aggressive promotion of the voucher-distribution program. The sec- Voucher antion through the ond distinguished pnvatization from hyper- large-scale inflation (which many thought stemmed By October 1992, even though vouchers Privatization from privatizaton) by portraying privatiza- were being distributed a month ahead of don as the principal means for econoniic schedule, litde progress had been made on prOcmi change. The next phase dealt with the irre- bringing enterprises to the market. So at the versibility ofprvatization. In this phase, the end of October the federal GK[ asked local campaign moved beyond discussing vouch- Kls for enterprises that had aready been ers by highlighting the national voucher corporatzed, transformed into joint stock auctions and identifying privatization suc- status, and were ready, at short notie, to cess stores. take part in voucher auctions. Bolshevik Another use of public information was Biscuit Company a cake and confectionery to increase transparency in privatization. baker based in Moscow, was chosen, after The priv-tization law required advtsing hurried negotiations with its management, for enEerprises that were to be sold in na- to be the first company to go hron dre tional or local media Additionally at bid auction. It was done at breakneck speed in centers, information on companies to be December 1992, amid a blaze of publicity auctioned was provided (such as sales and and considerable Western technical assis- export figures, number of employees, ma- rance. In that month, eighteen enterprises jor products, and so on). While this re- from eight oblasts or cities (induding Mos- qairement increased the cost of the public cow, Madinmir, Yaroslavl, and Perm) repre- information program, it was critical to senting a variety of industries (including keeping privatization traSparenL The pro- trucking, cement, and microchip produc- vision of public information also signified a break from the communist past hbIe 21 Ovennew of corporatiation in Russia, March 1994 Large entepries Medium-size entepr*s TOW Progress of mass privatization Nurnber Number Number Method dosen of firs Percent of firns Percent of fims Percent Co7poravnzanO Option 1 758 33 1.551 18 2309 21 Option 2 1,377 60 6,748 77 8,125 74 By March 1994, over 8,700 medium-size OptionL 3 22 1 83 1 105 enterprises had been privatized through the Unknown 125 5 348 4 473 4 lare-scaleprivatizationprocess(table2.1). Total numberoffirins 2,284 8,734 11,018 This was mainly because insiders perceived source GVRPK Perforimnce Center AN OvERaEw OFPPVATIION IN RusSm, 21 tion) went through the process. By March The figures become more dramatic 1994 some 9,500 enteprises in 81 regions, among individual enterprises (Boycko, accounting for 10.8 million workers, had Schleifer, and Vishny 1993). Zil, the au- sold shares through vouchcr auctions tomaker, with more than 100,000 employ- (table 2.2). It is estmred that of the ees, a ready market for its goods, and vouchers submitted by April 1994. 80 mil- substantial real estate holdings, is, accord- lion have been used in closed subscrip- ing to the voucher auction, worth only $16 ttons and voucher auctions and 5-10 milion. The second most valuable compa- million have been used in small-scale pri- ny that was auctioned by June 1993 was a vatizations, leases, FARP housing, and so Moscow hotel with 154 employees. Ural- on. By May 1994 some 45 million vouch- mash and Permsky Motors, eac with over ers had been collected by voucher fimds, 30.000 employees, are valued at $7 milion Bolshevik Biscuit of which 27.6 million have been invested. and $4 million, respetively Boycko, Company... was Sbleifer, and Vishny arue strongly that [auctioned] at Asiet valEf .these low valuations are a resuIt of the po- [auctionedJ at sition of outsiders in relation to insiders breakneck speed in Calculations based on voucher auctons and the govermment They point out that December 1992, and the voucher market price show asset much of the value of an outsidees stke in valuations to be unifoimly low. This sug- a company is expropriated by insiders, ei- amid a blaze of gests either a worthless capital stock or tier through workers' demands for high publicity and (more plausibly) that most wealth is re- wages, managers making asset sales to their considerable tai yinesiders. own companes, ellegally changig share- Ruanassetssuldbevaluedbasedon holder harte, and rigg shareholder Western technical an aggregate and on an individual basis. meetings, and government regulations, taxc- assistance. Assume that the assets sold at auctions are es, restrictions on layoffis, and so on. Paying rerscntative ofRussian industry as awhole. dividends to outsiders is a low priority. With ByJune 1993, 15 pecnt of Russian indus- so few shareholders' rights, it is not sur- try had gone through voucher auctons, sell- prising that the worth of minority stkes is ing an average of 20 percent of the equity seriously devalued. (about 3 percent of al Russian equity) for sr50 million. This implies that the whole of Shoe owwrsh4p Russian industry is wor just $5 billion-e value of one U.S. Fortune 500 company Managers and workers have been aggres- (Boycko, Shldfer, and VLshny 1993). srveinconsolidatingtheirshareholdings,us- Table 22 Voucher auctions in Russia, December 1992 to February 1994 Numberof Charter capital Weighted average Vouched Weighted Numberof Numberof employees sold (milfions chartercap*al accepted awage entewprisms sod regions fthousands? of fubks) sold (oemenO (thousands) auction rate December1992 18 8 44 513 17 158 3.2 January1993 107 21 189 706 12 229 3.1 February1993 197 30 206 1,629 19 612 2.7 March 1993 436 51 536 5.160 25 2,202 23 Apnl 1993 612 61 829 6,528 23 4,158 1.6 May 1993 581 53 609 5,305 21 4,305 1.2 June 1993 897 74 812 7,209 18 4,360 1.7 July 1993 907 62 754 8,170 23 6.641 1.2 August 1993 894 66 924 6.903 21 4,255 1.6 September1993 786 66 838 7.123 20 4.745 1.5 October 1993 963 74 906 8.289 19 4.557 1.8 November 1993 883 64 1,021 8.461 19 2,832 3.0 December1993 1,047 65 1.101 9,635 19 4,002 2.4 January 1994b 643 66 746 11,55Z 23 3.925 2.9 February 1994t 475 53 1,333 14,636 24 3,920 3-7 Total 9,446 82 10,848 101.551 21 50.091 2.0 a. Thousands of rubles share per vouch. b. Fgues forJanuauy and Febuary of 1994 are prerninary. Souqre: GORPC Ptfibnaince Centa 22 RussrL CESAmNG PmvAm ENTERPmIs AND EFFICIENT MARxn ing voucher auctions and the secondary the corporate govemance landscape for market to pick up further shares. The effect some time to come. of this activity is dear from two recent sur- veys (table 2.3)."I The Blasi survey shows Smwal-scaleprivatizaton that, on average, 70 percent of a privaized enterprise's equity ends up in the hands of Control over the small-scale privatization insiders, and of that, 17 percent is owned by program is concentrated in the hands of management Of the remaining 30 percent, municipal authorities. This was a result of a 16 percent is held by local property funds. December 1991 presidential resolution on Even so, outsiders have been active in the division of state property (and hence re- the voucher auction process. Outsiders sponsibility for privatization) between the hold about 14 percent of enterprise shares, federal oblast, and munidpal authorities. of which 9.5 percent is with large share- Esstially all small-scale enterprises (such holders-invesment funds, wealthy indi- as retail shops, catering facilities, and con- viduals, and private firms and, to a limited sumer services) were transferred to munici- extent, foreigners. palities. Given the sheer number of small An interesting featume has been the e- enterprises and the time scale envisaged, it tent to which managers have increased was technically and politicallyunfeasible for their stakes. In the dosed subscription, thefederaLauthordiiestocarryoutthesmall- managers would have received somewhere scale programL between 3 and 10 percent of an enter- prise's equity. After bidding in voucher Scope. The 1992 annual stte pnvatiza- auctions and buying shares from workers, tion program placed heavy emphasis on their holdings rose considerably Their in- small-scale privatization. Wholesale and re- fluence is not limited to equity ownership tail networks in the marketing of industrial alone. Often workers' collectives have goods, catering facilities (retaurants and thrown in theirlotwith managers, pledging cafes), and consumer serice, along with their shares to managers eitherinformallyor wholesale and retail networks from otherin- formaly (dtrough tust arangements). dustries that had a significant number of Insider wnership, with managers in the dri- small enterprises, were placed in the man- ving seat, wil be an inescapable feature of datory privatization category. Table 2.3 Distribution of shareholders, Blasi survey @xrrent) Insiders Puperty Out sdew Type of firm Workers Managers Total Fund Small Lawr Total Opion Food 20 60 80 0 15 5 20 2 Zil (auto manufacturer) 35 5 40 25 15 20 35 1 Machinetools - - 60 3D 10 0 10 2 Radio 55 10 60 2D 20 0 20 1 Trucking 90 3 93 D 3 4 7 1 Chalk 55 5 b-0 31 0 9 9 1 Trucking - - 80 20 0 0 0 1 Steel 89 11 1000 0 U 0 0 Lease Steel 29 35 54 1 0 3 23 26 2 Metal 66 18 84 0 15 1 16 2 Fumiture 46 5 51 49 No voucher auction yet 2 Textle 92 5 97 0 3 0 3 Women's wear 90 - 90 10 0 0 0 1 Machine tool 33 18 51 30 1.5 17.5 19 2 Pasta 57 4 51 20 - - 18 2 Wheat 28 45 73 18 8 1 9 2 Departnentstore 10 30 40 Z0 12 28 40 1 Trucing 45 30 75 22 2 1 3 1 Trucdong 58 5 63 30 6 1 7 2 Mean 53 17 69 16 - - 13 - Indicates data not available or not meaningful. a. The aveiage number of employees of the firms swveyed was 6.897. SoDu: Boydc, Shleifer and Vshny (1993). AN OVERIEw OF PRmvz:noN RUSs& 23 Russia's small-scale privatizaton is larg- with the option to buy after a year Federal er than in other Easten European coun- authorities, howevet have not indicated ties. The GKI estimated the number of the valuation methodology and legaiproce- retail and service outlets at the beginning of dures by which the premises can be sold. 1992 was about 270,000, of which a third This gap has effectively stalled the follow- were in the mandatory privatization catego- on sale of enterprise premises, even though ry. Given the exdusion of many enterprises there are thousands of bidders who (in the- fromthemandatorycategor}measuringthe ory) can exercise their option. This has led extent of the program is difficult. to a reluctance by entrepreneurs to take part in auctions and tenders. Framework. The 1991 privatization law Privatization legislation also provides and the 1992 annual state privatization pro- for liquidation of small enterpises. In this gram outline the main features ofthe small- case, a business is halted, its bank accounts scale program, leaving municipalities to ill closed, employees dismissed, and all assets inthedetags.Thelegislationstipularedthat sold. All liabilities are transferred to the small enterprises were noL to be corpora- municipal authorities and paid off with the tized (unlike large-scale enterprises) and proceeds raised fiom the sale of the assers. were to be sold for cash trough either an Apart from a few progressive municipali- auction or commercial tender. In auction, ties, liquidation has rarly been used. the enterprise is sold to the highest bidder, Bidding is open to all interested do- with no special conditions attached. All po- mestic parties, such as workers' collecives, tential bidders have to preregister, deposit Russian firms, or individuals. Foreign par- 10 percent of the price as a sign of good ticipation is aLowed only at the discretion faith, and bid in person. of the municipal Soviert which effectively The tender process gives municipalities excludes foreigners. Federal legislation greater discretion, which they have been gives workers and managas substantial quick to use. They can imposepost-privati- privileges. If they bid successfull} they re- zation conditions on poential bidders, with ceive a discount on the purchase price; if the highest bidder satisfing these condi- they are unsuccessfil or do not bid, they re- dons acquring the enterprse. Restrictions ceive part of the cash from the sale. To qual- can cover employment, investmen% change ify for the bidder's discount, at least a third of business profile, the financing of social of the employees must form into a partner- programs, and the prescrvation of histori- ship or joint stock company. cal buiings. Bidding can be open or If the employees' bids are successfil closed. Commercial tenders have been they get a 30 percent discount and can pay used for most sales. The two most common over three years, with a down payment of restrictions are a moratorium on layoffs and not less dtan 25 percent of the purchase on changing the line of business. There was price. Given that there is no adjustment for a failed attempt at the federal level to im- inflation, the three-year payment period pose atdree-yearlimitonpost-privatization dramatically reduces the real value of the restrictions. Such restictions can be in purchaseprice.If the employeeparumemip force from between one and fifteen years. or company does not win the bid (or does Because of the limited liquidity of the not bid) in an auction, they receive 30 per- Russian real estate market and the low val- cent of the cash proceeds, up to an individ- ue of the enterprise's other assets, usually ual limit of twenty times the national access to real estate is the only asset of real minimum monthly salary. If a competitive value that ownership of a privatized small tenderwas held, employees recive 20 per- enterprise brgs. Federal legislation has cent of the purcase price, up to an indi- stopped short of giving entrepreneurs the vidual limit of fifteen times the national right to buy the premises on which an en- minimum wage. terprise stands. For residential or multiunit buildings, a successful bidder acquires the Progpess report Small-scale privaization righttoleasethepremisesforfifteenyears, started in the city or NiAzny Novgorod 24 RJUSSTk CREATNG PmvArE ENERRmsEs AND BaENTlMAmErS (witi considerable assistance from the * Ywaku (Sakba Republc). No auctions Tble ZA International Finance Corporation) in April or tenders have ever been held and f 1992, nine months before the large-scale small enterprises were sold exclusively pnvawawn Perentag program began. Nizhny Novgorod was cho- to workers' collectives. Auo 20 sen as a pilot city because of the political * aganrog Sout Ceral trgion). Almost Cmmnrcal tender s0 commitment of tle oblast and city authori- all of the small enterprises slated for Lease vAth rights to buy 30 ties (both executive and legislative) to pn- privatization were leased under Gor- vatization. In April 1992 alone, some 6,700 bachev's leasing policy One kase enter- small-scale enterprises were sold through- prisewasaneighy-sevestorenonopoly. Out Russia The mnicipality patently failed to break- Since then, Russia has made progress, up a torg. though it is apparent that small-scale priva- VladVostock (Far Eastrqgion) The torgs tization has not catalyzed the growth of the were not liquidated, but reorganized small-scale sector. The GKI estimated that and leased to the workers' collectives. by March 1994, 75 percent of the 94,300 This has left few enterprises that can be wholesale and rcil networks in the 1992 sold through auction or commercial mandatory privatization category had been tender. The IFC is exploring ways of privatizedL Another 30,000 nonretail enter- dismanding the torgs. Municipal offi- pnses can be added to those estimates, cials have introduced an addizional making a total of about 100,000. eighty enterprises into the privatization The mixed success of the program can pipelinc and are looling at ways of in- be attributed to several causes. First, the traducing another 500 previously ex- number of small enterprises per capita and eluded enterprises. per unit area in Russia was low to begin * Peopavh-uk-Kwcatrki (Far Es re with. This has been compounded by ex- gwn). The authorinties sold only unprof- duding a large number of enterprses from itable enterprses and held profitable the program. Second, even for those in- ones. Te mayor has also recently trans- chuded in the program. the nature of their ferred responsibility for privatzation privatization has been uneven. It was orig- fromtheK[toadepartmentreportingdi- inally hoped that many of the practices rectly to himse4 stlig privatization. adopted in Nizhny Novgorod (such as *Nabodka (Far Ea region)- The cityK4I transparent procedures, the exclusive use department of trade, and the municipal of auctions, lack of restictions, and the liq- Soviet excluded forty of the city's lar- uidation of enterprises prior to the sale of gest enterprises from privatization "to assets) would serve as a model for other demonstratethecity'sabilitytomanage municipalites. But with few exceptions, property and trade enterprises." this has not happened. GK[ figures illus- Pzomab (Wesem Siberia region). The trate this (table 2A). mniipalSoviet removed sixty small en- Commercia tenders have clearly been terprises from the program Moreover, the favored technique. More than two- the municpal K[ is interestd in esab thirds of auctions and tenders have been lishing mixed enterprises," in which it won by workers' collectives. There are nu- retains an equity stake. Those enterpns- merous instances of post-privatization re- es that have been sold have been plaed stictions on changes of business profile underparticularly onerous conditions. In and employment It is estimated that more the case of one caf, the KIwent so far as dtan 90 percent of auctions and tenders toinsistthateachsevingofdumplngsbe have been of enterprises as going concerns, limited to 200 grams per acstomet rather than liquidation prior to sale. Voonezb (GC il region). Eighty per- The Intemational Fnance Corporation cent of the municipality's enterprises estimates that 14 percent of all municipal have been leased with right-to-buy pro- objects have been removed firom the priva- visions by theworkers' collectves. Some tization process. It has also identified many of these enterpises, on privatization, abuses: have tried to resurrect the old torgs. AN OvE0E OF PRIvA=AnON nq Russu 25 * Volsgd4 (Nortb region). The municpal creditispoorandwholesalesupplyandtrams- Soviet flouted federal legislation by sell- portatin conditions are unreiable It will be ing all enterprises to workers' collec- crtical for municipalities to drascaUlly re- tives for book value without using duce both their involvener in the rmning auctions or commercial tenders. of small enterprises and the tax burden, and take up the supervisory roles more traditon- Conclusion. The problem of the small ally associated with municipal authorities in number of retail outlets has been com- the West, such as trade promotion, encour- pounded by a faiure to privatize what there agrment of investment, and so on. Only if is and to privatize it efficiendty To rectifyr the progress is made on all these fronts will situation, privatization procedures should Russian consumers benefit frm the flour- be modified, the connection between priva- ishing small-scale private sectors that are a The problem of the tization and a commecial real estatc market feature ofotherEastern European countries small number of strengthened, and thebusiness environrment for small scale entrepreneurs improved. 1994 program retail outlets has To increase the privatization pipeline been compoundIed torgs should be liquidated, enterprises ex- The 1993 privatization program was never by a failure to cluded in the 1992 privatization program enacted because of political opposition. privatize½what there should be brought in, and the scope of the Instead the 1992 program remained in privatize what there 1992 program must bewidened. force- The 1994 program retains the same is and to privatize it But privatization is only one input into stucturce of the 1992 program, in part dari- efficiently. the development of the small-scale private fing the 1992 program, in part incorporat- sector Another is a liquid commercial prop- ing the presidential decrees issued in 1993 in ert markeL Because of a lack of suppoting lieu of the 1993 program, and in part adding legislation, E -.atization has become a surro- new components. New components indude gate for such a market. But given the restric- bringing new industries within the scope of ttons placed on hanges in business line and the program (such as ago-industies) and the bias toward workers' collectves, it is a giving a mandate to develop pivatization poor one. Federal authonties should quicldy programs in others (such as heah care). lay down the metodology by which owners Furber, the 1994 program clarified and of privatized enterprises can buy premises strengthened shareholders' rights. Changes and allow these owners to sel or lease their to a joint stock company's charter now re- property This will lay the basis for the emer- quire the approval of holders of three-quar- genceof newbusinesses (though restictions ters of the company's equity The same is on changes in business profile wvil continue true for a change in the conLpany's capital to slow down reallocation of resources). All limitaions on the sale of shares in an Allowingownerstobuytherpremiseswould open joint stock company are now foibid- underscore the federal authority's commit- den, and companies with more than 10,000 ment to not changing the 'rules of the shareholder5smusthaveaboard withatleast game. In contrast to Wstem retailers, who nine members, of which no more than a rarelyowntheirpremises,butwhohavewdl- third can be employees of the company defined and legally enforceable property in addition, new ruleswtre induded for -ghts, Russian entrepreneurs are likely to specific types of investors. Thus, the liit on have hostile municiplities as landords. the stake a voucher fund codd hold in any The way in whih municipalities have one enterprise was increased to 25 percent, conducted the privatization pocess does not a recognition of the widespread floutng of bode well for the fiture It is not just a ques- the previous 10 percent limit on vouche don of post-pnvatization restrictions; entre- funds. Restrictions were placed on banks, prenems also usuaUy face excessive currently one of the most profitable and municipal taxes as well For exampl busi- cash-rich sectors in Russa There was sgif- nessmneninOtiol, acityin the Central region, icant anecdotal evidence that banks were us- face city taxes of up to 48 peret of profits, ing their cash resources to buy up large with federal levies on top of that Access to amounts of equity Banks are now forbidden 26 Russ&: CREATING PuVM EiNImESAsD EICIENT MARKE1 to own more dtan 10 prcent of an enter- and false trades. Little or no self-regulation pri5s equity and cannot have more than 5 has emerged, and mistrust of exchanges is pecnt of their assets in the shares of any widespread- As a consequence, the ex- one enterpnse. changes are becoming less relevant, at least for the eaity market. The Moscow Central Gpital mwke: development Exchange, the oldest and one of the Lagest Russian exchanges, had a 1993 tunover of In contrast to the privatization program, in just 780 million rubles-less than $1 mil- which both the rules and impetus were gen- lion. Most trades (up to 85 percent) are crated by the center (and the implementa- conducted thmugh the over-the-counter ton left to local agents), the development market Most of the actvity on this market of much of Russia's capital markets over has conssted of brokes accumulating the last three years has been initiated and blocks of equty for enteprise managers . .. the development implemented by private secr interests. To wishing to increase their shareholdings in of much of Russia-s a large degree this should be wekome, but their own companies. markets this development has taken place against a In addition to managers and investment backdrop of litde effecmve govement or fiuds, banks have also been particua ac- over the last tbree self-regulation. The lack of central direc- mive in aqiring equity in pratizd enter- years has been tion can be parially blamed on the dsion pnses. The most liquid stocs i Russia (or initiated and of regulatory responsibilities betwcen van- those that have the appearance of being the ous bodies, such as the GKl, the Central most liquid) are bank shares. These banks implemented by Bank, and the Ministry of Fiance. Thus are not pivatized state banks but instead privae sector the GK[ is responsible for licensig vouch- havebeenpivatelyestshed- Inmanycas- er investment Binds, the Ministry of es they have bit their capitad bass though mnterests Finance for brokers and all other types of primaryissues.cIndeed,manylhavehadmore investment funds, and the Central Bankfor than one issue In a sense, many appear to be banik But a Russian Securties andc Ex- in a continuous subscription mode. A large hiange has recently been ttakblied o number of these banks (through thiir bro- which all the relevant central bodies have kea operations) make markt in, thdr representation and work has begun on own shres, and given the extent to which buadingbothan insitutional and regulato- these banks are issuing pimary stock, they ry framework have a p-ma fade conflict of interest be- Russia's numerous regional exchanges, tween their positon as a pnmary issuer and some of which appeared as early as 1990, their position as a dealer in thir own shares. were all prnvately sponsored. These ex- Gien that nascent eqity markets (both pn- changes initially focused on trading com- mary and seconmdary) are drven by players modities, rangng from grain and metals to who have litle interest in seeing trly liquid auto parts and computers 'With the distri- and transparent markeLs appearing, it is not bcaion of vouchers in 1992, most of these surprsing twat thy have not appea exdhanges moved into voucher trading, and Efforts have begun to rectify this situation by with the acceleration of the puivatization bypassingtheprivatelysponsoredexhanges. program in 1993, most now make markets The Russian Securities and Exchange wilL in the shares of privatized enterprises. sponsor the creaton of NASDAQ-type ex- Alongwith the cation of these excanges, anges in Moscow and St Petersburg. numemus brokerges have been estab- Along with growth in trading, develop- lished. It is esimated that by the end of ment in the capitmarlket infrtmucue 1993, there were 200 to 300 brokers in has occurred, such as registrars, deposito- Russia, with many established by banks. ies, clearing agents, and settlement cen- Though exchanges have proliferted, ters- But it has been haphazard on both an best practices on the exchanges have not institutional and regulatory front. For ex- There is litde real liquidity and transparen- ample, most enterprises wil maintain their cy on the exchanges. There is anecdotal ev- own share regisry, a source of obvious idence of considerable price manipulation abuse. Or bmkers, wit managemeth's AN OvEnIvw ov PmvAalz&noN mRussN 27 support, combine the role of registrar and August 1993, dte Central Bank announced the main market-maker in an enteprise's that non-Russian entities would be allowed, stock Further, few companies have issued for the first time, to buy rubles on the for- share certificates, enty in the share register eign exchange markets and open ruble ac- being the main form of ownership confir- counts in Russia for in ent. marion. This has lead to lengthy delays as Foreign investors could buy shares in mvestors (or thderbrokers) checksharereg- the secondary market from workers and isters before deatng trades. Steps are now managers. The problem is that the embry- being taken to improve pracuces withi the o nic secondary mars (and isiders' re regstrar industry An enterprise with more luctance to part with shares) make it lilely than 1,000 shareholders must now have an that this approach will take a consideble outside registrar (though there are few re- amount of time. A foreign investor could ... the new entities sources curredy devoted to ensuring en- concevably begin negotiations with an en- must be forcemnent). Tventy-five to thirty best terprise bere it goes tough corporahiza- practice dtird-partr registrars are to be crc- tion and ty to secure an equity stake ahead restrctured to run ated across Russia and a Registrar Support of pivatization or bid in a commrcial or more efficiently, Center, which is to form the nucleus of a investment tender. The success of any of and enjoy the self-regulatory organization, is to be estab- these approaches depends on the circum- lished in Moscow. It is also envisged that a stances of each enterprise and the enthusi- benefits of registrar specaflizing m companies with asm of managers and local authorides. corporate more hn one milion shareholders (of Despite the hurdles faced by foreign in- governance. which there are around sixy to eighty com- vestors, a number of venture capital funds panies) wil be created. For clearing and have been established in Russia In addi- setlement, a best practce system is to be non, the Russan PrivatZation Ccnter and established in Moscow and St. Petersburg, the Group of Seven are coordinting ef- the intention being to replcate the system forts to set up other equity finds under the rq two other cities. auspices of bilateral donors. The U.S. gov- ernment, for example, has established the Foreign investment Russian-American Enterpise Fund, simi- lar to those estabished earlier in Hungry, Legly, the Russian prrvatization program Poland, and the Czech Repubhc. It has al- does not discriminate against foreign in- so estabshed a series of funds though the vestoS. In reality there is a built-in bias Overseas Private Investment Corporati against outsider ownerhip, be it domestic (OPIC) for capital-intensive industies and or foreig The 1992 privatization program a fund for defense conversion. The Euro- broadly treats foreign investors as it does pean Bank far Reconstrucin and Devc- domestic investors. There are restrictions lopment and the International Finance related to foreign ownership in strategic in- Corporation have created a number ofven- dustnes such as fuels, energy, minerals, de- ture fimds dtroughout Russia. fense, or certain small-scale industies The establishient of a liquid secondary (wholesale and retail trade, public catering, market is vital to the success of such funds consumer serces, auto twaportation, because it provides an exit vehicle for the and construction). Approval is needed sale of equity holding in a given company from the Russian government, the republi- Moreover, without a liquid capital market, can government, or the muncipal authori- emergLng market funds-a source of capi- ty for strategic industries. ta-wil. be unable to invest in Russia There are no restictions on foreigners purchasig vouchers per se, but there are Conclusin other hurdles. To acquire vouchers, a stern imvesor has to have access to "At present, many people do not seem rubles, andthe only practicalwayto acquire to understand that real pnvatization is them is dthogh ongoing operations. not over as soon as a mechanical trans- Progress has been made in this area. In fer of tide has been made, even if po- 2g Russrm CRAurnc P%m EErRmsANDEFFcEJTrMARE5 litically this is considered to be the pi- the need for extensive central oversight of mary task. liansfer of title is only the the pmcess in general, and the need for ex- initial and largely superficial stage of tensive cental review of prvazation plans privatization: the new entities must be in parcular, which the Czech and Slovak restructured to run more efficiently programs required. Indeed, decentraliza- and enjoy the benefits of corporate donwascentraltotheprogram'sspeecLThe governance."(Federov 1993) GK[ laid down the ground rules for local oblasts to follow, using moral suasion, in- So wote Boris Federov, the former Deputy canives (sale of shares for cash), and presi- Prime Minister for Finance and Economny dentLal decree to ensure inplementation. It and a key reformer in the Yeltsin govern- never attempted to carry out implementa- ment. With a lack of progress on other tionitselHaditdoneso,theprocesswould fronts, privatization stands as one of the probably have ground to a halt Decen- More important is few reforms to be canried out in Russia. tralization also emasculated the power of whether after the Indeed, the sheer volume of mechanical manycentlbranchministries.Withimple- t ' title transfers of titles" that have been carried mentation carried out on a local level, there taP4& of ttle out indicates how succesful the program was litde formal role for many branch min- takes place, the has been. Clarifying the line of causation isties to play and litde they codd do tohin- privatization between the program's design and the ra- der the process. Thus a potential source of pidity of its implementation is a valuable delay was mostly eiminated. program has truly part of understanding what lessons can be Decentralization did brng its own prob- created a learned from the Russian program. But, as len. With so many oblasts to monitor fameworlk within Federov states, the volume of ransfer of ti- whether local pfrntizdon programs fol- ' .m des is only one criterion by which the lowed central ground rules dependedheav- which economic Russian privatization program should be ily on local attitudes. Abuises were common, agents have the judged. More important is wheher, after and there are wide discrepancies among in; ntives and the the transfer of title takes place, the privati- oblasts in the speed and scope of privatiza- zation program has truly created a frame- tion. In the mnre progressive oblasts, most means to carry out work within which economic agents have of the enterpnses in the mnandatory catego- the restructuring of the incentives and the means to carry out ryhave been sold, while in others, privatiza- Russ enterprises. the restucturing of Russian enterprises. tion has not yet readced the halfway mark The most striking feature of the Russian In yret others, privatization rates fall el privauzation program is its speed. A Lawe below even halfway Likewise, though de- part of this is explained by the privileges centralization considerably reduced the in- granted to insiders. With so much equity fluence of many ministies, it did not available for so little cost, this is not surpris- eliminate it. Key strategic ministries such as ing. But otherifcets oftheprogram's design oil, gas, defense, and so on were able to ex- also helped expedite the process. First and empt certan large enterpnses within their foremost, like the Czeh Republic and range of control from the mandatory section Slovalia, Russia adopted a ma privatiza- of the mass privatization program. In these tion program. Thus, they immediately side- industries, the ministry in conjunction with stepped the problems of Hungay and managers andtoalesserextentworkers, has Poland, which laid primary emphasis on a beenabletodictatethenatureandspeedof mixture of trade sales and IPOs. The case- privatization with little outside scrtiny by-case naLure of these methods has meant There are no publicly available figures on that in both countries privatizadion has been the number of enterprses that have been extremely slow, with considerable loss ofpo- exduded from the large privatization pro- litical capital and momentum. Unlike the gram, though it is not unresonable to Czechs and the Slovaks, however, Russian assume that they number in the thousands. refonners restricted the menu of privatiia- In addition, numerous enterpis were tion options avalable and made no provi- "grandfathered" into priatization under sion for competing pratization plans. the leasing law established during the Russian poliqmakems thereby elminated Gorbachev reforms. AN OvERVE OF PRIAVTKON aN RusSai 29 The manner in which vouchers were dosed and open subscription and through distributed also contnbuted to the speed of secondary-market acquisitions, has meant the program. Setting the price at which that insiders have emerged from the priva- vouchers were sold to the public so low tization program in Russia in a far more clearly led to a rapid distribution. Further, dominant position than elsewhere. This wll the distribution of vouchers at the earliest have serious consequences. First, there is possible opportunity not only jumpstarted the conflict of interest between insiders' the program, but helped ensure its irre- role as enployees and their role as share- versibilit t Once vouchers were in the holders. Any internally generated reuc- hands of the general population and the ex- tunng that threatens mranages or involves pectation had been created that the vouch- large-scale layoffs will be muted. But the ers would be converted into shares, it was consequences of insider giveaways are ...state enterprises much harderforopponents of privatization much larger than simply the blunting of in- must be to reverse the program Indeed, once sider incentives to restucture, because the vouchers had been distributed, the pres- extent of the insider giveaways has circum- polutcized -to sure was on the GCI tO move quicldy on scmbedthescopeoutsideshareholdershave make them respond voucher auctions. to influence and replace insiders. There has to the pressures of Pivatization, though a necessary step to- been no direct replacement of insiders as an ward restructuring, is dearly insufficient. As imnedate consequence of the Russian pr- the market rather Boycko, Sldeifer, and Vishny (1993) 'wrte, vatization program, unlike the Czech pro- than politicians." state enterprises must be depoliticized 'to gram (which made explicit provision for k). make them respond to the pressures of the lhusthe main channel for outside influence marketrathertanpoliticians."Privatization in Russia will not be voucher auctions, but alone will not raise sufficiently the costs to the development of liquid capital markets. poicians of interfering in the rnning of Of course, outsiders emerged through enterprises. To avert interference, an effec- thevoucher auction process. There are sub- die corporate governance system and an stanial numbers of Russian voucher funds economically rational mechanisn for the al- and cash-rich private individuals and firms. location of capital must follow privatization Potentialy profitable firms have quiicldy at- Only then wfll commercial decisionmaking tracted their interest In this context, al- beoutof the reach ofRussin politicans. Of lowing voucher trading has dearly proved course, the corporate govisnance and capi- beneficial in fostering the growth of large tal allocation mechanisms that evolve are not blockholders and is, as such, a useful anti- independent of the privatization program, as dote to the power of insiders. In this regard, might be the case say in aWestem European it made a lot of economic sense to raise the pivatization progpam. The nature of the 10 percent ownership limit on voucher Russian privatization program will critically fimds to 25 percent in the 1994 program. affect the development of Russia scorporate Given the limits placed on outsiders in govemance and capital market systens; or, the privatization program, if outsiders are to use Earle, Frydman, and Rapacynskis ever to influence and overtum insiders, a (1993) more encompassing temi, Russia's liquid, transparent, and vibrant equity mar- mass privatization program will substantial- ket combined with a vigorous market for ly affect its "private property regime." corporate control will be necessary. Giving equity to managers and workers Progress toward these goals has so far been has been a feature of most prrvatzation pro- patchy Though there are numerous pri- grams, both in and beyond Eastern Europe. vately sponsored exchanges throughout Insider equity holdings vill obviously to Russia, there is litle liquidity or trans- some extent, align insider objectives with parency As a consequence most trading those of shareholders. As such, insiders wil now takes place on the over-the-counter have a much greater interest in remsting the market (The development of the marketin coslyinterventions of politicians. However, vouchers provides some comfort that the the amount of equity insiders (particuarly obstacles to a liqulid market in shares are managers) have emered w both in the not insuperable) 30 Russx CREATNG PmvAmE ENRIEzuS mD EFFIcEN MArs With respect to the market for corpo- valuable asset may tum out to be its lobby- rate control, when outsiders have threat- ing connections and power. ened takeovers, insiders have employed a The Russian mass privatization pro- variety of extralegal methods to repel them. gram must be seen as the first phase of re- One common source of abuse is the control form. It represents a transfer to new, private many enterprises have over their own share owners, who now have the responsibility to registries, allowing the registries to ignore restructurc and modernize their companies or mnisrepresent inconvenient trades. or to sell ownership on the secondary mar- Discipline so far has actuafly been provid- ket to agents who can restructure. To com- ed by outside majority shareholders (or the pete in world markets, these companies discipline provided by the potential for a (now largely decapitalized and obsolescent majority shareholder to emerge from a by Western standards) need access to capi- group of minority shareholders). tal markets. Russian managers must recog- Much has already Further, and perhaps more important, nize that it is in their interests to raise been accomplished the influence outsiders gain from their po- capital in secondary ma&kts or to seek for- sition as minority shareholders is less than eign investors. in a short time, but would be expected. Aside from the proW Over time, workers and managers of because of the lems that one might expect from a lack of fims that survive transition will sell their nature of the minority imvestor protection rights and the shares to outsiders when they realize that risks of investing in an employee-dominat- they can get a high price, and capital struc- RUSSid2f pnvattion ed shareholding structure, the availability tures will gradually change. It is unrealis- program, much of cheap credits from the Central Bank has tic to expect all of this to emerge from remains to be done, undercut the power of outside minority in- mass privatization alone. The ultmate vestors. Lacking the power of a majority in- success of the privatization program is vestor, the major influence a minority dosely linked to a tighter credit policy and investor has is based on an enterprise's the development of capital markets, the need to return to the market to raise capi- latter in part a function of the former. taL So long as the Central Bank provides Much has already been accomplished in a cheap credits, 'insiders have every reason short time, but because of the nature of to distribute the profits of the enterprise in the Russian privatization program, much the form of wages, bonuses, and other remains to be done. compensations to themselves rather than pay dividends to shareholderse (Earle, Bibliography Frydman, and Rapaczynski 1993). ikge- wise, with litde need to go to minoty in- -~ ~ ~~~ ~rt . . Boyka, h§=manr rd Andre Sbleifr. 1993. -Me vestors for financing, enterprises have litde Voucher Program for Russia," in A. Aslund and need to restructure. R. Layard, eds. Cbnig the Economic System in In the absence of hard budget con- Rusia. St Martin's Press. straints on enterprises, the impact of the Boycko, Maxim, Andrei Shleifer, and Robert W whole privatization process will be serious- Vshnby 1993. 'Privadzing Russia? Paper pre- ly undermined. The weak position of pared for the Broolings Panel on Economic Russian minority shareholders is bome out AdiAS. by the low values that have been placed on of PCriape Majoh ctue, s A,a Sl Petrrb1g. ASvch- stakes sold through voucher aucions. nical Paper 228, W d Bank, Wasngton, D.C. Without greater control on the part of the ChImbais, Anatoy and Maria Vishekays. 1993. Central Bank of its credit policy, Russia's -Main Issues of Piivaization in Russia," in K capital markets will remain moribund. Aslund and R Layard, eds. Chaging t6h Indeed, considering the market for corpo- Fcomonc Sysem in Rssia. St Mardtin's Press. rate control, if outsiders were to gain con- Comnission of European Communities, Euro- tol of an enterprise, the degree to which pean Bank for Reconsuction and Deveop- ogment, and the Stat Commintee of the Russian they would deviate from insiders in lobby- Fedntion for the Management of State Pro- ing for access to Central Bank credits is a pety lGKI). 1993. The PN iadrion Manlu moot point. A management team's most vols. I and 2 AN OVE0W OF PmuvAnznoN mN RussIA 31 Debevoise and Plimpton. 1993. 'Piivatization in St. Gies, Mark and Sally Buxton. August 1993. The Russian Republic.' draft. "The Role of nvesttment Funds in the Russian Djeic, Bozidar, and Natalia Taukanove. 1993. Privatization Progmrmme." London. Draft. '%ucher Auctions: A Crucial Step toward Pri- The State Committee of tde Russian rtdemtion for vatization." Redio rn EuropRadio Lberty theManRgementofSuate Pmperty August 1992. Raemrck Report, -ol. 2 (30). "The Russian Ptivatization Progrn: A Guide The Econom,it July 1993. 'Russian industry the For Foreign Investors." Draft. revolutio begins." Thomas, Scott and Heidi Kroll. July 1993. "The Earle, John, Roman Frydman, Andneei Political Economy in Russia.' Draft. Rapaczynski, et aL 1993. "The Privatization World Bank. 1992. 'Russian Economic Refonn: Process in Russia, Ukraine and the Baltic States," Crossing the Threshold of Economic Reform." chapter 1. Central European University Prss. Washington, D.C. Earle, John, Roman Frydman, and Andnej Rapaczynski. 1993. "Transition Policies and the Notes Establishment of a Private Propery Regime in Eastern Europe." 1. A more detaied analysis is provided in European Bank for Reconstruction and Develop- Gorobev's Ssugle for Economic Reform by A. ment. July 1993. "Privatization in Russia." Aslund. Discussion Paper for the Consultative Group in 2. Nellis (1991) points out that dtese numbers Pais, are likely to be underestimates, since a significant . April 1993. "Ptivatizing the Bolshevik number of enterprises are made up of subunits that Biscuit Factoqr" Draft. in tde West would be considered independent Federov, Boris. 1993. 'Privatization with Foreign firns. Indeed, as privatization has got under way a Participation." in A. Aslund and R LI;ard, eds., significant minorit of enterprises has splintered in- Chaging the Economic Sym in Rusi. St tosmaller units. Marit. 's Press 3. For a contrary view on industrial concentra- Harding, ApriL 1993. 'Small-scale Privatization in tion in Russia, seeAnnette Brown, Banrylckes, and Central Europe: Lessons for Europe." Draft Randi S. Rytermuan, "The Myth of Monopdy: A International Fmance Corporation. 1992. "Nizhny New View of Industrial Strucure in Russia,' Novgorod: First Ptivatization in Russia.' Drft October.1993, World Bank . 1992. "Small-Scale Privatization in 4. See chapter 10. Russia: The Niaimy Novgorod: Model (Guiding 5. The 1992 state privatization program, entiled Principles)." Draft "State Progran of Privatization of State and . July-Novenber 1993. "Russia: Small- Municipal Enterprises in the Russian Federation Scale Privatization Monthly Report." Draft. for 1992," was issued in conjunction with the . October 1993. "Large-Scale Priva- 'AmendmentsandAldditions totheLawofRSFSR tization in Russia.' DrafL onPrivatization of State and Municipal Enterprises Liebeman, Ira. 1993."Poland's mass privatization in the RSFSR.' program."Word Bank. Draft. 6. For a more detailed comparison of these mass Milanovic, Brarmko. 1989. Libemliauon .M prvatizatiOU programs, see Ira W Liebenman, Enupnnemrp 4Dami of Rebin Soalm AndrewEwing, Michal Mejsrik,Joyia Mukberjee, end Captam. Newlbrk:Annonk, MESharpe. and Suhai Rahuja, "Mass Privatization in Central Nefis, John. 1991. Improwing the Perforanc of and Easten Europe: A Comparative Analysis." Soviet Ensterpri. Discussion Paper 118. The World Bank, forthcoming. World Bank Wahington, D.C. 7.The privatization laws and decrees sometimes . 1993. "Bolshevik Biscuit in Private define large enterprises as those with over 1,000 Hands.' Trnddon, Vol. 4 (2). The Wod 1. employees end book value of over 50 million Washington, D.C. rubles, and sometimes as those with over 1,000 Pheps, Edmund, Roman Erydman, Andrzej employees or book value of over 50 million rubles. Rapaczyndid, and Andrei Shlrifer. March 1993. There is a similar inconsistency in the definion of "Needed mechanisms of corporate goverance snall enterprise. and financeinEastern Europe." Wrlking Paper S. See. section on small-s Ae privatizations 1, European Bank for Reconstruction and hereiL Devdopment, London. . 9. The privatization plan included information PriceWrerhuseJune 1993-March 1994. "Funds such as the fim's name, its location, the type of Monioring Report." Draft. propertyitwas (fedeal oroblast), its legal form, the SawyeMier Group. October 1993. "hiva- number of woers it emplyed, basic financia in- tization and Pbpular Mandat: Using Commnu- fommation on the finr, its sharhobdngs in other niations to Ensure Sustainable Reform' firms, its business acivities, the products it manu- Wahngton, D.C. DrafL fCactues or sevice it offers, the oumme of the 32 RuSsA QwTnwG PavAn ENuRS s AN D EFIcmNr MA S vote on die dosed subscription, and an outline of 14. Employees may fail to subscribe for die fiUl how equityremaining atr the closed subsciption allotment if the enteprise is particularly capital- is to be disposed. intensive. 10. Interim Methodological Gwdelines for dte 15. It was only after vigorous marketing by one luation of Prperties Tated for PRivtiAtion," particlar investment fund dut prticipation gre issued as Supplement 2 to the Acceleration dramatically. In the end. almost three-quarters of Decree." those eligible collected their coupon books 11. Holers ofprefered hars rceiv: Eixd div- 16. In reality, the potential inflationary impact of idends of 10 percent of the previous year's prfits. vouchers was a nonissue give thhat, because of oth, If the holders of the comnron stock receive higher er causes, ifation was in excess of 1,000 percent dividknds on a per share basis than prefercd share during 1993. hldde then dividends on prefeed shar hae to 17. GKEI gulation of Fbuary 12,1993. Note be increased to match those on conmon shues. this regulation refers to the perenmtage of each en- 12. Refeing to the 25 percent nenvog stock, terprise's equity hat has to be sold specifically in eachenployee annotreiveshareswithabookval- the voucher aucton The 80 pct rnle irs to ue greater than twny times the minimur mothly the cortl percentage of each enterprise's equity that sasy guamntcedby law. Refering to the 10 percent has to be soId fDrvouchers, induding vouchrs col- voting stock, eaic employee can not meeve shares lead in the dosed subscription, te voucer auc- vith a book value more than six times the minimum tion, and so on. monthly salay guranteed by lw. The minimum 18. A state company is defined as one that was monthly saly guaranteed by law as of July 1, 1992 more than 25 percenit state-owned. was B rubles Th isms been adjusted. 19. Surveys bave been cari ed out by Joseph 13. Opto 2 and3 wereincluded in the privati- Blasi and KIatarina Piscor of the GKL Quoted mi zadon prgm becuse of the csiderble lobby- Boycko. Shleifer and Vishny (1993) and in ing powerof enteprise mangers mndworkers. The Webster (1993). oiginl proga had only option iL Am OvEvoEw OF PRIVATIAON iN Russi. 33 CHAPER 3 Privatization in the Regions: Primorsky Krai Alexandra Vacroux The distance between Vladivostok, the cap- sions between municipal and krai-level gov- ial of Primorsky krai (region), and Moscow ernments within regions In addition, be- spans seven time zones and 5,778 miles. cause the pivaization of bigge Soviet A study of Under communist nile, this geographical entprises has stimulated morepoltcal lob- privatiton in separation did not prevent Primorsky and byig and maneuvering than the sale of priZrsky krai nine othet far eastem regions from being smaller establishments, a discussion of large- fully integrated into the econoniic and po- scale privatization inPrimorskykrai provids reveals more than litical life of the former Soviet Union. Since insights into how the inteactions between the difficult and the dissipation of the USSR, the highly cen- political actors (such as officials) ancd eco- evolving relationship tralized bureaucracy and Communst Party nomic actors (enterprise manages and en- structurs hat linked the regions to the cen- trepreneurs) are shaping Russia's flture between the center trhave been all but eliminated As a result Primorsky krai is an interesting venue and the regions in Russian regions have had to adapt to a low- for a case study because it is both far from post-communis er level of economic support and a higher and important to Moscow The krais strate- degree of political autonomy than before. gic location near key Asian mares, cou- Russia. Primorsky krai has adapted to post- pledwith its three major ice-free ports and Soviet Russia in much the samewayas less- valuable natural and industrial endow- distant regions. As before, regional officials ments, provide both Moscow and the re- still rely on personal contacts in federal- gion with an interest in maintaining control level state offices to obtain financial and po- over local resources. While it is impossibe litical support for residents and enterprises. to test anyhypotheses or theories with a sin- As elsewhere, Primnorsky officals have de- gle case, a study in this pivotal region veloped new strategies to demonstrate and should yield suggestive conclusions about augment local autonomy Designed to ex- how privatization is being implemented in tract the maximum amount of resources the Russian regions. from the federal govenment while ceding as little control as possible over regional as- The economy of Primorsky lrai sets, these strategies are being applied across all policy areas, and have con- The Primorye area of Asian Russia forms tributed to growing antagonism between the western banks of the Sea of Japa It regions and the central governmenL In sharesborders with theKhabarovskykraiin Primorskykrai, the power strugglei btween the north, China in the west, and North region and center has been particularly Korea in the southwest. Population esti- acute in the area of privatization. mates for the region converge at 2.3 million Astudyof prvatization in Primorskykrai but probably do not take into account the reveals more than the difficult and evolving significant miflitary presence.' Just over relationship between the center and the re- three-quarters of the population lives in ur- gions in post-communst Russia. It Illstrates ban areas of the krai. the conflict between the executive and leg- The region has abundant natural re- ilative branches of government (both of sources, mduding ore and mineral deposits, which were assigned privatzation responsi- diverse chenical and timber reserves, and bilities) and affords a glinpse into the ten- marine products. The regional economy PRivAImoN IN THE REGIONs: PiEtiRXRsW1IAK 35 depends prmarily on fisheries, foresu the Muniipal governments have respond- nonferrous metal industry, sea transport, ed well to the cash incentive built into the and the ship repair industry. Though it oc- small-scale privatization process. In cupies only 2.7 percent of the far eastem Nalhodka, for example, cty soviet Deputy land mass, Primorsky krai accounts for 80 Chaiman Oleg Oksuzian emphasized that percent of the area's mariDne transport ca- the city deliberately pursued an aggressive, paity. As a result, the region's three large small-scale privatization strategyin orderto seaports serve as the departure point for cover the municipal deficiOt The monetary much of Rus.ia's raw material and con- incentive to sell small businesses has also sumer goods exports? created problems. In Vladivostok, the de- Krai adminisration sources claim that 5 lineation of krai and ity property led to percent of regional enterprises (sixteen in confliCtbetween the different levels of gov- In Nakhodka... the all) were part of the mflitay-industrial com- ernment Sergei Soloviev, Chairman of the city soviet dept p Ot30her officia statstics indicate that Vladivostok city sovietr complaied that chairman... in late 1993 the defense industry employed the Primorsky krai administration success- 20,300 (8.3 percnt) fewer workers tan it filly designated a few' hairdressers, movie emphasied that the did in 1992. (If accurate this suggests that dteaters, and other "dearly municipal" city deliberaely the distressed military complex may actual- businessea zs krai property eam income pur 2ed an ly play a much more important role in the from tci privatization.7 Since small-scale pursuecs an iical economy than is suggested by admin- privatization began, there have been com- aggressive, small- istraiion figures.) The downturn in the lo- plaints that privatized stores fail to meet the scale privayjion cal defense industry can be attributed to a needs of the population. Some interviewed strategy ins order to reduction in federal government orders public officials daim that the reprofiling of comfreo bined withits failumeto pay for 250 bil- smal shops after privatization has made it cver the municipal lion rubles worth of orders it placed. Enter- difficult for the populaton to get basic ne- defiat. prin in other economic sectors are also cessities such as bread and milk, but this havng troble adapting to the current tran- author has not come across any surveys or sition perio4 prvatized stores in Primorsky krai that Despite current economic difficulties, would confirm or deny this c6lim many of which are affliting enterprses all To overcome some of the perceived over Russia, Primorsky has the potential to shortomings of small-scale privatizaion, develop rapidly. The region, and Vladi- some municipal officials in Primnorsky krai vastok in paricular, is a transportation hub have turned to local legislation. Oksuzian for Russia with easy access to foreign mar- provided examples of this behaor when he ke.ts In addition, it has a generous supply explained that the Nakhoda soviet passed a of raw materials, a strong industrial base, regulation that allows the localpropert fund and a highly-qualified labor force common to'wihidraw an entpisefrom auctionvwith- in defense-related enterprises, out specifing a reason if the offered price is perceived tO be too low; another regulation Sma-scale privatization reduces the payment period granted to win- ning labor collectives from 3 years to 6 Primorsky CHI data for Apri 1, 1993, in- months if asomeme else is standing behind dicates that the region had 1,835 small- the collecte (as some invesors might take scale businesses eligible for privatization. advantage of the 30 percent discount to col- Of thes, 929 (51 percent) had been priva- lectves). More study isneededto detemine tized by the end ofthe first quarte of 1993. whether the use of supplementary lcal pri- The lueis Statisics Department reported vatization ruations is wndespread. If so, it that 65 percent of all enterprises were pri- could be distorting small-scale privatization vatized through competitive tenders, while by gvng local authorities more disction 31 percent were pnvamzed tbrough auc- than was intended and by discouraging the dons. More than half of the small pnvad- restuctring of smalbusinesses. zations may have been completed with Ihenreu ring and reorganization of some restrctions on their futre activity5 small businesses is also hampered by a 36 Russz& CREAtDNG Pmvxr ENTERPRsEs AND EF-icENrMAES shortage of credit. Both privarized and new privatization. However, an enterprise that small enterprises report that they have difi- has completed voucher auction should not culty obtaining affordable financing, Unlike be considered private so long as the prop- large enterprses, smallbusinesses do notre- erty fund continues to hold shares. ceive government assistance and must find Moreover, privatizing an enterprise does their own sources of financial supporL In not necessarily create a more efficient and principle, both state and commercial banks productive business, but it may instead are willing to lend money to smaller opera- serve to betray the inherent unprofitability dons, but given the high inflation, they are, of an operation. Merely distnbuting shares namral1y mosdy interested in providing -to private investors does not necessarily short-term, high-interest loans. One reason stimulate an enterprise to behave different- given to explain this phenomenon is that ly in the short-run.9 Thus one should not banlks apparently fear that small businesses assume that the pace of voucher auctions is The voucher are disguised mafia operations created to synonymous with the pace of playpriva- action a get cash and vanish. Moreove; banks may tization, nor can it serve as a proxy for the be atuacted to large enterprises that are un- rate of genuine industrial or corporate crtical stage in likely to dose and that have access to alter- utnsformation. A region's abiliy to suc- an enterpnrse's native sources of financing to bail them out. cessfully organize many voucher auctions privatization, for To begin to rectilj this problem, the krai's can serve, however, as an indicator of how ' Anti-Monopoly Committee and Japan's commimted locd priatization offcials a it transfers a third Ministry of Intenational Trade and In- to completing prvatization, and of how or more of an dustry have jointly created a center to sup- quicdy the state's stake in the large enter- enterpise from portsmallandmedium-sizebusinesses. The prises is being dminished. Japanese have contributed $30 milion to The Primorsky GKE and property fumd state to private tiis program and are expected to agree moved quickly to design and set up a hands. shortly to set up four "adapting centers" for voucher auction system in late 1992 and businesses in the near future.8 early 1993- The fund, responsible for orga- nizing the distribution and sale of shares, Large-scale privatization used an unconventional approach and pUt large enterprises up for auction in two- The privatization of a large enterprise is an month 'waves' of 40 to 50. By the third incremental process. First the enterprise is quarter of 1993, the fimd had completed corporatized. Then, up to 51 percent of the voucher auctions for almost 100 enterpis- joint stock company's shares are distrb- es, and was among the top 15 regions in the uted among workers and managers in a number of enterprises sold. This brisk pace closed subscription. The amount of stock ofvoucher auctions suggests thatPrimorsky distributed within the enterprise depends officials were reform-onented and respon- on which benefits option was selected by sive to policies formulated in Moscovc This the labor collective. Once the workers have impression was consistent with the results voted on an option, the property find pre- of the April 1992 referendum, in which pares a voucher auction for the sale of no more Primorsky voters supported Yeltsin less than 29 percent of the company's and his reforms than in Russia on average. shares for privatization vouchers. After the Regional officials appeared to be commit- voucher auction, some shares remain with ted to implementing federal privatization the rcgional property fimd. These shares, policy Given this apparent support for usually amountingto 20 percent or more of voucher auctions and large-scale privatiza- the stock, are earmarked for the auction or tion, many observers were taken by surprise tender (for vouchers or cash) at a later date. by the joint krai administration and the lTe voucher auction is a critical stage in Council of Peoples' Deputies announce- an enterprise's privatization, for it trafers ment that, as of August 1993, privatization a tiird or more of an enterprise from state would be curbed ostensiblyto save local en- to private hands. It is also the first oppor- terprises and voucherholders from the im- tunity for outside investors to participate in pact of bankruptcies. PRWVATIZAToN IN THE REGIONS: PnoR K 37 P 'riorsky's (ultimately unsuccessful) Fedel government playen bid to stop the privatization of large enter- prses was not the only one of its kind-sim- Govement officials hierarchically superior ilar attempts sere made in Novosibirsk and to local players may also get involved in re- Cheliabinsk in Apri 1993- Nevertheless, be- gional privatization. As institutions compet- cause it happened in a region percved to ing for jurisdiction over the process, the be successful, the stoppage led many jour- federal Gla and property fund will compete nalist, officials, and business people to ask at the local level if neeary and wil, on oc- what had gone wrong wit large-scale priva- casion, joinalocalcontestbetween fundand tization inPrimorsk The conflict mobilized committee. In some cases, the federal level and exposed the institutions and individuals organizations create tensions between local involved in the PrimorAy privatization pro- privatization organs that had been effective- Federal GIG relied cess, allowing one to dearlyidentify the lead- ly cooperating The Federal Property Fund, on a strategy of ig political and economic actors. An for instance, tied on a number of occasions analysis of the intection amnong these ac- to deny local propery funds the right to sell carrots. . . and tors illuninates the danamic underlying the 29 percent of federal enteprises at voucher sticks.., to large-scale prnvatization process in Primor- auctions. Tis intervention, which frequent- encourage loc sky krai; at the same time, it illustrates how ly took place after the local fund and local is affecting the regions, and GKEhadfinalied auctionpreparations%ap- officials to follow the regions are influencing the overall peared to be motivated by the Federal prjivatization prcess of privatization in Russia. Propery Fund's desire to delay auctions un- legislation. tdl they had put in place a more lucrative Locagovernmet intttons mecaism for privatization Federal GMI relied on a strategy of car- The main players in Primorsky's privatiza- rots (promises of technical and financial as- don process are, first and foremost, those sistance) and sticks (such as threats of that wield significant economic and polit- annulled auctions) to encouge local offi- ical influence. Regional governmental in- cials to follow privatization legislation. stitutions responsible for privatization Meanwhie, the Federal Property Fund (that is, the local GK[ and property fund) -which was brought under control of the have the authonty to determine what wil government following the dissolution of the be privatized and when. While dtey can be Supreme Soviet in October-nerally act- successfully countered by recalcitrant ed as a bra2ke on privatization. One of the diectors who manage to sway federal of- Fund's Deputy Chairmen even lobbied ag- ficials against their enterprise's privatiza- gressively for a new variant of privatization tion, local privatization institutions have that would have sold large enterprises to administrative powers that give them employees. The fundamental philosophical leverage over local enterprises. gapbetweentheFederal PropertyFund and Local executive branch players (the r- Federal GKI, a reflection of the diverging gional administration and GM[) are distinct views on prnvatization held by the govem- from legislative branch players (local sovi- meat and Padiament, intensified the iwus- ets, deputies, and the regional property dicional stuggle between funds and GK[s fund). In addition, while the local GMI is at all levels of governmenL It did not, how- often dosely aligned with the regional ad- ever, prevent local fund officials, assigned ministration (the head of an oblast or krai personal responsiblity for the sale of enter- GIM serving, by laur, as a Deputy Governor prises, from having closer relationships with of the oblast or krai), the regional property the more supportive Central GIC than with fund tends to operate fairly independently the Federal Property Fund. of the regional soviet. Thus the loca ad- ministrtion, local GK[, local legislature, Enpriser and local property find should all be con- sidered separate actors, eachwith their own As i Soviet times, large enterprises contin- incentives and powers. ue to play an important role in regional eco- 38 Russr& CRnmNc PRvAn Enrtxs Am ErxSaN MAnnM nomnics and politics, though this role has fulroleinPdimowky'spdvatizationpraces. changed as fiactories and firms become Representaties from Primorsky's political more independent Thle centraly-planned parties andc movements inde pendently te economic system meant that regional polit- tified that their organizations have had no ical officials existed in large part to secu influence on the design or implementaton compliance with industrial plans. Cor- of large-scale privatization.Thisis partlybe- respondingly, enterprise production vol- cause pratization legislation is drafted at ume was a major determinant of regional the federal level, and therefore falls under (and personal) success. As part of the tran- the jurisdiction of nationa rather dhan local sition from communism, the state has been party suctres. Nonetheless, given the im- gradually ceding its control over the econ- portance of pririzaton in redistriuting omy and enterprises have begun concen- regional assets, the passivity of local parties rating on obtaining private contrats. But and movements would seem to reflect ei- The strategy used despite a reduction in enterprise depen- ther ineffectiveness or a marked lack of am- by entrepreneurs dence on govenment, enterprise perfor- bition-orbotht mmcc remains critical to the growth of Labor movements b to exert ln1buence local economies and local officials. Big en- Though workers received great benefits in on the politics of terprises are still the lagest taxpayers, em- the 1992 Privatizauon Program, the organi- privatization ployers, and suppliers in most, if not al, zations that caim to represent them have P regions)" In many cases, they also contin- filed to translate this victory (and their has gradually ue to be the primary provides of housing Soviet legacy of newspapers, offices, and shifted from and social services. personnel) into political power Most unilateral to unions have been margmalized by th sepa- c t at Enn=ews ration of industty and state Deprived of of' collecte action ficl authority widtin factories, and lacdng over the course The potentially high rewards of pnvatiza- grass roots legmacy among workers, they of 1993. tidon have also stimulated the involvement usually cannot affect dte course of privati- o of actors who did not inherit political or zation witbin any given enterprse. The economic power from the Soviet regime. Prinorsky Krai Federation of Trade Unions Many of them can be considered entre- has tried to tansform itself into a consult- preneurs. These include both investors ing operaton for workers in pratizing en- (such as wealthy individuals and voucher terprises. But the complexity and specificity investment funds) and organizations that of each large-scale prvatization, often cou- have sprnng up to support and profit from pled with friction among workers, makes it the voucher system and large-scale priva- difficult for them to have an impact on the tization (for example, stock exchanges laborcollective, let aloe onmanagement.? and brokerage firms). All these have made or expanded their fortunes through priva- Primorsk'spr ation aois tization, and are interested in seeing the process continue. They have expressed Privatization in PRimorsky started in much this interest more than once by launching the same way as in other pam of the can- public relations campaigns to counter the try. The regional State Property Committee more virulent attacks against the pnvati- and property fund were created, staffed, zation program. The strategy used by en- and assigned responsibilities that included trepreneurs to exert influence on the the privatization of large enterprises. A politics of privatization has gradually municipal level administrator, Gennady shifted from unilateral to collective action Tokulenko, was appointed Chairman ofthe over the course of 1993." GKI; in contrast, Valerii Lusenko, a for- mer general director of an assocation of l- Pohicadplayen cal enterprises, was selected to chair die local property fimd. Only actors with official phlitical power or Whenthefirstpdvatizatioprgramwas economic assets appear to play a meaning- being debated in the spring and summer of PRIVAUZAION IN IIE REGIONS: PiMORw KMI 39 1992, enterprise managers in Primorsky and in the middle of last year, PAKI' is a holding across Russia opposed corporacization and company whose founders indude 31 large pivatization. Primorsky's privatization insti- enterprises. A publicity brochure prepared tuions began to work with rsistant direc- by Anatoly Pavlov, President of PAK, list- tors and slowly convinced them that ed the orgaization's goals: to expedite the privatization was necessary and advanta- structural reorganization of the Primorsky geous. Directors came to understand chat krai economy, to firther regional interests privatization could make them personally in the Padfic Basin; to facilitate the devel- weathy, that they would not necessarily lose opment of competitive technologies and their dominions, and that foreign (and do- services, with foreign participation if pos- mestc) investors would be more attracted to sible; to preserve and increase the effec- private compames. According to Lursenko, tiveness of krai industry by means of ... many enterprises by the fourth quartr of 1992 skeptical di- inter-regional cooperation and byencourag- developed close rectors had been persuaded to prepare ther ing development of small and medium cn- enterprises for transformation into open terprises; to create sn economically efficient reraztzonsr4rps with joint stock companies. Along the way, many finandal investment system that can pro- privatization enterprises developed dose relationships vide insurance against seasonal and struc- agencies, since an with privatizarion agencies, since an infor- tural fluctuations in markets; to transfer informal alliance mali alliance with the fund or GO was a capital frm nonprofitable to profitable means to ensure dtat one's interests would branches of industr, and to create a social- witb the fund or be taken into account as much as possibk ly stable and economically protected swuc- GIC was a me-ans to These dose relationships were cited by G ture for voucher investment by krai citizens ensuretatu and fud officials as being one of the main and Russian voucher funds during the peri- ensuere that onze s reasons that PrimorAky became one of dhe od of economic instability and bankruptcy interests would be fe corporaizing and privatizing regions Though there are many financial-indus- taken into account in Russia trial groups forming in Russia, PAST is one Primorsky GMG data on corponatization of the most controversiaL Unitmg krai en- as much as possible. by Jabnuay 1993 reveal two intresting terprises across a wide spectrum of indus- facts. Firs, labor collecies chose to buy tres (from ship repair to meat processing), out 51 percent of their enterprise in nearly PAKTIaspires to replace the old branch mo- 90 percent of large enterprises. Ths is sig- nopolies that dominated the local cconomy nificandy higher dtan the corresponding (The regional anti-monopoly committee has national statistic of 77.8 percent?3 Second, apparently ruled that PAKC is not a mo- the amount of charter capital being pnva- nopoly.) The PAKR leadership is currently tized (through voluntary corporatization working wnth member enterpnses to devel- and sale of shares) excee-s the amount sub- op a unified restructuring plan. Where two ject to compulsory corporatization and pri- membes compete in the same market, vatization. These facts imply that by 1993, PAKr will determine which is most cost- directors of medium and large companies effective and reprofile the other for prduc- in Primorsky had become aware of the po- tion in areas in which it is has a comparative tential gains from corporatization and pr- advantagc The stated goal of the organiza- vatization. They do not explain, however, tion is for associated enterprises to provide why Primorsky's labor collectives are so of- all the inputs and finished products re- ten in favor (and able) to buy up over half quired by other PAKRT enterprises.'4 of enterprise stock Pdnvatization has served as both a cata- Besides woking closely with fund and lyst and instrument in the development of committee officials, some enterpnses joined PAKRT Boris Fadeev, PAKR General Direc- forces and created a financial-industrial tor, stated at a public roundtable that "the structure called PART-the Primorsky central prnciple in the earliest stage [of Manufactues Shareholders Corporation. PAKI] was to protect future member-com- Initiated by local enterprise directors (with- paries' independence during pnivatization. out pressure from Moscow), but allegedly That is, we made sure that as the enterpris- approved by Prine Minister Chemomyrdin es were converted to joint stock compamnes, 40 Russ: CEnhG PmuvArErENrEmmss&AND EFFIcENT MAmcs local majority interest was maintained economic control were pushing krai enter- against the capital pourg into Primorye prises toward bainkptcy and nsldng mas- from al over Russia."' PAKr has pursued sive layoffs, striks, and isodal-political this objective by particpating in the vouch- dissaisfaction with curn economic re- er auctions of member enterprises. The cor- form among krai residents." The adrminis- poration either buys shares for the holding tration and legislature acted upon the let's company or it gives money or credits to the recommendations and issued a joint regula- enterprise so that it (presumably manage- tion that allowed the local government to mert) can obtain a majority of shares.)6 This temporarily hold on to its shares in "crucial approach has alarmed observers who have and socially significant" enterprises (a cate- denounced the use of privatization as a gorywhich encompassed 64 krai eterprises means of reconsodidating regional econo- and 108 federal enterprises); create a re- mies (and politics) in thehands of directors. gional governmental commission charged ... some enterprises PAfls eonomic strength is difficult ith cdeciding which enterprises were bank- joied forces and to assess. Members claim that they repre- ruptand formuaigaplan forresinuctueing sent the best of far easten enterprises, the local economy; and hbat aU Primorsky created a financial- while opponents deride them as morbund voucher auctions. industrial structure defense factories. As a group, the PAKr The announcemcnt of this regulation called FAKT- enterprises employ 90,000 people (9 per- created a stir across Russia. Local and na- cent of the local workforce) and had a tional investors began dumping their shares the Primorsky combined charter capital estimated at 25 in privatized Vladivostok companies. PNi- Manufacturers billion-0 billion rubles ($25 million-$10 morsky krai traders boycotted the securities Shreholders million) as of August 1993, according to market and the Vladivostok Iemational figures from the Pavlov PAKT handout Stock Exchange cancded trading ir Corporation. Regadess of their actual economic puis- protest The head of the stock echag, sauce, PART members have amassed a Viktor Sakharov, launched a publicity cam- great deal of political power. On May 19, paign opposing the move. He was joined by 1993, Evgenii Nazdratenko, General investment fumds who had purchased Dector of the far eastem mining compa- shares of local enterprises, and who threat- ny ostok"-a PAK member-became ened to take the local administration to Govemor of Primorsky krai. By the end of court In addition, Anatoly Chubais, Chair- the summer he had appointed three more man of thefederal GKl and a Deputy Prime PAKr industialists to serve as Deputy Minister ofthe Russian Government, called Governors in his administration. the local administation to warn that stop- The new administration has aggressive- ping voucher auctions was tantamount to ly tried to help local enterprises find state violating presidential decrees. Coming on or private investmenL As in other regions, top of pressure from entrepreneurs, the krai officials have also sought to increase duress applied by a top-level federal gov- the authority of the regional administra- emment official precipitated a cancellation tion in relation to the federal governmenL of the krai decision. In a departure from more conventional re- Given the extent to which the directors' gional strategies, the new administration lobby has captured the Primorsky lrai ad- tied to increase its power by operly chal- ministration, it is unlikely that Nazdratenko lengng the center's right to implement re- acted against the wishes of local enterprises form in Pmimorsky krai. lhis challenge and PAT. But why wouldtle krai's indus- came in the form of a lcal regulation that trialists want to stop large-scale privatiza- fundamentally altered the large-scale pri- tioniftheyhadbecomeconvinced tatboth vatization process. they and their enteprises would benefit In earlyAugst, adimirKolesnichenko from the process? wrote a letter to the Chairman of the KIrai A credible answer lies in the rapid de- Soviet and Kri Governor Nazdratenko velopment and integration of Russian f- The letter stated that the Russian goven- nancial markets. When voucher auctions menes austerity policy and the absence of startd in late 1992, investors who wanted PMivmAmoN IN THE REGIONS: PEMo&wDIRar 41 to participate in auctions outside their re- regional interests, it seems to have retained gion were obliged to travel to the local auc- eough power to enforce its important eco- tion centers and place bids in person. nomicpolicies Quickdy, brokerage firms emerged and be- gin to take orders from nonlocal bidders Conclusions across Russia. Primorsky and the distant Far East were not initially protected from This case study of privatization suggests a this outside investment by their remote- number of conclusions about politics in ness. Though nonlocal bidders tried to ob- Primorsky krai. It is important to keep in tain controlling shares in local enterprises, mindthatasinglecasestudycannotyieldin- they rarely succeeded. formation about whether a region is typical By mid 1993, however, the Vladivostok or atypical. For example, from the above In short, the central International Stock Exchnge had become analysis, one cannot assume that pro-priva- government bas not one of the most active in Russia. GEl had tization forces are strong enough to defeat been cut out of put into place a depository system that al- gradualists and anti-privatizers acmss been cut out of lowed bidders to deposit their checks in a Russiaz Nor is it possibleto ident iwbich regional politics, local depository and bid in remote voucher factors most influence the privatization though it does not auctions with a receipL In addition, many process inRussia asawhole Aregional case Russian regions had set up voucher aucton study can, however, act as a map for future appear to exert centers that allowed them to run nation- research: condusions drawn from the analy- direct, daily control wide auctions, and Primorskykrai was un- sis of one region can serve as hypotheses to over local politics der pressure to put its enteprises up for be tested in other casestudies. Similarly, the sae in national auctions.'7 In short. it ap- factors (variables) isolated in one case study and economics. peared as if the voucher auctions for locl can serve as the starting point for addition- enterprises would soon be opened to par- al studies which compare the importance of ticipation by powerful natonal investors. these and other variables in other regions. Russianm industrialists, not surprisingl fa- vored privatization when they realized it CWemptpebery relarions meant transferring prperty nghts from the state to themselves When there was even a The relationship between the central gov- risk that they would lose contro over their emient and the Russan regions has con- enterpnses, or receve no diecbenefit, man- tinned to evolve since the collapse of the ges resisted ihe pocss. Managerial oppo- Soviet Union. By their accions, it seems sition would be even more likdy m cases dear that Prinoraky krai authonties would where continued state ownership is per- like to be responsible for regional issues. ceived to be less intrusive than difused though the prrvatization crisis revealed that shareholder ownership In PrimorskyM the the region is neither wholly autonomous nor composition of the regional admiistraion forgotterL When its jurisdiction was threat- ensures that the state would be hijgly syrn- ened by local actors, the Russian State pathetic to enterprise concens Together, Property Committee responded assertivdy these facrs, coupled with the administa- to correct the region's deviation from fed- tion's obvious desire to increase its control eral privatiation legislation. Prime Minister over the local economy and the gmwing Victor Chemomydria's tour of the Far East threat posed by outside investors, explain in August provided additional evidence that why large-scale privai2ation was essentially the center still supevises regional activities. cancled inAugust 1993. Simply put, the kai In short; the central government has not govemmenes decision to halt vouche auc- been cut out of regional politics, though it tions and manage the economy more closely does not appear to exert direct, dagy con- was consistent with the self-intes of loca trol over local politics and economics enterprises and the regional govenmenL It is difficult to assess the extent to The center's abty to overulethese concur- which the relationship between Primorsky rent interests demonsrats that, alough lrd and the center is a function of region- Moscow may have ceded its rigt to define al specificities. Primorsky's rich natural re- 42 Russi ClEATiNG PivAmETE REsEsANDEmazrrmuArss sources, proximty to Asia, arid access to By August, the PAKr Vice President international transportation networks have would say that 'it is no secret that the new contributed to a regional sentiment that [local] government is from PAKLTY19 the krai could survive without the assis- PART's ability to competein regional elec- tance (and demands) of the central gov- tions will provide an ongoing indicator of emment. This is not the case in many of the its political power. One could hypothesize other Russian regions. that, while employees of PAKRT enterpris- es would be more likely to support 'their' The regional poltics ofpriuatizeon candidates, the rest of the population may be indifferent (or perhaps even hostile) to Economic actors have eclipsed political structure devoted to advancing the future parties and movements in the regional pol- of certain large enterprises. A PAKR can- itics of privatization, and perhaps in polit- didate's defeat of other candidates would ical life as a whole. Even the trade unions, provide evidence that there is popular endowed with a legacy of potentially fun- support for PAKRs mission. gible resources, have been outmaneuvered The Pinorsky kuai experience demon- by more motivated and dynamic enterpnse strates that, wible prvatization reduces state managers. Research completed in the sum- control over enterprises, it does not guaran- merof 1993 indicated that these aggressive tee that the regional economy wil become entrepreneurs and savvy bureaucrats are more competitive and diversified? Wide- playing the biggest role in shaping Russian spread voucher privaization may actually capitalism, for tiey seem to best appreci- inhbtprogresstowardacompetiive,decen- ate the potential gains. alzedRussianmarketbyempowenglarge The elections for the national legisla- enterprises torecentralizetheeconomyalong turein Decemberof 1993 andforlocalleg- geographical rather dtan industrial bines islatures in the spring of 1994 maymobilize Instead of striving for greater independence4 sluggish political actors into campaigning some enterprises in Primorsky are pursring and lobbying By that time, it will probably new dependencies that wM ally them with be too late to influence the voucher auc- oherT (possily suggling) entrprses. PART tion phase of large-scale privatization. does not include all large krai enteprises, Parties and movements may then try to in- and its membship does not appearto be in- fluence the post-privatization process (that creasing dramaticaUly, despite the high profile is, private and public investment policies) of PAKIT leaders in local politics. In the long or they may select some other issue areas term, therefore, it seems unlikely that PAKR in which to act will succeed in monopolizing the krai econo- my In the short term, however, PAKJZs po- Ineraction of politics and economis litical and economic influence may slow the development of an open and competitive re- The large-scale privatization process in gional economy Primorsky krai is allowing managers to consolidate control over enterprises and, Notes to some extent, over the local economy. In the latter regard, Primorsky's industrial- 1 Primo*s Krai Suaistics Deparnuent, Thrd ists have gone fiurther than those in other Qw,jRepofi 19.93, as exrctd in Uho Rori, regions. Enterprises of Novgorod have al- October26, 1993. so united in a corporation, and "financial- 2. Fmm an -Economic Map" ofPrimorskykrai industrial groups" have become popular produced by the Cartography LabOratoY of the across Russia, though none of these orga- Russian Academy of Sciences' Far Easter have succeeded in Institute for Economic Research, 1992. Far nizauions seem to nEas Aeogeodeky Enterprie. Note that amassing PAKT's level of open political in- ship xepair- is usually a euphemism for miitary fluence. In April 1993, a PAKr director mant., stated in an interview that the organza- 3. According to a brochure distributed by the tion "had no political program thus far"' Pximorsky kri administration (Prino Regiou, PRIVATIZAnON IN M RtEGMINS: PwMORSKY KRA 43 1993, Ussuni Publishers, p.8), these enterprises a1- 135, p3. For examples of attmpted influence in legedly produced 13 percent of the ar's industri- other ames of efixm, se tEnurepes do not al outpuL are wih the firing of Glazie"v in KommXan- 4. In an August 1993 lener to the Govemor, V Dail, Angust 25, 1993, no. 161, p.3; Entre- Kolesnichko, Deputy Govemor for Economic preneurs discssed the initiators of monetary Refonr, and V Ignatenko, a representatve of the refomn," in Kommnm-Dfity,July 28, 1993, p.1; Primorsky lrai property fund, esrnaredthataone- "Young capitalists aspire to power in a Russian thrd of Primnshy krai's industrial entpris and province [%cogda], in e*e September 10, one-sixb6 of consruction-related enterprses we 1993, p.2; and Voisy and Skokov fight for influ- bankrupt The perception dtat the economy is in ence on industrialiss" in Koonmre-Dzl;y trouble is widspread in the bcal admiistrtion August 28, 1993, no. 141. For an illustration of (thoughitisdifficulttoevaluate thcdatausedtocal- politidans' effots to mobilize entrpreneurial sup- ciare the rtios mentioned in the klt). port, see artides discusing Gaidar's Association of 5. These restrcoons may indude obliging the Pvatuing and Prvate Enterprises (sch as new owner to finance socl seves affiliated with "Ciubais decided to strengthen his posidtn from the enterprise, retain a ceraiin number of workers, the 'top down' to 'bottom up:' Komnenw-Daly, or invest a speciied amount in the enterpnise The Septenber 4. 1993, no. 169.) tender may also specif at the buyer cannot 12. nterviewinVladivosrokApr22, 1993,wizh change the busines primary actvity The condi- Anatoly Shabmanov. Deputy Chairmsn of the tions are permited by sectin 5.6 of the 1992 rimorsky Kmai Federation of ¶iade Unions (PKF- Privatization Program TU), andMilinash. Head of the Socisl-Economic 6. Tneviewiin Nakodka, April28. 1993. Department,l MU . Adrift regulation signed by 7. Inview in Vladivostok April 22, 1993. RCbubai, theChaianofthePKPTU,noesthat & Intervw with liri Uskov, Deputy Head of 'the influence of trad unons on puvaizaton has Primorsky krai GKAP and President of the Far been pacticay limited, and a l part oFthe col- Eastrn anenawonal Center for SmaiE and Medium lective's soc achievements have been liquidated" Businesses, August 19.1993,VladiokL (unnumbered draft dated December16 1992). 9. Directors and privatizationofficials alke hNe 13. Boycko, Shleifir,Vsny (1993), p.19. mentioned in interiews that large enterprises do 14. Tpliuk (August 19, 1992 meein and Boris not inMsitt signigfican changes immediately foil Fadec PAKrGencamDiretor,quotedin "PAKE lowing privatization, in pa beause a sharehold- United We Stand," Vladhivook News, 9 July r' meeting is required before major resucturing 1993 (no. 13), pp.1,3. can rake place. (Tiis comment was made, for ex- 15. Fadeev, ?PAKr UnitedWe Stand,' p. 1. The ample, by Geogi PI-us, Seimor Vie Presden of desire to keep out nonregioa investors is not the FrEasterm Shipping Compan; and byVAleii unque to Prmnky krai Piamorsky has appar- LutSenko, Chairman of the Pdmorsky krai proper- ently been fairly successful in keeping national in- ty fimd on Aprl 22, 1993.) Boycko. Shleifer, and vesutnent fundsandothernon-Primorskyinvesor Vishny (1993) emphasize the diffence between from taking a Ilrge number of shares at voucher the Largely foml transfer of ownership of cash auctons. (EastisFasrhanWest,DdovoiMr, flow and conmrl" and real changes in operations." 9 June 1993, no. 1074675.) 10. The 1993 third-quarter report on the 16. Tepliuk asserted that PAfl has managed Primorslykrai economystated that only35 pent to buy 20 to 25 percent of member enterprises of the workfoe is emplryed in the nongoven- through voucher auctions. mental sector.' Primoisky Kai Statstics Depart- 17. Interview with Lutsenko, April 22,1993. mient,i T itRd QuWFR eponJforl993, as exervtcdmin 18. Leonov intervie'u, April 23, 1993. Uba Rc4i, October26. 1993. 19. Tepliuk meeting, August 19, 1993. 1 1. The Russian press frequentycovers stories of 20. Boycko, Shleifei, and Vishny (1993, espe- entepreneurs tying to influence polts and eco- cialy sections 2, 5. and 7) emphasize that priVa- nomic refomL For an exanple of support for tzation must be supplemented with measures privatization, see "Investment Funds support designed to increase the competitiveness of the Chubais," in Komemant-Daiy, July 20, 1993, no. Russian market after printization. Russ: CIRD;11NG PRmAE ENm ES AND EFFICEN MARtS CHAPTER 4 Investment Funds and Privatization Mark St. Giles and Sally Buxton If Russia's fledgling finncial sevices indus- on all aspects of the Mass Privatizaton ty is to achieve greater efficiency and legit- Program, presented a completed law that ma, there will have to be conderable took the form of an Ukzz signed by In RsSia, voucher revisionofthepresentsetofregulationsand President Yeltsin. Three "schedules" were investment funds the way the business is supervisedL Given also issedcovermgmodelprospectus, find face a mre the extraordinary pace of change in Russia charter and contractual agreement5s. and the demands created by the privatiza- Observers and foreign firms advising on competitive tion program, it is remarkable that the f investment fuinds have been, in tum, excit- entvironment than nand alservices industy has developed as ed, challenged, worried, fustated, and de- d t i rapidly and as well as it has. Relentless po- lighted by the progress of events. The O ose in oter litical pressure to transform the Russian enthusiasm and intelligence of many peo privatization economy has left ltde tirne for the consul- -,-de in the goverment and the private sec- processes in Eastern tation and debate that would normally tor have prevented the hectc pace of Europe accompany major policy changesinestab- development from creatng greater disas- lished free-market ecDnomies There was teas ia those that have already come to no existing infrstucure for an mvestment light Even the accounting and manage- fimds industry nor did it have the financial ment problems that investment funds face expertise around which to constuct the now seem solvable, despite some gloomy management and ancillary serices for new predictions following the scandal of the businesses Even basic financial vocabulary Moscow-based "Technical Progress" oper- had to be invented for Russia. ation and, more recently, problems at the li- Early in the planning of Russia's Mass censed fund Nefte-Almaz. Nevertheless, Privatization Program (MPP) it was decid- action is needed to stabilize the financial ed that investment funds should play a sig- services industry in Russia to forestall fu- nificant rolw Funds were to provide an ture problems. outlet for the vouchers of citizens who did not work for enteprises being privatized, Voucher investment funds and for those who did but wishd to diver- sify their investments into a professionaly In Russia, voucher investment funds face a managed fund. Moreover, the Ministy of more competitive environment than do SocialProtectionwantedtocreatefindsfor those in other pnvatizabon proess in disadvantaged cizens (orphans, disabled, Eastern Europe. The issue of vouchers in chronicallysick, pensioners, and so on). The bearer form (that is, tradable for cash) of- resulting "sIpecial funds are strcturallythe fered an option not available to citizens of same as voucher investment funds. other countres, such as the former Drafting the necessary law began in July Czehoslova1ka. Vouchers can also be used 1992. Deaclines were tight, but the State as a form of currency to bid direcdy for Committee of the Russian Federation for state-owned enterprises (SOEs) at auction, die Management of State Property (known as opposed to purely for funds, as in the as Goskomnimushchestvo, or GKI), togeth- pr"posed Kazakh and Polish programs. er with the Ministry of Finance and mem- Sponsors of funds therefore face strong bers of an intemational consortium advising competition for customers and have, in INvEsThENr FuNDS AND PmvAON 45 some cases, made exaggerated daims as to United States. Provision for open-ended the returns investors could expect funds is made in the regulations, but given By March 1993, these factors, and the the probms ofvaluation and liquidity, such fact that approval for die first investment funds wil probably remain inappropriate for funds was not granted until early December the foreseeable future. (tlree months after the first issue of vouch- The main provisions of the legislation ers), gave rise to concern that the industry's for investment funds are: development would be slower than hoped. This was compounded by worries about po- Form and nature of funds This covers litical uncertainties. funds other tha specialized investment To make matters worse, there was a ma- funds (that is, those that accept vouchers). jar fraud in St. Petersburg in February 1993. Such funds are licensed by the Ministry of By the end ofJzly Ihe sponsors of a fund, whidh had gathered Finance, whereas specialized investment 1994... there may at least 300,000 vouchers, disappeared- funds are licensed by the GKL In theory, .wth all the vouchers. This was widely publi- both open-ended and dosed-ended funds be some 45 milon cizd and led many to believe that fund may be created under this regulation, shareboldfers in the sponsors were criminas The "Technicl though in practice, open-ended funds are 600 finds. Proress scandal in Moscow sharpened the inoperable in the current market. One im- perceptons of politicans, regulators, and portant povision is that state bodies can- the public of potential danges in the systemL not establish fuids; the restriction defines Some of these fears proved groundless. such a body as one in which the state has an Major marketing campaigns by legitimate interest of more than 25 percent This was operators and a campaign of public infor- to meet a concemn that investment funds mution (incuding the regular publication might be used to retain or regain control of of lists of licensed funds in leading news- enterprises to be privatized. papers) have counterbalanced some earlier worries. In hindsight, many concerns arose Fowundg and iedng of fnds. The from desin putting groups of founders lkaz also established the procedure for togetier and raisng finance, iuing shares, founding and registering funds and the re- gti=ng lcenses, planning and implement- quired capital paid in by the founders. ing maketing campaigns, implementing There is no ban on the participation of for- campaigns, and coping with shareholder eigners either as fund management compa- registration and securities custodyin an un- nies or founders of funds. dwevloped market. At the end of 1993, there were an eiad- hInnulhnftaeows Investment restric- mated 600 funds nationwide with perhaps tions cover the maximum percentages of the 15-20 milion shareholders. By the end of portfolio that cY;n be ivested in any one se- July 1994, when vouchers expire and the curity, in the voting stock of any one issuer, first wave of mass corporate privatization and hi affiliatrd companies Borrwig is al- will be completed, there may be some 45 so restricted. The imit on investmncts in a mMion shareholders in the 600 fimds. singlrconpany (a maximumof 10 percent of thevoting stock) caused much debate- Some LIvestment fimd regulations institutional managers wanted the limit to be inacased to make it easier to exrt presu The law on investment funds took the form on compames to improve their effectiveness, of aPresidentialtlkaz (no. 1186). It created but the cuntelng argument (tat this a regulatory fiamewrk for both nonvouch- might place too much power in the hands of er and voucher investment funds. Voucher financial institutons) won. The limit was lit- investment funds were pemitted only as er inmceased to 25 percent It is too early to open (not open-ended) joint stock compa- determinewher fund mnanagers,infomnal rues. These would be called investment tust or inmform combinton, are starting to use companes i the United Kingdom or their votng pows There have been one or cosed-ended investment companies in the two instances of shareholders flexing their 46 Russ>: CRawG PrAm EErNT rs AND EiED fxrrMAhs musdes, and the energence of a sharehold- * They are licensed by the GK1 or by re- ers' rights campaign is enoouragng. gional fl; * They cannot be open-ended fimds; Management ad supervxn. This regu- * Since funds are intended for mass own- lation establishes the supremacy of fund ership, the investment restrictions are shareholders voting at an annual general more onerous. The restrictions include meeting to detennine key matters such as no investment outside the Russian Fed- appointment of directors and auditors, ap- eration, and the funds are not permit- proval of annual accounts and dividends, ted to accumulate more than 5 percent changes in the charter of the fund, and liq- of all vouchers in issue (approximately uidation. Duties of fund directors are also 7.5 million); and defined, as is the requirement for forma Permitted charges are higher (an all-in- contracts with the depository and auditor elusive 10 percent) than the 5 percent Maximum management charges are laid ceiling on nonvoucher funds. down (10 percent for voucher investnent funds and 5 percent for other). Model documents Dirribuionofprofi±t Thephrasingofthe The section on model documents was de- section on distribution-n which dividends, signed to provide guidance for founders of interest, and trading profits are distbuted, funds, ficid managenent companies, and subject to a decsion by directors-seems their professional advisers Another aim was Ilkely to cause difficulties over excessive div- to make the task of the licensing body easier idend payments and taxation of fimds. Most by having a stndard against which to judge fund regimes (except in the United States) licensing applications. In theory an applica- treat income from investments and interest tion using the 'standard format3 documes as separate from capital gains for tax pur- may be given a "fast track' to a license. poses. Some regimes forbid the distribution Much of the information contained in of capital in any form. the documents is repetitive. The significant points are: Reporting to sbahbode and regkaor Funds are required to report quartely to Model chart. This is the founding doc- shareholders and to regulators, providing a ument of a fund whose provisicras indcude: balance sheet and portfolio breakdown, a * The legal nature of the fund and details profit and loss account, a statement of net of its founders; asset value per share, a statement of fees, * Investment objectives anda description and information about changes in manige- of investmnent policies and restrictions; mcnt or in other contractual arrangements. * A statement of the opening capital of a Guarantees of future perfonnance or re- fimd; tums are outlawed. Even so, problems con- - Rights of shareholders; cemning the difference between a guarantee * General meetings; and a forecast continue and overentudsias * Terns of reference; tic marketing has raised expectations to un- *- Vluation and distibution of profit justified levels, parcularly in relation to statements; dividends. * Arrangements for, and cost of, managc- ment; Lqudation. Tbir must be the subject of * Details of the custodian of the fund's shareholders' appral at a general meein& assets; * Accouting and reporting, Specialized investment funds * Audit; and * Liquidation. These fimds are covered by provsions more or less similar to those for ordinary in- Model dposiboy agreement This agree- vestment funds. The main differences are: ment establishes the important relationship KIvEsnawr FUNDs aD PzmVnAlN 47 between the depository the fund, and the tion. Tlb protect fund shareholders, it also manager and defines the duties and re- provides for revocation of the contract by sponsibilities of each party. The important the directors of the fund (on the grounds of role a depository must play in investor pro- inadequate or nonfulfllment of the contract tection is emphasized. but banks have been by the management company) and sets unwilling to undertake depository func- maximum expenses and charges payable by tions. They are unconvinced of the com- the fund to the management company In mercial viability of such operations in an essence, the management company is re- environment where banking operations quired to: have been so profitable. Funds and man- * Manage the assets of the fund within agement companies have been obliged to the terms of the charter; create their own parallel operations, a less * Report to the directors, detailing in- than ideal solution. It is somewhat surpris- vestment strategy and decisions; ing that the major firms engaged in global * Present a fornal annual report to fund cusmtody have not taken more interest in this shareholders; field, but once the market becomes better * Report quarterly to directors on find established, separate custodians and de- expenses; positories will lielv emerge. - Prepare quarterly fund accounts; The deposiry is similar tothe cusWdian * Carry out administrative work on behalf (or trustee) in other fund markets in that it of the fund; * Holds all the assets and cash of the - Maiantin confidentiality and carr out fund; duties (such as payment of dividends) • Receives all the interest, dividends, and correctly; other income; * Issue reports to find shareholders; and * Executes transactions in securities * Market the fund. and for cash on instructions from the The agreement entitles the manager to: manager; * Deal in securities for the fund, within - Applies money to the payment of divi- the terms of the Charter and Russian dends according to the decision of federal law; directors; * Represent the fund at meetings with in- * Confirms notices received from in- vestee companies and relevant orga- vestee companies relating to meetings, mzations, capital changes, and dividends; * Appoint a representative tO attend • Informs the board of the fund and the meetings of the board of directors; and manager if there are anybrearhes of the * Request necessary powers from direc- Russian Federation low or the fund's tors to sign documents, and so on. charter; and The directors of the fund are required to: * Maintains accounts of the capital and * Assign the manager any necessary au- incorne of the fund and of expenses for thitionas signatoryfortheffund; and statutory, regulatory, and shareholder * Monitor the manager's satisfactory information purposes. performance within the management Managers must provide depositones contract ith all necessary cooperation to enable The agreement specifies a fixed annual them to fulfill their functions. remuneration to the manager or manage- ment company based on a standard calcu- Fwzdmangemengtareent. This agree- lation of the find's average net asset value ment defines the role of the fund manage- over a year. The agreement also determines ment company or the fiund manager and whether a performance fee is payable and, their responsibilities in relation to the fund, if so, at what level and on what criteria. it its directors, and shareholders. It requires also prohits the management company the management company to act in accor- from investing the fimd's assets in itself or dance with the charter of the fund, the in ffiliated organizations and from making Russian Federation find, and other legisla- agreementswith other invesunent fimds or 48 RUSSI&A CREAmwG PiuALzEwNlR AND EPyciENT MARKS vith investee companies in which 5 percent ganizations were barred from launching ormDreofvotingequityisheld.ithoutrthe finds. Thus the briance was tilted toward authority and prior agreement of the board the applcat to obtain a license to operate of directors. funds. This was not entiredy risk-free. Tb be FmalIy the agreement specifies the licensed, management company applicants term of the contract and provides for ter- had tD provide details of their compang its mination with particular notice periods, to- officers, and its capitalization, together with gether with fees payable upon such a rudimentary business plan and a dedara- termination. It also lays down the legal re- tion that none of the key officers or employ- sort for contractual disputes. ees had been convicted of criminal offenses. The investment funds also needed a li- Model pmpecto. This document out- cense. That application incuded details lines the minimum required contents of the about the founders, the directors, the aims issue or other prospectus of the fund, which of the fhid, the amount of founders' capital, indlude: and the amotut of shares to be issued- That * Investment purpose, policy, and limi- funds ar closed-ended presents some prob- tations; lems. Specific amounts of capital need to be e Information on the size of the charter authized and issued; when a tranche is cx- capital; hausted, a new tranche must be created, but * Detailsofthe valueofasingle share,the not until three months after the dosing of type of shares to be issued, and the the previous offer Sincefund sponsors find sarting price on subscription; it difficult to estimate demand, what would * First and last date of placment of shares; idealy be a continuous offerng from a sup- - Iformation on the founders, its direc- ply of sIIeIfM stock has become a series of tons, and their background, and similar secondary issues. The problems of this pro- information on the management of the cedure were compounded by the initial re- company or manager; quirement to issue quarterly (at least) - Detafls of the depository and indepen- valuations of vouchers held at a mandatory dent auditor, 50 percent discount to their 10,000 rpbles = Charges and cxpenses payable by the face value- This, howmev, has been resand- fumd; ed and vuchers can be valued at marketval- * The most recent accounting report of ue (later increased to 40,000 rubles). If the fumd, equity is to be preserved between incoiisg * Shareholders' rights; and eisting shareholders, the valuaton reg- * Theformandpowersoftheannualgen- ulation needs to be reviewed. eal meeting- OriginaIy, the fund and its manage- * A set of warnings to investors regardig ment company were to be separate entities; risk and inability to guarantee results in this would have protected shareholders dividends or capital growdt; and againstthe po ility thata anaged * A summary of the investment pordtlio fimd might have financial problems where and results in dividends or capital excessive management expenses were grwth over the last reporting penod, charged against the fmd's inmcome. A fund induding a cost to net asset ratio. that contracted vith a management com- pany, even though the latter might find it- Issues self in financial difficulties, would be immunized against any tireat to sharchold- Several practical issues emerged in the ear- en' equity. But many finds have been set lystages of implementingtheseregulations. up on the basis of self-management, anM. it now seems that excess expenses are eatig Liceinig into shareholder equity. Regimal KIs were given the task of li- How coudd it be assured that fimd sponsors ceasig both funds and the fund manage- arefitandproper?InRusa,govemmentor- ment companies. This has raised a number INJVzsMNT FUNDS MND PmvAnzAnorN 49 of concems. The first is some loss of con- in funds' portfolios at5,000rubles,but, to re- trol over the process. Not all s have been dress the balance, a value of 23,600 mbles scrupulous in providing information to the was established for 1993 year-endvaluations. central database,which means it is nor pos- With the voucher price at 11,000 rubles in sible to be precise about the number of September 1993 and predicted to rise fur- funds in existence. Nor is it possible to de- ther, funds that kept a stock of vouchers for terrnine whether regulatory disciplines are attractive future oppornities would be at a being applied evenly. disadvantage compared with funds that in- The real problem of licensing, however, vested all their vouchers (and were thus able is the failure of unscrupulous operators to to carry the sbares of companies in which seek a license, either by deliberately ignor- they were invested at the equivalent of face ing the law or through a series of nrses that value if thy could establish a market price or The valuation appear to eliminate the need to be licensed. at a 50 percent discount if not traded). This problem will grow These funds operate as "trust companies" threatened the preservation of equity among or argue that by purchasing vouchers from different dasses of shareholders and seemed as more funds take subscribers for cash and then directly in- likely to cause competitive disadvanutges to in cash or raise cash vesting the vouchers in the fund or trUSt, funds wien net asset values were published through market the requiremert to be licensed as a vouch- in comparative form. er investment find is irrelvant But even if These problems come from the unmre- sales, as companies this were true, a licenise would need to be solved question of whether a voucher is a start to be listed obtained from the Ministry of Fmance; in security or whether it is a claim on future and if the voucher most cases, this does not occur. assets, in which case its current value is ir- National and regional reguators are relevant Most funds have adopted a prag- prices continue to taking their responsibflities seriously, but matic approach, offering (usually) between rise. there have been notable scandals involving one and ten shares per voucher and requir- unlicensed funds. Year-end fiing of results ing cash subscriptions to be made at the (due by the end of February 1994) uncov- voucher price on the day of subscription. ered several problems that wl need to be This way, subscribers encer the fund on dealt with. There is the possibiliLy of further equal terms. Cash subscriptions have typi- compensation of distresed investors. caly accounted for between zero and five Beyond chat, further training and technical percent of subscriptions, though this figure assistnce are needed to consolidate and increased as the voucher period drew to a improve the quality of regulation. dose in June 1994. In a country as large as Russia, creating The valuation problem will grow as a regionally-based securities supervisory more finds take in cash or raise cash system is rational, but prudent regulation through market sales, as companies start to and planning is required. be listed, and if the voucher prices contin- ue to rise. It can be argued that net asset Subsgcro to bfids value calculations are unimportant, or less important for closed-ended funds than for Voucherinvstmentflindswereoriginallyde- open-ended ones. But with semicontinu- signed to provide a home for vouchers not ous subscription, even without opportuni- destined to be applied to the shares of enter- ties to redeem, it is necesary to adiust the pises or sold for cash. It was felt, howeve, subscription exchange rate, however crude. that cash subscriptions should also be al- And, once the shares of funds themselves lowed This created a dilemms A fundwith can be traded, a guideline to calculate net both vouchers and cash would have apotrn- asset value will be needed. tml valuation problem during a contnuous Since a voucher is a bearer document, offern& This ptoblem was compounded by marwets in vouchers quicky sprang up on the ban on changing an issue prce basis dur- street corners and inthe slighly more formal ing the issue of a tranche of shares based on exchanges that operate all over Rssia. any one pmspectus. This was made even These exchanges are the centers of eie- harderbytherequirementtovaluevouchers preneurial trading activiL providing some 50 RUSSi& CRAMNG PRiVAE ENPIES AND EFFICEmr MsucnS iquiidity for the trade of goods and com- Research shows that the better fund modities. Nationwide trading quiddy har- managers are investing their funds' vouch- monized regional varations in voucher ers, vith some finds more than 50 percent prices-to the point that the day's voucher invested, but they are still hard pressed for price became announced in the media. The cash. Their portfolios have become more decision to free voucher valuation was sen- iDiquid, as higher percentages are invested sible. but rhere is stil inequity in the issue in shares raher than in vouchers. price, given the prohibition on varying the "exchange rate" during the issue ofa trnche Invffrlent activeies based on each prospectus. Later-subscribing shareholders thus get a bargain at the ex- Having obtained operating licenses and pense of those who subscribed earlier. gathered subscriptions, maznagers must in- Now that active trade in the shares of vst. This is proving to be the most difficult Now that active newly-privatized enterprises is beginning to task yet. Data and accounts to be analyzed trade in the shares develop, the valuation problem is becom- are generally inadequate. But the fact that ing more acute. Most business is done off- company accounts and profit and loss ac- of newly-privatized market, and there is no coherent scheme counts fall short of international standards enterprises is for collecting and publishing prices. This is has proven less of a challenge than the un- beginming to a great concern, since the inability to estab- even flow of information about forticom- lish a fair valuation undermines the most ing auctions. Only the most progressive develop, the fundamental principle of collective invest- managers have been able to track the re- valuation problem ment fucins. sults of auctions and derve statistical data is becoming more A decision in May 1993 preventing funds on valuations. Local pressure to prevent from trading vouchers was a surprise; itvas outsiders from participating in bidding for acute based on the mistaken belief that such tad- regional companies is common, and some- ing was driving the price down. liquidity in times sucoesful Moreover, there is a grow- the voucher market provided finds with ing security problem that derives from cash needed to pay fund management fees. transpordng large amounts in bearer docu- Apart from founders' capital, subscribed in ments. Physically transporting the vouchers cash, funds have no regularrevenue streams is risky and it consumes resources. Repre- fo divdends and interesL sentatives of the fimd must accompany the The fact that the voucher price rose af- vouchers to the auction and often must go ter the May 1993 decision was unrelated to through nonstandard bidding systems- the ban. It was a function of stronger de- devised they suspect, simply to make life mnand for shares at auctions, which entered difficult for nonlocals. into fiull swing in the summer of 1993. Shrewd fimd managers made the calcula- Dividends to sbareholes tion, based on auction results, that the net asset value of "Russia Incorporated' was a The payment of dividends is the prime, and considerable underestimate of the real val- in some cases the sole, objective of many ue of the enterprises to be privatized in the managers. Given that for taxation and ac- Mass Privatization Program. The price of counting purposes thewhole portfolio is re- the voucher rose from a low level of 4,000 garded as irventoy, all capital gains are rubles in early 1993 to 11,000 rubles byjul; regarded as trading profit, taxed, and paid and to nearly 30,000 rubles by end 1993. out to shareholders. Many predicted a further rise until the the- This has led to competition among oretical expiry date June 30, 1994. The manages as to who can promise and pay price hit 42,000 rubles in June 1994 as the the biggest dividend. Many shareholders final phase was announced. Many fund havebeenmanipulatedbyclaimnsandcoun- managers are ignoring the restriction on terdaims. Some advertiig claims divi- voucher trading or circumventLing it (forea- dend payments of several hundred petent, ample, they are paying management as- but such dividends have been paid to about penses and commissions in vouchers). twenty among thousands of hareholders. INVISIMENr FUPNAM PMAnMzano 51 Lo,ng-term capital growth is misundcr- foundation of a savings industry that en- stood or ignored by the public. The better compasses pension, life insurance, and in- managers find this fustrating, since they vestment funds. are pressed to lquidate their most promnis- ing investments, pay tax on the gains, and Cbarging pay the net amount as dividends. The process is seriously eroding share- There has been much debate on fimd holder equity in many cases, pardculady charges, which are high by intrnational when excessive management expenses are standards. Annual charges are capped at 10 taken into account In the more serious percent for voucher investment funds and cases, funds may become inadvertent 5 percent for other types of funds. Typical "POnzi" schemes as new subscriptions are charges in developed fund markets range The opportunities used to satisfy the appetite of existing from 0.25 percent for money market funds are enormous for shareholders for umrealistic returns. This to 3.0 percent for highly specialized funds domestic or foreign may result in some surprises when year-end of aventure or emerging markertype. Tobe domes freign accounts are filed, as expenses have eaten fair, the Russian figures represent a total ex- management away the value of smaller funds and as the pense ratio-stated charges elsewhere may companies that supply of new shareholders starts to run notindudearangeofitemstakenasasep- dry One solution would be to halt any dis- arate charge on the fumd*s income or assets. have the patience tribution of capital gains or capital itself; The chges are not as extrem as they to deal with initial the latter is illegal since charter capital is appear since they are levied as an asset val- difficulties and nominally sacrosanct. ue heavily discounted by the accounting rules. Charges on real asset values, when the vision to see 7 ion theyemetge,yw fllikey be 3 to 4 percent what could be. Those who argue in favor of this high The Russian fiscal regime may tax dtvi- maximum stress the start-up natwre of drends to shareholders at least twice. much of the expenditure, the large nuniber Realized gains will be taxed at normal cor- of small shareolders (with vouchers at porate ta rates in the hands of the find 25,000 rules and the exchange rate at and must then be distributed as if theywere 1,300 rubles to the dollar, the average hold- 'short gains, as in the United States. This ing is $20), and the need to encourage the is a contrast to the system known in most of fomaation of funds and management com- Europe, where the concept of fiscal trans- panies as commercial enterprises. In any parency is universaly accepted (though not event, charges are govered by reguation always rationaLly appliod). Under this sys- that is subject to administative change tem, realized capital gains made inside the rather han by decree-cdanges that would fund are not taxed, but the shareholder is taketime.Itisthusarguedthattimewillde- taxed when the evental gain is realized as termine whether the hih charges are press- a result of the sale of fund shares. Some ing too hard on shareholders' equity As it proposals to adopt a more equitable taxa- happens, a number of managers have tak- tion regime seemed likely to create even en a commercial view and opted to lower greater complexities through taxing short charges to roughly 4 percent. The mai and long gains at different rates, as well as problem remains liquidity from which to having another rate for gains that are not pay the managers their fees, togeer with distributed, but reinvested. cost overruns that result from excessy It is always a long process to change a fi- ambitious markting expenditures. nance ministry's mind on taxation. But it is important that a regime be establisheed that Conclusion does not disadvantage shareholders in funds compared with those who invest di- Investment by the better funds in enter- recdy. This is pardculary necessary if in- prises being prnatized is moving at a fast vestment funds, or any kind of pooled or pace. Any business that evolves in less than managed funds, are intended to form the a year against a background of inadequate 52 Russai CRuEAING PIRvAEE EmuIS AND EFrCINr Mm= financial infrastructure and in an uncertain gue that dishonest operators are undermin- political and economiic dimate, is inevitably ing the entire systemL gDing to have initial difficulties. But if the Stll, the investment finds business is technical and logistical problems discussed quickly becoming established. It will go here are not addressed quickly, scandals through a difficult period as problems arm and collapses may discredit the whole exposed in 1994. but if solutions to those process. problems are forthcoming the business Not all finds are fraudulently or in- should grow and eventually flourish. The competently managed. Many are striving to opporunities are enormous for domestic or meet the highest international standards. foeign management companies that have Some managers are becoming frustrated at the patience to deal with initial difficulties the failure to address problems-they ar- and the vision to see what could be. iNnMrFUNDusAND PIavAm2TON 53 CPTER 5 Voucher Investment Funds Andrei Volgin and Yuri Milner All established processes undergo a da- - 18 percent had exdhanged the voucher matic and rapid change when a country as for stock in privatized comparnies big and as complex as Russia drastically al- * 28 percent had exchanged the voucher The option of ters the nature of its economy within a few for shares in voucher funds. exchanging years. The implementation of Russia's sys- The option of exchanging vouchers for vouchers for shares tem of voucher investment fiunds is an ex- shares in investment funds proved to be cellent case in point In a short span of quitepopular,despiteanumberofapparen in iflvesment fienis eighteen months, investment funds were obstacles. Initially, there was a great deal of proved to be quite conceived, then coilected vouchers from speculation that lower-class and elderly cit- popular despite a citizens and invested them. In 1992, less izens would sell theirvouchers immediately han ten small funds existed in Russia. Alit- for cash. However, avaiable information in- number of apparent tue more han a year later, more than 640 dicates that a large proportion of working- obstades. funds were competing for individual class voucherholders decided to invest in vouchers. As of mid-1994, voucher invest- funds. Furthermore, inexperience with se- ment funds have millions of sharehoiders, curities and market operations and a lack of and have proven to be the most active play- understanding of the nature of investment ers on the privatization field. finds was supposed to create a reluctance As the first stage of Russian privatiza- to invest A third factor impeding fund in- tion-voucher auctions-cornes to an end, vestment was that no infrastrucue existed inmvestment funds wil try to sunive in a for the distribution of the funds' shares. highly competitive envimrnment, whe main- Given such obstades, the fact that 28 per- taining their images as sound financial insti- cent invested in funds is quite remarkale. tutions. This chapter analyzes the present Most funds hired their own sales forces status of voucher investment funds, cle- to collectvouchers. Inter-regional fimds es- sibes how they arose, and reflects on perti- tablished networks of sales offices in dif- nent chacteistcs of their present forms. ferent cities. In addition, several funds used existing networks of Sberbank (a state- Voucher sales and their results owned savings bank with 42,000 local branches) and post offices. This approach Approxmately 150 million vouchers were proved more effective in terms ofcollecting distributed i Russia, with each eligible indi- vouchers, but was quite expensive. Some vidual receiving one vouchem Some employ- funds invited individuals to send in their ees of companies undergoing privatization vouchers by mail. Unfortunately, due to the used their vouchers to purcase stock in poor quality of the Russian postal service, their own firmns All other voucherholders thousands of vouchers were lost in transit. had to either take part in a voucher auction, exchange their vouchers for shares in invest- Kinds of vouchers ment funds, or sel them on the open mar- ket for cash. A survey carried out inJune of In order to analyze the role of voucher 1t4, revealed that funds in Russia, one must diaggegate the 30 percent of those questioned had sold funds into categories and identify them by the voucher their representative characteristics. Ther VoucHERaINvEsmErrFuNrm 55 . ~~~~~~~~~~~~~~~~BOX 5.1 eqrwof their manager uith adverdig Voucher find dhssfication by type of promoters and DO .mxetieo hinmngr ih detsn Vuef csfaibr and agm slogans such as "eading foreign investors VoUdherJidIJproma& ge thbeywedesignedbyindustria pants trust us.' Some funds appealed to sectoral Fhzacfid hrudow (nonspecialists) to encoua employ- interests of valuable assets (for example, og, Speil find managemet companies ees to buy shares of tiur compuiies at gold, and diamonds), whie otiers targeted were set up bya few laWbank.Mostof voudcer auctions. Some amateur hands seif soial grous induding the military, these fimds raised their capital with were also started by individuals and vceand ofacg omclcem vouchers from the bs' individuld private companies. Of the antem verans, and police officers. dients and frM enplyees 'Of nSti- funds that vewr set up, few have sur- Several funds even tred to g k tional cusmer Ihse fimd manage- vived due to theirlack of capital or pro- advertisements to lure the attention of indi- ment companies chose to pursue very fessional epcist vidual investors. One fund advertised that coservtive inemnent staresis Mast Ma-y amateur fiuds were ornid investors could win a luxury apartment in of the asses were ivested in pwiatized by local or rceional audinries-AlMa elgh companies that were and remain the rcgulanassupposellyprohlhantho- Moscow, while another daimed-falseor- banks' customes ntiesfiomndelpromongfinds,lol at it bad been given a certicate of Honor bureaurat desi1ed uneomus ways to by the King of Belgium In most ase filse VoMDaerfimdrpmonad by nlrs indktdy create and pport funds. advetsing backfired on the fund. Inter- Manyjaeatandentk A esgingl in many cases the appeal of an ad- bany ioers ordvertising campaign did not seem to bear a worrmgunhe fildo finantcalnservices tnfnarel3 a o strong corrlation to the actual content of ThesefindshavefoUlovedarangeofin- set up with only one goal in min"o the advertsement Iad, advertsing suc- vestment statgies and have usedvary- collect as much money and vouchers as cess appeared to be based on the frequency ing instment tchniques without a possible and then subsequently disp- 'wit which adversments appeared on discernable pattem. pear These hinds capitaized on The Russian television or radio programs. ITis- naivete of Russian invests and on the s i ed to be- L ve =Amtufimds lkwere so caloed because ±Zat ofsianfiu a to advertisements heard most fequetly Ama____fi_ds___ere_so __ca_led_because_______________________ and were attracted by funds with large ad- vertising budgets. are several ways to classify voucher funds. Box 5.1 offers a classification criteria based Registrar system on the goals of promoters and managers, while Box 5.2 charactezes funds accord- FLnd manae had no prior experience in ing to their size and geographic spread. placing lage issues, but surprisingly their actuons proved quite effecuvea Most funds Advertising and public relations issuedcerificauesofshares,wileonlyafew maintained book-entry system. There was Most finds started to market their shares no depository and registrar sYstem avaiable within one or two months aftr their regis- for voucher funds in 1992. Consequendyl tration. Each fimd had to overcome the li- the creation of registrars was very time-con- abilty of being a new and untested suming and epensive. In a number of large institution and had very litde time to build funds reviewed, between ten and thirty-sir confidence based on actual results. The people were sinultaneously entering in most successful marketing strategies in- computers information about shareholders. duded aggressive advertising and huge A two to three maath delay in registrng public relations campaigns. In fact, most shareholders was the norm. voucher funds spent 3 perce.ut to 10 per- Under registrar guidelines fund share- cent of their assets on advertising holders either had to apply to registrars Marketng approaches tried to capitalize personally (quite a difficult feat for share- on the strengths of each individual funmd holders of inter-regional finds), ortheyhad Regional funds that promoted local nvest- to apply through a find's local office that ment sought to exloit sentiments of region- acted as a transfer-agent for registrars. alismornationalisminethniclyhomogenous Howeveri most funds scrapped their de- areas, while large firms climed that stly centralized system of local offices after they was natunally assocated with sze. Some finished seling shares, thus fiuther comph- funds tied to stress professionalism and the cating the process. 56 tRUSSu: CaWANG PiWME ENpusES MD EmCaEr Mhrs Trading and liquidity Voucher fund. cassified by size and geogaphic spred The lack of an efficient registrar system Smal rFqIoMdfiMd cesstoinfonmatonsevessadefinitead- placed severe limits on the organization of Several hundred small regional finds vantage far regil funis the dome r a liquid secondary market for find shares. we started With 1,000-10,000 share- laionsi with mnament can also Howeer, now that regulations on restrar holders and capia of $20,000- operate assa sedans hormnig fior a $300,O000theydo norhave the resources shareholder's perspecdvt- and depositoxy activities have been intro- to cw tlfte eqxenses of fund manage- duced, it has become possible to increase ment. Recognizing this, many smll lntOinlfias the number of secondary transactions by himds havc alady stated the proess Between fiy and sixy mter reginal developing local secondary markets. of mergingwithlargeones. fimds possess 40,000-250,00 share- For example, Adamant Fnancial Cor- molies a$O miion. capitse alubdsof h1 poraton (Derzhava fund manager) became _aiorsyeio nsi vuche lexpnde their ulrd and have O Ib~~~Tere am boult hhfy regonal voudier acpaxld their numt an,d ives a market-maker in Derzhava shares in fiscomn4sng50,000300,000 share- ment acivies as a number of dif- January 1994. The volume of secondary holes, possessing. capitalbasc of $15 erents transactions has increased to about 20,000 rnlMion12imillion. Mstoftheassetsin shares a month (0.8 percent of shares out- tfinds areimeredwst liun terown Icg naftab4mdr standing) in approximately 500 transac- region. Due to ie local nature of ivest- Five lamrp vouchr fds in Rusn pos- tions in Moscow and five local offices. ments, reinal finds tend h ave amuch s li Mo illion sh a ireholesand better infoixnatio with regard to thenst- acapitalbaseof $ZSmIioon-$5million. Unfortunately, there is still no usa of tus of piauzed acmpanics, and also Thesfim3spmrfiedfcaread- stock exchanges because of the inadequate tend to enjoy more pezonas raions vetting in all rego of Rusia, and trading, clearing and settlement systems. innw g cetrac- fbomn sh sal by postoffic - Secondary markets for funds shares are thus based solely on market-makers. Many man- agers have begun the process of buying and ment finds. At the same time, fund seling funds shares, but most markets are managers are not admitted to these insufficiendy liquid due to poor regist markets direcdy. systems, insuffcient sales infrastrucure, or * Privatized companies do not follow fall inadequate cash reserves of fund managers disclosure prnciples. Investment man- In their transactions, fund managers prefer agers have partial and conflicting in- to deal with each other face to face for the formation about the same companies following reasons: and prefer to deal in a more confiden- There is a lack of public corporations tial manner. with listed stocs. Most corporate In these ccs, evry transac- stocks attract just a few investors; usu- tion on the market takes a great deal of ally large institutions or top corporate time, effort, and money Counterparts have management, both fighting for controL to meet each other face-to-face to sign con- with the result that liqid secondary tracts (to date there are no other ways to markets do not exist manage this in the Russian legal system). - Tradi&g financial information, deposi- Furthermore, taxes on securties transac- tory custodial clearing and settlement dions are paid independendyl and then the systems are being developed, but they contract and confirmations of tax payments are still embryonic and ineffective, have to be brought to the registar of the * While some "networks" eist, there are company to transfer the stocks. no obvious lcaders in trading systems. To some extent, these issues do notpre- Consequently, fund managers hesitate sent major problems since most funds are to join any one particular network be- not actively managed and have only three cause the probability of their customers to ten transactions each month. \ucher being members of the same trading sys- speculations were something of an excep- tem is very lo. tion, but in their case there was no need to * There is not enough competition be- register deals. tween banks and brokers in existing It is still too early to discuss the possi- trading system, and the high cost of bility of "opening" esting funds. First of conmissions is proibitive for invest- all, the low liquiidity of the stock market VOUWCERINVEsrETFUNDS 57 makes itimpossible to raisecash quicidy by (1,940 rubles to the dollar dines 05) in seling stocks, and also prohibits the use of June 1994. Fund managers are forced to net asset valuation (NAV) as a basis for buy and sell assets much more than neces- siare prices. Secondly, registrar and depos- sary suinply to keep the balance value dos- itory systems need to expand in order to er to the market price. semre a large number of transactions more Some fund managers initially employed effidently, and fund managers need time to toO many people, an especially pressing develop their back offices. The final reason problem for small funds. At the same time, whyit is premature to 'open" existing funds any increase in management fees would is chat special accounting for closed invest- danage funds. Consequently, fund man- ment funds and mutual funds needs to be agers are looking for ways to strike a bal- ineroduced. Currently, funds cannot create ance between the quality of management Unfortunately, and cancel shares simultaneously. and its costs. Unfortunatey, mostmanagers there is still no use While itwill take at least two or three manage small funds, and therefore the re- years for mutual equity funds to appear alistic altematives open to them are ex- of stock exchanges on the market, it is possible that open panding their businesses by raising because of the money-mnaiket funds could be started in additional capital, launching new invest- inadequte trading, six to twelve months, if the accounting ment and pension funds, or simply getting system for open funds is introduced. out of the fray. clearing, and settlement systems. Commissions Iuvestments Most fimds pay their fund managers the le- Very few funds followed one specific in- ga limit of compensation, or 10 percent of vestment strategy throughout the privatiza- average net assets as a fund-management tion process. Most funds changed their fee. While some have complained chat this investment objectives repeatedly, thereby payment is exceedingly high, it is important maling the classification task more diffi- to takle note of several considerations. First, cult. Nevertheless, some of the most popu- the fees are usualy paid after the end of a lar investment approaches maybe defined. quarter and hh inflation reduces the real value of payment compared to the real val- The speadative appoach ue of assets at the end of the perioL Second, Russian fund managers have to Many fiud managers made their invest- spend a great deal of money finding in- ments purely on a speculative basis, with formation on privatized companies and de- the hope of immediately reseling the veloping their activity These start-up stocks.Privatization in Russia provided fer- investments should increase the perfor- tle ground for speculative adventures for mance of portfolios significa[tly to the ben- two reasons. First, managers and insider- efitoffunds' shareholders. Third,netassets owners in privatized companies fought for are now calculated on the basis of the his- control against external investors. Quite of- torical CostS of assets. The book value of a ten top-level management used the cash of particular holding may be exactly the same the company to do so. This practice was for a few years in spite of a rise in the mar- technically i,ega but impossible to effic- ket price. Furthermore, all balance values tively controL Consequently, there was al- of stocksmustbe multiplied by 05, except ways at least one buyer interested in stocks 'with market value! The Securities keeping control of a company regardless of Commission is supposed to announce the price. Second, the voucher auction proce- list of such securities, but to date the an- dure was guided by the prnciple that the nouncement has yet to come. Therefore, a more vouchers invested, the higher the lot of stocks bought in January of 1993 for stock price. While it was nearly impossible 10 million rubles had a NAV of approxi- for a single investor to buy all of a compa- mately $11,236 (445 rubles to the doUlar ny's shares, in many situations large in- times 05) in January of 1993, and $2,577 vestors bought lots of shares from other 58 Russx CRETG PRvATE ENTEs AmND Erncamn MAins participants at an auicuon. Frequently, it For the next several years, industry ori- was more efficient to take part in the auc- ented investment funds will remain among tion with a small amout of vouchers and the most stable. But when amateur and use saved cash to buy stocks after the fraud funds disappear and competition aucion. among funds and between other insitua- Many funds benefited as a result of this tons becomes severe, fund managers using favorable environment for speculation. At the sector specific approach wili probably the same time, it was hard to predit have to revise their investment strategies. whetherlargeinvestorswould participatein a particular auction, or if an auction would Shorn-er7m speculation prevent insiders or large external investors pins venbvesfnentr from buying shares at the higher price. Furthermore, in many cases it was easier Some fund managers decided to finance and less expensve for large investors to buy new ventures or develop new investment shares fiom employees who had obtained projects and have invested a substantial them at a discount One voucher fund part of their assets in business centers, in- bought 15 percent of the shares outstang dustrial plants, or high-technology compa- for the same amount it had previously paid nies. The huge discrpancy betwem funds' for 4.6 percent of the company's share. As a assets and capital required for any serious rest, although specudative himds benfited greenfields venture forced managers of from lcky reselig, they also hdd many thesefundstobeveryactiinformnigvar- nonliquid stocks of poor investment qualy ious financial groups, or issuing stocks of Some funds concentrated on specula- new companies. The First Voucher Fund dions with vouchers. Buying snall lots of now promotes a First Pension Fund to in- vouchers from indmiduals or small dealers, crease capital avaflable to finance their nu- and then selling them in big lots to various merous projects. Many smaller funds have companies proved to be a profitable busi- followed this policy, and some thirLyto forty ness. However, several sharp unpredictable prnvate pension fimds have been started re- changes in the price of vouchers (three cently by voucher fund managers. This times a gain in price of 100 percent to 150 group of funds has not managed to an- percentwivhin aweek, oncealors of 60 per- nounce any positive results thus far, though cent withi dtree days) brought big losses a quick and high return for inveso ws for voucher speculators, because voucher promised in their advertsing. prices went up when most speculators held cash and vice versa. Overall, speculative Longtermpor#folio investment funds have thus far produced quite moder- plus zwvre &wntment ate results compared to other finds. This group of finds started with long-term Sctorspeic approach portfolio investments in privatized compa- nies. Mangers of these funds are now de- Many funds chose specific industrial sec- veloping restuctrng and investment tors as their investment priorities. Better projes mainly for the companies where knowledge of specific industries was sup- they have major holdings. Fund managers posedly a serious advantage of these funds expect large returns on capital invested in the mass privatization environment from the increa'x-d effciency these compa- Sector specific funds ended with almost no nies should, it is hoped, soon enjoy. stodcs of poor investment quality in their Portfolios of these funds may be easily portfolios. But most of these funds were divided into active and passive components. promoted by companies from the same in- Managers try to be active investors in a se- dustry; and therefore managers had-and lect set of prvatzed companies and dte- have-other goals in mind besides simply fore attempt toinfluencetheirmanage_ent insuring the top performance of portfolios In most cases, fund managers would prefer for the lenefit of their clients- to have dominant control of the companyso VouabmEsrr FuNDs 59 that post-prratizaionrestructuring, unpop- dividual income tax which can be no lower ular with employees, can be performed as than 12 percent on dividends received from quickly and decsively as possible. Invest- investment funds or on capital gains. ment funds are allowed to purchase up to 25 Inflation levies heavy burdens on in- percent of the common stocks of any one vesunent funds as welL If a stock was company, and theyactivlydo sointhefirms bought inJanuary 1993, for 10,000 rubles in which they have a major inerest Two or ($22.47 at the current exchange rate) and three vouiher funds often share effective sold in June 1994, for 20,000 rubles control of these companies. As passive in- ($1031), the fund would have to pay a 38 vessors in other companies, fund managers percent tax on 3,800 rubles ($1.96), even are not terribly involved in their manage- thou this investmnt tured out to be a ment, but still carefuly monitor the actions net loss. The existing tax of companies' top executives to prevent any The exsting tax system wifl kill invest- system will kill serious damage. ment funds if substantial change is noA Uncerainties and persisting problems forthcoming. As it currently stands, the sys- investment funds ! f have forced managers to select stocks more ten significantly hinders and distorts the substantial change carefuly and pay attention to invesunent investment decisions of fund managers is not forthcoming. qualit rather than speculative potential This group of manags has not prmmised Accounting any immediate profits for imestors and, consequently the financial position of these Investment funds do not have a special sp funds is much more stable an most other tern of acounts and accouning proce- dures; yet they sill use accounting DAws$dfWdk principles of normal enterprises. Con- sequeny, accounting is inconvenient and Most regional fimds diversified their port- costy for find managers because they must foios and currently hold shares from 70 to go through many useless steps and pmce- 240 (usually) small companies. The average dures. It is also impossible for investos to investments of $15,000 to $20,000 are too evaluate the current position and financial small to xlke a difference, and operational result of investment funds, and numerous costs and the costs of protecting finds' opportunities for account manipulation ex- ownership rights are highL Due to over-di- ist I is quite possible that manipulations verfication, all future prospects of these cannot be prevented before a tru liquid funds are dosely intertwinedwith the eco- stock market develops or before funds hold nomic situation in Russia in general. isted securites. However, a way should be found to make accoumng more appropri- Taxation ate for find mangers and investors in the inter ZIL Investment fumds in Russia are not tax trans- parent for final investos Funds pay tax on Prospects profits (38 percent in Moscow) that is equiv- alent to a capital gains tax. SinceJanuary of Although many investment funds did not 1994, vucher finds have received a tax ex- announce any dividend payments after emption on dividends rceived within two 1993, the financial positions of most funds year of initial registration. However, this are not terible. Speculations with equities priege does not cover dnivdends fiom of pnvatized companies have proven prof- 1993, andmostvoucherfuidswlll celebrate itable enough and the potential for long- their second biday befire the end of term growh is great. But many fund 1994. Most funds wiZl thus not be able to managers still fed unesy in the fund man- reap the frmits of this tax reliefi agement busiess. Most managers want to ILvestment funds must pay municipal divers their business, seek the right to taxes (for roads, police support, and edu- buy real estate, borrow mone% or provide cation), while investors have to pay an in- commercial loans. They want to continue 60 Russr CRATING PmvnE ENiEs mD EFFICENT MSnn their business expansion but not in fund * POfboO invstments. It is difficult to management, because other types of finan- imagine voucher funds becoming nor- cial services are not nearly as regulated. mal portfolio investors, at least in the Moreover, the current dissatisfaction of in- near future. Some new investment vestors makes it difficult to raise more cap- funds will be managed according to es- ital in existing funds, and thc tax system is tablished portfolio principles. viewed as unfair. Few opportunities for quick profits Possible scenarios for voucher funds remain in the fund management busi- include: ness. Fund managers may hope for high * Bankruptcy. Many small voucher funds and stable profits, but this will only come will merge with each other, with larger about in an enviromnent of equal treat- funds, or will eventually be managed by ment of all financial services and with the large groups. Some fund managers will imnplementation of a fair tax system. As simply disappear, unable to survive in foreign investment in Russian equities the new competitive environment. grow and the Russian private sector ac- * Hotdings. Many sector-oriented funds tively invests, the liquidity of the Russian will prefer to hold porfolios of closely- stock market will continue to improve. related stocks over a long period of time This wil create a more comfortable en- and will choose to be actively involved vironment for portfolio management. in managing these companies. The first international fund management * Iswcent comspanes. The most popular groups have started their operations in role for a fund manager to behave is that Russia. It is hoped that they will increase of investment consultant, broker, or in- foreign investments substantially and vestment banker. Msny funds will take will introduce high standards of fund on more of a role as prot.'ers of invest- management. ment services and financiai advice. In the next century, Russian find • Venuure andpoolio inueszents. Some management companies will continue to funds will continue to follovw strategies grow. They will manage more funds with of long-term portfolio and venture in- larger assets and play an increasingly vital vestments. These funds will be among role in the restructuring of the Russian the most active players on the post- zconomy and the development of a sound voucher stock market. financial system. VoucRlINvFmiFxTFuNDs 61 CH4PTER 6 Techniques of Mass Privatization: Inplementing the Voucher Auction Program October 1992 to June 1994 Jeffrey L. Schwartz and Zoanne L. Nelson This paper presents a summary of the opera- the timely inplementation and contributed The deliberate lack tional phases of the voucher auction process to the success of the program. Tis design of complecity in wich was adopted by the Russin goven - also made it possible to effectively use tar- the procas facili- mentin 1992 as part ofthe mass priatization geted international technical assnce and program. The overal results of the voucher financing to support the program's replica- tated the timely auction program's transfer of more dan tion tionghout the country As the coordi- implementation 12,000 enterises from government to pti- nating miisty the GKI has been hbi{ and contibuted to vate hands are wll known. In par, the suc- effective in using technical assistance to cess of mass privatization in Rssia is due to support the program's design and imple- the success of the the program's design and mechans, which mentation. Teduical assistmce has been program. llowed for rapid replication and unpemen- provided by professional staff and prvate tadon across the country Between October consultants supported by USAID, the 1992 andJanuazy 1993, the Russian govern- World Bank, and the EBRD. ment issued eadh Russian citizen a pnvatza- In outlining the design and mechanics tion voucher; almost 150 milion vouchers of the voucher auction privatization pro- we distrilbted. A mechanism of publicly- gram, this paper examines the three oper- held voucher aucons was establishedby the ational components ot the program. The govenmmet to provide the opportunity for first step in the mass privatization program citizens to invest dirtly in large-scale enter- was the mass corporatization of enterpris- pnses undegoing privazation or topartici- es which were to be privatized. The key pate in one of more than 600 voucher steps in the mass corporatizaton process investment finds which were lcensed to op- are outlined in the first section. The pubLic erate in Russia and operational focus of the nass privati- Themns privatization program was mi- zation progran were the public voucher tiated by the State Commnittee of the auctions which were conducted in almost Russian Federation for the hManagement of everyregion across the Russian Federation State Property (Goskomimushchestvo, The main elements of the regional vouch- GEl). According to the Russian Privati- er auction process are oudined in second zation Center, as of April 30, 1994, eighty - section. The last section summarizes tl six of the eighty-nine regions in Russia hart operations for national auctions, such as initiated voucher auction programs, and for the mass privatization of enterprises approximately 11,000 enterprises hadbeen which were simultaneously auctioned in pratized. The pcogram was scheduled to multiple regions. be completed with the expiration of prnva- tizatin vouchers on June 30, 1994. Key steps in the aopo ion ad The overal design of the mass corpora- pre nazation of Gn enter- tiation and privatization program included prise in the mas pria ion progtam the use of simple and standard procedures at each lvel of the process. The deliberate The initial phase of the mass piatization lack of compleidry in the process failitated rcgram inolved the preparation and mas TMHQUES OF MSS PRAToN: I MEG IHEVOUOCHERCUN PROGR0M 63 corporatization of thousands of enterprises options for privatizing the enterprise. The auoss the country The mass corporatization three privatization options involved a range processindudedstandardproceduresforthe of share allocations to enterprise insiders selection of prvatizatios options, the draft- (enterprise managers and employees) and ing of a privatization plan incuding a stan- outside investors. Shares available to out- dard valuation of an enterprise's assets, the side investors were distributed through transfornationofenterpyies intojointstock, voucher auctions or investment tenders. companies and the comnpilation of docu- Each of the privatization options specified ments to register the shares to be distributed that 29 percent or more of available shares and sold at intemal and public auctions. would be distributed through voucher auc- tions unless the enterprise belonged to a Phase 2: Preparation for prt*tization group of enterprises whereby less shares In practice, options wererequired tobe sold, such as energv.e- 1 and 2 have been There were three key preparation steps re- traction, and refining enterprises. The share predominat ,1quired to transform an enterprise into a allocations for the privatization options are joint stock company. The Director General summarized in table 6.1. A dominant fea- choices for of each enterprise was responsible for es- ture of the mass privatization program was enterprises tablshing aworking commission for priva- the availability of lare percentages of tization of the enterprise. The commission shares to employees and managers in enter- un2dLergoitng was charged with the following tasks (see prisestobeprivatized Eachofthe tiree op- privatization. figure 6.1). tions involved between 50 and 60 percent of the inital shares of newly privatized com- Valution of aueas. Enterprises' valua- panies to be distributed to enterprise man- dons were mechaically deived summares agers, employees, or the Enterprise of an enterprise's assets. These valuations Employees' Shareholder Fund (EESF). were primarily driven by book values and The selection of privatization option 2 were prepared according to requirements or 3 required the approval of two-thirds of specified in GKI Reigulation No. 763p. the employees either in a general meeting of the wo.ikers' collective or by obtaining Privaizaion options. According to the signatures of the employees. If options 2 or 1993 State Program of Privatization in 3 were not selected, option 1 was chosen by Russia, each commission was required to default. In practice, options 1 and 2 have provide information to the employees of the been predominant choices for enterprises enterprise in order to choose one of three undergoing privatization. Approximately 70 percent of enterprises selected option 2 Figure 6.1 Preparation of a Russian enterprise and approximately 30 percent of encerpris- for voucher pivatizaton es selected option 1. Less than one percent of enterprises selected option 3. Many of Local ft the largest enterprises chose option 1 by de- -_ - Dea mn i Share | and shae * ' due, in part, to difficulties in organiz- d_ds _s , Ink l9w banshued i hnd mg a workers' meeting or difficulties for C* S n Fltion __ \ t emplWees in purhasing the majority * caawrlsin p-n cn sa /ed amount of shares for large enterprie with caien, * Vtcahbow snd, if subneipSn high leveLs of statutory capitaL .Pn -ons - The key elements of the privatization d'ar options are summarized below. Loca comnmes Locl com.utes htnuil depaenots adamrnsatsdepa_muts OPTION 1. Enterprise insiders can ob- tain control of up to 50 percent of the Etuprise shares. Ffty percent of the shares are avail- 10 nminee able to outside investors through voucher * - 4 1' auctions or investment tenders. From the roe me:z 2-Emamhg authorized capital 64 Russx CAmmo PmvnrEENTrsES AD EFcMTrr MAnn • Employees are give prefefred nonvot- * If a group of workers or anyphysical or ing shares representing 25 percent ofthe legal person takes the responsibility to charter capitaL These shares are distnb- fulfill the privatization plan and to en- uted fiee of charge to all members of the sure the solvency of the enterprise, and work collective provided the value does receives the consent of the general as- not exced 20 times the legal minimum sembly of the work force under an remuneration for the employee; agreement which should not exceed * Common shares constituting up to 10 one year, the group has the right with- percent of the charter capital, but not in a specified period to acquire 30 per- exceeding six dtmes the legally estab- cent of the conmnon shares at the lished minimum remuneration of one nominal price. employee, are sold by closed subscrip- Enterprise workers (including mem- tion to the work force at a 30 percent bers of the above group) can purchase discount from the nominal price of a common shares constituting 20 per- share Payment can be made in install- cent of the charter capital not cx- ments over a three-month period with a ceeding 20 times the minimum 50 percent initial payment of the nomi- rermuneration at a 30 percent discount nal price, from the nominal price payable over a * Management can acquire common three month period with a 25 percent shares constituting five percent of the initial payment. charter capital at a nominal price not to * If the managing group cannot fulfill the exceed 2,000 times the legal minimum provisions of the agreement, the shares renuneration; and of the group will be sold to the public at * Tle work force may establish an Enter- a specalized voucher auction (or for prise Employees' Shareholding Fund cash after July 1, 1994). (EESF) which is eligible to receive 10 * Shares transfemrrd to the EESF should percent of the charter capital with a two not exceed 10 percent of the charter year option to purchase the shares at capitaL their nominal value. Transfer of the Table 6.2 illustrates the allocation of shares firom the EESE to the employees shares among intemal and extemal in- is conditional upon the completed sale vestors for selected enterprises. of 80 percent of shares including the sale for vouchers of the shares estab- PnaSaizidon plan. The privatization lisied by legislation. plan for an enterprise details basic infor- mation on a company and its privazation. OPION 2. Enterprise insiders can ac- This includes a sign valuation of the enter- quire 56 percent of the shares and 44 per- cent are available to investors through Table 6.1 Allocation of shares under privatzation options 12, and 3 voucher auctions and future cash sales or eOreno investment tenders: Option I Optin 2 Option 3 * Employees have the right to buy com- mon voting shares representing 51 per- Sold to employees 25 20 Said to emnployees at 1.7 index of nomiinal value cent of the authorized capital at a price fcash or vouchers) 10 S1 equal to 1.7 times the nominal value of Sold to nanagement at nominal value the hars , (cesh or vouchers) 5 the shares and Sold to employee group committed to fulfilling * The EESF may retain up to 5 percent the privatization plan and managing the enterprise to be puriased within two years. at nominal value after one year (cash only) 30 Sold to Enterprise Employees' Shareholder Fund (EESF) with two-year right to purdcase (cash only) 10 5 I 0 OPON 3. Enterprise employees and Subtotal retained by enterprise 50 56 60 managers can acquire 60 percent of tle voucher auction (mninimum percentage by law) 29 29 29 shares with 40 percent of the shares to be Investment, tender, retained by government or other 21 15 11 sold through voudher auctions and invest- Subtotal available to investors or government 50 - 44 40 ment tenders or cash sales. Total 00 100 100 TEcn'QUES OF MASS PRIvAZllON: INPLEMEKING TB VoucEAucnoN Pnocuu 65 prise's assets and the proposed number tal number and nominal value ofshares, and allocation of shares to be issued.Atyp- the percentage of preferred and com- ical privatization plan depicts the following mon shares, and the form of shares (ac- information: tu certificates or central registrar). • Summary characteristics and informa- The plan should include a table which tion including the name, address, summarizes the proposed placement of ownership status, bank name and ac- the shares to employees and manage- count numbers, names and addresses ment, along with extenal placements of wholly-owned and partially-owned (suclh as voucher auction and invest- subsidiaries, number of employees, ment tenders). founding capital, list of products The prnvatization plans were signed by made by the enterprise, and informa- the chairman and members of the auction tion regarding the location of compa- commission and chairman and members of ny plants and operations. The plans the local property committee. also indude lists of all social, as wel as productive, assets. Ankle of the joint stock company. A * The selected privatization option and model corporate charter was provided in the names of the commission memibes. the attachment to Presidential Decree No. * The distribution of shares according to 721 entitled, 'Reguations for the Com- the pnvatization option including the mercialization and Tansformation of calculation of shares outstanding, and State Enterprises into Open Joint Stock for whom specified amounts of shares Companies.' The decree provided a de- are available. tailed example of a company charter in- * The proposed placement of the shares cluding the company's purposes and the of the enterprise including the new role of the board of directors and compa- nameofthe joint stockcompany fie to- ny's management Table 6.2 Distribution of shares for selected Russian enterprises Sransk LukoiI Factofy Kbaimn KasnKyask Tomsk QObita Amwenergo neftegas KIasnyask TsBK Neftekhin*hes (semi- (ectrc uirF (oi dding Trme (celubse, TeIztilmash Factory ZIL conductor ties and ther- andgas Factosy paper and (texti (oibased Company xincrlpaindusq) (autonobio devkes) malpower3 extrctionj (tires) cardboarc9 komsw chemnkal Privatizaton option I 1 1 1 2 2 2 2 Intemal plaeument oercenO Preerred stodc placement for employees (option I only) 25.0 25.0 185 18.6 0.0 0.0 0.0 0Q0 Cosed subscription of common stockforemployees 10.0 10.0 5.6 10.0 51.0 51.0 51.0 51.0 Comrmon stock placement for managers (option 1 only) 5.0 3.6 5.0 5.0 0.0 0.0 0.0 0.0 Enterprise Employees' Shareholding Fund (EESF) 10.0 10.0 10.0 0.0 5.0 0.5 0.0 5.0 Total internal placement 50.0 48.6 39.1 33.6 56.0 51.5 51.0 56.0 External plcement (oercent? Voucherauctions 35.0 29.0 11.9 17.3 29.0 29.0 29.0 44.0 Retained by government or holding company 13.0 20.0 49.0 38.0 15.0 19.5 20.0 0.0 Distribution to population in the far north and employees of the oil transportation companies and subconractors 0.0 0.0 0.0 9.7 0.0 0.0 0.0 0.0 Investment tenders 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Cash sale 2.0 2.4 0.0 1.4 0.0 0.0 0.0 0.0 Total external placement 50D0 51.4 60.9 66.4 44.0 48.5 49.0 44.0 Total shares (percent) 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Akte: Figures ame rounded to the first number after the decinal point SouWt: Privatation Plan of the Enteprses 66 RtsrsLt CREANG P&mvE ENTEnsss AND EFFrrICIE MAMrs Phase 2- Trafonsfation to ajoistock Disiont of sham. Upon registration, company the company had fiftee days to conduct a dosed subscription auction in order to eiter Enteprses changd their legal status to jcit transfer the hares free of charge to the em- stock companies through the registation of ployees under option 1, or to make available their privatization plans and founding docu- for purdcase the shares under options 1, 2, or ments by the Local and Federal Property 3.Employees,pensionedemployees,andun- Committees. The process included: dercertain regulations, the employees of sup- pliers or native inhabitants of the regions, AppraL Privatizaton plans were to be subnuted applications for te receipt or pur- submitted by October 1, 1992 to the in- chase of shares. Applicationswere prooesed dustudl departments of the local property to determine the allocation of shars. management committees- The committees Typically 29 we required to approve these plans with- Shareiry. Following the distibution Cent 0 in seven days of their submission- If a plan of shares to employees, the list of applicants peIente o yan was not approved, the committee had one formed the basis for drwing up a register efterPfse s shares week to amend and approve the plan. The of shareholders. These lists were later ex- were allocated to be approval of the central government and the panded to incude new shareholders such dibuted through GK[ were required for certain size compa- as the winning participants in voucher auc- pic voucher nies and industries.' tions and investment tenders. auctions. Regoian. 'Within the property com- Phase 4: Vouch prpivarttion inttces, the industral department submit- ted an application, foundation documents In accordance with govemrnment regulation for registration, and a prospectus for the and the approvedprivatization plans, a per- registr-tion of a securities issue for ap- centage of shares from each enterprise was proval by the administratve departmenL allocated for distibuton by the govern- The enterprise is considered transformed ment to extemal investors through public into a legal joint stock company upon its voucher auctions. The percentages for dis- registration. The new shares of the enter- tribution through closed and public auc- prise are registered by the finance depart- tions were specified in the privatization ment of the regional authority. plans. Typically 29 percent of an enter- prse's shares were allocated to be disti Board of directors- As part of the legal uted through public voucher auctions. registration and transformation process, Vbucherauctionswereconductedbysel- the enterprise formned a Board of Direc- ers designated in the privatization legisation. tors which by law included the director The localproperycommitteeruansferredthe general or a representative from that of- enterprise's registration documents to the fice, a representative of the propert com- seller who assumed responsibility for the mittee, a representatrve of the work force, shares created in the process of privatization. and a representative of the local authori- Sellers were generally the Federal Proprty ties. The board of directors' composition Fund for companies which wer federaly and duties were oudined in the model cor- owned, or the appropriate local property porate charter included in t.e attachment find for companies that were under owner- to Presidential decree No. 721. ship of the tecritores, regions, the cities of St. Petersburg or Moscow and municipalities. Phase 3: DisriNbtion of shares to employee The sellers managed the voucher pnv- (closed suscr$ion) tization process. At the regional level, voucher auctions induded a number of According to the privatization option cho- fundamental steps. sen, enterprises were obliged to allocate * Assgning an auction commission to pro- shares within the company according to the vide oversight to the conduct of the auc- approved privatization plan. tion and approval of the auction results TECHNIQUES OF MASS PRIZV&TnON: ItEMUNI THE VOUCHERAUcnON PROGRAM 67 * Anngingforpublicationof requied an- voucher priatizarion progrm. To establish nouncements for the upcomig auction %aucher auction programs, regions devel- * Conducting the voucher suction oped similar systems of processing voucher * Compiling and calculating the results of auctions which incuded the basic steps out- an auction, legitimizing the auction by lined below. the signing of a protocol of auction re- sults, and ensurng that the sharehold- Pieliiee management ers are entered into the share registryof the enterprise Working with the local property committee, * Announcing the results of the auction the propert fund :iIntfied enterpises to the public whichwereeligibleforsellingsharesthrough * Ensunng the cancellation or return of voucher auctions. Tley then performed a The location and vouchers minimum level of due diligence on the en- reach of voucher - Conductng a cash sale auction for a terpises, and generally organized an auction small percentage of shares to cover the 'wave* for the auctioning of several enter- auctions was a expenditures of conducting the auction. - simulaneously A typical wave would function of the size include anywhere from five to fifty compa- of the enterprises... The tegional voucher auction process nies being auctioned simulaneously in atwo weckperocL The initial voucher aucion phase of the The location and reach of voucher auc- mass prinvatization program emphasized the dons was a fimction of the size of the en- development of regional voucher auction terprises: companieswith a fixed asset value capabilities to conduct auctions for of less than 250 million mble could be auc- medium-sized, local enterprises in the re- tioned only in the seller's region, enterpris- gionswhere companies conducted their pri- es with a fixed asset value of between 250 mary activities. Eighty-six of the eighty-nine and 500 mnllion rubles were required to be regions in the Russian Federation had initi- offered in at least five regions, and enter- ated and conducted regional voucher auc- prises with a value of greater than 500 mil- dons prior to the prgramm's close at the end lion rubles were to be auctioned nationally of June 1994. The Russian Fedeation Committee for Bid collecton the Management of Property (G) was re- sponsible for overseeing and supporting the The local property fund established a re- development of regional auction capabilities gional auction center and several bid recep- and ensuing that local regional programs tion locations thro hout the region conformed to the Laws, decrees, and regula- depending upon the size of the region and tdons govening the mass privatization pro- distribution of the population. Over 750 bid gram. Followg the program's basic design, coUection sites were operating natioswide regions participating in the program estb- (approximately 10 sites per region) during lished comparable systems providing the the last six months of the voucher auction opportity for citizens to invest in p- program 2Each region operated a central tizatimonvouchers thrugh auction centers or regional auction center which was run by bid reception centers located m cities and the property fimd or their designated towns throughout the regions. The use ofba- agents. The property fond or agent general- sic auction procedures and decentralizedbid ly subcontracted with commecal or gov- reception centers facilitated a widespread emment entities to open a network of bid implementation of the program. LThe use of reception sites wlich received applications common bid reception and auction proce- forvoucher auctions. Consulants at thebid dures also made it possible to integrate re- collection sites provided basic information gional voucher auction capabiites into a (drawn from the prvatization plans) to po- national systm to conduct auctions simuka- tential applicants about the voucher auction neously i multiple regions for the largest process and companies being auctioned. Rusian enterprses paricipating in the Additional staff accepted and processed ap- 68 Russx& CRATNG Pinan EinnEwmss nn EmcIDFIvMhxs plications, and submitted the colected ap- regions. Regions were pernitted to develop plications to the regional auction center for and use their owm software provided that it processing and calculating auction results. was tested and certified by GEL Most re- gions used versions of the standard auction Type I vens type 2 bids software issued by GK. Results of the auctions were presented Two types of bids were allowed under the in a protocol which was approved by the voucher auction program. Each applicant, Auction Commission. Attached to the pro- whether an individual or legal entit, was en- tocol summarizing the auction results was a tided to select the type of bid to be made in list of winning applicants which was tram- an auction. If an applicant submitted a type ferred to the share register of the company. 1 bid, he would automatically become a After auction results were announced, the winner in the auction and receive some vouchers of winning applicants were can- number of shares in the auction. Type 1 bid- celed and the vouchers of the losing type 2 ders were indifferent to the strike price (the bids were rctumed to the applicants for re- number of shares per winning voucher). submission in subsequent auctions. Under a type 2 bid, the applicant specified the mfinimum strike price at which he was Cash sale wiling to accept shares in the company. If the calculated strie price was equal to or To defray the operating costs for local vouch- lower than the indicated bid, the applicant er auctions and to provide incenfives for became a winner (for example, an applicant agents operating local bid reception centers, who specifieda strike price of five shares per post voucher auction cash sales were orga- voucher would be a winner in an auction nized in regions which conducted voucher where the strike price was five shares per auctions. IlTese were typically simple open vouchers or lower). An estimated 95 per- outcryauctionswhenlotswithvarnmgnu- cent of allbids in the voucher auctionpro- bers of shares were sold for cash- Regional gram were type 1 bids. property funds could sell up to 5 percent of the amount of shares sold through the vouch- Auctin resztrpmcemi7g er auction for enterprises which sold less than 29 percent of their shares, or they could Once the auction was closed, all bids were sel up to 10 percent of the shares allotted to entered into a computerized database pro- voucher auctions if29 percent or more of an grant Te auction results were calculated enteprise's sbares were sold thugh vouch- according to an algoritm which deter- er auctions. Proceeds fo cash auctions mined the strike price of shares per vouch- were collected by the property fund and re- er. I there were no splits in the number of distributed to participating agents which op- shares being offered at the auction at least crated bid reception centers. Agents were 80 percent of the shares were to be sold. If generally reimbursed on the basis of the there was a split in shares being offered (for number of vouchers which were collected example, 300,000 shares of 1,000 rubles and canceled (the presentation ofa cancElla- nominal value were split to 600,000 shares tion protocol to the sdlerwasnecessaryin or- of 500 rubles nominal value), one of two der to receive compensation). Lists of things occured. If therewas asplit in shares winners of shares in cash sale auctions were being offered and less than 29 percent of also forardedtothe compn-yorits registrar the shares were offered forthe auction, then to be includle in the share regstry 95 percent of the shares were to be sold However, if a split occurred and 29 percet Exmples of regional rcheracion of the shares or more were offered, then 90 systems percent of the shares were to be sold. To ensure the accuracy of voucher auc- To illustrate the operations and results of re- tion calculations, GCI developed and dis- gional voucher auction programs, the activi- tibuted standard auction software to the ties of five regions are summarized below TECHcNIUES OF MASS PJUVADoZf LON: ldLEzrNr Tm VouanHEAucIN PxoGRAM 69 Sverdtovsk RegionalAuction Cnter The ed this arrangement and developed is own property fund designated the Ural Stock center. This was a trend in seveal regions as Center (USC), a commercial entity, to act the privatization program was drawing to a as the agent for the region. The fund played close and property funds were seking to a key role in creating this entity mi cooper- identify future roles for their organization in ation vith a private consulting firm writh the post-voucher privatization ystem. funding provided by USAID. Initial fund- * Bid reception netuwork There were six bid ing of the bid process was provided by US- reception centers thatwere operated di- AID until the introduction of post-voucher recdyby the propertyfuncd and its agent. auction cash sales enabled the system to be- In addition, twenty-hiree bid reception come self-financing. sites were operating in the region a: the * Bid reception network- The USC opened local postal offices and district property approximately 30 bid reception sites to fund or committee offices. provide coverage in the 20 districts of * Auction sofhware. The prperty fund the region. Locations were primarily in used the GKI standard auction soft- the local house of culture or the district ware for calculating local and national property funds or committee offices. auctions. * Aucton software The property fund de- * Auctins results Sarato mroperty fund veloped their own software which was has auctioned approximately 250 enter- certified by GEI for use in local auc- prises in twenty-five auction waves, each dions, but uses the GIG standard auc- was e consisting of approximately ten dion software for national auctions. companies. Enterprises were auctioned Aucions reuts By the end of June forarwoweek perod. 1994, the property fund conducted an estmated sixteen auction waves for a Orenbug Regonal Auction Centr The total of 350 enterprises. property fund signed an agreement with a local currency exchange to act as their rep- Omi ReionalAuction Cenw The re- resentative in the region. The exchange re- gional auction center was managed direct- caved start-up funding from the local ly by the property fund and was created property fund and comnmittee. At the re- with start-up technical assistance and fund- quest of GKI, periodic technical assistance ing provided by USAID. After the intro- was provided with funding from USAID_ duction of post-voucher auction cash sales, - Bid reception network. Up to twenty bid the operation became self-financing, reception points were operating in • Bid reception netzor&. The property fund Orenburg through ai agreement with subcontracted with the local Sberbank the local Sberbank- (government-owned savings bank) -Auction software. The property fund branches, which opened two bid coflec- used the GC; standard auction soft- ton sites in the city of Omsk and two in ware other population centers in the region. * Auctions reslt. Approximately 100 en- * Aucon softwar. The property fund teprises have been auctoned, each used the GE0 standard software for cal- company being auctioned for four culating the local and national auctions. weeks. The property fund auctioned * Auctions resu& Omsk property fund companies individually as opposed to conducted an estimated twenty waves grouping them into waves. of auctions for a tota of 194 enterpris- es.Auctionsweretypicallyheld forape- Tla RegiondlAucton Center The prop- riod of two weeks. erty fimd managed the regional auction center direcdy. The voucher auction pro- Sarrov Reginal Auction Cener The gram had been financed by the property property fimd oially delegated the auc- fund without outside assistance. Periodic tions to thelokd stock exchange. Towards the technical assistance was provided at the re- end of the program, the property fimd end- quest of G1I1 with fumding from USAID. 70 Russat CREATNG PRVAT ENTERIE AND ERmcmwr Mn * Bid recptbon neiwort Over forty bid re- remained essentially the same as regional ception sites were opened by the prop- auctions except that bids were received in erty fumd by subcontractng mwth a local bid reception centers across the coun- pnvately-held bank to open sites in ty The bid reception process for national twenty-five branch offices and with the district pmperty funds and cc mittees Table 6.3 Partidpating regions in the National Auction System in another fifteen locations. in Thetherfifteen loc rtioper f The following regions in the Russian Federation partcipated as selling agents for the national Au on software. Ile propery fund auction system Regions with an asterisk offered companies to be privatized through the used the Gfl standard auction soft- national system. ware. 1. Abakan ' 41.Neftqyugansk Auctions rnsnd 166 enterprises were 2. Anadyr * 42. Nizhni Nougorod 3. Arkhangelskc 43. Novgarod auctioned by the property fund in dtir- 4. Astrahan * 44.Novosibirsk * ty-eight auction waes. Each enterprise 5. Bamaul 45.Omsk Oblast &. Belgorod *46.Orel was auctioned over a two week period. 7. Blagoveshensk * 47.Orenburg * & Bryansk * 48.Penza The Narionni Auction System 9. Cheboksary * 49. Perm Tiie Naiotud Action Sstem I0.Chelyabinsk *50. Petropavlovsk Kamchatski 11.Cherdcssk 51. Petbzavodsk * In pbrury 993,theNatonalAucion 12-Chita 52.PSICov In February 1993, the National Aucti:n T3.Dudinka * 53.Rstov-on-Don * System (NAS) was created as a mechanism 14.-Ekateuriburg * 54. Ryazan * for conducting voucher auctions for large t6 Elista * 55.Salekhard 16-Irkutsk 5&Sarmaraa Russin enterprises in multiple regions si- 17.hvanovo * 57.Saransk multaneously. It was designed as an over- 19h Kaliningrad * S9 Sroensk lay" of the regional auction system utlzing 20.Kaluga 60.5tPetersburg the processes and procedures that had al- 21.Kemnerovo * 61.5tavropol * ybeen implemented at the reional 22.Khabarovsk * 62.Syddyvkar ready been implemented at tile regional 23.Khanty-Mansrjsk * 63.Tambov - level. The National Auction System en- 24. Krov W 64.Tornsk abl,d ,,ucherholders ,.1wrA , R to 25.Kostroma 65.Tula * bled voucherhold ers throughout Russianto 26. Krasnodar * 66.Tumen pamcipate in voucher auctions for the 27.Krasnoyarsk * 67.Tver Largest enterprises without travelling to the 28.Kurgan 68.Ufa region where the companies were located. 30. Kyzyl 70. Ulyanovsk - Rssian legislation stipulated that en- 31.Leningradskaya Oblast 71.Vladikavkaz 32. Lipetsk *72. Viadimir terprises with a fixed asset value greater 33.Magadan * 73.Vladivostok * than 500 million were to be offered for sale 34. Mahachkala 74.Volgograd * 35. Maikop 75.Vobgda nationally3 The first company to be auc- 36Moscow 76.Voronezh * tioned throug. the NAS was the giant au- 37. Moscow Oblast * 77.Yakutsk . -, . . . ~~~~~~~38. Murrnansk 79.Yaroslal toinaker ZIL wlch was offered i twel3e 39.Nahoda * 79.Yashkar-la regions througliout Russia. These twelve 40. Nalchidc 87.YUhnoSahalirsk * regions indcluded the locations of Zu plants, major supphs, majorinvestors and Table 6A Performance results of the National Auction System voucher investment fiuds. From Marh 1993 until the conclusion of the voucher May?, 1993 May? 7,994 June 30 7994 auction program on June 30, 1994, 313 Number of companies companies were auctioned thrugh the sold (dosed) 3 113 313 sDld orin proems 3 157 313 NAS in eightY regions. Regional PartiaPa- Total charter capital (thousand rubles) tion in the NAS is presented in table 6.3 sold 6.082.034 239.060fi98 439.425,289 and a, summary of.the ice results sold or in process 6,082.034 316.532.042 439.425,289 and a summary of the perfornuncc results Vouchers collecled 1.149,038 23.763,134 34.060,139 of the NAS is presented in table 6.4. Bids received 80.526 269,697 325,270 To coordinate the national auction sys- Number of regions 26 79 80 Number of shares tem, the National Network Center (NNC) offered 1.910.764 83,086.466 118,917.045 was initiated under the auspices of GXL soida 4.701.750 160.188,649 239.102.8S1 wasT luatd uner he NNC racifof GKL Number of regions transmittng The NNC facilitates the cooperation bid data electronicaly 0 36 40 among partucipants to conduct national auc- a Number of shares sld win steed numberoffeed in thecaseofsharesprtng during the caluon of tions. The procedures for national auctions the aucfion. TEcHQUES OF MASs PIVAmA;oIIN: DumEm£ G THE VOUcHR AUcION PROGRAM 71 auctions was typically four weeks as op- local bid reception networks. All regions posed to two weeks for local auctions. The participating in the NAS received initial NNC was responsible for essentially the training and inspections by NAS staff prior same basic functions as the regional auction to participation in the system to ensure centers. These main functions are summa- compliancewith national auction standards rized below and summarized in figure 62 and procedures. which oudines the auction process at the re- gional and national levels. Announing the auction Managing the auction pipeline The NNC worked with the sellers to ensure that the legal requirements for announcing The NNC worked doselywith the GK[, re- auctions in the national press were met be- gional and federal property funds, local fore any deadline. property comnuittees, and the enterprises to coordinate the pipeline and to schedule Commencng the auction those companies to be auctioned nationally. Privatization plans and other essential doc- Contracting with the seller umentation necessary for the bid reception sites to conduct an auction were delivered The NNC drafted and arranged for the to all participating regions. Each region signing of contracts between the regional confirmed that the bid collection had com- property fund responsible for selling an en- menced in their region. terprise, and participating propery funds in other regions which accepted bids for Closing ie auction shares through local bid reception centers. The NNC was required to invite all regions At the end of an auction, regions collected to participate in the auctioning of enter- the applications and entered them into the prises available for national auctions. standard computerized database program. The actala bids and vouchers were main- Developing regional participation tained at the local bid reception centers where application bids were offered. The By the end of the program, seventy-nine re- summary auction data from participating gions had participated as agents in the regions was then carried by hand or trans- NAS: shares of companies slated for na- miteed electronically to the NNC. Upon re- tional auctions were offered through their ceipt, the data was tested for accuracy and completeness prior to being incorporated into the national database for the calcula- Figure 6.2 Sequence of regional and national voucher auctions tion of the auction results. Prepare Process Comvpiling and calulting the auction agents Annouc Coduct uat Announce P for auction auction auction maction losng a audioln |a tsI mult mlnces sal In Ethe presence of a member from the auc- * Signagefxy * Bid canme * Cormpnlb * cae To m 2 tion commission, the NNC compiled the agreements receive auctionbids vwinning biddes data from pariicipating regions and calcu- - D;stbute *eaics - Cakulate vuhr auctiopand auction Update sham lated the auction results. A draft protocol en results Ilegw m with the auction results was prepared and imanton * Signauction *Distribute *p OM ha presented to the auction commission for notsiHiorns approval. Regional voucerauction (19 weeks totl 4 2%eeks 1042Iwee* 3 O 4J2 . .wees Processing e auction results Natona voucher auction (24 weeks tota Following approval of the auction by the +2 1;;+, 4 wees 1L4 6EweuPj 12 commission, the NNC prepared sununa- 72 Russit CREATING PuvAmE ENTE'usES AND EcmNr MArzs ry reports for the selling property fund, ties of these general agents include the fol- enterprise, partidpating property funds, lowing steps: and winning applicants. Each new share- * Polling potential investors, holder was issued a notification of owner- * Colecting applications and deposits ship confinning the information that was prior to the auction, to be entered into the share registry of the - Agreeing with local agents in other re- enterprise. Results of the auction were an- gions to partidpate in the auction, nounced in the Federal press. At the local * Connecting the agents to a telecommu- level, winning vouchers were canceled nication network to conduct a simulta- and destroyed and losing voucher bids neous auction in multiple regions, were returned. * Conducting the auction in an open out- cry format (lots of shares are sold to the Natonl cash sales highest bidder), Cash sales for * Processing the auction results, and ational auctions In addition to managing national voucher ' Coordinating distibution of proceeds to auctions, the NNC coordinates a post- the partiipatingvoucher auction agents. have generated voudcer auction cash sale to sell a percent- significant funds to age of the company's shares for cash. The Regionalaucon defray the system's proceeds from these cash sales are used to defray the costs of conducting national auc- In certain cases, grven the relatvely low operating costs. dions. The percentage of shares offered for percentage of total shares available for sale is the result of the difference between the cash sale and the limited number of the amount of shares available for the potential investors interested in purchas- voucher auction and the amount of shares ing shares, cash sales for national auctions actually distiuted during the voucher are conducted in the region where the auctioa Ihe maximum level of shares selling property fund and er.erprise are available for cash sales is the same as forre- located. The NNC works with the local gional cash sales: either 5 percent of the property fund or their designated agent to shares sold in the voucher auction if less conduct the cash sale using one of a van- than 29 percent of the enterprise's shares ety of formats: were putup for auction or 10 percentif 29 O Cpe outcy The shares are dividedin- percent or more of the shares were avail- to varying sized lots which are auc- able for auction. tioned to the highest bidder Upon conclusion of the cash sale, pro- Bokening. Shares are placed on the ex- ceeds are distibuted to participants in the change atafixedpricewhichcanbemod- voucher auction to finance the operadonal ified by the broker according to the costs of conducting the auction. The NNC buyers' demand. This approach was used monitors the cash auction process until all in a number of regions, with active local funds have been distributed. Since the im- stock exchanges such as Vladivostok. ception of the National Auction System, Closed tender During specified time pe- several mechanisr s have been created to riods, closed bids are accepted in sealed implement the post-voucher auction cash envelopes that are opened on the an- sale. These include the following, nounced date by the auction commis- sion. Shares are sold to the highest Intengionad open cash auctions bidder in the amount indicated by the bidder untl all shares are sold. The NNC has overseen the management of Cash sales for national auctions have gener- cash sales in up to four regions simultane- ated significant funds to defray the system's ously. Cash sales typically are managed by a operating costa By the end of April 1994, third party general agent induding broker- cash sales had been conducted for seventy age companies or stock exchanges which compani which had been auctioned by are responsible for organizing and con- thity-nine property funds in national auc- ducting the cash auction. The responsibili- uons. These cash sales genrated approxi- ¶ftdnNIQuES OF MAss PRVAMZAnON: INwEDG IE Vouc1m AUCIION PROGRAM 73 mately 7.4 biion mbles oran estimated $4.1 privatization programs, induding efforts million. Wile the results for the lrest corn- aimed at pmviding restucuuing and finan- paniesgeneratedthelatpmeeds, the av- cial assistnce to newly privatized enterpis- erage resat for national cash sales was es, will be the development of standard 105,000,000 rubles or $58,500. approaches, tools, and systems which also can be widely replicated and implemnented Conclusion with targeted intemnational technical assis- tance and finaning. Between early 1993 and mid-1994, voucher auctions were conducted nationally and lo- Ns cally in eighty-six regions across the Russian Federation for sbares in more dtan 12,000 T ofthis paper ar management consul- medium-size and large companies. Te suc- t with P Intrationa Priva- cessful completion of the mass corporatiza- iaon Group. They diected and participated in a tion and privatization of an unprecedented program of technical assistance.apported by US- number of companies wa the result of a AID. toworkwitheGiaintshedevdopmentand number of pditical and economic factos unplmenution of the national auction system. This paper has focused on the standard op- 1. practce itk as not ahways possible to meet erating procedures utfized in the corporati- these deadlines as there vere logisucal and politi. zation and voucher privatition programs. b ddays in both the prepuation d apprv: of Tlle use of standard program procedures fa- the montps of the vouer auction 2. The last sixmotsothvuwxaci cilitated the rapid and geaphicaly far prog as the first half of 1994 reaimplen entation ofvoucher privati- 3. Some large entseprises below these levels zation. One of the main challgs in de- wrem offercd the option to use the National signing and supporting post-voucher Auction Sysm 74 Russi& CRATING PWA1ENR E AND EFFcENTYMAIS CHAPTER 7 Next Steps in Privatization: Six Major Challenges Maxim Boycko and Andrei Shleifer ByJuly 1, 1994, mass privatization inRussia enforcement, and otier reforms essential was officially complete. Some 15,000 medi- for a market economy rather than concen- um- and large-scale enterprises will have traing their lobbyng efforts in ar of fur- ...pfnvatization been privatized through distnbution of ther subsidies. is not the goal, shares to insiders and voucher auctions. In Yet despite these successes, rati- but a means Of a situation incomprehensible fiveyears ago, tion has only stared the long and arduous two-thirds of the Russian industrial labor process of restructuring the Russian econo- accomplisbing a forcewvilbe employed by privatized firms. my which, after a1, is its ulitimate goaL larger goal of Equally as astnishing, over 50 million Most enterprises continue to be rn un- ecnmic develop- Russians will have become shareholders in challenged by the old management teams, either privatized enteprises or investment which often lack the human capital and in- ment and stability fimds. This transfer of ownership has been terest to initiate significant restrcuig, in Russia. accomplished in approximately eighteen While these enterprises dabble with re- montis, with relaively few major scandals structurng and try new products and mar- or severe setbacks. kets, their management is prncipally The successful sale of state-awned en- dedicated to preserving traditional product terpnses does not tel the entire story of lines, which may have no markets, as their econonic transformation. While privauiza- core activity In many cases, enterpnse won may be labeled a success, privatization managers have consolidated their control is not the goal, but a means of accomplish- bybuying shares in the aftermarket and are ing a larger goal of economic development simply kiling time hoping for a miracle and stability in Russia. Therefore, after the (and credits). Enterprises that do want to utnsfer of ownership has taken place, a restructure often lack the capital to move more signficant change in enterprise re- aggressively Private markets have not suc- structuring must occur. in some instances, ceeded in delivering capitd to privatized there are real econonic successes behind finns, so the govemment continues to be these numbers as welL Most priiatized the principal source of finance. Of course, enterprises have begun to restructure.They with govemment finance, the hope of de- are changing their product lines, reducing politzg privatized firms is entirely in employment, startng joint ventures with vain Finally, the legal and regulatory envi- foreign companies, and so on (World Bank ronment in Russia has gready discouraged 1994). Corporate governance mechanisms foreign investment, which Russia needs as are rapidly becoming established, as large an important source ofknowledge and cap- investors, who accumulated their blocks in ital. Despite the joy over the speed and suc- voucher auctions and in post-auction trad- cess of the Russian privatization program, ing,bgin to actively challenge and displace the limited progress that has been attained okl-school managers. Perhaps most impor- in enterprise restructuring, indicates that tandy, privatization has created a political the real work has only just begun. constituency of owners who have begun to This slowness is both economically and lobby the govemment for further reform in politically troubling The restructrng of corporate governance, including the cre- the Russian economy is necessary for a suc- ation of securities markets, improved law cessful transition to a markt-based econo- NEXr STEPs IN PmvxnzAnon: SIx MAJOR CHALLENGES 75 my Newly privatized enterprises must cre- Vishny 1993 and 1994). As long as enter- ate jobs if refon. re to be sustainable. prises, privatized or not, continue to ad- Theymust producegoods thatare attractive dress the wishes of the politicians and to consumers both in Russia and abroad if bureaucrats in exchange for subsidies, no production is to grow. A substantial number genuine restructuring can take placc And of pnivatized enterprises must show their while privatization has gone a long way to- ability to survive in private markets for the ward reducing political influence over government to significantly reduce its influ- firms, politicians continue to dominate the ence on the economy If privatization fails to allocation of export rights, capital, space; deliver a substantial restructning, its politi- and other essential Uinputs." cal opponents in Russia will be only too The second goal of restructning poll- ready to renationalize the economy when des is to provide private capital to priva- As long as enter- they gain political power tized firms, so that they have the resources prises, privatized or Perhaps the most important factor of to restructure Undoubtedly, firms can restructuring is that, in the short run, enter- make many improvements with their own not, continue to prise rtnuu n ing is essental for macro- capital, such as employment reduction and address the wishes economic stabiliztion of the Russian modest changesin.heproductlines.Yetse- of the politicians economy. Stabilizadon is not just a matrer of rious rsnucturin' requires a more sub- moving towards a balanced equilibriumL o stantive change in operations. It requires an and bureaucratsm in succeed, stabilization requires a viable influx of capital. exchange for sub- economy that can survive with limited sub- The third goal is to facilitate manage- sidies, no genuine sidies and generate tax revenues on which ment tumover Many managers in Russia the govermnent can support itself In recent are unqualified or ill-motivated to oversee r-estructuinzg can months, the Russian govement has shown the resucuring of their enterprises, so a take place. an interst in stabilization, but has done chan in management is a precondition very litde to accelerate reforms that wl de- for a change in operations. Baxris, crease the sociald prce-tag associatedwith it. Boycko, Shleifer, and l;ukranova (1994) The restrctrng of the Russian economy have found that, in a sample of small-scale dterefore, must be accelerated for the sake pivanzatious in Russi, complete owner- of both grwdt and stabilization. ship change is the best predictor of resuc- Not surprisingly both the refonners and turng. These goals suggest sx policy the conservatives in Russia support enter- priorities, listed below in no particular or- prise restructuring. The question at issue der. It is apparent that these prioities can howevei is how is restcturing to occur? be implemented as viable reforms and that This paper addresses this question on two the political climate in Russia is ripe for levs. The firstpartofthispapervwilbroad- them to be imposed. ly outline six key strategies for enterprise re- structuring. Although progress in these sic Tamnsition to cash prikadzon areas might vary in degree, it is reasuring to observe that the political conditions exist to With voucher privatzation completed, the make some progress possible in all of then. politiual imperative of creating Millions of The second part of this paper discusses one shareholders has vanishedL As a conse- of thesesrategies, namely the rasfer of so- quence, it is now possible to move to cash cial assets from entepnses to local govern- privatization, which wil take the form of ments, in greater detail in order to illustrate cash sales of shares. These shares can be how the broad strategies can be translated residual stakes that the govemment still into viable econonmic policies. owsm in already privatized firms or they can be shares in state enterprises that have so far Six priorities of restructuring escaped privatizatiorL The principal point is that proceeds from share issueswillbe, to a Policies that promote restructuring have significant extent, retained by enterprses three goals. Tthe first, overrching, goal is and can be used to finance resrucing. in depolitcization (see Boycko, Shleifer, and the case of new privations, some of the 76 Russ55 Cwmwxw Pam ErmmmnsnEsDpEFncIxznMAms cash proceeds wi also be kept by local gov- in most cases retnain unchaflenged by emments and by privatization authorities to shareolders. Part of the problem is that increase their incentives to privatize. Prime managers and workers own over 50 percent Minister Chernomyrdin has endorsed this of most privatized firms. Outside share- approach and has bravely rejected the no- holders often have trouble even exercising tion that privatizaton proceeds should be a their minority rights. They have difficulty source of federal revenue. getting information, communicating with Politically cash privatization is the most fellow shareholders, voting their shares, sustainable approach to privatization at this getting share transactions registered, and juncture. It is sure to enjoy broad support so on. Many outside invesmrs believe that of the relevant stakeholders, including minority shareholdings in Russian compa- enterprise managers, local officials, and nies areworthless. iMoscow politcians concernedwith finding The situation with creditor rights is ... cash privatiza- resources for enterprises in a regime of (rel- even worse. Neither the commercial banks ative) austerity. Cash privatization also ad- nor creditor enterprises have any legal dresses all three objectives of restrucunng mechanisms for collecting what is owed enjoy broad sup- that were mentioned above. them. The new bankruptcy procedure port of the relevant First, cash privaization is likely to move largely ignores he creditors and gives the stakeholders, more fis into private ownership initat- control rights in banlruptcy to a new gov- ing the process of their depoliticizatioL emment agency,rather than to the creditors mncludng enterriTse Cash sale of residual goverment blocks al- who have actually lent the money. managers, local so reduces the risk of local officials using The shortcomings of corpDrate gmver- officials, and their power to vote these blocks to influ- nance pose severe problems for enterprise ence privatized firms. truc First, many dircors inca- Moscow politicians Second, cash privatizations in which pable of overseeing enterprise restructuning concerned with proceeds are retained by enterprises supply are entrenched at the hel while the most finding resources privatized finns with sorely needed capital obvious mechanisms forthrowingthem out, and, in this way, provide them with re- such as outside shareholder insurgency or for enterprises in a sources for restructring. The need for ex- banlnuptcy reman fairy meffectivt regime of (relative) panding private ownership of large Second, the likelihood that investors will steWiy enterprisesandbuildingapoliticdlcoalition supply private capital to enterprises, given for reform through large-scale privatizatior. the weakness of both shareholider and cred- is not as great now as it was in 1992 and itor rights, is remote. With private capital 1993, when mass privatization started. provision lacking, enterprises rely on public Rather, privaization should be seen pri- capital, which, of course, preserves political marily as a mechanism for gettng necessay control over firms. Improvements in corpo- capital to firms. rate govemance, including both sharehold- Third, cash privatization speeds up the er and crediLor rights, are thus essential for process of management turnover as suppli- speeding up restructuring. ers of capital demand control in exchange Porinmately, privatization has created a for cash. As in Western economies, incum- political constituency of new owners and bents give up control only when they have commercial lenders who are exerting polt- to, and, as some recent sures show, bring- ical pressure for putting in place gover- ing in new capital maybe the bestwaytore- nance mechanisms. New regulations giving move control from them. ouside investors more rights, including the right to vote and to transfer shares, are be- Corporae govrnance and gal reform ing implemented. These regulatiors will become more important as employees con- Although substantal progress has been tinue selling their shares and long run own- made in improving corporate goverance ership structures emerge. If corporate procedures in the last few months (such as governance regulations are sufficiently ag- the decrec on independent share regis- gressive, outside investors will begin sup- trars), managers ofprivatized Russian firms plying capital to the privatized firms once NEC. STEps IN Pkimnzmnor: Six MJR CHALTLoaEs they can obtain tangible control rights in re- problem that significandy slows down en- turn for their capital. eerprise restucturing. Tax laws in Russia The progress wich creditor righs has are inconsistent and impossible to obey, been excruciatingy slow, as control over and scare away both domestic and foreign banruapt finns has been tumed over to a investors. Contract law does not exist and new government agency. In fact, many contracts are not enforced by courts. The would argue that rather than being labeled result, of course, is that organied crime en- prgress the decision to turn bankruptcy is- ters to protect propery rights and enforce sues over to a government agency consd- contracts (Shleifer 1994). Laws governing totes a step backward. This central agency creditor rights and collateral do not exist, has the power to decide whether to try to and, as a consequence, only government- restructure these firms using govemment and mafia-enfoxced lending play important The weabkess of the subsidies orto liquilate themn. The one fun- roles. legal system has damental principle of bankruptc, namely The weakness of the legad system has been a majorbdcat of private creditor rights, has been comn- been a major deterrent to the provision of been a major pletely ignored. As a result, the new bank- capital and know-how to the Russian en- deterrent to the ruptcy proxedure wil not only fail to terprises. It has been the greatest complaint provision of Capital promoce restucnting, it will delay it for a of foreig investors, whose role in enter- number of reasons. First, the enunnous priseresructuringislelytobeprominent. and know-bow to powres of thebarAcuptcyagencywllonlyin- The weakness of the legal system also the Russian crea poitical control over firms, as man- strengtens the role of the bureaucracy as enterprises. agers beg (and perhaps bribe) bureaucrats the arbiter of disputes and thc protector of for restuctring subsidies, rather than face last resort, and so retards the desired effect the alternative ofliqidationL The goal ofde- of depoliticizing finns. All of these factors politicization is thus defeated. Second, if pri- point to a sore need for legal reform in tay vate creditors hive no rights and a bankruptcy, and commercial law, and in gove:nment agency decde the fate of a land and otier reform to speed up restrc- fian, private loan markets are unlikely to de- tuing. A genuine demand for such reforms velop. Third, the agency is lkly to be cap- now eists, primarily because privatized tired by the existng management and and newly private firms need legal protec- therefoeworktokeepthatmanagenent in- tion and commercial laws to restctume. staled, rather than threaten the stabiliry of Cntics of privatization, who argued that le- their jobs. A new approach to banklrptcy gal reform had to precede privatization, ilac gives power to creditors istead of the sirply have missed the boat in their ae- governmentisneededifprivatecreditm-ech- ment of political capital A year ago the po- mnisus are to work in Russia. liticaldenand forlegalreform did not exisL We conclude our discussion of gover- At this post-prdvatization point in the natce by notng that a wide varety of gover- Russian economic reform process, howev- nance mechanisms emst around the world. er, lega reforn is both essential and politi- Some countries, such asjapan and German, caly feasible. have developed goveance mechanisms based largy on bank debt Other countries, Creaton of secuties market such as the United States, have equity-based goveran ce mechanismsd It is not yet dear New equity issues are liely to become an what type of system will emerge in Russ A iportant source of capital for privatized mechanism that gives control ights to the finnsinRussia, in partbecause of continued pivatesuppliers of capital is esstiI if they problems with bankruptcy iond creditor are toturnresourcesovertoprivatizedfirms. rights that stife the private loan market Tfhe mode of fncing that accmmodates Many firms are already planning to issue eq- the inveors' needs most efficiently will uiq, but are concerned about their abit to dominate. distribute shares to inestors. These irms The shortcomings in corporate gover- are prwvidig the needed demand for the nance are just a few examples of a legal services of a securities market tat can fa- 78 Rusm CTATG PkmV& ENTaFls ND EFIcmENT MNum cilitate the distribution of shares. Many ot- ernments, who view control over real estate ers need securities markets as welL Some as the most convenient mechanisra for con- potential blockholders need them as a wav traoling both business and corruption in- to consolidate share ownership and to buy come. Indeed, in large cities, such as shares from the workers. Foreign investors Moscow and SL Petersburg, real estate is unwiling to participate in disorganized mar- probably the most valuable asset entepris- kets are waiting for organized securities eshave(asconfirmedbytheextrernlyhigh markets before they begin investing in valuation of firms in these cities-see Russia. The time for securities markets has Boycko, Shleifer, and Vishny 1993). Not come. They hold the potential both to ad- surprisingly the governments of these cities, dress the capitul needs of the Russian firms including Moscow city mayor Luzhkov, and to facilitate corporate governance. have passed various decrees designed to The difficulty in creating capital markets maintain govermment control over the leas- There are several in Russia is to make them a mechaiism of ing of real estate and to prevent the creation components of ld depolitcizaton, rather than the reverse, of private real estate markets. In this polici- Many countries have opted for one central- cal environment, the creation of private reform in Russia, ized exchange, a choice that offers signifi- property in urban land has been as slow as including the cant benefits of uanparency and liquidity that in agcltual land. reorganization of In principle, one centralized exdhange also Since control over agricultural land is can offer firms raiSing capital access to the conmected to the politically sensitve sub- collective fanms, largest possible number of investors- In ject of food securir the bueeaucracy has the creation of Russia, howeve, establishing one central- managed to prevent both privatization of private ownership ized exchange is not desirable at this point, land and registration of ownership of the since such an exchange is likely to becme existing private land plots. At the moment, fights in small land controlled by the Central Bank or the it is clear that Russia is not politically ready plots.. the creation Mnistry of Finance. The result would be for a genuine reorganization of collective of ownership fights that a governiment agenc)0 rather than mar- farms. Although the govenment has ac- f g ket forces, would detemaine who gets capi- cepted some models for fam reorganiza- n land used by the rl. Aless centralized networkofexchangs, tion, such as the so-called IFC mode, enterprises, and the controlled by bcoker dealers rather than a participation in reorganization is voluntary privaization of real govemmentagency,couldoffergreareben- and few collctive farms will join, especial- efits in termis of smaller political influence at ly given their fear of losing subsidies. There the current stage of the Russian economic is no serious program for mass reorganiza- reform process. tion of coUective farns. Thus, for the near futuir, collecinve famis in Russia are likely Land and real emoe rorm to remain intact and wil continue to waste an eDormous amount of public resources. There are several components of land re- At the same time, prospects for conscli- form in Russia, indudng the reorganization dation of ownership fights over personal of coflective farms, the creation of pnvate land plots, and land under enterprses, m ownership rights (induding transferability) particular, are much better Making the land in smal land plots used for both recreation under enterprises a private asset that enter- and small-scale faiming the creation of prises both own and trade can do a lot to ownelship rights in land used by the enter- stimulate restructuring First, it eliminates prises, and the pnvatization of real estatc. the pncapal mehanism of local poitical Over the last two years, despite President control over firms, namely the control over Ylsin's forceful efforts to decree change, real estate. Not only do enterprises benefit, land reform in Russia has been systemati- afl others who need or have land indiecty cally sabotaged by the agraian interests benefitaswell,asthelocalgovemmentslose and, most notabl by the State Comnittee their monopoly over urban real estate. This on Land Management (Roskomzem). will open doors for Iccal business growth in Moreover, privatization of real estate has Russia, an area wThere progress has been been delved m most intnces by local gaov- conspicuously lacing. Second, because en- Ncr STn's INUPrvsAn : SIX MAJOR CHUEING 79 terprises own a lot of land and buildings that competition is an cssential element of a na- they don't need, sale of this land can pro- tional resrucuring strategy. vide enterprises with badly needed capital Progress in this area in Russia has been (without a social cost), which they can use relatively slow. The central government has for restructring. Third, land under enter- imposed a varety of foreign trade barmers, prises can be used as collateral, prnviding including tariffs and quotas. Local govern- enterpnses with debt capitaL Tbis can be ments have also caught he disease, impos- the beginning of private loan markets in ing many administrative baffers to Russia, as bankswill begin to lend to firns intrerreonal trade. Both the central and if they can grab land and buildings in the the localgovemments haveinstituted ava- event of a default Thus, establishing prop- riety of licensing requirements that handi- erty rights in enterpdse land can become a cap entry Perhaps the geatest danger is the At the core of the very effective and productive restrctuning cmstant risk of formation of the industrial problem witb the sIttehe . holding companies, which aim to monopo- RussiansocialIn Russu, the prmapal mecham of thlizetrindustriesandextractcreditsfrom Russian social urban real cstate reformiis registration ofdin- the central government (Boycko et al 1993 safety net is the terests in land and real estate. Until now, andJoskow etall993).XRussiadoesnotyet undeniable faa control over registration has been shared by have an active oompetitnon policy ttmay overlapping jurisdictions, induding Nonetheless, even in this area there are that the majoity vanOuS agencies of the lc1 govemments signs of pmgress. Fst, so far the privatiza- Of social serices and Roskorzem, a conseative federal don agency has rested most major efforts are provided by agncy. However, it appears that there are to form financial industrial groups. As a re- now two factors that make progress in land suIt, except in a few regions, such as -entreiprses. registanon more l1k4 First, priatized en- Yekateinburg, these groups have not taken terprses and otherbusiness interests have a hold on a major scale. Second, the anti- genuine interest in this reform and are cre- monopoly agency is beginig to develop a ating enough potical prssure actually to rational pro-compeOttion policr that focus make it happen. Second, local govemments es on monopohistic abuses rather than on arc finding themselves in great need of tax regulation of al large firins. Third, Russian revenues. Registration of urban real estate trade, despite all the regulations, is expand- vill be a fim step toward creating the most ing Whilewe continue to be skeptald about natural tax base for local revenues and, the lielihood of an aggressive competition hence, conditions for real estate axation. policy it does not appear to be quite as re From a political viewpoint, the registration mote as it did a year ago, when Boycko, of real estate is more iely to happen now Shleifer, and Vishny (1993) wrote. than it was in the recent pasL Socidsafety net Conmetition poicy Perhaps the single mostimportmnt deterrent The prinipal driving force behind restruc- to effective enterprise restructuring in turing in most countes is product market Russiaisthe socidal sfetynetAtthe core of competition. Under competive pressure, the problem wi the Russian social safety finns hange their products, reduce cost, net is the undeniable fact that the majority fire incompetent managers, reduce labor of social services are provided by enter- forces, and take many other actions associ- prises. his includes such services as hous- ated with rsuctring. Moreover, product ing, linderarts, and hospitals, which market competition leaves less rom for enterpnses provide to their employees free political control of firms, since competitive or at a price substantially below cost. Even firns cannot offer politicns the rents to unmployment insurance is now effectively dissipate on politically motivated activites, paid by enterprises. From an efficiency such as excess employmenL For tis rea- standpoint, the logic behind this system son, as stressed by Joskow, Schimalensee, seems incredible, as enterprises are forced and Tsukanova (1993), product maket to keep people on 1og-term vacations at so RUSSIA: CEAMNG P1vEENEPxSSAmN EFIncpNMan5S very low wages, rather than lay them ofE gartens), medical care, sports and cultnral Effectivey a Russian worker now relies on facilities, and so on, unquestionably repre- his enterpise for both income and con- sents a substantial financial burden on en- sumption, whether or not the worker is pro- terpises. One estimate places the cost of ductively employed by the enterprise. social assets berween 5 and 25 percent of This siaion presents severe problems total labor cost. Another estimate reports for restrturing Fiz paying for the social that the cost of social assets for Russian em- safety net is a tremendous financial burden ployees represents up to 80 percent of en- that takes up an enterprise's resources that terprise profits (Yasin 1994). In a business might be better used esewhere. It also drains environment where enterprises are barely substntial management time, which can surviving, these expenses are enormous. serve as a large cost as welL Second, commit- Maintenance of social assets also consumes ments to the social safey net keep some a large amount of top iarnagement time. potental imvestors, particularly fog in- Some reports indicate that directrs of vescors, frm alking equit posiions since large enterprises spend hours organizing they are afraid of the social liabili This plumbing repairs for employee housing and might explain the prevalence of joint ventures kindergartens- with foreigners, rather than direct imvest- By far the largest expense is represent- mets by thenL Butjointvenures are no sub- ed by housing, which, according to World snitute for substntial equity inestmets Bank estimates, is over half of total social from the viewpoint of restrucng Third, asset costs. (mis total does not indlude on- social comnmments give enterprises enor- the job unemployment insurance.) Enter- mous kverag in bargainingwith the cental prises subsidize the housing of their govement for chep credis and subsidies. employees, including, most importanly, hiis coniutes one of the prnpal deter- utiits and matenace expeses. In rents to the lepoiticizarion of pdvatized some cases, enterprises own the housing in firms. Fourth, by tying workr to firns, aders. they pay for it even though the enterprise-provided social safety nets reduce housing is controlled by the local govern- themobilityoflaborandhinderthefonnaton ments. Interestingly, the World Bank esti- of a vibrnt and productve prvate sector in mates that only approximately 60 percent RussiaThleislitdedoubtthatrest tuing of the residents in enterprise housing are in Russia is damatically inhibited by the ex- employees; the rest are outsiders benefit- istng social saft net rangements. ting from the generous subsidies. There are two appraces to solving this The second largest expense is on the problem. Ihe first is the creation of a social maintenance of child care {kindergarcens), safetynet, such as unemploymt insurance, which represents between a quarter and a outside of firms. While the issue of creating third of the total According to a study by an unemployment insurance program is ur- the Russian Pivatzation Center, it cost gent, it will only be created when significant about 25,00D rubles a month to support open unemployment (above the curret 2 one child in a kindergarten in 1993. Of this, percent) appears in Russia. As a reslt, this the parents paid between 5 and 20 percent, issue is not addressed below. The second and the rest was paid for by enterprises. complimentary approach is the transfer of The ke- point about these numbers is that social assets from enterprises to the local the illcst of child support is a substantial goverments. In the next section, a method fraction of an adults monthly income, per- to transfer social assets is presented that is haps as much as 50 percent for the less ad- both politialy feasible and potentially pro- vantaged workers. This implies that a full ductive as a resmxcuing strategy. prnvatization of these organizations would deprve many people of their services. This Lansfering social assets would bear tremendously harmful social costs upon the Russian populace. The same Maitenance ofsocial assets for employees, problem applies to housing, where many incling housing chld care (kinder- occupants are simply unable to afford the NEr EPS IN PIIzAnoN: S MAjOR CALLENGES full cost of living in the apartnents they oc- sponsibiliy for these services when enter- cupy. In the cases of both kindergartens prises already do the job? The answer is that andhousing, some subsidies are essentialas public financing of social services trough part of the social support of the population. enterprises is extremely inefficienL This type Not surprisingly, many privatized firns of equation does not bode well for a counrty have found the maintenance of kinder- whose economic viabilty is intecrtwined with gartens to be too expensive and have been the degree to whih it can successfillly re- dosing them down. Moreover, in many structurc newly privatized enterprises. cities, kindergartens occupy valuable real First, there is no guarantee that the sub- estate that enterprises would rather lease to sidies are used for the social safety net only. commercial entities. As a result, the num- Some undoubtedly are used to increase the ber of kindergarens in Russia has been production of goods that the rnanagement ... using enterprises falling. (It is important to remember that is dedicated to producing. Inevitably, some as providers of birth rates in Russia have also faUllen sharply of the subsidies also go into managers' and mothers have been getting fairly or- pockets (Blanchard 1994). Much more of social SCTVWeS tensive leave when they have children-so the subsidy is wasted than would be the means that enter- the demand for child care has fallen sharply caseiflthe moneywere direcdy dedicated to prises have to as well.) socal safety net expenditures. This type of financing of services by en- Second, the provision of safety net ser- sun'ive if socal ser- terprises creates serious economic and so- vices through enterpnses greatly reduces vices are to survive. dal problems. When credit constraints on labor mobility. A person quitting a job with Th is is a dangerous enterprises tighten, the first thins cut are a firm risks losing benefits, including hous- implication for an these social expenditures. The most direct ing, in addition to employment. If the implication for an consequence of this is that the goven- housingwereprovidedbythemuncipalit, economy where menefs attempts at financial tightening are the employee would be more liely to thousands of firms made with a maximum social cost, since leave, thus providing greater efficiency in appea to begoin they immediately translate into a reduction the marketplace. alppear to be going of vital social expenditures. Further com- Third, using enterprises as providers of out of business. plicating the matter is the fact that the ex- social services means that enterprises must isting arrangement gives enterprises survive if social serices are to survive. This tremendous bargaining power with both is a dangerous implication for an economy the national and the local govemment for where thousands of firms may be going out credits and subsidies. As a result local gov- of business. ernments such as Yaroslavl have been in- Fourth, social safety net commitments ceasing their subsidies tO enterpnses in (perhaps even more than evmironmental recent months. Of course, when local gov- obigations) make fimls extrmely unat- emments give subsicies to enterprises, they tracinre investment cancddates. As a result, demand political quid pro quos that are not enterprises lose access to the capital typically consistentwith restructuming. The needed for restructuring. In sum, enter- extreme version of this problem is that an prise fiancing is a poorwayto maintain so- enterprise in Russia cannot go banlu=pt, cial services. since, if it does, its employees not ody lose Theptrivatizationprogramattempted to jobs, but also housing, child care, andso on. solve this problem, but it was not b ery suc- Because the social obligations of enterpris- cesafuL In the program, enterprses were es are so high, the new bankrptcy proce- given the option to transfer their sodal as- dures probably wil lead to an attempted sets to the budget of the local goverment, rehabilitation of all firms using govenmment if the latter ageedL In some cases the local subsidies and tovtuay no liquidations. governments have accepted responsiblit This anabsis raises the obvious question. for the social assets, but in the majoriaty of what is wrong vith the provision of social cases they have ref used. As a result, despite services (including unermployment insur- rapid progtess with privatization, most so- ance and housing) through entepnses? cial assets remain financed by the now pri- Why create new institutions that take re vatized firms 82 Russu:t CwREIG PRIVxE ENEmPms AND EFFCIENT MARKT For the reasons oudined above, most wi be less atached to firms, therefore, la- people who have looked at this problem- bor mobiity should increase. In sum, the both in Russia and in the West-have transfer of social assets will promote de- found the situation unacceptable. Indeed, politicization of 'mterprises and increase a consensus proposal seems to be emerging their access to private capitaL on how to deal with the social assets. The A possibly crucial obstacle standing in essence of this proposal is the transfer of the way of this transfer could be firm man- responsibility for social asset financing to agers. Managers understand that a transfer local govemrnments. Some versions of the of social assets to local goverments is, ef- proposal allow for continued subsidization fectively surrendering the one hostage that of social assets by enterprises on a de- allows them to exract money from the gov- ing scale, even after the local govemment emient. Why would managers agree to assumes the responsibility. give this up? The managrs of viable firms The transfer of However, if the temptation for local are likely o embrace the transfer because it housing and governmnts to dump these social assets will free up resources they need for re- g back on the enterprises is to be avoided, a structurin& The managers of banlkupt kindgarens to dean break must be made. The link be- finrs may, in some cases, recognize that the municipal govern- tween enterprises and the provision of so- inevitable shift to a market-based economy ments has to be calsericeshshouldbesevereditmediately. will eventually doom their enterpnse. There is also an issue ofwhether individual Therefore managers might accept the mandator sice social assets should become jurdicl per- transfe, as the additional resources it cre- they are not sons. Alternativel, they can become part of ates would allow them to stall alittlelodler interested in the local government or part of some pseu- In a few cases, this extra time could be in- do-independent corporations controlled by centive enough for manages to give up assuming the the local govemment It makes a great deal their hostages On the other hand, most additional costs. of sense to make kindergarrens and apart- managers of nonviable firms wil resist giv- ment buildigs juridical prsons, since this ing up, in which case some central govern- would greatly simplify their privaization ment enment (suh as a threat to and condominiumization in the future. eliminate credits anyway) could be in order. This would also allow simpler mechanisms The transfer of housing and lknder- for foreign aid support of social assets. gartens to municipal govements has to be However, to advocate immediate privatiza- mandatcy, since they are not interested in don of social assets would be foolish since assumingheaddioal costs.Thisraisesthe that might deprive too many people of ac- next question: where will the local govem- cess to their services. mens get the money to finance these addi- The transfer of social assets to local gov- tional penditures? It is quite possible that emments obviously provides ene.unous some of the main benefits of the trnsfer il benefits to privadzed enterprises, since materiaize in the form of local government substantial liabilities are now gone. These finance reform that wil be stinulated by the firms will be in bettershape to use their own transfe. resources to restructure, as well as in a bet, First, the local govemments are likly to ter position to attract additional resources generaterevenuebyrangsomeprices (in- fiom both domestic and foreign investors. eduding prices of utilti and kinder- Atthesametime, enterprises illosemuch gartens). They may try to discriminate of their political clout and, hence, the abil- against those who are qualified to pay for ity to obtain credits. Both the central and the services so that only the poor are subsi- local governments wil lose some of theirin- dized. Either way, the pnce under the bud- terest in supportng the inefficient finns gery pressure may come closer to the and some of them might decline signifi- marinal cost. candy or even go bankrpt. This is exacdy Second, the local govements wil try what restucturing should accomplish-t to raise revenue through aation, as they should allow viabe firms to survive and have already tried in the last two years (for nonviable ones to go unden Also, workers other purposes, indudig enteprse subsi- NEmr Sns IN PAmnzAN: Six M1LOR CHALENGoS 83 dies). This is a healthy development, since will not suvive. Populist politics work in theRussiangovernmenthasnotbeenanef- Russia in ways very similar to those else- fective tax collector. One strategy for taxa- where in the world. don will be to tax enterprises for the The greater risk is that the local gov- services the local government provides (as emmentsvill use dheirresponsibilityforso- inYaroslavl)-An example would be the pay- cial assets to lobby the central government rol tax, which makes sense since the level for more finds or for the right to retain of services is roughly proportional to em- more of the tax revenues they collecL This ployment. An alternative way to finance so- is Russian-style fiscal federalism, in wich cial expenditures is real estate taxation. The local governments, by threatening sepa- great advantage of this is that, to raise such ratism and social unrest, extract resources revenues, local governments have to ex- from Moscow (,4uich of course finances the At the same time, pand their tax base-which, in Russia, expenditure by printing money). In fact, the problem of means privatization of realestate. This re- Russia's record in this regard has been dis- form, as mentioned above, is desperately mal. Tiesman (1993) provides remarkablc fiscal fecsera&zsm needed. evidence that the sepaatist regions of must be addressed Third the local govenments wil try to Rusia have been able to cxtract vast sums sooner rather than use prvtizaton as a mechanism for raising of money from the central govemment. fimds to support social spending. This, ev- OpposingYeltsin seems to be a reliable way later. identlyiswhathappenedinPolandandthe to get cash. Other evidence indicates that former Czechoslovalda. If this approach is regional govenments Ihae been keeping adopted, privaization of real estate (the more and more of their tax revenues at the conspicuous laggrd in the Russian pro- expense of remittances to the central gov- gram),will accelerate, which wi give. a big emment (see Freinkman 1994 for boost to smal scale privatization aad new ros6avL) The resultisthatthecentralgov- business development Putting sodA pres- emmentfinancesitsexpenditurcs-includ- sru on the local budgets may turn out to ing agriculture and entprise subsidies, be the most successful strategy for gettng defense, and so on through--inationary local govrnments out of the business of finance. controlling local assets. There is no eaW solution to this prb- These thre types of financingare alde- lem. Many scholars have recently exressed sirable. In fact, if the transfer of social as- great enthusiasm for iscal fdeaism using sets to local governments entails a decrease the example of Chinz. They believe that of local subsidies to enterprises, an increase this arrangement creates hard budget con- in real prices charged for social services, Strailnts for local governments and enter- privatization of local assets and real estate, pises. Russia also has fiscal federalism, but and a switch to payroll and real estate tax- the result has been much less satisfactory. ation by local govemments, the whole local The central government has bem unable to goverment in Rusia, and not just indus- deny subsidies to regional governments for trial firms, will be restrctred. This would enteprise and agriculture support. As usu- move all refoxm (induding stabilization) aL superficial analogiesbetween China and rapidly forward. Russia do not work. Of course, in Russia, things often hap- At the same time, the problem of fiscal pen differently from what is expected. In federalism must be addressed, and it should the case of the traer of social assets, there be addssed sooner rather than later. The are two uignificant risks. The first risk is that fiscal relationship between Moscow and the local governments will simply ignore these regions, curenly best descrd as bargain- asets and continue to spend money on oth- mg overtax remittances andtransfers, prob- er activities, such as enterprse and agricul- ably cannot continue in the long rim. Ln tore support (as they do, to some extent, in many countries (including, for example, the Yaroslavl) This strategy is probably not the United States, Italy, and China), the rda- greatest danger, since it is likely to ,:ad to tionship has been determined by a ldind of massive sociuresthatlocalgovements consitutional covention that determines 84 Russr& CEATNG PxE EsnRS ANDE RCENrMARK the nature of cash flows between the capital program turns out to be relatively straight- and the regions. These convennons have forward to implement. proven to be an effective antidote for sepa- Research by the RPC estimates that the ratim.w Russia desperately needs such a con- initial subsidy that may be needed to fi- vention in the immediate future. The nance the transfer is $10 per child per success ofalleconomicreforms inRusdawMll month. If a region manages to bring 10,000 depend on the central governtment in Russia children into the program, the directcost of negotiating a long-term constitutional agree- the subsidy will be roughly $1 million in the ment with the regional govenmnents about first year and perhaps $2 million over three tax remittances and regional subsidies. years. Note that the city of Yaroslavl had under 10,000 children in kindergartens in Foreign aM 1993, the city ofVladimir had under 20,000 and the city of Yekaterinburg, Russia's The previous section ilustrates how the fourth largest, under 60,000. Not all of ntansfer of social assets from enterprises these children, of course, are enrolled in will entail significant fiscal tensions be- kindergartens supported by privatized en- tween the various levels of government terprises and not all privatized enterprises One mechanism for reducing these ten- will choose to join the program. Thus, even sions is foreign aid. In fact, the Tokyo pack- if one were to double the expenditure to age that G-7 has proposed in 1993 allows take overhead and other extraneous ex- for substantial amounts of aid to be used penses into account, the $20 mfllion bud- to support the social safety net. The transi- get for the pilot can take care of about tonal support of the financng of social as- 50,000 children, which easily covers half a sets as they are transferred fiom the dozen major metropolitan centers in enterprises to local goveruments is a very Russia. Recall that the totaWorld Bank as- good use of these funds. It wil prevent tre sistance to the Russian sodal safety net, dosing of kindergartens and heat and util- promised in Tokyo but hitherto undis- iy cutbacks, whfle also facilitating enter- bursed, is at least several hundred mnilion prise restructuring It will also, indirecy, dollar reduce pressures on the federal budget One potertidal problem with this pro- and, hence, support stablization. gram is that it will not stick. Specifcally lo- llis raises the question of how to de- cal govemrments will take the absidies, but sign a foreign aid project in support of the thenrrenegeontbeircommitmenttofinance transfer of social assets from enterprises. the social infrastructure after subsidies ex- While such projects are stSi discussed on a pire and either dose the sindergartem or grand scale, the Russian Privatization dump them back on the local governments. Center (RPC) as proposed theWorld Bank This is a legitimate concern, for it under- a $20 million pilot project (financed from scores the need to combine this program the loan already allocated to the RPC) that with fiscal reform of the local govemment, may show how foreign assistance funds which includes accelerated privatization, could be used to support the transfer of expansion of the tax base, and introduction kindergartens. The RPC proposes to start of newtaxestofinancelocalgvemmentex- its program in several regions. All lknder- pend&tres. Once the local governments re- gartens currently supported by privatized alize they can afford these expenditures, enterprises in these regions wil be eligible, they might show a wllingness to take them The RPC proposes to use foreign assistance on (just as the govenments in the Best funds to subsidize the kindergartens ac- have), especially when they learn that these cepted by the local governments on a de- expenditures win votes. cining scale for three years. Over time, the The above analysis is not intended to be local govenmment assmes greater and definitive. Rather, it shows that a reason- greater responsibility over the finances of ablysmallamountofaid,properlydesigned each kindergarten, until, after three years, and administered, can go a considerable it is fully responsible. Organizationally, the way toward addressing a major social prob- Nrxr SIEPS i N PRvAnEAmIO Six MajoR CHASNs 85 lem in Russia-encouragement of enter- this stage of enterprise reform as thcy have prise restuctring-an perhaps even to- been with prtivatization. wards refonn of local government finance. As of this writing, the World Bank has not References approved the use of the RPC loan for this purpose- Barberis, Nick, Maxim Boycko, Andri Shleifer, and Natalia 1iuknova. 1994. 'Why Does Conclusion Privatization Work? Evidence Frmm Sma1l Scale Prntatizaon in Russia." Draft In this paper, the priorities of the nom smge Blandhard, Olivier. 1994. Comment on Sbleifer. Draft. of the Rusin enterpise reform and enter- Boycko Maxi, Andrei Shleifei, and Robert W prise rcstructunng, have been presented. Vishn3 1993 'Privatizing Russia," Brokings Six major reform challenges-cash privati- Papers an Economic Acivity zation, cororate goverance and legal re- - 1994. 'A Theory of Privatizationr" form, creation of the securities markets, Draf land and real estate reform, competition Freinan, Iv 1994. "Te Tnsformaion of , and suciI safety net refrm-hve The Regional Fiscal System i Russia: The Case poIicM and sucial saetey net reform-have arof irslav World Bank. Draft been outined, and an argument has been Joslwk Paul, Rihard Schimalensec, and Naralia presented laiming that the Russian econo- Thtkanov2 1994. -Anti-Monopoly Policy in my is politically ready for these reforms on Rusa Brookings Papers on Economic some scale. The final portion of this paper Acdvitr. Miaoeconoics. Fordhomin& is dedicated to looking beyond the general- Sheif Andrei 1994. "Establisiing Prperty ities in order to portray how one citcal re- R nitsPaperpretedatWoddBankABCDE. form, the transfer of social awsets from ,iesma DanieL 1994. enterprises to local govemments, cm actu- n Evgn 1. cnc± of the Sepa- ally be implemented with modest amounts dion of the Social Sphere of the Enterprises." offoreig asstance. We can onlyhope that Paper prepared for Prime Minste the Russian reformers are as successful at Cbemomyrdin 86 RUSSW CREAMNG PmvE ENqIMmI MND ErFRCENT MAnEL-s Part Two CAPITAL MARKET DEVELOPMENT CHAPTER 8 Capital Markets Development and Financing Russia's Transformation Claudia Morgenstem ForRussia, thedevelopmentof capitalmar- markets development? And finally, an kets is a necessity, not a 1uxury Given the obligaaoy gaze into the aystal ball wll at- scaleofthetasksthatitsfinancialsectorwill tempt to identify ways in which healthy ...the political be called upon to perform in the coming market development might be encouragd SgcCess of mass decade, Russia cannot rely principally on its and major risks avoided. banking sector to provide necessary finan- This paper must be prefaced by severl nvzat:on cal services through dassic intermediation caveats. It should be recalled that almost depend on the of deposits and loans. Furthermore, the the only safe generlization that can be rapid devlopment mass privatization program has produced made about Russia is that Russia is rarely an ownership pattern of financial assets susceptible tD generalizations, and this is fCap markets more akin to that of countries with highly- particuay true when talking about the be- instutions. developed equity nmrkets. When it comes ginnings of capital makets activities. Each to Russia's capital markets, the question is region has its own institutional charactezis- not whether, but how to promote their tics and activity pattems, with Mosco, St. health;, development. Petersburg, and Vladivostok especially dis- Over the last two decades, long before tincaive. Both the extreme youth and the 'emerging markets" became fashionable, a dharactrstics of the emerging Russian eq- substantial portion of the Intemational uity markets dictate that data about mar- Fmance Corporation's (IFC) activities has ket activities and institutions are more been devoted to promoting capital mar- anecdotal than the results of formal sur- kets. IFC's emphasis on capital markets de- veys, and are more qualitative than quanti- velopmentis predicated on the fact that the tative. In addition, conditions in Russia are prindpalsourceoffinancingforsustainable so fluid that any analysis of the market is economic development must be domestic partly out of date by the time it is present- savings. Applying experience from other ed.' The final caveat is a famiiar one-that emerging markets to Russia requires a dose the following are personal observations reexamination of assumptions often taken which do not necessarily reflect policies of for granted. Transidon economies present a the International Finance Corporation. number of issues that are not found in most other emerging markets. But even within The importance of capital markets the category of transition economies, it is to Russia safe to say that Russia is unique. The objective of this paper is to exam- A number of factors which characterize me some ofthe distinctive characterstics of Russia's transition economy make the de- what has been witnessed over the last year velopment of capital markets a key objec- and a hal since the launch of voucher auc- tive of Russia's reforms. Each of these tions. First, why is the existence of healthy factors has important implications for poli- and active capital markets so important to des that have been and will be pursued by Russia's transformation? Second, what are the Russian goverment some of the farors special to Russia that Perhaps the most ugent reason to pay are likey to affect the process of capital attention to Russian capital markets is CAITAL MAnS DEvEPEW4T AiD FI NANCG Russwes TRNSFo¶ N 89 that the political success of masS privati- directed credits or are, in effect, merely zation depends on the rapid develop- the corporate treasury departments of ment of capital markets institutions. The lare enterprises. It is unlikely that the mass privatization program represents banks will be institutionally capable of an implicit contract between govem- meeting the enormous demand for fi- ment and citzenry that the assets dis- nancing enterprise in the coming sever- tributed in mass privatization represent al years. Furthermore, given the cunrent meaingu property rights. Privatiation economic environment facing Russian has created a huge class of small share- enterprises, most commercially viable holders, who need basic capital markets enterprise will need additional equity. infrastructure (registrars and transfer Enterprises are unliley to have sufNi- agents, secondary markets, shareholder dent retained earnings to build up their Well-functioning voting, and dividend payment arrange- capital base, and heavy reliance on bank capital markets ments) to realize the praperty nghts they lending would leave the corporate se- have acquired. tor over-leveraged. Fmally, even on the are also important * Wl-functioning capita mksare also debt side, in the current macroeconom- sources of important sources of disciplines and in- ic climate, banks wl notbe able to pro- disciplines and cenaie for retuuring enterprises ide much intermediation of tem incentives forPrivatizationissiiplynotcmpletewih- structue. Enterprises will have to look mcenttEes for out the development of a propery func- to the capital markets for an important restructuring tioning and competitive financial sector. part of their long-term financing. enterprises. In its absence, enterprises wof neces- * Dussion of the importance of Russian sm continue to stn their plsnning capital markets tends to focus primarily andoperations aroundtheirabilityto lob- on the urgent financial needs of enter- by the govemment and legislature for prises. But markets are a two-way street; subsidies, privileges, and protections. and in Russia it is equally appropriate to Capital markets provide a particarly take a populist view and look to the effei form of financil sector disci- needs ofthe gneral publicn promoting pline. The transformation of the Russian capital markets development. The cre- economy requires that managers be ac- ation of a range of reliable financial ser- countable to enterprise owners, not to vices for individuals will be a critical govemment bureaucrats. Small and larie element of the tnsformation of the shareholders alle must be able to disd- Russian economy-the Rsian public pline nonperforming managers, either needs a variety of ways to acquire prop- thr diectexercise ofvotigngits or erty and provide for their own financial by "aeiting" their investment in the sec- securty From an econoric standpont, ondary market, thereby threating the the emergenceof attactive savingsvehi- value of the managers! economic stake as desis necessarytopooldomesticsaving the market price for tne entewprise's for investment Politically, the avalabili- shares drops. For these reasons, Russian ty of reliable savings veidces is also es- policykers have repeatedly adopted sentiaL The Russian public has seen rules to strengthen minority share- inflation eradicate savings, destroying holders' ights. the most widely-distr form of pri- * Of course one of the most vital func- vate property Given the lack of credirfor tions to be perfrned by Russia's capi- durable goods and housing individuals tal markets will beto impro the access who want to buy a car or a residence by enterprises to new capitaL Russia's must savc. young banking industry is small relative This is not just theory-recent econom- to the productive sector and quite inex- ic surveys confirm a rapid increase in perienced. Only a handful of banks are Russian savings. But the Russian public has actay in the commerciai lendg busi- no place they trust to place their savings. It ness. The balance have been actngprin- is, therefore, not surprsing there has been a cipally as conduits for subsidized simarly rapid proliferation of nonbank 90 Russx CREANG Pam Etnnomss AND EmcIENrT M Sa financial products, including purported eq- 'he more unusual role for Russia's gov- uity investments such as the infamous emment securities markets is likely to be in MMMA/O, targeted at retail investors. The the area of municipal finance. As responsi- advertisements can be found everywhere in biliy for services 1ikc health, education, Moscow-on television, billboards, and and housing shifts from large enterprises to even in the Metro. Wtth eroding confidence local authorities, there is a huge and grow- in the government or enterprises to ensure ing demand for cash to fund these services. employment or provide for old age, the pub- This desperation, when matched with the lc's interest in financial products like pen- increasing appetite of Russians for non- sions and insurance is also certain to grow. bank savings instruments, is likely to pro- Concern about the quality of many new duce an explosion in municipal bonds, prolucts was behind two presidential de- many of which will be of very low quality. crees in June 1994. One introduced truth- But if the municipal securities markets are in-advertising standards. and the other developed with care. municipal securities began better regulation of the distribution could play an important role in helping lo- of new issues and financial reporting by is- cal authorities manage their revenue and suers? The decreeswere followed injulyby expense streams. Especially in infrstruc- accelerating pressure against apparent ture projects, where user fees can generate Ponzi schemes through a string of wanings cash flows that, at least for Russia, are fair- by public officials against practices of ly predictable, like aiport reconstruction or MMM and other so-called finance or in- expansion, revenue bonds could make an vestment companies. important contribution. It remains to be seen whether the exam- Organized capital markets wil play a ple of MMMN s collapse and the govem- critical role in attracting larger volumes menets enforcement of restrictions on of foreign investment to Russia. Interest advertsingbyMMM'scompeitorswilhave of foreign investors in making portfolio a salutary effect on the expeccations and be- investmnems in Russian securities has haviorof smallinvestors.Atleastinitiallythe been growing rapidly: Well-functioning prncipal impact has been on MMM itsel capital markets wfll also contribute to not on promoters of similarly dubious retail the climate for foreign direct invest- products. The lesson learned by many ment, bcause publidy-traded Russian Russians seems to have been that buyngin- enterprises wil be encouraged to meet to pyramids can be hily lucrative, as long higher standards of information (espe- as you time your exit before the crash. cially financial reporting) and gover- Further government action may be required nance. As the marketplace insists on explicidy to outlaw pyrmids and other higher standards, the financial interests frauduent activity The MMM episode has, of Russian enterprises wil create grester however, highlighted the existence of a sig- economic incenives for development of nificant potential demand for nonbank fi- the Russian auditing and legal profes- nancial pmducts at the retail leveL sions and the adoption of corporate Most of the attention paid to Russias transparencyandgovernancestandards, capital markets has been devoted to eq- even for enterpriscs that are not publicy uities because of the vast number of traded. shareholders and publiy-held compa- * A strong emphasis on capital markets ries that Russian privatization has pro- development has the further advantage duced, virtualy overnight But important of reducing systemic risk in the rapidly institutional innovations have also been growing Russian financial system. Even happening in the govenment scurities if banks were able to take in sufficient markets,withthesupportofateamatthe deposits to meet enterprise financing Central Bank. These are mport first demands (and increase their capital suf- steps in developing a range of gover- ficientlyto support those deposits), such mentsecuritiesthatwillfcillitatethe con- a strategy would be dangerous. With no duct of monetary policy. experience in assessing commercial CGIruL Mwrs DnEVEU ENTAND FINANCING Russues TRANSFORIMUON 91 credits and limited mchanisms to se- The post-prvhaation market is a cure loans with adequate collateral, the 'one-way control market" majority of banks would have balance sheets loaded with questionable assets. Current share transfer actrivty is dommat- This would represent a significant dan- cd by a post-privatization "control marker," ger for the solvency of die Russian fi- which is characterized by one-way transfer nancial system. Encourging the direct of shares fom smll holders who acquired prvs.on of capital by investors through their shares in privatization. Buyers are capital markets instruments, rather than most often enterprise managers, using ava- relying on intermediation through bank riety of techniques to sop up small share- balance sheets, would help to limit an holdings. Sometimes they buy in teir excessive expansion of risk 'm the na- personal capacity. In other cases, the enter- The control market don's deposit-taking and payment sys- prise sets up an affliated investment com- is not a particularly tems. Of course, given Russia's decision pany to do the acquisition, using enterprise auspicious enviro.t ,to pursue a universal banldng model, resources. Other dosely relatedbusinesses, 4UStW?OUS CflVtTOfl these protections -4ill be undermined in such as the enterprise's principal suppliers ment for the rapid the absence of appropriate contrels over or cusrommes, may also make up par of the development or the conduct by banks of securities aiiv- insider group of buyers. Of~ ities and careful surveillance of their fi- As voucher investment funds and other collective imWtu- nancial condition. strategic investors have become better or- tions that make up ganized durng the year-and-a-half or an active secondary Characteristics of Russia's emerging voucher auctions, an incasing number of market... equity markets sharepurchaseshavebeenarrangedbybro- kers on behalf of outside investors. Duing Russia's mass privatization program is trly 1994, these outsiders increasingly have in- one of the most amazing undertaking in cluded emerging market surfers hoping to econormic histor3' In the course of approx- catch the world's next great emerging mar- imately 18 months, the majorty ownership ket wave and longer-tem foreign investors of over 12,000 Russian enterprises was acquiring stakes it ritical sectors at what transferred into private hands. The number appear to be. rdative to fixed assets, bar- of Russian citizens owning shares in pniva- gain-basement pnces The potential com- tized enterprises or in voucher investment petition between insiders and outsiders is finds is somewhere between 30 million and becoming an important feature of the con- 40 million. These facts alone have had, and trl market. will continue to have, a profound effect on The control market is not a particdlarly the shape of Russia's capital markets. auspicious environment forthe rapid devel- Internationa bankers and investors familiar opment of collective institutions thar make wid' the typical sequence of emerging mar- up an active secondary market-particular- kets development must cake all ther old, ly stock exchanges or oanized over-the comfortable assumpuons and smply stand counter trading system', and deaning and them on their heads. setlement arrangenents. Despite the fact The scope of the privathzaion program that there are more han l00 exchanges li- is not the only feature of Russia's capital censedtotrade in securitiesin Russiawoday market tat will make its development (down from several hundred over the last pattern unique. A number of other dharac- severalyears), virually all trading of equities teristics are affecting the institutionaliza- takes place off-market Successful ex- don process, especially in the equity changes in most cities are those that are markets. Most of these characteristics tend open to the public for the auctioning of to encourage fragmentation rather than in- bearer instruments, principally vosuchers tegration of market stru . Some of but rndztly new issues of documents pur- these characteristics appear to be transio- porting to represent an equity interesL ry, but others will most likly be around for Excbange-based tading is estimated to be some time to come. no more than 10 perent of the transaction 92 Russw C.w7mG PRIVME ENITEI AND EnImtMEW ElS volume in registered shares,even for shares centage of transactions. As a result, of companies where a control market does there has been no great pressure to stan- not dominate. dsrdize inter-broker procedures and Most economic incentives faced by se- manage inter broker counterparty oblig- curities intermediaries during the control ations through collecve insttuiions. market stage operate to discourage rather The limited amount of broker-to-broker than encourage collective action by market trading has not necessarily been bad for participants. There are recent signs that the long-term competitive health of the these incentives are starting to shift in a Russian securities industry. It has al- healthier direction, but the control market lowed the entry of entrepreneurs with continues to create impediments to institu- modest capital into the brokerage busi- tion-building in the secondary markets. ness without creating concerns over the The foElowing description of the control lack of prudential surveillance of finan- market, although impressionistic, may help cial condition by regulatory authorities. explain why none of the existing exchanges Bythe time conditions are ripe for a real have succeeded in attracting or stimulating secondary market, brokers wfll have had significant trading volumes to date. the opportunity to build up their capital base from operations. Hopefully, once The brs'pric4al astomen, and often efficiency gains of an organized market the brokers themelies, have ltk economic in- begin to appear attracive, brokers will fns in trnparency and liqdty.4- also have grcater incentives to introduce During the post-privatization control financial responsibility and accept a cer- market, issuers are usually not interest- tain degree of regulation to make the ed in having an active market for their systerwork. shares. Brokers' customers (whether they are managers or outside investors) liwvstorspa&iaic g in the control mar- are principally interested in vacuuming ke do not value te priceonnationfimdon up small holdings at as advantageous a of a liuid trading market price as possible. If a control battle be- * When brokers use exchanges to trade tween insiders and outsiders is possible, equities, the exchange is rarely used as secrecy is also of prime interest othe a way to find the best current price or broker's cstomer. determine a market value for the - A broker who is assembling blocks on isares. Many transactions on exchanges behalf of a dient will usually prefer to are entered into merely, as one young have litde orno price andvolumetrans- Russian fund manager has put it, to parency. The broker's trading activity "beautify" the company, for advertising will not lure competition from ocherbm- or price-manipulation purposes. kers (who might steal the client) or from The general public does not yet seem at- other investors Lack of transparency tracced to trading gains. Most actity also allows the broker to achieve much reflects a "bond" mentality driven by more substantial spreads, and published the issuer's promises of exceptidonally. pnces can be more readiy manipulated. high current payout (often plus a lot- tery-type premium) rather than an 'eq- Control market ransaction pemr do not uity" mentality that looks to price inwolive over ofsecwiies betwee intense- appreciation. The large amount of cur- &darr, and cunrquenty tees hlde 'two- rent retail activity in new issues is in re- way trading' tat would bneffiom collective sponse to mass advertising rather than fomnnaiton orinsiinalsrupport information on the issuer's prospects. Trading is curendly dominated by one- To the extent trading gain are an at- way transactions between off-market traction for small investors, the gains sall sellers and large buyers. Although are simply the result of the issuer's re- broker-to-broker volumes are increas- demption practices or "madret- ing, they still remain firly rare as a per- making" activities andnot the reflection CAPrAL MARKErS DEVELOPMENT AND FBAcalNG Russits TAI45RMII2ON 93 of investors' supply and demand in a participants. Brokers are especially sus- tme seconday market. picious of collective institutions, such as Brokers acting as distrbutors or re- exchanges or depositories, because of sellers of the new mass-distributed is- the potential for abuse of information sues view their role either as order suchinstitutionscouldgainfrom having processors (acting for the issuer) or as a "view of the market" or knowing wholesalers (acting for their own ac- about the activities of brokers. count). The provision of services to a In order to control risk, each broker customer base of potential repeat in- tends to develop its own trade con- vestors is rarely part of their calculus. tracting, securities delivery, re-registra- The dealers have few expectations that tion, and payment procedures. Firms investors might want to trade through are reluctant to rely on outside institu- them as well as buy new products, and tions to perform these functions, even if for future sales to the same investors, they control those institutions, in a the distributors rely on mass advertising sense, through collective ownership. by the issuer tO bring them to the door. Each broker must be assured that the * Analyzing the potential market value of collective facility is as competent to per- a share is extremely difficult, given the form the function as the firm's own in- limited financial information available ternal staff Curreny, the back-office on company performance, the inability processing capacity in which a brokrr to project future profitability from past has invested is often viewed as an im- perfornance, and the frequent desire of portant source of competitive advan- manages to, at best, hide cash flow tage. As a rest, brokers are hesitant to and, at worst, siphon it off It is not un- grve up this advantage when the common for managers to avoid paying prospective return is an increase in the dividends to make it cheaper to buy up overall efficiency of the market. shares from discouraged small investors Similary, successful brokers have had and employees. Consequently share to develop a sophisticated network of prices often remain tied to some multi- contacts that allows them to find shares ple of nominal value, since the nominal and determine an appropriate price to value was originally set in relation to the pay for them. Unless an exchange or historical value of the enterprise's fixed formal over-the-counter market can do assets-only quasi-reliable financial in- a much better job of reducing search dicator available. Furthermore, most costs and deEemining market price, the Russians'experience withsecuritieswas brokers will continue to internalize limited to state bonds, so they tend to these functions. endow the notion of nominal value of shares with excessive meaning, using it in most regions of Rusia, rokers view as a reference to establish dividend ex- 6he*pruinca customers as the isue wbr pectationsanddeterminemarketvaluet thn the bweorsm This is particulary the The recent experience with vouchers, case when the broker is a stock department which had a nominal value but awidely of a bank that has a financial relationship fluctuating market price, will hopefully with the issuer. go some way to changing these expec- * This accounts, in pert, for the high de- tations. gree of integration often found within a securities firm (or affiliated grup). The Each bhker sees contmrol of economc en- same firm acts as brokei, market-maker vimoman as a higher priority than operaing (m the sense either of being the princi- efieiey, espec&lly where efcncy gais pal firm adverdsing for sclers on behalf would he achiewble only though ghth up of a single purchaser or of using the in- some control over opeations to or formation in the issuer's register to lo- * It would be difficult to exaggerate the cate potential sellers), transfer agent, lcvel of distrust among many market registrar, and depository. 94 Russx CRATNG PvAIENEnmss mD Exn7cznMnwn The broker often gives away some of his great deal more paper than a certificated senies to the isswe This has been especially one. For a variety of highly practical rca- prevalent in the performance of registrar sons, in today's environment Russian in- functions, where the broker's objective is not vestors and market participants often to make money on the registrar business but prefer a certificated security. Furthermore, to monopolize the transaction flow for a giv- given the uncertainty under current en issuer, malking money through transaction Russian law regarding finality of transfer of charges, commissions and spreads, often registered certificates (that is, without re- bome disproportionately by small sellers. registration due to the absence of a 'bona Cearly such a strategy is not consistent with fide purchaser" rule for registered securi- the establishment of an active and competi- ties), a preference for bearer paper iswide- tive trading market. The good news, howev- spread among small traders, who also find er, is that, as the market develops in regions the immnediacy of trading without re-regis- Arguments for an like Moscow and St Petesburg, there are trauon attractive. aostheboard healthy signs of finctional segregation, if not For a number of practcal reasons, the specialization. pratizationprogram did not reqire enter imposition of book- prises to incur the cost and administave entry arrangements The is no single sysem for evidecing burden of issuing cerifiates for shares dis- ignore the impor- ownehpsb nd transfrr ofsecr s tributed during privatization.Consequendy, privatization did result in a lare number of tant economic The most immediatel visible factor in the unceruwicated shares being handled by functions that post-privatization stage is a subject usually book-enty. But these book-entry arnange- certificates Perform. reserved for back-office specialists, corn- ments are not maintained by a centralized puter system designers, and legal scholars, depositorysetup to facilitate secondarymar- butwhich has been atopicofheated debate ket activM as contemplated by the G-30 in Russia for the last two years. Some for- recommendations for intenational stan- eign advisers have advocated that Russia dards. Instead they are the responsibilky of take a single great leap forward, skipping issue andtheirregitars,scatteredinthou- the stage of market development which re- sands of locations across Russia, and con- lies on certificated securities to evidence trolled by the issuers rather than by the ownership and effectuate transfer They markets. - have argued that immediate introduction Realistically, it is to be epected that of book-entry systems would avoid getting Russia will have, for some time to come, a Russian citizens in the bad habit of relying number of share ownership and transfer on documents Russiawould nothave to in- systems operating in parallel. This is not cur the costs involved in converting to a necessarily a negative characteistic-a va- pappedess system at a later date, once ac- riety of mechanisms may more easily ac- tive trading starts to develop. commodate the highly heterogeneous Arguments for an across-the-board im- nature of both the securities being issued position of book-entry arrangements ig- and investor preferences. The different Sys- nore the important economic functions tems will, however, have an impact on trad- that certficates perform. They also over- ing behavior, the evoluton of market look the fact that a system of uncertificated institutions, and the ways foreign investors securities, in order to perfonn the same can enter the Russian markets. Because of fimctions as a certificate-based system, their importance, they wil be reviewed in would require an immediate installation of some detaL highly sophisticated, nationwide Communi- cations and accounting infrastructure as Dect hod gs ofuncerficated regised well as a reliable arrangement for delvenng secwia. Equity secaities m Russia ac, by confirmations and periodic account state- law, required to be registered rather than ments, which the Russian postal system bearer instruments. For at least the next cannot provide. It is often forgotten that an decade or so, the largest number of regis- uncertificated systen acually generates a tered shareholders will be small mdividual CAPA MAumc DvauopmrvTjnD FncmcNG RussrLs Tw.zsPOmIAON 95 investors (employees and voucher auction form of stock certificates rather than regis- winners) who own shares they received dur- ter extracts. Given the cash-on-the-barrel- ing privatization. Typically, these snall head nature of the market, it is not shareholders will own the shares in their surprising that large investors want to have own name, not through anominee. Ofthese their securities at hand, ready for delivery, shares, a substantial portion are uncertifi- if they decide to sell. cated, because the privatization program permitted newly privatized companies to Indirectboldingsofregsteredsecuries. It confirm ownership of shares upon the is difficult to overstate the potential for shareholder's request by the issuance of a marker efficiency gains if traded shares can confirmation (called a register extract) be "delivered" by a broker merely by in- rather than by a stock cerdficate. structing a depository to transfer shares These small shareholders will justifiably held in the broker's account to the account expect the issuer's registrar to maintain of another member of the depository. For a their records of ownership and to provide customer of a brokerage firn who wants to the basic services of processing sharehold- be able to move quickly to sell his shares er entitlements, such as voting rights and when the price is right, maintaining the dividends. Sales among friends or transfers shares in the broker's custody is particular- by gift or inheritance can be performed by ly attractive, and the costs of that custody the registered owner trotting along to the service wil be significantly less if the bro- company's registrar, often located on the ker can'hold the shares in street name company's premises or at a nearby bank rather than in the customer's name. braneb. Such nonmarket shareholders have Depository and custodial services using no need to use the services of market insti- nominee arrangements are starting to tutions, such as a broker or depository, un- emerge in Russia, and the process should dl the time they want to Dbtain a market be assisted by the recent depository regu- price for their shares. lations issued by the RFCSE (Commission on Securities and Exchanges under the Dhre holdig of cenficaed registered President of the Russian Federation), secrites A large number of Russia's rti- which defined norinee arrangements as a zens exchanged theirvouchers for shares of valid type of custodial service and clafied a voucher investment fund (VIP) Most of- rights and duties of depositories and their ten these funds issued pieces of paper customers? called certificates, with the name of the in- It is unreasonable, however, to expect vesror written on the document and en- large numbers of shares to move immedi- tered in the VIF's shareholder register. ately into nominee holdings for a variety of Whether many of these documents satisfy reasons. As mentioned above, the large ma- all of the safety features that should be met jority of shareholders are small unit holders by negotiable securities is highly question- who have no need to pay for custodial ser- able, but the documents are in theory ca- vices and will accordingly, remain direct pable of being used to effect transfer ofVIF holders. Ihe brokers are only now starting shares in the secondary marketIt must be to see repeat investors as a developing recaled that VIPs are dosed-end funds, so client base of prospective customers. It will trading in their shares is not outside the take awhile for those customers to have the reali of possibflity, and several large VIFs confidence in both the quality of operations have taken steps to list theirshamewth and the financia str engtof the brokers to tradingmarkets. be wflling to leave their shares in street The shareholdings of large investors name. Only as the one-way control market also often take the form of direct holdings shifts to a two-way trading market, with of certificated, registered shares. Investors brokers on both sides of anonymous trades, engaged in assenbling blocks of shares in will'there be a significant need for central- privatized companies often insist on receiv- ized depository services to effect rapid de- ing confirmation of re-registration in the livery of shares. 96 Russit CREATING PuMWu Emus AND EFFInCNTMwrm Bearersecaitie. Given the difficulties in fiuth advantage-whie the shares are on geting in and out of a company register at deposit with the company managenent in the time of a trade, first to confirn owner- effect has the ability to vote the shares. ship (if the shares are uncertificated) and AWA's strategy deverly appeals to sev- then to re-register the shares in the name of eral characteristics of many small Russian the buyer, it is not surprising that a growing investors-they tiink of buying securities number of bearer instruments are finding as buying paper rather than financial assets cherwayinto %heRussianmarketplace.The (the term for securities in Russian means principal use of bearer instruments is by valuable paper); they prefer an emphasis on very large offerngs targeted atvery small in- current return (dividends, interest, or vestors. The classic example is AWA, the 'guaranteed' future redemption price) ARl-Russian Automobie A1liance, which is a rather than appreciation, an attitude which shell company affiliated with AvtoVaz. the physical dividend coupon helps to rein- AWA was established to raise $3 billion force; and they prefer their "up-side' to be trough a nationwide distribution of shares in the form of tangible premiums (lotteries over the next four years to finance a pro- for cars, houses) rather than as trading posed joint venture with General Motors. gains. To give some comfort to investors This paper will pass over the merits, or lack that the value of their investment is not be- thereo£, of the company and its offering to ing eroded by inflation, AWA adjusts the focus exclusively on the type of security that primary distrbution pruce of the shares up- AWA hs quite imaginatively invented and wards weekly to reflect inflation and that other issuers have rapidly copied. changes in the U.S. dollar exchange rate Russia's joint stock company regula- with the ruble. tions require company shares to be regis- The push for bearer equity instruents tered secaities, but AWAwanted to avoid is coming from a number of market partic- the costs and delay of establising a regis- ipants and exchanges, who view bearer trar and transfer agent system large enough, shares as a way to rapidly replace the lost and with sufficient geographic outreach, to trading actvity in vouchers (which for most handle inputting the ownership informa- purposes expired at the end ofJune 1994)- tion on al the smal investors they hope On the debt side, a growing number of woudd buy the shares. Furthermore, with- state and local authorities are issuing bonds out orgnized trading raarkets hooked di- in bearer rather than registered form be- recdy into the bookkeeper for the AVVA cause of the lower up-front expense re- issue, small investors would find it difficult quired to create an easily tradable security to transfer the securites if they were regis- Apart from the attractions to the investor in tered-under Russian law, each time regis- terms of confidentiality and tax avoidance, tered securities are transferred it is at least bearer instruments have the benefit to the highly advisable, if not legally necessary, to issuer that they do not require institutional return to the regirar for re-registration. infrstructure to support primary distrlu- AWA's solution was to create bearer tion and secondary trading. Tlansfer is ef- deposuory receipts, which can be converted fected simply by physical delvery and is not into shares held ondepositwith the compa- dependent on getting in and out of the ny. The receipts have divndend coupons, "book," whether a depository or the is- whc can be dipped and taken along to a suer's register. dividend payment agent if and when divi- There are a number of policy reasons to dends are declared. Ingeniousl, the receipt discourage the proiferation of bearer instru- also serves as a lottery ticket for a series of ments. They create considerable costs, such drwngs fornew cars (to be purchased fiom as physical safekeepig, ant-counterfeiting AvtoVazwithaportion ofthe proceeds ofthe measures, provisions for lost, stolen, or de- offeing). To reduce the incentive to convert stroyed documents, and so on. In the currmt the receptinto shares, thelotteryticketceas- envonmcnt in Pussia, the widespread ac- es to be vald when exchanged for shares ceptabiliy ofbearer paper would seem tobe From AWVAs standpoint, the scheme has a an invtation to fraud by any enterpring CApmx. MAiucan DEvaopMiNrAnw FNmaNG WRssies TLwisr-onmoN 97. scum artist who produces handsome certifi- this year, in its first regulations, the RFCSE cates issued by shell or fly-by-night compa- chose to issue two important sets of rules on nies. The difficuties in handling shareholder registar and depository operations. These entitlements when equity interests are repre- rules help to resolve a number of practical sented by bearer documents should also not questions about the nature of the responsi- be underestimated. It is likely that bearer bilities of these qpes of institutions and the documents will prove unacceptable to for- legal rights of investors, as well as give guid- eign investors, who will demand the certain- ance on how to effect a transfer or pledge of ty that theirpropert rights wl be recognized shares. by the issuer. Finay, because bearer instru- Although the registration process re- ments can be transferred by anyone on the mains highly imperfect, a growing number street comer or in the Metro, they draw sig- of Russian issuers and registrars have a ba- nificant activity away from the organized sic understanding of the function and are markets where regulation and tranwparency begnning to perform it with some regulari- are easier to introduce because they are more ty. This process has been greatly assisted by consistent with economic incentives of mar- USAID-funded projects, which have sup- ket participants. The important market dis- ported the dissemnination of how-to infor- ple, created by brokers' accountability to mation, demonstration registrar pilots, and their customers, is completelyundeniinedin development of procedures and software the street-corner trading of bearer secuities, for registrars interested in improving their By diverng reuail demand into bearer in- operations. Shareholders and potential in- struments, regstred securities are made vestors have a growing set of shared expec- uncompetitive, and intermediaries are dis- tations about the basic standards of couraged from investng in the operating sys- pe e that issuers and registr are, tams and infrastructure necessary to support in theory, obLiged to meet. the participation of retail investors in orga- Cunrentil there are four major concerns nized markets. about the future development of the regis- Most costs associated with bearer cer- tration function: tificates are not direct cost, and adcvocates * The functionwilbe performed ata low of bearer equity instuments do not appear standard of operating efficiency and re- concemed about how those costs will ulti- liability, due to the easeof entryintothe nmatelybe paid. Strategies to limit the use of business by small, unqualified regis- bearer instruments should, therefore, also trars (often captive operations of their address how the deficencies in infrastruc- client issuer) and the lack of regulatory ture, which bearer instruments help to over- overight; come, can be mitigated. The fragmentation of the regisar indus- try will make intedfces slow, expensive, There are lage and imdiate dawndsfor and unreliable, between the plethora of complex btfiwatdre to nqpporn secwities small registrars and deaing and settle- ownerinbp a4ndfranfr ment artangenmets for trading mrkets, The liSihood that smaller independent In the post-privatization stage, a major dif- regitrars will not be commercially vi- ficulty in the emergence of equity market able, both because of their lack of busi- actvity has been the absence of legal rules ness experience and because issuers are and commercial practices with respect to reluctant to pay for the senrice; and evidence of ownehip, regisation, trans- * The risk that current efforts to produce fer procedures, and nominee holdings. A legislationgoverningsecurities issuance presidential decree in October 1993 was a and trading (Civil Code, Joint Stock major step forward in clarifying the role of Company Law, Securities Market Law) securities marcket inbarructure institu- will utlize legal concepts or implicidy tions.6 The decree required companies with dictate insttutional arrangements which more than 1,000 shareholders to usethe ser- wfi be incomrpatible with emerging vicesofanindependent registra InAprilof practice in this arca 98 RuEssTM CREAING PwvrAiE EN Dmu AND EFniaENT wMAxm Depositories are, in theory, one of the compettive with bearer securities, the principal protections for small investors in development of low-cost customer ac- investment funds, which are required, by counting services will be key. law, to have their cash and securities han- * The participation of significant foreign died by an independent depository. Few in- institutional invesunent in the markets vestment funds have followed the spirit of will require the rapid creation of custo- this requirement, and the forthcoming dial arrangements that meet interna- shake-out of the VIF industry will also tional standards. There are increasing probably have an impact on the deposito- indications that foreign banks or do- ries. Surviving VIFs will be pushed to regu- mestic and foreign joint ventures will larize their rlations with independent shordy be developing services to satisfy depositories, which will hopeflly stimulate client expectations. the development of this important industry Horror stories segment by creating greater demand for The Rsn payment system does not satis abound about the quality depository services. the requirementsfor efficient and reliable *fficof the Depositories that provide services to share ieance or rijfero permit more immediate trading (brokers Russian payments holding securities for customers) and sup- Horror stories abound about the ineffi- System port dearing and setdement (depositories ciencyof the Russian payments system, and holding securities for brokers or other fi- many of the cash flow problems of Russian nancial institutions) are also beginning to industry have been attributed to its inade- emerge. quacies. In the last year or so, however, the Critical issues for depository develop- Central Bank of Russia (CBRG has made mant concern chiefly the legal principles on strides in improving processing. Equally which the depository/depositor relation is important, the private banling system has based (including restrcting potential not stood idle but has invented a variety of claims by tiird parties to assets held on be- ways to make funds move, principally half of the depositor), the financial capaci- dtrough large correspondent banking net- ty of depositories, and potential conflicts of works that can handle inter-regional pay- interest in the case of affiliations between a ments. Commnon estimates are that good depository and other financial service funds (that is, credit to a CBR setdement prvidert account) can be movedwithin a manximum In addition to actions that the RFCSE of three days in Moscow and two weeks in- can take or encourage, the marketplace is ter-regionally Nonetheless, it would be a likely to provide certain incentives for the major leap from today's payment system to development of both the registration and a stem capable of supporting clearing and depository functions. setdernent systems for securities that * Some large issuers are already demon- achieve deivery versus payment (DVP), es- strating an appreciation of the impor- pecialy inter-regionally c: internationally, tance of quality registration services. without awkward and cosdy pre-position- Enterprises which are interested in ob- ing of funds. taining new capital by issuing shares To date, the general unreliability of the have an economic incentive to assure process of transferling and re-registering new investors that their shares will be shares has meant that the inadequacy of the reliably transferrable property rights payment system has not been a binding and that they will be able to enjoy share- constraint on the development of the equi- holder entidements (voting, dividends, ty markets. Due both to the characteristics and the like). of current supply and demand and to the * As the volume of secondary market ac- awkward mechanisms for delivery of secu- tivity becomes more important, the de- rides and payment, the market is charc- mand by investors will grow for brokers terized by cash-on-the-barreihead. Often, to provide reliable depository services. a trade is not treated as binding until phys- In fact, for registered securities to be ical cash and securities have changed CAPiAL MARKErS DEvPmENT AND FINhNcING Russ Is ThANSOEMAnoN 99 hands. Furthemiore, investors often dis- pationbyinvestorsfromabroadandotherre- trust the issuer or its registrar, fearing that giuns. So do Vladivostok and Novosbirsk, re-registration of a large number of shares both with major ambitions to be financial in the name of an outside purchaser will be capitals of large subnational regions of refused or at least delayed excessively. Russia. The prospects for other areas are Accordingly, some large buyers require, less self-evident There is evidence of an prior to payment, the delivery of new stock Urals center fomiing around Yekatcrinburg. certificates already registered in the name Nizhny Novgorod hopes to develop a Volga of the buyer. Where the transfer of a large Region market, with itself as a leade, but packet of shares is involved, ingenious whetherthe proxinityto Moscowwilltugthe arrangements must be devised, sometimes Volga Region within Moscow's institutional flying representatives of both buyer and doiination remains to be seen. The South seller to the city where the company's reg- would seem to be a candidate for another ister is located and using foreign banks to large subnational calchment basin, but the move the fimds. center of that region is not obvious. As the transfer of shares becomes more In the area of capital markets develop- standardized and reliable, and as potential ment, the regional bias of Russia's eco- trading volume grows, the current "pay- nomic and political arrangements was ment after delivery" arrangements will be- reinforced by the fact that the large-scale come less aaceptable for investors and privatization process was dominated by re- brokers alike. In order to reduce the expo- gional distibution patterns for shares. sure to sellers, some sort of mechanism for Most companies selected the privatizaUon achieving DVP will be required. The diffi- option that resuted in 51 percent of the culties in moving fumds will then become a shares going to employees. Tn addition, the bottleneck to market development. It can- organizers of large-scale privatization auc- not be expected that the CBR will have a tions and sellers of the privatization shares redesigned payment system in operation were the local property comrittees and by that time, so special funds setdement funds. Although some companies went arrangements will need to be developed through a system of inter-regional or na- for the equity markets which meet the safe- tional auctions, the bulk of the enterprises ty expectations of large investors, especial- were auctioned only in voucher auction ly foreign portfolio managers. centers located in the oblast in which the enterprise was headquartered. Some intre- Russi's capital marketr have a strong pid investors, particularly voucher funds, regiondl bias traveled to auctions around the country But obviously, the great majority of the di- As anyone who has traveled or worked in rect shareholders of a newly privatized en- Russia wgl confirm, Moscowv is not Russia. terprise are residents of the oblast where Apart from the political ambitions of the re- the enterprise was auctioned. gions to be independent of Moscow, the lTis regional pattem is likely to continue sheer geographic scale and diversity of the in the future for many of the medium-sized country dictate that there will be a number enterprises that will have public distribution of economic centers. Although Moscow of their shares. Especially in the curmre en- will be an international money center, it is vironment of lite available information on both politicaly and economically unrealis- the financial condition and prospects of en- tic to expect other parcs of Russia to look to terpnises, it is the "locals" who typically pos- Moscow istitutions to serve all their sess the most reliable and relevant financing needs. information, with regard to both nex issues Just ivbh cties will develop iable inde- and secondary trading. As was found duing pendent financial sectors is somewhat diffi- the voucher auction process, the neighbors cult to predict St. Peteubrg stands out, and employees are likely to have a feel for with its lage privatization program and rapid what has been happening to the company's growth in financi acdvit induding partici- cash flotX any problems with major cus- 100 Rus4 : CmNG PmuArz ENwmsEs AND EFrmczNrMN S tomers or suppliers, the company's capital unlikely; Russia has an absurdly high num- investment pattems, how plans for restruc- ber of licensed exchanges, given the smal turing operations have proceeded, and so amount of current activity Moreover, the forth. Furthermore, a medium-sized compa- brokers conduct most of the limited trans- ny may have strong local name recognition action volume off-market rather than but litde ability to raise its profile with in- through a formal taiding market. Although vestors in a national context. Yet such a com- therc has been some consolidation of cx- pany may already have a substantial number changes, most of the reduction in number is of shareholders, often numbering in the sev- simply due to the disappearance of money- eral thousands. A regional over-the-conter losing structures. market to support occasional twading, like This raises a troublesone question. Xgin- the old U.S. "pink-shecets system, might deed, a two-way trading market starts to servethesecompanieswelLand couldbeor- emerge in the coming year, vill brokers Russia has an ganized at low cost channel their activity into a small nuber of absurdly high effectve insutuions, or will there be a pro- number of licensed Thpere is a shkirig heerogeeity lifcmtion of newr institutions all tring to be- ofissuer and imiestors come the market (whedter national or exchanges, given regional), the depository the settlemet or- the small amount The folegoing comments suggest another ganization, and so frth? important force pushing toward multiplici- The apparent motivations behind the of current activity. ty of market structures. There is, and wil proliferation of trading institutions give *ontinue to be, an extreme diverty in the sorAe cause for concem. It is difficult to ac- tpes of companies (size, sector, current count for the survival of such a large num- condition, prospects) with publidy-distrib- ber of exdhanges unless they are the result uted shares. As forein investors become of some maret pariicipants rying to dom- more inmterested in Russia, and as financial inate a particu market by imposing their institutons look for ways to provide a wider sctures on others. Some of this behavior range of products to retai investors, the may be attibutable to Russian exerience, ypes of investors likly to be interested in when success was achieved by using influ- invesung in shares will continue to diersfy ence to obtain grants or charters for eco- This suggests that a one-size-fits-all nomic privileges from a mercantilist lar or trading strucmre is an inappropriate design a central planner. Consequendtl at the be- to sadsfy Russian requirements. These fac- ginning of the transition process, before the tors, combined with the natural regional- potential profitabilityof a particular market ization of market activities, make a single could be determined, people with ambi- central market, and central infrastructure dons to be players organized themseles in- supporting it, not only politically impossible to what might be best understood as and operationally and tedcnologically im- lobbying groups or clubs. They were not practical, but also probably not healthy for really interested in the immediate comnmer- the long-run ability of the capital markets dal viability of the clb as a provider of ser- to meet the needs of both Russian issuets vices to the market. Instead, the dub was and investors. established so it could stake out its position in the market-to-come and use its influence Other sourcs of market fragnmendon with political and bureaucratic mentors to capture a variety of privileged profit oppor- Manyofthefactors previousdiscussed are tumities at the expense of other potential sufficient to explain on economic grounds competitors. why Russian markets are fragmented, but By the current stage in Russia's econom- there appear to be other sources of frag- ic tansition, attiudes have started to shift mentation as weill. The last several years sharply As brokers gain concrete expice have seen a remarkble number of attempts running brokerage operauons, the more se- to create trading institutions, despie the tious among them are thinldng about who fact that their early profitabilty was highly their potentiallients are, bow the market is CArnAL MAIYS DEVELOPNEmTAyD FININcING RussWs TW5oRwMAfON 101 likely to evolve, and how they can position for nonbank financial instrumentswith ed themseves competitivedy to provide services growing interest by enterprises to use the eir cients wl want to buy. These brokers markets to raise new capital. Many man- will demand quality servces from collective agers are staruing to realize that continued institutions, and on a commrciadly accept- lobbying of the Duma and govemment will able basis. Such a shift in attitudes should, in not produce sufficient financing resources tum, lead to a much smaller number of com- for the restructuring and modemization peting market institutions. ahead of them. Equally important is that The danger of course, is that some of the managers who have succeeded in consoli- lobbying groups will be able to atact sufh- dating control positions, often through the cient polical and bureaucratic support so as acquisition of shares in the current control to undermiine the viabiliy of those institu- market, are now vlling to see a more active tons trying to opeate on a commercial ba- and transparent secondary market in their sis. It is unlily that any lobbying group will shares develop. Sophisticated managers be able to succeed in creaung a marketplace have realized that eventually they will have attrctive to market partcipants, issuers, to comply inth greater disclosure, filler and investors. But such initiatives may have protections for minority shareholders, and negative power, that is, the ability to block the like. However, these managers have other, more realistic and modest initiatives. tried to postpone compliance with higher standards until they were comfortable that Prospcts they were operating from a position of Given the extremely fluid conditions in The appearance of new corporate issues Russia!s emergingmarkets, it would be fool- by enterprises whose managements have a hardy to predict what market actnity will strong interest in active trading in their look like a year from now. Certain factors shares will be a necessary condition for the can, however, be identified which will affect emergence of collective institutions that the pattern of development, for good or for form an efficient seconday market This is il1, and vhih can be grouped in two main because it will accelerate the shift of incen- categones: tives of securities intermediaries. Brokers * The constandy shifting constelation of will cease organg their business around economicincenives and disincentivesof supporting managers' control objectives Russian market players-issuers (both and will start to look at investors as a po- companies and local authorities), in- tential customer base. vestors (both domestic and foreign), and A change in brokers' focus from issuer intermediaries; and to investor can represent the beginning of a * Acons taken and not taken by the virtuous circle, as the desire for new prod- Russian government and legislature. uct to meet the interests of investors will Bilateral and multilateral assistance, create an incentive forbrokers to workwith both at the policy level and to support mar- enterprises to bring new products to mar- ket development projects, have to date and ket Broker-to-broker activity will grow, in- willintbefitureplayanimportantroleinac- creasing the attractiveness of efficiency celerating postive developments and con- gams offered by collective institutions and solidatinggains. But such assistnce can only reducng the imperative of controlling risk stimulate and build on, not subsitute for, through internalizing all functions. Control undertkui of the Russian private and market disincentiveswithrespecttomarket public sectors. transparency will be reduced. And incen- tives will increase to improve transparency Sb49ksg market incenives-the rosy scenafo in order to enhance the attraciveness of the market to investors. The brightest hope on the development If shifting inacntives begin to produce horizon is the apparent convegece of a quality new issues and the beginnings of or- rapidly rsing demand by Russian tizen panized trading, participation by foreign 102 Russ& CREa G P nmv EENhNusEs F mD ENmcwir Manis portfolio investors in Russian equities will in the financial sector. By far the largest accelerate rapidly. This in turn worl- pro- body of rules are the constantly evolving in- vide a host of other, highly imnportant, fi- dustry customs and practices (induding nancial incentives for positive broker rules of industry organizations such as stock behavior and the development of market in- exchanges and clearinghouses) that allow stitutions, particularly in the areas of cus- market participants to do business with tody and clearing and settlement. Leading each other efficiently. Russian brokers are already investigating The Russian approach to date, some- ways to improve the quality of their services times consciously and sometimes by de- in these areas in order to meet the standards fault, has been to leave much of the rule that foreign institutional investors insist up- development and institution-definition pro- on. Participation by foreign investors would cess to private actors. This is not to suggest also have important benefits in generally im- that there are no Russian laws or regulations proving the quality of disdosure and corpo- conceming the issuance and trading of se- rate govemance practices by domestic curities. On the conrrai a variety of gw- issuers. Availability of foreign fimds for pr- enment bodies are responsibI. for the mary offerings would reduce some of the licensing of exchanges, securities intermedi- pressures on large offerings to raise all of the aries, and investment funds, and licenses financing domestically. And finally, despite can be, and have been, withdrawn. Brokers the bouts of xenophobia which will no are subject to examination requirements. doubt continue to be reflected in Russian New issues of securities must be described politcal debate, a high degree of foreign in- in a prospectus registered with the Ministry terest wfll enhance the confidence of of Finance or Central Bank A growing body Russian investors and improve the credibi- of rules conceming corporate governance ity of the markets generally. can be found in laws, presidential decrees and privatization regulations. Ministry of Policy deelopment a-nd implementation Finance regulations provide a basic outline for a securities market regime that has a For the shiting incentives of market par- number of features familiar to developed ticipants to produce healthy development markets. of market institutions, certain areas of pol- In some ways, these rules have helped icy will require attention. Unfortunately to shape the institutions and practices that ccnmron to most policy issues is a set of are appearing in Russia today. But in other problems that cannot be resolved exdu- ways, these rules have been irrelevant to sively on technical grounds but are part of market activity. This should not come as a a major debate over the structure and reg- surprise, because people typically try to ulation of the financial sector. Before ex- avoid or ignore rules that are incompatible amining specific issues on which policy with their economic circumstances or ob- attention is required, the broader regulato- jectives. This is espedally true in Russia to- ry debate needs to be reviewed, day, where economic opportunities and interests are in a constant state of flux. Designing a regktoiy s*ne Capital There are several reasons why many of the markets are, in an abstract sense, nothing formal rules conceming the capital markets but a set of commonly recognized rules. have been irrelevant to market develop- Unlike tangible propern financial assets ment. First, the rules ofter do not resolve have only those characteris that society basic matters regarding the issuance and agrees theyhave, and they can be produced, transfer of securities. Most of these ques- possessed, and transferred only through ons are being setded pragmatically by recognized institutionai arrangements. rapidly emerging industry practice, but on Some rules are found in basic law on con- some matters there remains a fundamental tracts, negotiable instruments, secured legal vacuum that custom alone cannot fill. transactions, and so on. Others are in spe- Second, compliance with law and regula- cial laws and regulations governing activities tions often has been unnecessary or impos- CAPrr MARmSS DEvELopMzrTaND FnCiNG RussiXs TIwoRNuANON 103 sible for new market participants. Russia's ty to suspend licenses is usually on the securities industry is going through a num- grounds of failure to file mandatory reports ber of stages at an extremely rapid rate. or meet certain objective qualifications. Brokers have only recently begun to engagc Licenses are generally not taken away for in certain types of primary and secondary failure to conduct the business in accor- market activities that present important dance with the spirit of the laws or regula- questions of rule complance. Similarly, in- tions. It is easy to bc sympathetic with the vestment funds were first authorized by rulemakers'suspicion, if daily reports in the regulations issued in late 1992, but only Russian press accurately depict the chaos now are independent custodians starting to being created by constant changes in rules offer services that will allow funds to com- and interpretation, especially by middle- ply with the spirit of the regulations. A third level functionaries in the tax and customs source of difficulty can be attributed to the services. multiplicity of sources of rules-legislature, Without important functions tied to presidential decree, government decree, oversight or sunveillance, the responsible and ministry regulations, instructions and agencies have usually chosen to react to the like. Each rulemaking body has its own problems only once they have become high- set of urgent practical problems to solve, in- lyvisible. Even then, the authorities have of- stitutional ambitions, and constituencies, ten been slow to take action, and when they resulting in a piecemeal approach to rule- do act, the outcome is uncertain. Setting maldng which often creates technical in- aside possible coruption, bureaucratic in- consistencies and policy confficts. fighting, or simple incompetence as reasons One of the greatest problems with the forslowresponse.itisclearthatpursuingef- rules has been the almost complete "dis- fective enforcement action is difficult at connect" with mechanisms for their en- best. Prosecutors are overworked and inex- forcement. Of course, enforcement is perienced in bringing these sorts of cases, effective only if the majority complies with and courts are inexperienced in reviewing the rules, so that discipline need be applied them. The definitions of, and evidentiary only to deviant behavior at the margin. If rules for, 'economic crimes" such as fraud, noncompliance is sufficiently widespread, so misused under the Soviet system, remain attempts at cnforcement are fairly useless. murky. And standing is also highly uncertain However, that does not explain the lack of for private parties to bring suit, if they have enforcement against cleary deviant be- been damaged by another person's failure havior, tat is, fraudulent or obviously un- tocomplywithregulatorystandaras.There- sound practices. There are a complex set of form of admmiistrative law and the civil and factors that explain, in part, the lack of en- criminal court system is beyond the scope of forcement. Many of these factors seem to this paper, but it is part of the background underlie the broader problem of introduc- for understanding the constraints on intro- ing sensible economic regulation in Russia ducing a sensible regulatory regime. It also more generay helps explain why Russian regulators seem Even though the laws and regulations to swing from one extrene to another- governing securities actnities contain quite from being paralyzed to conductng armed a bit of detail defining acceptable behavior, raids of companies which are alleged to the duties expressly assigned to the gavem- have violated the rules. ment regulatory authorities are typically Although the process of rule develop- limited to such matters as licensing or reg- ment for the Russian capital markets has istration functions. Reflectng rulemakers' been fairly chaotic over the last year or so, deep suspicion that govemment bureau- the Russian reliance on industry practice crats will abuse their authority and have lit- and market discipline, rather than bureau- tle undemanding of the new economic cratic controls, is beginning to st.W results. structures, the licensing procedures are A legitimate equity market is starting to ap- mostly a matter of assuring compliance pear, in which participants (brokers, in- with form requirements. Similarly, authori- vestors, and issuers) have begun to place 104 Russi& CREATING PmvAM ENTExusz AND EFrcmNr MARN Ss value on the quality of products and services their own ambitions to build or control mar- as wel as on that important intangible, rep- ket structures. This configuration of con- utation. Brokers are beginning to organize flicting interests has, to date, generally themsdves into associations to formalize produced inaction, but in the wake of trading practices, and they are looking for MMM, it is likely that new laws or regula- ways to increase the amount of new product tions will be produced. available for trading which mects higher The lawmaking process introduces sev- standardL. Similar self-regulatory functions eral risks for the organized equity markets will be playi by the new clearing and set- that are emerging. For many aspccts of tlement organizations (CSOs) being estab- Russia's infant markets, it is premature to lished with USAID assistance. For example, codify appropriate industry practice and in- as the CSOs begin to offer more complex stitutional structures in laws and regula- services to improve efficiency, such as net- tions. This would not be a significant .. pressures are ting, the success of the CSOs will depend problem if rules could be drafted around bilding [or the increasingly on the financial qualifications basic principles or econornic functions Ion r a andoperatingpracticesofparticipatingbro- which would be flexible enough to accom- adoption of a kers. The CSOs will undoubtedly need to modate the rate of innovation and changing comprehensive oversee the financial condition and opera- economic incentives in the markets today. SeCUritieS Market tions of their participants, much as is already But compliance with form requirements done by several of the private bank dear- plays an ertremelyimportant role in Russian Law, together with inghouses that handle payments. lawmaling and enforcemienL Premature more aggressive Despite these recent signs of progress, codification on the basis of legal form rather regulation. pressures are building for the adoption of a than economic function would simply en- comprehensive Securities Market Law, to- courage the invention of clever and non- gether with more aggressive regulation. tansparent amangements that slip through There is a significant rangc of views with re- loopholes or bypass the intent of the rules. spect to both the future shape of the capital Of the coming battles over a securities markets and the manner of regulating them. markets law, the one which i- likely to be The batde is not simply between those wnth most vigorously fought will be over the as- a deeply ingrained hostility towards finance signment of regulatory fimctioils :mong capital and those for whom an effective fi- government entities and between govern- nancial sector is a top priority Among peo- merit and the securities industry. Foreign ple who see the importance of capital advisers have almost universally recom- arlkets to Russia's future, an important mended a single, specalized, and profes- power struggle is occurring over such issues sionally-staffed agency, which would as institutional structure (espeially the rel- consolidate regulatory authorty of the se- ative role of universal banks and specialized curities markets and oversee the self-regu- brokers), limiting versus encouraging in- latory activities of market partidpants. dustrial-financial linkages, govemment es- C-iven the existing bureaucratic interests tablishument of specific markets versus and other political forces that are at play competition among private market struc- however, such a straightforward solution tures, and the degree and allocation of reg- appears unliely ulatory control (within the government and The outcome of this battle is unpre- between govemment and industry). dictable. Proposals to increase the regulato- Complexiy is added by the multiplicity of ry authority of exsting ninistres will be government ministries which already claim opposed vigorously by many Russian some jurisdiction over the securities mar- reformers and market participants. Their kets, or which have ambitions to do so. opposition is based on the conviction that Furthermore, central bureaucratic initia- the ministries will undermine the essential tives are certain to be attacked from the re- contribution of capital markets to Russia's gions, not only by market participants who economic transfrmation. The reformers do not want to be forced to use central in- look to the capital markets, much more than stitutions but also by local authorities with to the banks, to ensure that financial re- CAPrAL Mhmmn DEvEonrNr AD FNANCaNG Russis TANSFORMATN 105 sourceswili be pooled and allocated to com- ity of financial products available to small merciadlyviable businesses on market rather Russian investors. This is not only necessary than admninistrative criteria. Privatization, to address investor protection. Given the which is rapidly moving assets out of the dominance of advertising over market infor- hands of the state, is only the first step in the mation in distributing securities to Russia's creation of a market-oriented economy. inxperienced investing public, offerings by Currently much of the Russian economy re- responsible issuers will be drowned out by sides in a neverland between bureaucratic the siren calls of Ponzi schemes. controls and market forces. The Russian Some product enhancement will come govcrnment remains dominated by struc- from the market itself. Legitimate operat- tures that are obsolete but that have bud- ing enterprises interested in attracting sig- getary resources and are looking for a nificant domestic and foreign capital will The nightmare of mission. Redeploying their staf£ who have begin iv) differentiate thcmselves in the both Russian little understanding of markets but a tradi- marketplace on the basis of product quali- tion of control, is an unpromising strategy ty. They will improve their access to capital reformers and the For a generatia.i to come, Russia will have by showing that they comply with intema- new entrepreneurial to bear the costs of these anachronistic gov- tional standards for prospectus disclosure, class is illustrated all ernment structes while encouraging them financial reporting and corporate gover- to atrophy. In the meantime, there will be in- nance. These quality standards will also be- too vividly by the sufficient resources for regulatory capacity come increasingly important for brokers current Russian tax appropriate for a market economy. engaged in underwriting the securities and system.- The nightmare of both Russian reform- for trading markets that want to have a rep- ers and the new entrepreneurial dass is utation for reliability. illustrated all too vividly by the current Tlere are, however, a range of harmful Russian tax system- a proliferation of poor- activities which have been impervious to lywritten rules adminsteredby apparachiks. market discipline. The most common Compliance by legitimate business is virtu- fraudulent and abusive practices today do ally impossible, which pushes otherwise not involve the organized markets. Instead, healthy market activity into nontransparent these scams internalize all market func- arrangernents and leaves legitimate business dions, from production, through distribu- at the mercy of local power barons, corrupt tion, to exit for the investor Pyramid middle-level bureaucrats, and criminals. schemes are not harmed economically by There is considerable potential for bureau- the refusal by legitimate market partci- cratic interference in the markets, for arbi- pants to do business with therm An MMM tary abuse of power, and for corruption is simply indifferent to such threats. when current government structures are giv- The MMM-type problem is not, how- en regulatory authority. Russian poicymak- ever, a securities market problem, and it ers are therefore facedwith a dilemmawhich cannot be controlled by normal securities will require a careful balance between ob- market regulation. Instead, it is a broader jectives and constraints, and this in a politi- matter of fraudulent or unsound practices cal system which has difficulty achieving in the arena of retail financial products, balance through anything resembig an whether they are caled securities issued open process. by a joint stock company, shares in an in- vestment fund, deptosits with a finance Pvior&ifesfor polcy. Setting to one side company, investment contracts with an in- policy issues that would be presented by a surance company, or any other form of fi- cornprehensie securities market law, there nancial promise to a small savecr. Any are several areas which need immriediate attempt to attack this problem needs to be policy attention. Some call for disciplinary based on economic effect, not legal form, action while others have market develop- in order to hold in check creative Russian ment objectives. scam artsts. The objective should be to The political fallout fron MMM dictates place competition among different types of that immediate attention bepaidto the qual- financial products on a healthy basis. 106 RUSSi& CEATING PMvI ENTERPRSS ANDEFFicENT MARcrS A second, closely related area will be to have not yet developed an active securities tame some aspects of the primary markets, intermediation business in the same way such as addressing the proliferation of bear- brokerage firms have. erinstruments, reducing the offering perods Despite the limited presence of banks for new issues, and controlling redemption in the markets to date, the more sophisti- activities by issuers. Currently, the distinction cated specialized brokers are anxious about between the retail distribution and secondary the potential domination of the securities trading of bearer securities is hopelessly industry by the banks once the markets blurred, with the conconutant obliteration of start to look attractve. The larger banks are responsibility of those engaged in distnbut- better capitalized, have access to financing ing new issues forwhat they sell to the pub- through deposits, inter-bank instruments lic. Dealers are disciplined neither by the and the Central Bank, and often have im- market, since reputatin is not an asset for portent political mentors. Another source dealers handling bearer securities for small of potential conflict between banks and investors, nor by the legal and regulatory brokers is that banks are often the backers regimes. of securities exchanges, which transact lit- The development of secondary market tde business but succeed in blocking other institutions is also weakened by these prac- initiatives due to their greater financial and tices. Pricing is managed by the issuer, by political staying power. Banks are also frequent increases in primary offering viewed with suspicion because of the inter- prices during indefinite offering periods locking ownership with industrial groups and, cn the sell side, by either redemption that are potentially some of Russia's most policies or manipulation of the limited important issuers of securities. amount of secondary trading. Of course, Given the importance of a healhiy se- the issuer's pricing policies are designed to curities industry for rapid capital markets attract more funds .rom new investors, not development, the relative role of brokers establish a tme market price for the shares and banks should be treated with care, es- based on the value of the company or its pecially because of the risks to the financial prospective performance. system presented by under-regulated uni- Once again, these are areas for govern- versal banking structures. At the very least, ment rulemaking because market disci- policies should address issues such as pro- pline is unlikely to have much influence on tection of bank deposits from inappropri- the most abusive practices. In addition to ate securities market risk, controlling the causing harm to investors, these practices most egregious forms of conflicts of inter- undermine the healthy development of the est, and levelling the playing field between organized markets. Although street-corner banks and specialized securities firms. markets have had a role to play in the early Another area requiring emphasis is the stages of development, they are fraught investment fund industry The rosy scenario with dangers and, in the long run, theywill for Russia's capital markets is driven by a do litde to raise large amounts of capital for shift in the attitudes and behavior of issuers legitimate businesses. and intermediaries in response to the inter- A third area of policy concem is the fu- ests of large investors. But healhy develop- ture rnle of tne banks in the securities in- ment in the long run wll also depend on a dustry. A number of banks have been growing appetite for investments by ordi- involved in securities activity (such as act- naryRusans, either direcdyorthrough cd- ing as regstar or market maker), usually lective investnent vehiles. With the end of providing services to enterprises that are ei- voucher auctions, the VIFs are entering a ther a client or shareholder of the bank, of- new stage oftheir business, and they can be tentimes both Those banks that have either a positive force for market develop- issued shares to increase their capital also ment or a source of difficulties. First, they use their securties departments to manage should be encouraged to stop taking in new the distnbution and trading of their own shareholders and become true dosed-end shares. Generally, however, Rusian banks funds, as required by law. The larger and CAPITAL MAICE DEVELOPMENTAND FANCNG RUSSIA's TrANSFORMAION 107 more promising funds are obvious candi- adopt operational regulations and messag- dates for listing on trading markets. But this ing formats that meet intemational stan- must be accompanied by disclosure of their dards for electronic funds transfers. Fnality portfolios and net asset value, as well as in- of transfer and allocation of risk are depen- formation on income and administrative cx- dent on how basic Russian law wil resolve penses. Conseqnently, it is important that such matters as the legal characterization of there be clarification of accounting and re- payment orders, principles goveming net- porting requirements applicable to the ting, and arrangements for semred transac- funds industry which take into account dte tions and insolvency illiquid nature of much of the finds' current Only a year-and-a-half ago, Russia's portfolios. Those funds vith strong name mass privatization program began to create recognition and good distribution neworls a critical mass of issuers, investors, and se- should be encouraged to create new prod- curities around which intermediaries have ucts, differentiated by investment policies begun to oganize market strunces These and portfolio management strategy The institutional arrangements are maturig at a growing Russian finanial press would cer remarkable pace. For market forces to con- tainly be an eager conduit for information tinue to work, however, policies are needed on legitimate investment opportunities and to provide basic certainty regarding intangi- market prices to the gencral public. Fnally, bk property rights and payments, remove the current process of consolidation of the impediments or distortions to insttutional more than 600 VIFs must be watched care- development, and prune away the fraudu- fuly. Although there are positive signs that lent and abusrve practces that are damagin tie market is produang appropriate con- the credibility of the infant markets and solidation, scandals in large fimds could miking legtimate financial pducts un- cripple investor confidence to such an ex- competitive. Deveopment of Russis capi- tent that the domesuc demand for invest- tal markers will progress in zigs and zags, meats wil dry up. with moments of euphoria mixed with dis- Russian poicynakers interested in the aster The are, however, grunds for opt- development of the capital markets cannot mism that the capital markets wi begin tO limit their attention to seazed securities play iteir appointed role in supporting makers laws and regulations. The future Russia's transormnatio.L shape of Russia's capital markers, and the degree to wicht hey wll be able to integrate Notes with intemational markets and attract for- eign capital, will also be affected geatly by 1.Apimncxmpleofhowquidkydeveen fundamental legl reform initiatives, at the cantakeonimpornceisthecapseofrheMMM level ofthe CivilCode orotherbasiclaw. For (Opyammidscheme,wbichroocplaebeen the example, in the area of secuities ownership conferce at which his paper was presented and and transfer theinstitutionalsupeucte puticailL Aldwu MM did not, in fac$ in- must be built on a solid foundation of legal vIveI the sltts mak it brouj to the for concepts, includig the Ciil Code defini- S Important aspec of both financial prducts dion of secuirities, certafin principles in the being peddled to the publi and governmaent regu- ltion or lack thereof Several point made in the general law on obligations, and the rules re- i*navc he eeq epventhe garding finality of transfer, obligations and poential impact of de MMM epsod defenses of issuers and transferors, and rela- 2. Decreeofthe PzedoEtheRsuianFcdera- tions between nominees andbeneficial own- tion No. 1183, June 10, 1994. Decree of the Psesi- ers. Drft laws often try to use traditional dent of the RussianFederti No. 1233,June 11, concepts, which do not always serve as an o994m adequate basis for a modem securities sys- . Alhough the entgre nagofveapirnmaetr tem, especially one involing securities that maet tm gommnnt secw tiswopmtctadqitymka,vfi are uncertificated or immobilized in dePo- imunt conx to make to R=s =ns- tories. Similarly in modemizing the Russia, fotmaton, the balnce of this paper will focus al- paymets system, it will not be enough to mosrelusivyonthe equitymarkmThernsults RussuL CRuTING PrIYA1E ENTEREs AND EFpacmNrMAris ofRussia's mass priazation progra hbave ret- 6. Decree of the President of the Russian ed remarkable set of oppotnities andproblems Pederadon No. 1769, October27, 1993. dtat will occupy Russian bankers and brokers, en- lb undertad securities iastuur isues in terposes, government policymankers legislators, the Russian contex, a note on Russian vocabuly foreign investors, foreign financial institutions, is in order The tem registraris used in the RFCSE and multilateral organizations for years to come. Reguatons to dnote an agent of the issuer, 4. Throughout this paper, unless odtewise whaerperfioningthefnmcdons(inU.SS.n )of specified, broker is used as a short-hand for ali- registra or rnsfer agent Then depositoy in- censed financial insitution acting as a secunities chids any instituion keeping securties acounts, intermediary, whether as agent or principal and direcdy or indizctly, on bellf of owners, whether whether a finn specalizing in securties actvities the securties am held in th name of the owner or or the stock department of a bank in the name of the ins as nomiee ThIus, de- 5. The Commission on Semrities and poity covs (in US. terms) a deposiwro, a aLs- Exchanges under the President of the Russian todian, or a broker-dealer holding customer Federation was formed by Prcsident Yeltsin with secutines. Until the RFCSEs Regulations, thet the appointment of its initil members in March deposiry was used in common parance to de- 1993 Its eight members are rpresenaies ofvar- scte anykeepeofsecu:ities accounts,wher for ious govement bodies with some jursdiction theissuer or the investorc Needess tosay; the regu- over securities actvities: MinyofFmance, State lations introduced critical disdnctos in these dif- Committee for the Management of Stat Property feent ecomicmtiosbydefingddentsets (GKI), Anti-monopoly Committe, Central Bank, oflegadng8htsrnIdoblg bs.hesedistinctoasare and Federl Property Fund. Its chairman is cur- essenti in any modern sstem for share ownership rendy the Chief of the State-Legal Deptment of and trnsfer (other than thos which cobinc reg- the PresidenL The commission has limited au- isnyanddeposiyfcinsinacentrlbook-u- thoriy ancd no independent staff try istuio suc as in the Czech Republic). CrnAL MARKErS DEvnPEN AND FINANcNG RUSsJ4S TxANSFORMON 109 CHAPTER 9 Securities Market Development and Privatization Roger Leeds and Michael Harman Theeztraordinargrlev,eof politicalandeco- correctly noted that the pzaton pro- nomic turmo in Russia notwihsnding, gram has been implemented so quicldy be- the prvauzation program has defied the cause it is "understood, accepted and With an incredible naysayers. Today, the country can boast an suppoed by the peoplY However, this 35 percent of the estimated 40 mlion pnvate sharehoklder considle achievemnt will be st if this in companies once 100 percent state- mss of nascent shreholders cannot soon rr populton owned. Tens of thousands of small enter- trade eir stock in a liquid, regulatd m- sudenly trans- poses have undergone privatization, and kaeplace. This is only beginning to happeaL formed into direct thousands of the larger enterprises are con- The ukimate objece, of course, is to o i&st share- ducting pomaLy share offerings and be- rpilly tansform these thusands of enter-tt h th e coming publidy-traded companies in 1994. prises mto m productie, efficiet assets boke, the This rapid transfonnation has been - forte benefit oftheir shareholders and the importnce of a blelargdybeause of the 1992 distribution counny-at-arge. In Russia the process is viabledSe of vouchers-which then could be ex- wel established and Wfiguire Co&^ changed for shares in pnvatized compa- 9.1). Altiough steps 1 and 2 are importa '?Zt cannot be nies-to almost every Russian citize, prerequis, entepise manager must be overemphaizeS Despite a continuous array of roadblok, inducedtoundertakethepainfuLbutessen- the Russian privatization program has in- tial restucing measure that lead to en- deed become the catalyst for maret-on- hanced enteise pedomance Herein is ented reforms and it has establshed solid the direct linkage between pnivatfadon and foundation for dte development of a secu- seacties market development Managers rides market A widespread andsformation are mos l to change theirbebavior and of ownership has occurred and a new dass actions to opimize enterprise perfomance of shareholders has been created. when they areheld accountable by an actve, Although the voucher pvanization pro- infomed group of shareholders who have a gram has been a success, a number of seri- vested interest in enterpise perfornce, ous stuctral problems remain. Foremost and perodicaly have the tight to vote for a among them is the absence of a fimcioning slate of diectr and managers who will aa seconday securiies marker,thatwould per- in thir interest. Enterprise performance al- nit these new shareholders to tade their so is affected by access to capil at compet- holings. With an incredible 35 percent of itive rtes. In large measure this depends on the Russian population suddenly trans- perceptions of future peormance, which in formedintodirectorindirectshareholders? tum is reflected by the price the public is the importance of a viable secondary mar- wviing to pay for the comys shares. ket cannot be overemphasized. The publi, Thus restructuang is most likelyto succeed so assiduously courted during the creation when mn ntis hed accuntable bya and implementation of the pnvatization group of shareholders who are wel in- program, wi lose confidence in the process if the fiudamentals for securities market Figure 9.1 dedopment are not in place. Anatoly 1 2 3 Chubais, Deputy Pime Minister andhead KIZJ7Th of Russia's pnvatization agency (GKI), has a SEacus ?wLtDXErwPw;rANiDP zaT 111 formed about the enteprse and have the damental conditions results in a predictable capadyto efficientlybuyaandseltsharesde- array of consequences, such as a lack of in- pending on their view of future enterprse vestor confidence, unacceptably high trans- performance. action costs, and a high incidence of fraud. As in all emerging economies, public In short, the system is inequitable and re- participation on this level hinges on an ac- tards the essential task of enterprise re- tive secondary securities market with a stuturig and economic growth. number of characteristics: To address these key problems a techni- nlmation andpublidcJrM. Infor- c assistnce program was created in 1993 ration is of reasonably high quality, by Russia's pvamtization agenqc I brie£ timely, and equally accessible to all mar- the mandate was to rapidly create the inst- ket partiipants. notional and regulatory infrastructure that The sbare registry * Intmmd ria Market intermediaries would permit shareholders to casily gainac- ultinzAtely (brokers and dealers, custodians) are cess to and trade heir stock and to ensure dltermimtelwell trained and handle client accounts that the holduin would be secue. This, it determines all farly washoped,wouldleadtobroad publicpar- shareholder rights... * Tradi Share trading and prices are ticipation in shareholding and securities not easily manipulated by any one par- tradingandwouldp pres the managers to ty and networks of communication are undertake enterprise restuctuing. More- sufficient to order and execute trades. yove enhanced secondary market lidity * Regitao Share ownership is regis- almost certainlyvould increase publi con- tered to the party which actually owns fidence inseurities markets, wh, in tum, the shares and that owner reccves thde wold encourage more of the public to en- rights to those shares. trust their sans to equity markets that * CkarWng and selment. Clearng and would be channeled to capital-short enter- setdement of transactions is completed prises. A secondary objective ras to begin on a timely and accumrate basis. training a new generation of registrars, f Ration- Prudential regulations gay- transfer agents, and otherpartacpantsin tde erning standards ofbehavior forissuers, functions and operations of the securities intermediries, and irvestors arc fair, mrd...m reasonable, nd effectively enforc When the Russian privatization pro- The need for viable securitmes mar gram was launched in 1992, none of tbese conditions were in place. Asserve goe- A number of factors explain why Russian ment intervention was required to create securities makets have not been effectiv- the basic conditions that would permit a ly meeting einteresu of either the poten- secondary equity mrket to serve as a cata- tial supplies or the users of equity capitaL ly for enterprse restructuring,aswellas an Fist was the nature of the privatization ouldet for domestic savigs. The govr- program itse wich inadvertendy created ment recognized a dear need to create an disincenfives for enterprises to raise capital organized institutional infastruce (that trugh public marcets, altiough now is, brokers and dealers, custodians, share many have begun to do so. By mandating registras deaning and settleent agents) the sale of sbaresforvouchershoughpub- that fims the core of the securides market 1k auctions, a sign"icant percentage of to- Of course, these institutional particpants tal eqit value has been absorbed outside would require trained professional staf4 the markets. Moreover, most of the re- technicaly able to record, trnsferi and maiming equitj under the unique rules of trade securties. And, as in all developed se- Russis privatization program, has been al- curities markets, there was a need for the located to the enterprise emplcyees at very physical infristructe reliable commu- attractive, heavily discounted prices. Thus, nicatons netwok that would allow for trsd- onlyasmallfractionoftotalequityhasbeen ing to ocmr in a timely, inexensive, and avaiable for sale to outside investors, pri- transparent manner. Absence of these fun- madly though market auctions. 112 Russt CwREATINGPiuW IENTEhaISAND EFncmNrTMARrs Shbare regihtfion independence of the registration process from corporate management when many In the absence of an efficient secondary corporations managed their own registra- market, once an enterprse is privatized don books. Several enterprise directors most shares remain n in individual ac- were said to take extreme measures to pro- counts because registration of ownership tect their own interests, such as refusing to transfer is controiled by the enterprise man- record share tansfers in the share registe; agers themselves. Registration refers to the physically threatening shareholders, tam- process of noting the owners of a company's pering with proxy votes, and creating share- outstanding shares in a registration book, or holder trust organizations to ensure that a share register. The share registry ultimately majority of votes supported the .positions determines al shareholder rights, including taken by corporate management. who should obtain dividends, updated in- These problems were compounded by Clearing procedures formation on the company's actvities, and the absence ofregulations and investor pro- ensure that the two the right to vote for company directors and tection regarding the registration process. other corporate decisions at shareholder As a result, shareholders were without re- brokers agree on the meetings. If the register is not controlled course when abuses occurrd. terms of the trade and opeated in a manner that is indepen- which is to be dent from enterprise management, which is Cleang and settdment ttled Settlement often the caseinRussia, shareholders' rights are undermined. By controlling the register, Whfle efficient share registration facilities procedures ensure the directors can effectively impede the are a necessary first step to dte operation of that the two transfer and trading of shares. any functioning securities market, modem Given tis role, registrars must have two markets go firther The absence of good brokers actually important features. Frst; good operational cleaing and settlement procedures, anoth- exchange the funds and administrative procedures mst be in er prequisite for a self-functioning secu- for securities at an pace to ensre that share ownership is reg- rities market, also linited secondary isteredaccuratelyandminaimelymnuerIf market traing in Russia These procedures greed upon tme registration is not accurate, the wrong assure that the contract entered into by two and place. shareholder might be recorded and the cor- brokers who execute a trade results ini the rect shareholder's ights could be lost Slow timely exchange of funds for securities be- re-registration wl reduce market liquidiy tween the two brokers. Clarg proce- by maiking it difficult for a new buyer of dures ensure that the two brokers agree on shares to quicldy resell those shares to an- the terms ofthe trade which is to be setded. other inveator. Settement procedures ensure that the two Another key feature is that the registrar brokers actually exchange the funds for se- must not have a vested interest in the own- curities at an agreed upon time and place. ership and rights of any particular investor Many undeveloped markets do not have If for instance, the registration process is formal dearing and setdement procedures controlled by coporate management, the and the processes are done informally The management maywisl to avoid registering a two counterparties to the trade review with shareholder who anmsses enough shares to one another the terms ofthe trade and then have signficant control over the corporanon, agree upon a time to exchange funds and se- since that control poses a threat to corporate curities. Such informal procedures increase management For this reason, in most devel- the likelihood of setdemt errors and de- oped serities markets, the registration lays due to cearing Mistakes, particularly in book is controlled by an independent thid higher volume markets. They also increase party the chance of setdement failures since there The Russian ad hoc sysm of sbare reg- are no mechanisms for sanctioning failures. istraion sffed from administrative prob- If one broker fails to setde obligations, the lems in the early days of privatization which trade is simply canceled. slowed equity trading More importanrtl In a market with low trading volume, there were serious problems concerningthe setdement delays and failures do not sig- SECURMS MAmmTDEvELopmmT pmm P¶vATvATm 13 nificandy upset market activitry. But in high- cedures in the early 1990s. Until recently er volume markets, setderment delays and most trades were settled on a cash basis, ei- failures can cause a series of defaults by char privately or through brokerm Tere other market participants. Consequently, were no clearing or settlemer. institutions. the likelihood of frequent settlement fail- Consequently clearing and settlement were ures in a securities market can significantly slow and often inaccurate, with many de- reduce interest in share trading, particular- faults. Moreover, there were limited facili- ly among foreign investors-and among ties and procedures for efficiently clearing domestic investors as welL inter-bank credits, and there were no means For these reasons, most developed se- for the safekeeping of share certificates. As curities markets have formalied clearing a result, transaction costs were extremely and settlement procedures that normally high. These inconveniences created disin- are operated through some type of central- centives for broad-based public participa- ized cleriing and settlement organization tion in the country's securities markets. (CSO). After a trade is completed, the doc- In addition to these problems, the phys- umentationforthetradeisforwardedtothe ical infrastructure needed for an efficient CSQ The CSO then confims the tenns of securities market has been absentin Russia the trade with the two brokers who execut- Although intra-regional trading is possible ed the trade. It then makes certain that se- if somewhat cumbersome, it is extremely curities and finds are setded on time. In difficult to execute inter-regional trades. addition, most dearing and settlement or- Most importantly, tdephone communia- nizations "net trades-they calculate a tion in Russia remains rudinentsry, partic- net amount of funds or a net amount of se- ularly between outlying regions. Moreover, curities that any one broker must submit to there are limited facilities and procedures the dearng corporation to settle all of the for efficiently clearing inter-bank credits, trades contracted on any one date. Netng for settling trades or for providing for the trades significandy reduces the volume of safekeeping of traded securties. As a re- funds and secunties that must flow from suk transaction costs can be extremely one brokerto another This, in turn, reduces high and these incomrveniences create disin- setlernent errors, delays, and defaults, and centives for broad public participation. allows securities narkers to handle higher Given this array of problems, coupled trading volume, thereby instilling greater with the rapi emergence of a huge number confidence in the market. of new shareholders, it is hardy surprising Funds and securities can be setded phys- that pressure began to mount m Russia to ically or electronicaly The trend in funds improve the clmste for trading secuities. setdtement is for counterparties to setde The loudest clamor came from the have- their obligations electromnically hrough the nots among the investing public, the small regular banlkng system. On the secrities and medium-size shareholders and their side, moast developed secunties market are government representatives. Equally dissat- increagy doing book-entry setdtenent isfied were the growing number of invest- Institutions, called depositories or custodi- ment funds that have become very popular ans, or the CSO ksel£ vil store pysical with the public and are an increasingly in- share certificates of sharholders and mnain- fluential force for securities market refornm tam a cetralbooknoting forwhom they are To date, there are apprcomately 650 funds, holdng certificates. To settle trades, the de- and they control an estmated 40 percent of pository erier debits or credits its book for all distruted vouchers. And finally, pres- a broker's holdngs of certificates. This im- sure for reform has come from an emrging mobilization of share ceficates significant- group of broker and dealer finms and other ly increases the efficiency and reliabilty of entrepreneurs who have gained substantial setement and reduces the risk that certifi- experience in the market and have a direct ares will be lost or stlen. stake in expanding publc participation. An Not surprisingly, Russia had minimal if ineffcient securities market that dampens any formaliz cleanng and settlement pro- public enthusiasm is hardly in their interest 114 RusSxL CQnncPRmaENTEmusrsND ErFlcNmrMiucs Technical assistance for securities Strategic asswnent Addeing te needs of market development sekebolders This diverse combination of factors was the The strtegic assessment portion of the as- stimulus that led the Russian privatization sigunent-the diagnostic phase-identi- agency (GK[) to accelerate implementation fied the specifc nature of dte constraints of a technical assistance progam to pro- that were inhbiiting the market reform motre the development of efficient securi- process in Russia and recommended an ac- ties markets.The immrnediate priority was to tion plan for implementing practical solu- design and implement a program that tions to these constraints. Given the would povide Russia with the necessary in- extraordinary regional diversity of Russia, stitutional and regulatory infrastructure for interviews were conducted with officials securities markets to operate more effi- andmarket participants from the geograph- The immediate aendy, and to protect the rights of the mil- ically strategic cities of Mosco, St prioi was to lions of new Russian shareholders who are Petersburg, Ekaterinburg, Novosibirsk, and struggling to understnd and use the new Vadivosk Ii each of these cities there is deSgn and imple- markets. More specifically, the program at least some financial infastructre and a ment a program was designed to: reasonably high level of voucher actity that would provide * Support the development of an effec- A representative sampling of insutm- tive and efficient securities market tional participants, such as banks, brokers, Russia with the regulatory framework and of govern- and investment funds, offered opinions necessary institu- ment and quasi-government regulato- about the most important constraints to the tional and regula- ry iostftuteons. developnent of the market and made sug- . ' Accelerate the development of the se- gestions as to howthey might be overcome. ty iascaure curities market infiastructure-an es- This preiminry stage focused on gaining for securities sential prerequisite for achieving broad first-hand knowledge from the key institu- mnarkets and to public paricipation in the market- tional stakeholders in the secuities market through the creation of model frame- and on mapping out an implementation protect the rights of works and procedues for independent strategy that would be pracical, relatively the millions of new sha registration, securities transfer simple to implement, and responve to Russian share- and safekeeping arrangements, and their needs. . hboldr... guidelines forsecondaymarkettrading Of all the instional representatives m- and settlement All agreed that this re- temvewed,threegrupsplay themostpromi- forn must occur, not only in Moscow, nentroleinthemarket andhold thegreatest but in other important regional centers stake in the development ofafuictioning se- across the country as well. curities markets: brokes and dealers, invest- * Create specific institutions to serve as ment fimus, and commerial banks. pilot organizations for security settle- ment and cash dearing -operations. Figure 92 Work schedule Such organizations are critical to re- solving liquidity constraints and to Ta*k IMont 1-2 AoknthsB-4 MAontis5-6 Mont 7-E Year 2 building the public faith in the sec- 5. _ ondary market. With these broad objectives, the priva- Dmvelpment tization agency tumed to foreign technical a,d gu _ expertsto rapidly underake thde design and pwt implementation of a results-oriented work hmpenntaon program. Overall, more than 100 foreign .Daoeo specialists and Russian professionals would UoAr no- bedirecdyinvolvedinthispioneeringeffort to stimulate rapid secutities market devel- opment. Sequentially, the work proceeded RoshOut Phs in the stages shown in figure 92. _ SBCUIMS MAR DEvELOPMET AND PEWAmlZA&ION 115 BEokenand deaLen. As members of the views were an important input to the strate- largest category of independent securty gic aessment registrars, brokers and dealers are key to Alfa-Capital, for example, is one of the breaking the control that enterprse man- largest mvestment fimds in Russia, with agers have maintained over the registration more than 15 mfilon subscibers in their of their firm's shares. If brokers can induce first closed-ended fund offering Due to a the enterprise managers to cede control of strong initial performance, the firm has the registar functon, they are in a strong started to establish a position of influence position to stimulate secondary trading. in the marketplace. Alfa has significant For example, one of the more success- blocks in twenty-two issues and sits on the ful firms of brokers and dealers, located in boards of four enterprises. As with the oth- the Moscow region, is OLMA1 Originally er leading fimds, as the management of The influence of an investment advising company founded AlfaCapital has gained conol of select en- Russian investment in the late 1980s, the firm now employs terprises it has begun to use its influence to funds also h7as over 100 people and maintans eight force restructurng. Recent publicity over funds aSso has Moscow locations. Having convinced sev- the proxy batde to remove the management grouw very quickly. eral large issuers of the importance of hay- of the Bolshevik Biscuit Company inwhich ing an independent registra, OLMA holds Alfa Capital maintains a large minority the registers of nine pivatized enterprises. share, has brought the importance of in- Throtughits affiliate organizations in thirty- vestment funds to the attention of man- five cities, OLMA has been involved in the agement and goverment alie. Tis is issue of 200,000 shares via auction, and in precisely how the architects of Russas pri- thle collection of over one mfllion vouchers vatization program hoped it would vork- In the secondary market, the vast majority a core sharolder with a significant of the firm's activities have been in uAns- financial stake in an enterprises perfor- actions related to issues forwhich they hold mance g-ns control and seaes as the cata- the regist For example, OLMA is con- lyst for much needed restucurng. sidered the market rmaker for both liTUM From the perspective of the securides and Cosmos, two of the most significant is- market infasuture, these investment suers in Moscow. It is unliely that the cur- funds can fulfil a very important role. Wth rent volume of tading activity in these theirownruiementsforcontrolngsales issueswoulddhaveoccurrediftheshareret and registry through national networks, istrar had remained with the enterprises. Alfa Capital, for example, maintains rela- tionships with 600 representaive organiza- Iweument fix.1 The influence of tions in 200 cities. Their systems can easily Russian investment funds also has grown be adapted to become clearing houses ancd very quiidy. An estmaed 40 percent of all third-party registers for other enterpises. vouchers are controlled by these funds, The further development of the scurities which quickly have become an important market il only conribute to the success niecham for Rusin cizens to partic- of the investment funds. By taking advan- pate in the privatization process.The xpla- tage of low share prices and improved se- nation for the popularity of the funds is curityand liquidityintheseuiiesmarkett dear-investors exchange the right to use investment funds are exected to become their vouchers to obtain shares in one en- significant players in the future Russian terprise in favor of an opportunity to invest market. in a diversified portfolio, managed by well- inrmed po fessionals. Some of the invest- Commercid bank. Starting several years ment funds-relatively large pools of ago from a centralized system with a single investmt capial, w strong market re- state bank, the commerciabaing sstem search-are considered to be among the now includes 2,000 banks registered in firstWestrstyleinvestorgroupstoemerge Russia. Alhough, the numbers are decep- in the Russiar. madret Due to their market tive because most of these banks int mnowledge and signifiant position, their less than 100 million rubles of capital 116 R]uss1& CnEAxx PRwIEENrERPRsES AND EPHxmNT MAms ($60,000)4 and therefore have little impact Consistent with these recommenda- on the securities markeL There are still a siz- dions in October 1993, President Yeltsin able number of larger banks with over 200 signed the Decree on Measures to Provide million rubles of capital that play a signifi- for the Rights of Shareholders. The decree cant role in the market. Based on the made significant strides towards the estab- German universal bank model, the com- lishment of a legal framework for a tran- mercial banks hope to develop in all arenas parent securties marke. These induded of the financial market Some aleady are provisions that all enterprses with over providing a full range of commercial and in- 1,000 employees would be required by law vestment banking services to their cients. to use a third-partr independent register, As their wealth and influence have con- that a shareholder's right to have ownership tinued to expand, these national banks changes recorded in the company register in have become ideal candidates to fulfill the a timely manner would be protected; that As another independent registrar function. The adci- there must be regular dissemination of in- indicator of the tional costs to the banks of providing these formstion on investment funds and owner- . services ar insignificant relative to the op- ship issues; andthatthe concept ofnominee growing interest in portunity to broaden the range of services ownership be introduced (by which a finan- securities markets, they can offer to their corporate clients. As cia advisor is allowed to hold a single gen- some banks also are a rcsult, a new and significant provider of eral account on behalf of clients). The becoming partial registra services has emerged. decree was less successfil in estiblishingef- As another indicator of the growing in- fective enforcement mechanisms, a prob- ownes of most werest in securities markets, some banks also lkm that continues to undermine the exchanges. are becoming partdal owners of most ex- effectiveness of the established safeguards changes. For example badks participated in the creation of the Moscow International GCui&eherfrkzdepmdentrgistramanda Stock Exchange (MISE), the Russian Inter- piloprogram national Money and Stock Exchange (RIMSE), and even in the Alfa-Capital The Russian financial institutions most af- Investment Fund. At the same time, as the fected by the October 1993 decree were the attractiveness of banking has become more registrars. In order to provide technical sup- apparent, other securtes markers players por to this fledglng category of enterprses have begun to examine seriously the indus- that were becoming increasiy important try as a possible new line of business. Several to the sucoess of securities markets, the first brokers and dealers in SL Petersburg and task was to develop guidelines and require- Moscow, for example, have applied for ments for share regist operaons. The banking licenses and some of the larr documentation was extensive. For example, fimds report that they too may petition the it included general descriptions of the func- Central Bank for limited banking licenses. tion and purpose of registrars, procedural The strategic assessment identified two descrptionsfor manual operation of a regis- fundamental problems that need to be ad- rrar,theinformationto betrckedinthereg- dressed in the near termL First, the analysis ister according to international standards, dearly revealed that enterprises restricted and suggestios of appropriate methods and access to the register for the re-registration fonmtrs for firLure electronic communica- of shares and used this control to imit share tion between enterprises, banks, and regis- trading, which severely arrested the devel- trars, domestically and intenationaly. opment of the securities market and imped- ed much needed enterprise restructuring Pilot inplenmataion:A naional network of Second, the lak of a structured and trans- regirnrs parent clearing and settement mechanism gready retarded the evolution of the mar- Once the operational guidelnes were in kets. To correct these problems a series of place, the next task was implementation on concrete recommendations were made to a pilot basis. The immediate need was to the piivatization agency. put in place a set of institutions that would SEcu1RIIS MsAxErDAowNTD PmRvmN 117 satisfy the functional guidelines and speci- tention of national or even regional regis- fications and serve as an example that could anr, but that are required to maintain their be replicated by other insmtutions through- share register with an independent regis- out the country. The first challenge was to trar. Because the profitability of running rapidly create a network of independent these local operations is questionable, com- share registrars. Once selected, each model munity registers are usually associated with registar was provided with training, com- local or national government institutions puters, and software to increase theirshare- that are able to underwrite the group's ac- holder capacity and to ensure compliance tivties. Alogicalchoice wouldbe one of the with the recommended guideines. institutions created to support the national After surveying a represetative set of voucher auction process. For most of these active registrars, pilot orgazations were se ypes of organizations, the education and National registrars lected on the basis of an objective set of cri- implementation process begins at ground are typically teriadesignedtopinpointthosethathadtthe zero. lTere is little orno experience with or independent potential to become model registrars. Three even exposure to the concepts and opera- independenzt ldasses of registrars were identified, eac tions of a register. organizations with distinct characteristics. From each of Once the pilot institutions were select- created to service a these categories pilots were selected- ed, each was provided with technical assis- tance to ensure that they could operate single large issuer, National regiiranr. National registrars according to the defined fimctional stan- usually a large are typically independent organizations dards and guidelines. After an initial dis- investment fund, aeated to senice a single large issuer, usw- cussion and a review of the basic intentions ally a large investment fund, large broker, of the technicl assistacre, a series of meet- larger broker, or or super-regional bank These organiza- igs were conducted to present the con- super-regional tions maintain strong national reputations cepts and issues raised. At that point, a banz. and are able to service and attract large na- more detailed audit of the operating proce- tional issuers. However, they do not be- dures was conducted for each pilot institu- come regsrars to make a profit Rather, ton, including an investigation of the they become registrars to strengthen their capacity to undertake both manual and ability to control the trading acivity in fte electronic procedures. market for specific issues For banks, being After the current condition of the enter- a regstrar also becomes an additional pise was determined, the business planning means of attracting new' business and isan- process began as an iterative process be- other step along the mad to becoming a tween epariate technical expt, the en- unvrsal bank. terpise maagemert and the local consultants. The resut was a realistc work Regionl rirn. These ar often bro- program fer each pilot insttution. A mult- kers or smaller banks that provide registrar tude of operational issues were considered, services to a few regional issuers who are including the quantity of enterprise issues quite active in the oblastes or larger geo- available in the region, the registar's com- graphic region's markers, but who raise lit- petmtnve advantage in the rnrket possible re- tie natonal interest As with investment gional expanson, and projectons on market fimds, these orgazations become regis- growdL Detaled operating targets for the trots in order to serve as the market maker firstyear were agreed upon and a marketing on local issues. Constraints to gmwth are plan was deveIlped to achieve these goals. usuay related to a lack of technical under- Finaly computer hardware and software re- standing of regir operations and proce- quirements were asessed and assstance was dures. This could be remedied though the provided to install the appropriate systems pilot program- The final portion of the registrar tech- nical assistance program was to determine Comm(niy nitr Community regis- and resolve training needs. For the region- trars ore designed to support small issuers al and local registrars the training needs that are not large enough to warrant the at- were fairly straigtforward and standard- 118 Ru=SSL- CGRNar Pzn EENnEmsssAND EwzcwNn MAs ized training classes could be organized to that Investor 1 decdes to sll shares to meet their n. ds. For the national registrars Investor 2. Investor 1 contacts his broker, the training needs were nire sophisticated. Market Partidpant 1, who sends-a sell tram- Standard training programs ranged from action tothe CSO. Likewise, Investor 2 con- the more pedestrian overview of registrar tawts his broker, Market Partcipant 2, who activities and functions, to more derailed in nun sends a buy transaction to the CSO. courses on fee structures and marketing At the close of the trade day all trades are programs. matched and settled. Data (such as price, To ensure chat this ambitious initiative nurmber of shares, and terms of settlement) would be sustainable afterwork on the pilots are confirmed. and le trade dedared is completed by year-end, a Registrar Sup- matched. At that point, the CSO reduces port Center (RSC) was created. Designed to serve as an informnation clearing house for is- Figure 9.3 Registrar implementation plan suers, registrars, and related organizations, the RSC is funded initially by donor fina- Create model ing, but eventuallywnil become self-sufficient Crejatm to through member and user contributions. implement The RSC is expected to keep track of issues recommended and legislation related to registrars, as well as to organize semninars and training programs v and to test newsoftwareproducts. It is hoped Epand Train Russian that this type of self-sustining support ser- capacty consultantsto vice wll become the model ofhow an indus- of regisars sustain wDork to service large of expatriate trv advisory orpnization can povide issues team ongoing support effectivly to the financida community and serve as a single source for 7 timey and accurate information. Roll-outphase Pilot selecfion Based on the practical experience ganed during the piot stage, a 'rol-out" was de- sgned in 1994, to replicate the project * PilOt evaluations Business plant preparation thughout the nation. The roll-out wil ntaly - Software enhancement increasingly on dhe experences of Russian Cmplementaton .computer hardware R Pegistrar support center consultants who have partcpated in tie pi- Training lot irnplementations alongside foreign ex- _ peu. Moving mto geographic regions N r beyond the scope of the original pro[ect,alrll these consultants will provide services to oth- er organizations that wish to become mide- pendent reeistrar A schematic of tFiegure 9A registrar implementation program is provid- edianfigmre9.3. Regr Clearing and settlement organizations A similar progreson of steps was followed bank operations ban 2 to create formalized clearing and setde- w/centalbank ment organizations and depositories strate- i gically located throughout the country Regional cearin The operations of the CSO are straight- centr o forward, as ilustrated in figure 9.4. Assume regional bank) SEcutrnm MAnrr DEvELonIErr AND PivAzAnoN 119 the nominee account for Market Participant Moscow and St. Petersburg, the first two I and increases the nominee account of CSO sites, the programming effort already Market Participant 2 by the number of is tunder way and will serve as the model shares indicatedinthetransaction. Once the CSO system to bo. roiled out to other day's batch processing is completed, a single regions. consolidated financial adjustment notifica- tion is sent to the setdement bank to net the Regional venus national implementation financial positions of market participants for that day. Since al accounts are held ata com- As with the registrars, CSOs will be estab- mon bank, settlement of cash occurs very lished on a region-by-region basis rather quickly. than through a single national system. This This structure provides a much safer is the only practical solution since inter- and more efficient method for the settle- regional cash settlement can take months ment of shares traded than does the current because of extremely poor communication system of physically transferring cash and links. Although somewhat more efficient, securities with each trade. The stocks nev- intra-regional transfers can require several er physically leave the CSO, and cash needs days as well. The proposed regional to be transferred only via electronc or pa- approach to CSOs takes advantage of the per transfer order. As a result, it is expect- stronger regional links and supports the ed that members will be able to trade in expected heavy regional trading patterns. higher volumes, with less risk of default on With the exception of a few strategic payment and reduced settlement costs. national issues, early evidence suggests th;at Demands on the banking system-current- the public is interested primarily in securi- ly overburdened by the volume of payment ties trading on a regional level, and there is ordersc alsowillbereducedbyprorvidinga little likelihood of signifcant of cross- single consolidated transaction for each regional trading until the national commu- member organization. And the common nications networks undergo vast depository will provide a general safekeep- improvements. ing facility in various issues. By the end of 1995, the technical assis- The implementation phase of the CSO tance project intes. ds to establish a series of project required the identification of possi- CSOs positioned in geographically signifi- ble pilot organizations in the selected cities cant locations across the Russian Federa- and the establishment of ties with the don. Each organization will function under prominent financial organizations in the re- identical governance structures and partic- gion. Only after bringing these financial ipant requirements,with identical comput- market players together in a common mem- er or manual procedures. At some point in ber agreement did the CSO start to evolve. the future, once the national bamking sys- In this way, the approach to CSO creation tem and the telecommunications network was developed specifcally to address the become more efficient, there are plans to needs of the Russian market link CSOs' activities between regions, The CSO framework developed for thereby establishing a seamless, electroni- Russia will be feasible as long as the volume cally-linked national securities clearing and of trades remains low, which is liely to be settlement system. the case for a significant period of time. Until this more advanced system ar- Eventually however, the CSO will advance rives, however, members that want to trade from apaper-dominated environment to an in the issues of another CSO must have electronic mechanism for matching and set- correspondent bank accounts in that re- ting trades- As with the registrar portion of gionL Trades then will be transmitted elec- the project, a detailed technical evaluation tronically between CSOs. But setdement of each region's potential trading volume of funds will have to oocur locally to meet was undertaken to deternine the eventual setdement timing requirenents. An expla- computer configuration that would be re- nation of the interim solution is presented quired to support the organization. In both in figure 9.5. 120 RIussik CRATING Pmaw EzNTERsR AND EFIcEN MARKmS Once the national system is functional AID), and a core of highly trained foreign and fully automated, settlement can occur specialists working effectively with Russian through the central bank. This more per- counterpart has led, in a reasonably short manent solution, projecied for a time when time period, to a set of tangible results that the nation's communications infrastructure contribute to the dual objectives ofsecurities is modernized, will, in prmctice, resemble markets development and enhanced private the schematic of the regional CSO itslf. enterprise performance. By March ¶994, af- The only additional information required in ter about eight months of work: the national system will be fields to track * The capabilities of fifteen registrars in the location of the bank and the security ac- seven cities had been enhanced, allow- counts on trade transactions and bank set- ing them to meet the basic needs of dement transactions. more than 10 million shareholders; * The Registrar Support Center that Conclusion eventually will be self-sustaining was up and running, providing an institutional The creation of this basic institutional and anchor for future training and other as- regulatory infrastructure that provides the sistance to existing and newly-created essential foundation for efficient securities registrars; market trading is inexorably linked to the - A core of local specialists and consul- ultimate success of privatization in Kusiua. tants were trained and in position to If most medium-size and large enterprises continue the roll-out ofnew registrars in are going to survive in Russia, they must un- other regions; dergo significant restructuring and they - A network of four regional clearing and must expand their capital base. Both of settlement organizations was estab- these achievements hinge upon the willing- fished, each with identical governance ness of segments of the public to participate structures and participant requirements; in equity markets, which will occur only if * The initial securities market regulatory theybelieve that the markets are reasonably framework was put in place, although a safe, efficient and fair. considerable challenge remains to ex- Attainment of this level of confidence, pand the scope of regulation (that is, in- and therefore participation, requires that fornation disclosure) and upgrade the marketplace satisfy a number of rea- enforcement capabiities; and sanable investor expectations. They must, * The fundamentals are in place for a for example, have access to reliable infor- gradual transition from a regional to a mation about the enterprises on a timely national securities trading system. and equal basis so that they can make in- vestment decisions; they must have a high Figure 9.5 Inter-regional dearing and settlement operations trading level of comfort so that trades can be con- summated relatively quicldy, easily, and Buy-side 7. Trade agreemnent Sell-side safely and, they expect their vote to count broker for something-they expect to be able to 2. Entyof buy side 2. Enr yof sell side hold managers accountable for enterprise Regional CSOI Regional C502 performance. When these basic conditions 3. Trade notification 6. Record in can be met, there is every expectation that Settlemen Setlme_ sontC broad segments of the population will be and clearing 7. Trade notification and clearing prepared to risk their savings to participate operations, operations, in the equity markets. dearing center clearing center The recet experience in Russia proies4 FundsRsettlement A Trde confmation encouraging evidence that a well-designed aearing and adequately-financed program of techni- er cal assistance can make a difference. Close Bside cooperation between the govemment (the account privatization agency), a foreign donor (US- sesde aolut SBcwirEs MAFn DEvEvPMENTAmN P&UvArIZnON 121 Know-how has been tranrd, some Notes new institutions have bee created, and oth- ersigniflcandyupgrded.Thepublicisgrad- Tle audhrs wish to thank Jonadtan Bulidey and uanly gaiing confidence in secunities markets Alin Hawood for dteir sipificant contnbutions and the early evidence suggests increased to dis paper market particpaion, direcdy or indkectly. 1. ompared to only 19 percenr in thie U.S. Ahhough, of course, there is muh tobe done 2. UNa&Sves Joura, December 19,1993, p.A5. before a single, electronically-linked natima 3. The project was hnded by the United States Agency for International Development (AID). ities market is a reality, the fiId andexecuted by private consulants, inluding the tals now are in place, which has given an im- authors. measurable boost to the achievement of the 4. As of May, 1994 the echage rate was 1.800 naton's privatization goals. rubles to the doll 122 Russrt CnEANG PmvAoE ENTmms AND EFFXCUNTMARKI Part Three CORPORATE GOVERNANCE AND RESTRUCTURING CHAPTER 10 Ownership, Governance, and Restructuring Joseph Blasi ith assistance from Darya Panina and Katerina Grachova ITRussia,seniormnagersofenteisesim- almost uniform across all 150 companies, plement privatization. Who, then, is beter the entire sample will be discussed qualifed to comment on the progress and The twenty-three interviews conducted problems of privatization? From August before ApIl 1993 were in enterprises in the 1992 to March 1994J on behalf of the process of considering or filing documents Russian Center for Privazation (RPC) and for privatization. Most had conpleted their Russian State Property Agency (GKI), 150 closed subscription, but not their voucher intervews were conducted in 150 different auctions. The 127 interviews from April to enterpdses, with geeral diretors and se- March 1994 were carred out in enterpris- nor managers of pnvatzed firms-a small es which had completed their voucher auc- but significant sample of 7,000 medium-size tions and were nearing the end of the first andlarWeenrterpisesthathadparticpatedin phase of the privatization process. The in- voucher pivatization by February 1994. terview data provide additional quantita- Interviews were also conducted with local tive informaton not examined in prvatization officials. Their insights on program-wide statistics and provide direct issues previously discussed with general di- feedback about privatization methods and retors prvded the oppormity to crs post-privatization developments inside the check observations made by the directors. enterprises in the senior managers' own The interviews covered 2.1 percent of the words. This information is of general inter- enteLprses participating in the pivaiztion esL It is also of specific utility to officials at program. Themes discussed were financal the GKE and the RPC to help with policy statistics, inter-enterprise relationships, cur- analysis, regulatory changes, and further rent ownersbip pattems, desirable parters, planning and to serve as a basis for outside corporate govemance, labo-managment policy advice and analysis to the GKI and relations and labor shedding plans and the RPC. problems for restructurin credit, needs for Most ofthe 150 interviews were inwhat technical assistance, and general observa- Russians classiy as medium-sized enter- tions of the pnivatization program. prises (that is, more than 500 employees) This paper distills from the interviews' with an average of 2,800 (median 1,200) basic concepts and trends and offers a tex- employees. Thirty-three or 38 perment of tal analysis of these interviews. Our find- the eighty-eight regions in Russia were vis- ings are based on a statistcal analysis of the ited. The city of Moscow and the Moscow employment and curret ownership infor- region were two of the thirty-three regions mation for 127 enterprises in thirty-three examined and no other enterprises wihin a regions and on the analysis of the twenty- thuee hour drive from Moscow were in- five most reoct enterprises visited in sev- cluded in the study. The other thity-one re- e - gions durng February and March of gions chosenwereintentionallywell-off the 1y94. As research is still in progress, and beaten path. Five were in Siberia or adja- ten to twenty new enterprise interviews are cent to Siberia, six were north of Moscow, being added weeldy, it was decided to ten were south of Moscow, five were due fieeze the research in two recent periods. east, and five due wesL The researchers re- 'Where the answers to questions have been peatedly vared requests to local officials so O0NEm, GovEnmNcE, Am RFxaunG 125 that they could not easily control the type of the prograrn as put forard by the of enterprise being presented. For exam- government. ple, the team requested specfic enterpris- Why this contradiction? One olvious es focusing on a far away town or one explanation is that those who feared the industry group or they requested general consequences of privatization and op- directors unfriendly to privatization. With- posed any change from a state-owned sys- out exception, officials of every region and tem, nonetheless, saw that it was town chosen eventually responded posi- preferable to control the divestiture tively to the fact that someone was sent process rather han have it controllcd by from Moscow who was willing to patiently external agents. Thus, they condemned the sit and listen to their ideas and those of program at the same time that they imple- their local industry leaders. This simple mented iL It was a case of following the At the same time fact removed most barriers. rules while trying to undermine them. that managers and The litnus test of enterprise managers' wporkers wuere Did enterprises cooperate? support is their atdtude toward state ver- sus private ownership. Almost all enter- making decisions, The state must not have any owner- prises still have the state as part-owner following the ship. The state must not be involved in after privatization, since most property the structres that make profit In all funds hold 'golden shares" or are prepar- proccurCl nils put countries with a developed economy, ing"packets. Golden shares are stakes the forward by the GK1, the state is financed only by taxes. local property fund held back in enterpris- and filing the neces- -Senior economist, steel pln for ma- es in the hope that they could be sold for a sary, ~ chine building, Moscow are higher value later Packets refer to owner- sary documents, ship stakes that the local privatiation au- tbey or their repre- Clearly, the answer is yes, because most thorities expect to sell at future voucher or sentatives in trade firms rapidly corporatized, chose dosed- cah auctions or at investment tenders subscription options, and went through The average amount of the enterprises' U7UOflSi, tnt&Ust7y voucher auctions That they would do this shares still held in state hands (by the associations, and wasnotinitially obviousto observers inside Federal Proper Fund) after privatization parliamentary or outside Russia. At the same time that was roughly 17.6 percent. The ownership factions... were managers and workers. were making dea- stake held by the state is reduced by about tactions. ... were sions, following the procedural rules put 5 percent to 12.9 percent when one takes bitterly denouncing forward by the GKL and filing the neces- into account Fund Ackzionirovama the privatizaion sary documents, they or their representa- Rabotnikov (FARP) shares that are as yet tives in trade unions, industry associations, unpurchased, but reserved for workers. program. and parliamentry fictions, along with the The Russimn Pariament added to the pri- communist and nationalist extremes, were vatization program the right of workers to bitterly de-.ouncing the pivatization pro- purchase an additional 5 to 10 percent of gram Twenty-three interviews were con- shares using FARP When asked to specify d-acted before voucher auctions began in how much state ownership would be opti- December. These discussions contain re- mal, most senior managers answered zero; peated and strong denunciations of pnva- in fact, less than 5 percent of those 150 tization, cnuism that rules and general directors internewed defended regulations were unworkable, caims that any future ownership role of the state in the (short) schedule to complete pnvatiza- their enterprises. Thus, despite continued tion was unachievable, and talk of plans to citicism of prvatization, almost all senior change the direction of the program managers overwhelmingly support the through political acion. Yet, almost every basic pnnciple. Nevertheless, most gener- enterprise completed the process, more or al diectors expressed mixed feelings about less on time. Indeed, even enterprises the specific mechanisms of this particular where respondents were most criticd pro- privatization program by fredy offering duced a detailed written privatization their ideas for redesigaing the entire plan, which usually followed the outlines program. 126 RUSSrA: CmEANG PRIVATE ENFRnRssAND Emawrr MAnrErs Ownership results (10 percent) whose current ownership at the time of the interview was not majority According to GKI's 1992 report, 63.7 per- employee ownership, seven had originally cent of all enterprises going through the chosen option 1 and six option 2. The re- program chose cosed subscription, that is, duction in ownership in the six enterprises majorty employee ownership; 70.7 percent that orginally chose option 2 reflects sales of medium-sized fims and 60.8 percent of of shares by employees to outsiders. lage firms also chose that option. About 3 Although the price of shares is a better percent of the 127 post-privatization enter- deal under option 1, most enterprises still prises in our sample chose option 2; but a choose option 2. IThis is evidence that the significant 45 percent went for option 1, overwhehning concern is formajority own- which does not give empioyees and man- ership- Of course, the more the liquidity or agers quick control of enterprises. Why? access to finance that insiders had, the Part of the answer is that in large firms it greater the likelihood of enterprises choos- may be difficult for workers to raise the ing option 2. As inflation incrawsed, insid- funds to apply option 2. But, it mus: alsobe ers found they could use resources in ralized that insiders can fairly easily enterprise accounts to make a cash pur- achieve majority employee ownership no chase, and this is precisely what they did. matter which dosed-subscription option Indeed, many enterprises reported that they choose due to subsequent opportuni- they easily effected the purchase and had ties to buy shares in various auctons. resources left over for participation in Instead of serving as two disigble voucher and cash auctions. forms of ownership (one majority insider What was the ownership pattem after and one majority outsider), the options privatization? Enterprise managers were have instead served as two mechanisms to asked to describe the current ownership of achieve similar goals for insiders. their companies. The average total employ- Thus, the initial decision on which op- ee ownership in the interviewed firms, in- tion to choose is not motivated by majority duding FARP (which is essentially a employee ownership. The reason is that sapplementary mployee share ownerhip most of the enterprises achieved majority opportunity) is about 65 percent; without employee ownership anyway, no matter FARP it is about 63 percenLAs noted, few what option they initially chose. Rather, it is enterprises that had chosen option 1 or op- motivated by an evaluation of means The tion 2 failcd to achieve majority employee decision is based on many aspects of the sit- ownership. In the case of firms that chose aution whether majonty employee owner- option 1, insiders bought more shares on ship can be quikly and easily secured after the voucher or cash auctions and repur- option 1 by buying more shares in auctions chased shares from outsiders who partii- or on the secondary market; whether em- pated in voucher or cash auctions. ployees and managers can afford to pay the Among the 127 post-privatized finns, higher price for option 2; the perception by the average equity stake owned by top man- the workforce that option 1 shares are a agementisabout8.6percerlt(median5per- better deal because dtey get 25 percent of cent). The average outsider (nonstate) the shares free, a discount on anothr 15 ownership stake is about 215 percent (me- percent, and pay only the pre-inflation en- dian 20 percent). A significant number of terprise value; how strong the desire is to enterprises (57 percent) achieved sizable gain inmediate control of enterprises be- outsider stakes (20 percent on average) and fore other mechanisms for selling shares to individual citizens acquired meaningful outsiders kick in; and the perception (real stakes. Blockholder stakes are defined here or imagined) of immediate threats to the as those comprising of more than 5 petcent control of outsidebuyers of shares. Of the of sto I is the 43 perent of enterpises 127 enterprises studied after privatization, without blockholder stakes where there is a 90 percent achieved majority employee potential for consolidation of shares in the ownership. Of the thirteen enterprises or coming months (tables 10-1 and 10.2). OwNERsH, GOVERNA, AND REsIRUcRuNNG 127 'What do these numbers say about the Table 10.1 Distribution of share results of pivatization? They provide a ownership powefl explanation of how, with a (percent) seventy-year history of communist control Average Medi3n of enterprises and state ownership, the GKI Ail insiders 65 60 mnaged to pivatize 7,000 medium-sized Top management 8.6 5 and large enterprises in less than tWo yeas outsiders (ntnstte1 2L.9 2 Indeed, msider ownership incentives seem to explain why the grass rots of Russian so- ety acrmss most regions cooperated. Table 10.2 Distribution of outsider Senior maaagers favored majority insider stakes ownership,overany kindorstructure, asthe L PrivatiZation equals initi form of ownership because they fa- Enterpises with blockholder stakes 57 mizfla orunship, vored sepaation ffrom the state. Enterprises without blockholder stakes 43 PIvatzanon equals mafia ownership, AveSg Median said R Ian said Ruslan Thasbulatov, former Speaker of Khasbulatov, the Russian Palament who repeated it fre- Allenterprsesinthesample 1 6 former Speaker,of quently on Russian television before his ar- Individual citizens 4 1 the Speak.e of rest in October 1993. Caeful study of the Onwy enterpnise wit blockholder shares data, however, suggests that sweeping Individual dtizeens 7.2 5.7 Parliament... cim that privatization has been hijacked by the Russin mafia is open to serious ques- ion. In our interviews, enterprise general the privatization program that no one in- drectors were asked to identify major out- tended. to achieve. That is, throughout side buyes of shares. In more than 90 per- 1992, many enteprise directors and sup- cent of the cases, they were invemnt porters of employee ownership said that the finds regitered with the goverrnent, com- govenment's claim that the program was in panies with previous ties to the enterprise, the interests of workers was a fraud, be- identifiable specfic Russian or foreign in- cause it did not provide employees with suf- vestors, or idviduals in the local commu- ficient access to credit for shares, and nity The asseriion of mafia ownership or because employees and managers would control was never made by enterprise man- never be able to buy a controlling stake- agers. Wie mafia interests maybe lurking Some Western supporters of employee behind some ownership agents, the data ownership took up this issue and repeated does not reveal such an inrvolvement- the claims. This criticism was featured What accounts for the gap between prominently in the pre-privatization inter- claims of mafia involvement and the facts views (beforethespringof 1993). Wie in- on the ownership disibution in the enter- siders in some bigger enterprises could not prises? In interiews where the word mafia fund 51 percent of the shares under option was mentioned, it became dear that mmny 2 immediat4 there were very few where a senior managers consider this a catch-all dominant insider stake of 40 to 51 percent phrse to descrbe any unknown, unwanted, was not easily achieved after the voucher or unpredictable outside buyers who might auction. threaten their control ofthe enterprise. This The real argument about employee desire to tighdy manage change is und&- ownership is wheher the 7,000 largst non- standable -v the decades of state owner- militay enterprses in a big economic pow- slip and control and the acute unceranty er like Russia should be cbsely held of what will happen after privatization, but companies, controled by small groups, or it is inconsistent with an efficient market open, public corporations with potential for economy- investor involvement and ownership sakes Subsantil employee ownership in the by all cis of Russia. Enterprise man- majorty of enterprises also disproves the agers saw 100 prcent ownership as away of clim that insider ownership was a goal of ensuring that their firm would not become 128 Russ& CREnaG Pavns ENENss AND EFPrKENrMAJJEI a public corporation easily open to un- average of 8.6 percent This is hard to ex- wanted investors. When they did not suc- plain given the ovrwhelming desire of ceed in making the privatizaion program managers to control their firms. Frustrat equal. 100 percent inside ownership, they over the low level of trop management own- used a varety ofmethods to make sure dtt ership is a major message in almost every they achieved majority employee owner- one of the 150 interviews. Most managers ship and insider controL Despite the fact that discussed this problem pointed to four that ty sewved as straw men in the argu- reasons for low top management owner- ments about the owneship format of pri- ship. First, they lacked personal funds to vatization, the opposites of the ownersbip partcipate in closed subscription, voucher, spectrum-closely-held companies with or cash auctions to the desired extenL many owner-do not represent the only Second, nonmanagement workers would optios for these firms. have been upset if managers acquiredlarge Ptivatization has The issue of management support for stakes. Tird, managers felt that the gov- achieved more employee ownership is more than aca- emient undercut them by not providing demic A purported government plot them wnth special deals in order to acquire employee o°nwnhip threatening employee interests and owner- eqiuy And fourth, a few senior manargr than in the U.S. ship motivated the Russian Padiament to felt that tying up their money in a firm's stock marketj which conside radical changes to the pgram in shares was less important than controgllng Febuary 1993, and again in October 1993. shares by marshaling their influence with has more emplyee In Februur a wide-ranging public discus- workers or gemng a friendly investor they owntesip than any sion took place on a fourth closed sub- could influence Wester stock scription option that would allow 90 Therisnoquestion,however,thatgen- percent of ail entprises to be purhased ernd directors expect to consolidate and cxc- market.- on state-given crdit at puchas prices that pand ther holdings. A small survey of wer not adjusted for inflation. Is option twenty-five entaprises i seven regions of would virtuly eliminate the vowuer pro- our sample showed that 52 percent of se- gram by allowing only 10 perent outsider nior managers had plans to repuhase em- p.aricpation. Large blocks of sock would ployee shares (two general detors did not have been put m trusts whose divdends answer the question posed). Moreover, 32 and votes were controled by senior man- percent of the senior managers had plansto ages (Blasi 1993). This proposd failed to organize a trust to collect and vote the em- win approval after a tough public fight was ployee shareholding, use pmxy voting to waged by the Deputy Prime Minister maintain control over the shares (one-third Anatly Chubais and the GKL of the general directors refused to answe In October 1993, in an attempt to 're- this question). cover the good features of opton 4," there Privatization has achieved more em- was a proposal pattmened on the American ployee ownership than in the U.S. stock ESOP (the Khasbulatov proposas) that makdet, which bas more employee owner- would allow employees and managers to ship than any Westem stock market (Blasi borrow money from the Russan govem- and KIuse 1992). In the U.S., 7,000 firms ment to repurchase the shares bought by in the market have less han 5 pecnt outsiders (Rutgaiser 1993). Again, these broad-based employee owners4 Burem- shares were to be held in trust and voted by ployee ownership has been growingwith an the general director. The proposed law average of about 15 peet employee own- would eminate outside ownership entirely erslip in roughly 1,500 of these corpora- and destroy the voucher pmgram; but the tons, and the set of firns with employee bill was never introduced because it was ownership geatr dan 20 percent is rapid- overtaken by the other events of October ly growing. Some defienders of more insid- 1993. cr ownership in Russia claim they are A most surprsing fict arsing in the in- emiulatingwidespread employee ownership terview is the low percentage of top man- in the U.S., which is, of course, incorect. agement ownership m the enterpnses, an The senior managers gave inaccate and 0wmmsw GOVERNCE, AND RESTRUCaJRJG L29 xaerted stics about U.S. cmployee ostensibly m support of expanding employ- ownership that provied thiir argument ee ownership in general and naking it eas- with the necessary Legiimacy and to cover ier to secure employee ownership through their desire to have signifcant ownerhip state-provided credits in particular leary, stakes for wp managmenL ownership agendas (such as the option 4 and the E :bula proposal) were simple Opdml ovmership attempts to doak managers' self-interest, (which the public would have had a hard Top managementwas asked howtheywould tme swallowing) with the mantle of almost design the ownership of the firm to mci- completeemployeecontrolthmuglnearto- mizetheefficiencyoftheenterprise.There- tal insider ownership; the ultimate result sults are reuealing (table 103). woud have been the end of the voucher ... enterprise Top managers' man complait with program by giving additional credits to em- Managers .. belieVe post-pnvatization ownaeship structures is ployees to repurchase al the shares that had that they have a small sk Managers uni- been awarded to outsiders. that subsuntial top versly want to increase their stkes (and In both option 4 and the Khasbulatov management gain control) and drastcally reduce broad- proposal, the general director of the firm ozwership is basedworkerownership.Thepercntagere- would be the sole tustee of employee-own- duction in empoye ownership, managers ership shares, vith furll voting control over necessary for the propose, is on average 33 peret (median these shares Option 4 also gave managers efficiency of an 26 percent). The proposed percentage in- income over the dividends of many of those enterprise.., and crease in outsider ownership is on average shares. As noted, many enterprise m gers 5.5 prcnt (median 10 percent). Manage- are designingsharebuybackprogramstore- that, in Russia at ment would lice to see its own ownership purchase employee shares and to consoli- the present, outside stake increase b aaverage of 31A percent dateandepandtopmanagementholdkings investors cannot or (median 25 percent). This data tends to con- It is too early to tel, however, whetier man- fim the widely held noton that general di- agement-dominated trusts or simply pur- will not play this rectors wih to pesonay control their dhases of shares from workers will be the role. companies. Indeed, they wish to control dominant method of attempted top enur- most of the top mangemet ownershp pnse manager cntol over dtese corpora- stake, althoug data on the genral direc- ions. Agt the back-drop of these tor's optimal ownership for himsef (or her- agendas, it is an impressive achievement self) was not avalable for each company. that the government's program managed to When asked what the total optimal rank- hold top management ownmersip to such and-file employee stame should bee, general reasonable levls and to introduce substan- ditors indicated rouly 15 percent This tial levels of outside ownership. In addition, is an interesting coincidence, g-en the U.S. the program resuted in small levels of state average for rank-and-file employee owner- ownership and the govemment succeeded ship stake is 15 perent n public compaies in holding back legislative proposals to ex- with employee ownerip. pand insider ownership even more in 1993. This data calls into question the sincen- In teir part, entepise managers offer ty of intensive campgns by mnagers, an economic analysis to support their Table 10.3 Optimal ownership of ,5st-privatized Russian enteprises daums They believe that substantial top accoding to the senior managers managemnvt ownersi is necessary for the rWen efficency of an enterprse on the reasoning Average Median that large enterpises need single or core groups of influential owners, and that, Optimal employee ownership (exduding top management) 32 35 outside inveswrs are unwilig to Optimal top management ownership 40 30 Optimal outsider ownership 27 30 play tis role. There is some logic to this ar- Optimal general director ownership 31 20 gument. Manage do not, howevez, gener- Nbte: A tedual analsis of all 150 interviews confifm s*tee trends. An updatea anasis of all data ,ii be ally know or appreate the role that stock aalable in March 1994.Top management is defined by the general diector as the topietotn members market investors and independent boards of the executhe team. Soume: Summer 1993. Jaruary and March 1994 sample oi 74 enerprise play in developing a well-fiuntioning firm. 130 Russu: CRnNG PaRna ENrE.rmmANDbFaw E NT AUn More tban tree-quarters of the nterviewed ivestors and we would reserve 20 per- enteprise managers say that they truly be- cent for diem. The rest 3040 percent lieve the largest Russian companies should would be disbuted among the em- opimay be more than a third owned by the plcyees of the enterprise but top man- top five to ten managers. WnUess these agentshouldgetthemajorityofthis, statements: say 30 pcent -Meapmv&tpm Vovnb The problem is not with prvate owner- ship but wih the ability to control em- Look at the situaionwe have IdaThe ployees.tispossibletohave:5 percent top management has only 5-10 percent owned by employees and the rest gv of the shares and the labor colective has to managrs ins voting trust that gives 30-40 percent. They are shareholders managenent the posslit to control buttheyarenotreadytoconsiderthem- the enterprise Managers must per- selv as owners. The enteprise needs a suade the state that ey can really man- real owner It is evident that those who age and if managers run the enterprse feel themelve responsble for their en- propery the stat should sell them terprse and int d in increasing shares at nominal value. Managers profis wM concentrate big amounts of would work hard for their ownaship in shares in their hands in order to contro order to get shares from the state. I the company: think that almost all would support that -Clig phlt Tve the govemment would sell them shares under this methodL And there is one In realit we want at least 60 prent to more fature Shares should be owned be concentrated in the hands of the top by m professionals. Now managersandtherestlobelongtosmal tey are bought by people who have outsiders. Employees ae interested in noig in common with pmducmn dividendsbutnotinvestmentsbutman- who got their money from trade opera- agers are more intersted in big pro- tions. This is a negative feaue that pre- grams for the development of the plant vents the development of production. It is betterwhen all shares are accumu- -Takfoaory, K1sk lated in the hands of several owners. -Seel plan Vologd reion The optimal distribution of ownership would be fior top managmet, employ- Top manager were almost uniformly ees and the outside investorwho brings negative in their evaluation of broad-based a lot of money for each have a tiird of employee owneship. They consider majori- the company. ty emplyee ownership to be a tansitional -Elctonicsplant, Yamslz phenomenon. In general many top man- agers have plans (or hopes) to develop em- Managers should ga east 25 pcent ployees into responsible sharholdes Thi's ofthe shares. By this Imean the top ten is somewhat disingenuous given their own people. The employees should have 25 spiited attack against te vemens percentofthesharesandtherestshould motives for indudig employee ownership be in the bands of citizen, preferably in the program and how it operates.'he pri- equal amounts to two to thre suppliers vate opinions of enterprise managers are in- of the firm. teresting, given the respectfil publc tone -Food-processing plant Njiy Nosrgord surroundingboththeoption4andtheRhas- bulatov employee ownership initiativet. The optimal structure is for 40-50 per- cent tobe in the hands of supplies and We want to create a controlling share- customers who supply raw materials hokler group and we have a strategy to and buy our mawhines. Our enterprise accompish this by the end of the yea would be open to foregn and domestic W will start buying share sold to our OWN,sHn. GOVEiWNc3, AND RESnRCTMJG 131 employees thmugh the closed sub- people. It seems surprising but people sciption and sold to them on the steal and drink even more. think that voucher auction. The optimal owner- those employees who want to have ship structure is for the top man- shares for profit should have nonvoting agers-fourteen people in our firm of shares. 1,100-to have a majority of the own- -Housebdopplinceplat, Novosibikk ership of the enterprise. Now all em- ployees are shareholders but not an Attitudes about mnanagement owner- owner. Employees you see are nor the ship favor sole proprietorship and closely- same thing as an owner. I would say held companies whose shares are not that top management would have no traded on exchanges. Senior managers more than 60 percent while the gener- have trouble recognizing that several 5, 10, Atuitudes about al dirctor himsdf should have 33 per- or 20 percent shareholders can own shares management cent of the shares. in their enterinse and influence its direc- ownsbip favor -De_ rtent store, NXjy Novgorod tion thrugh a board of directors or through contacts with managemenL They sole proprietorship Nothing changed with employee own- believe that day-to-day execuave control and closely-held ership. The ownership of every em- by management is not possible without an ployee is too small and we do not ownership stake in excess of 30 percent companies whose suspect there will be significant divi- and furhier stakes in the hands of investors shares are not dends. Employees started working bet- chosen by top management traded on ter but it is not because of employee Further study is necessary to under- ex:cbanges. ownership but because of unemploy- stand the extent to which general directrs exchanges. ment in Russian firms expect to control most of --See- pLn Cbewpovecr the top management ownership block per- sonally Such enterprises should belong to one How does this data on top manage- person, bui our employees wfll notun- meat ownership and expectatons compare deand this. They are interested in with the West? Management ownership is their salades but not in the manage- widespread in the U.S. and has recently ment of the enterprises. They do not been studied in detail (Blasi, Gasaway, and want to have aheadachebecause of the Kruse 1994). Average top management problems of the enteprise since they ownership is 10.9 percent in the 7,000 have a lot of their own problems. But public U.S. companies; considerably less our tadition of equal rights influences in Fortune 1,000 companies (usuallyunder the process of privatization and a lot of 2 percent) and somewhat larger in smailer time will pass before everything is public companies. There is no relationship made property. between the size of top management own- -Food-procesing pa4, Riazn ership and supenor econonic perfor- mance in the U.S. stock market. Rusian Regarding employee ownership, em- general directors often claim, wongly, that ployees do not understand what own- they are emulating Western management ership means to them. The only ownership practices. The more central advantage of employee ownership is questions arewhether a widely held public that the state now has no right to in- company with numerous small sharehold- terfere in the business of the enter- ers is what Russia's emerging capitalist prise. firms need to restructure and to operate ef- -Trdlefactory, nvo!region fidently and whether eastng manage- ment can or should play the historical role Anyway workers did not become own- of the capitalist entrepreneur-the core ers. Employees just stay to oe hired ownerorinvestor Examiningissues in cor- people. And now they spit and swear. porate governance wil facilitate a closer We need dozens of years to dhange consideration of these problems. 132 Rus: CREANG PritATE ENTERSE AND EFxamrMWmrs Corporate governance The "traditional" method of board election (as practiced in most U.S. corporations) in- The trends in corporate governance in the volves a nominating committee controlled interviewed enterprises were uniform. Top by the existing board and the chief execu- managers have engaged in actions that es- tive officer Management detemines a slate sentially turn the firms into closed corpora- of nominees and can usually ganer 51 per- tions, take them out of the market of cent of the votes necessary to elect the en- corporate control, emasculate employees as tire slate from passive shareholders and ihareholders, restrict outsider access to in- institutional investors spread across the formation, and tightly control boards and country who generally vote the manage- shareholder meetings and registries. ment slate. In Russia, this traditional Most senior managers reported putting method is made easier because the general offthe firstgeneral shareholder meeting for director does not have to guess about col- Top managers have as long as possible. Often, a reason (or ex- lecting the votes of diffused outsiders. A en aged in actions cuse) was that the 10 to 20 percent of majority of share isusuallyheld byinsiders, g g shares held by the Federal Property Fund most if not all of the nominees are insiders, that essentially turn had not been sold. Once the meetings were and the resut is more predictable. Despite the firns into held, less than 10 percent of interviewed the predominance of insiders, the wariness closed corporations, firms alowed confidential votrng of shares. of rank-and-file employee shareholding is The typical pattern is for shares to be vot- clear in boad structure; less than5pre take them out of edbyashowof hands. In largerenterprises, of the companies have -nt- the market of cor- representatves of employee shareholders employee representatves on their boards porate control, are chosen and given proxies to attend the Neverteldess, a closer analysis of the o atc meeting-that is, all employee sharehold- outside board representaton issues indi- em late ers do not participate. Almost all senior cate some fenrent employees as share- managers who discussed a sharholder * In November and December of 1993, holders restrict meeting in detail reported that they could general direaors weir asked whetier predict with confidence that the ma-m deci- they would support a mechanism such outsider access to sions they suppored would be voted in be- as cumulative voting for boards that informatior, and fore the meetng. Frequenty, the managers would allow minority shareholders to tightly control reported that this was due to their implicit attain board seats. The sample was boar& and share- control of the employee shares- because small but there was a growing willing- I have good relationswith the laor collec- ness to accept cumulative voting holder meetings tive'-their explicit personal control of the Perhaps, this can be explained by a and registries. votes in a trust, or a public method of em- recognition that potential large outside ployee voting of shares at the meeting that investors will demand board seats. rendered unlikely disputes with manage- * In January 1994, President Yetsin man- mentes position. dated new shareholder meetings before How are the boards of directors struc- the end of April 1994 with cumulative tured in the 127 post-privatized finms? Top voting. In February and March of 1994, management members numerically domi- interviewers tried to ascertain specifical- nate the boards in over 90 percent of the ly whether the Yeltsin decrees on cumu- finns with a majority of the members. Most latiue voting were being implemented. Russian general directors come to a board The general directors were exceedingly meeting with other manages who are their unwling to discuss this issue and many direct report. Fewer han 5 percent of the expressed strong disgreement with the boards include more than one outside citi- law mandating cumulative voting There zen or commercial or foreign shareholder is little evidence that cumulative voting In almost every enterprse visited before has been implemented except in a very February 1994, insider shareholders usually small number of firns. In several of controlled a majority of the shares, and used these cases, we discovered that cumula- the traditional method of board selection to tive voting had been redesigned by the elect a board entirely composed of insiders. enterprise to appear to abide by the new Ow1Nnnr GOVEmANC AND RESfTRRUIUNG 133 regulation while giving insiders firm nority shareholders can be expanded, control over the newvoting mechanism. blockholders already have an ownership To fiuther complicate these findings, a foothold in this significant numrber of substantial percentage, 32 percent or privatized firms. And an important fu- eight out of the twenty-five firms visited ture agenda for Russian privatization is in seven regions in February and March policies that encourage the sale of the of 1994 were found to have nongovern- shares that remain in government hands ment, outside shareholders on their to newblockholders in firms that do not boards of diectors. In three of the cas- have large outsider stakes. es the outsiders outnumbered the senior These disparate impressions do not lend managers- In the eight cases, outsiders themselves to a clear condusion. But they ownership stakes were 53 percent do suggest that outside board representa- Clearly, (voucher hind), 47 percent (commercial tion may be more widespread than original- management firm), 28 perent (commercial firm), 20 ly thought. They suggest that private entrenchment percent (businessman), 16 percent arrangements with outside shareholders, (commercial firm). 10 percent (voucher not the government decree, seems to be the regarding boards, fund), 10 percent (voucher fund) and 0 initial explanation for this phenomenon. shareholder percent (local expert). Unfortunately in They suggest that industry group alliances none of these cases was there evidence (kereitzu) may be a better explanation for a meetings, and that the outsiders elected as a result of lot of emerging outside board representa- shareholder registers the new cumulative voting decre. All tion relative to independent outsiders. A leaves the door total in the twenty-five firms, there were more definitive statement on the incidence forty-four outside government and non- of cumulative voting wll onlybe possible in open to abuse... government board members out of 187 the mid-summer after many of the 127 en- board members. Onlytwenty-one ofthe terprises have ben revisited and that data forty-four board memberswere not gOv- is analyzed erminent representinggovemment own- If there were an inquiry regarding the ership stakes. Of these twenty-one shareholder register almost all senior man- board members, could be considered agers would say that shareolders can see members of commecial firms that had only the numrber of shares they personally an liance orkereitzu arrangement with awn in the register. In every firm inter- the general director. This pattern is fur- viewed, the shareholder register was main- tier reflected in examining the top out- tained by management, although this was side shareholder of the twenty-five due to a change by government decree. finms. 36 percent of the top outside IThere is inconclusive evidence about how shareholders could be considered to be many firms are honoring the decree. commnercial finns that had an alliance or Clearly, management entrenchment ri- kereitzu arragenmet with top manage- garding boards, shareholder meetings, and ment. And 60 percent of the general di- shareholder registers leaves the door open rectors have a positive attitude towards to abuse, including decisions by manage- associations or holding companies in ment to dilute outside shareholder interests their industries that could potentially by sales of new shares to insiders, changes play this role. in the corporate charter which enhance the The average outsider stake of 21.5 per- rights of insiders, and attempts to have the cent (20 percent at the median) in the insider-dominated board of directors take 127 post-privatized fimis can be further decisions that should be taken by the share- analyzed for blockholders who have holders meeting. It is not possible, however, more than a 5 percent holding. In 46 to ascertain the exent towhich such viola- percent of the firms there is no block- tions of shareholder rights were taling holder. Among the 54 percent of firms place. In October and December of 1993, that have blockholders, the average President Yeltsin issued regulations to se- stake is 19.63 percent (15 percent at the cure shareholder rights, with a decree on median).Totheextentthatrights for mi- shareholder registers and the 1994 privati- 134 Russm± CEATING PRvt ENT4rnRsEsANDEFncmENrMTArs zation program. These regulations produce Communist past, where production volume a set of simple rules: was more important than profits and corn- • Changes in the corporate charter, the petitive markets It was impossible to ob- charter capital, or major transactions af- jectively clarify whether the general fecting25 percent or more of the charter director's restnrcturing plans were naive capital require a majority vote of 75 per- hopes orwhether they resulted from careful cent of shareholders in general meeting. business planning. Few general directors, * There is cumulative voting for the board however, provided evidence that they had of directors. Employees cannot com- an objective analysis. prise more than one third of the board, Almost every general director said that which must have at least seven members their biggest problem was shortage of cash or nine members where companies have to carry out large capital projects. Only one more than 10,000 shareholders. finn, a supplier to the Siberian oil industry It was impossible to • Annual shareholder meetings must be had readily available capital inputs. Every ob ectively clarify held within 120 days of the end of the other firm was receiving state credits, but X Y /Y fiscal year with basic rules of financial these were, in almost every case, a mere whether the general disclosure. fraction of those needed for capital invest- director's These regulationsbegin to address some ment. This may suggest that firms are bor- shareholders' rights problems, but many rowing to pay wages and buy raw materials restnactunng plans more remain. Further research is needed to and that even continued cheap credits at were naive hopes or darify the level of awareness of these new increased levels would not succeed in re- whether they regulations and the extent towhich they are structuring the enterprises. Before the res- resulted from being followed. Initially, it does not seem ignation of key government reformers in c I that privatization has a big impact on cor- January 1994, the government was report- careful business porate governance. But this should be put edly debating whether it could manage to planning. in context; there is growing discomfort of continue existing credits. investors in Western economnies with man- Another major problem for enterprises agement entrenchment and its inpact on was high taxes that curied their ability to corporate perfornance. Independent direc- use internal financing. Unfortunately, from tors staged coups in few major U.S. corpo- the perspective of the enterprise, even a rations in 1992 and 1993. Even so, government that chooses to offer extensive management-dominated boards are the state credits may still impose high taxes on rule in most Western economies (Oxford profits, thereby eliminating the ability of Analytica 1992). Since the goal of privatiza- firms to meet their capital requirements. tion is not simply to change from state to pri- High taxes on profits are seriously discour- vate ownership, but to create private aging capital investment through retained incentives so that the companies can be ra- earnings. A prelminary conclusion would tionally restrctured and improved, where be that real enterprise restructuring will not are the implications of our findings for re- take place without subsantial outside in- structuring prospects? vestment This is an objective barrier to re- structuring. Restructuring There are also some subjective barriers. The main problem is the expectations of se- Almost every enterprise manager had ex- nior managers about their power and own- tensive plans to buy mwahinery and imple- ership. Enterprise directors were asked to ment capital investment to rebuild, expand, estimate the total investment capital need- or renovate. Few general directors envi- ed to restructure the enterprise. They were sioned sbrinking the business (that is, sales asked for the total ownership they wished to of units), reducing product lines, or focus- have fortop management and for outsiders. ing on dear high-margin products or ser- They were asked who they preferred as out- vices. Every general director wanted to side investors.And they were asked for their expand and had a strong bias towards more attitudes about majority outside investor production. Unfortnately this echoes the owncrhip. OwNERsHr, GOVERCE, AND REStRUClRNG 13S Consider a hypothetical case where an ownership, it should be noted that man- outside Russian or foreign investor comes agement's main concern is to retain control to the enterprise rcady to invest the capital in order to direct the firn as they see fit. top management believes is necessary. The Personal ownership, trusts, employee prox- first problem is that the total capital need- ies, kereitzu, and domination of the board ed for restructuring, translated into share are the various means used to implemcnt capital, represents a far greater percentage this desire. Moreover, most of the enter* of outside ownership than management has prises are receiving state credits thmugh allotted in their minds. The second prob- commercial banks that are supplied with lem is that even if management is prepared credit by the Central Bank. These credits to reduce the stake of insiders in general, are presently supplied without any attempt they want to reduce it in their own favor. to evaluate their end-use, the expected Moreover, most of This would not be a bad idea if managers profitability of the (purported) investment, the enterprises are put real capital into the firm, based on the or the firm's ability to repay the credits. receiving state real value of assets (in a firm with good Keeping enterprises afloat through cheap receiving state prospects). But managers universally say credits simply magnifies the fairy-tale envi- credits through that they lack cash. Thus, managers want to ronment in which top management lives, commercial banks increase the ownership stake of a small and gives them another incentive to avoid group (rhemselves) who lack cash. Since an making ratonal decisions. that are supplied outside investor's infusion will dilute not There is insufficient information, too, with credit by the only the stake of employees, but also the on what the shares of enterpriscs are worth. Central Bank. current small stake of top management (5 One reason is that the selling price of most to 10 percent), then management generally enterprises in the dosed subscription and opposes, or at least is deeply suspicious of, the voucher auction was based on pre-in- their involvement. Rlation valuations of fixed assets, and does The third problem is that 60 percent of not take into account current prospects. top managers oppose majority investor Also, the lack of a stock market further re- ownership for reasons of control. There is a stricts the ability of the enterprises to raise lack of data about what employees think, capital at realistic prices. Moreover, there is but the general directors' adoption of this little data on which to base an objective view is certainly troubling. The fourth and analysis of the expansion and restructuring final problem is that a third of general di- plans of general directors. And finally, the rectors feel that outside investors should be corporate governance structure and related suppliers, producers, or customers predilections of general directors prevents with whom their enterprise currently doe5 them from gerting input from anyone oth- business. Yet, many possible partners are er than members of their board. Thus, any like the enterprises in a difficuk situation policy to restrcture enterprises will have to seeking their investment taclde each and all of these problems. To these attitudes of management, one Senior managers were asked what kind must add a number of technical problem-; of "kno-rledge-oriented" technical assis- in arranging restructuring through capital tance they would require, if it were provid- infusions. General directors are so fixatec ed for free. Responses reveal an interest in on arranging the ownership, that some are detailed information about equipment and selling stakes at "bargain basement prices" technologies in their industry and certifica- to related suppliers, producers, and associ- tion of products, operating in foreign mar- ations, as well as making plans to sell more kets and preparing documents 'ir exporting equity to other suppliers, customers, and (in terms of laws, currencies and technical producers. This scarcely answers the ques- arrangements), marketing, preparing busi- tion of who will put significant amounts of ness plans and managing the finances of the money into the firm. While it is true that entire enterprise, stock markets, the laws arrangements of sweetheart equity deals and legal norms of joint stock companies, forfriendlyoutsiders contradictsthe notion and likely imvestment partners overseas. that management is fixated on retaining Many enterprise managers have specific 136 RussiL CREATING PRIVTE ENrsEs AND EFFiCENT Mm rn questions about how bnks, suppliers, pro- govemance the ganral dircors favor. Most ducers, and consumers operate in ocher of the technical assistance gaps limit the countries. achievement of pe in their facto- It was surprsing that many general di- ry, their industy, their products, and their rectors, who were generally wMiling to speak own performance. This pepective is exact- for hours on many subjects, had crypti or lywhat they need to dealwithboards that are no answers regarding technical assistance incapable of giving tecnical blunt criticsi, needs. One general directorsaid that he felt capital investment plans that may not be ob- as if he was being asked to choose foods in jectively conec, and preferences for man- a cafeteria, without knowng the menu In ageial ownership that may be unrealistic. fact, enterprise managers in our sample The evidence is not all bad news. There have only a sketchy, impressionistic, and in- are preliminary signs of restucturng From complete idea of their technical assisunce a sample of forty enterprises sured, 58 Managers do not needs. percent reported new product development have... basic Severl needs which-in the opinion of Ffy-eight percent of enterprises also reprt- the intenrvewers-were evident from man- ed contacts with fiainvestr and about ifo tion about agers' discussions of their problems and op- one-third reported specific discussions about major world eranons were never clearly identified: jont ventures wih foreign investors. Fifteen competitors, Managers appear to need more under- percent of the enterxps surveyed were al- standing of how to negotiate with a do- ready invoved in joint ventmres with dames- potentil major mestc or foreign investor, price a tic or foreig investors. There is also some suppliers, and prposed investmen, and establish the cvidence that geneal direcroswished to de- potential customers rig and bilite of both aease enterprise obligaons regarding soci parties; assets such as housin d ns o outside te former * AIq lack infonnation on accounting on. Only one-third of the generld diectors Soviet Union... system that woud allow them to care- wanted to expad socid assets or keep exit- *flly discern the components of the re- ing services, whe two-thirds had given or aIl cost of prducts and wich ones are planned tO give the social assets to the mu- high- and low-margin; nidpalities to manage. * Managers do not have the names, tele- phone numbers, fax numbes, aDd ba- The role of employees sic information about major world competitors, potential major supplers, One might assume that all these majonty and potential customers outside the employee-owned enterprises are in fact be- former Soviet Union, various sources having just like the employee-controled for technolog3 research, and macin- fim which Western theoretical economiss ery, and internationally known investors have been discussing for the past twenty or financial organizations that invest in years. Each general director interviewed their industry was asked to comment on the role of the la- • They do not have enough infornation bor collective or the trade union, the level on measuring productiity and how and growth of wages and benefits after pri- their performance compares with com- vatization, the enterprise's plans for con- pewitars in Russia and worldwide; tinued funding in the social sphere (such as * They do not have enough training in fi- for housing), and trends in employment. nmncial analyis to compute a reason- The findigs were uniform. able estimate of the stake of their firm Some economists have predicted that they would have to sell to an outside in- employee-controlled firns would divert vestor (and at what price) to turn profits into wages and benefits for wokers around the business. and away from capit investment, tat effi- There is an interesting relatonship be- cient management would be inteupted by tween the technical assistance gaps, the worker control exrcised by a worke-domi- objective and subjective barriers to restruc- nated board of directors, and that employee tuing, and the dosed system of corporate ownersip would exit as a threat to outsider OCEMII, GOVERNCE, AND RESIRUCrURNG 137 shareholder ownership. Looldng at the sur- Third. the boards of directors are not at face, one might be tempted to conclude that all worker-controlled. There are nonman- n present-day Russia, after seventy years of agement employee representatives on these Communsm, the employee-controlled boards in fwer than 5 percent of the cases. nighitmare of theoretical economists was Most board members are top managers who comnig true and that employee ownership is report dirctly to general directors-who al- the central barrier to restucturing firms pri- so control the shareholder register, the agen- vatized to insiders. da of the board meeting, the by-laws of the We argue differently First, in our view, joint-stock company, and credit relations. tese posr-privatizedenterprises are not em- Workes in the jobs stdied are passrve as ployee-controlled as defined by theoretical both shareholders and trade union mem- economists. The seimor managers bers. There are very few firms where work- interviewed report that the collective bar- ers can confidentially vote their shares, and gaining relationship between the union and sotakeabigriskopposing ranagement Top management has totally broken down in the manr inteviewed tend to view the em- post-privatizedenterprise General directors ployee shareholder in the samne way that en- report that they are unilaterAlly making de- trenched managers of American fims often cisions on wage increases and the norm is to see the litdte old lady in Wisconsin who owns mcrease wages every fewmonths based sole- ten shares-they are a techncal nusance, a ly on inflation. But they report that they are problem to be effectvely m mnged trugh eitherdeaeasangbenefitstoworkers,charg- the manipulation of board meeung and ing workers for benefits they once received shareholders meeting. for free (such as housing), or planning to Fourth, managers also reporE that the wihdraw the firm from serving social we- trade union in most companies is a perfunc- fare finctions. Whe managers report that woryorganization. Indeed,theoverwheming dwy think workers are only intersted in conclusion about employee ownership is salaries and dividends, they do not report near complete passivity on the part of the any significant worker voice in the determi- Russian worker This is not surprising since nation of salaries or dividends. Thus, these it is entirely consistet with fifteen years of firms are more management-domiated social scientic research on employee share- than woarer-controlled holders in many other countries. Second, it would be easy to conclu-de One might expect that the Russian ma- that post-privatized enterprises lack cash jority employee ownership firm had at least and money for investment because they are protected workers by stabiling or increas- puttng it int salaries. A more detailed sta- ing employment Even this tums out to be tistcal analysis is rquired, but there is litde incorec Since 1991, post-privatzed firms evidence that salaries, which are not exces- havecutemploymentby2l percent. Indeed, sive, bear ansignificant relatonshi to cap- some general directors said that firings and ital invement needed by tei enterpise layoffs, not emloyee ownership, are mong This begs the question about who is setting the reasons some workers are being more salaries. Itisnot theworkers. Most managers carefil about the way they work. This does are raising salaries perodically to keep pace not mean that employment preservation is with inflation, but thy indicate that theqy not a priority When asked how many %.ddi- make the decision about the timing and the tonal employees could be cut if there were extent ofthe raise based on business and so- no social considerations, senior managers cial considerations. Many general directors said about 20 percenL There is no evidence are engaged in a tenuous balancing act as that anployee ownership is the reason for they try to maintain capacq deal with mas- this restraint; it is probably related more to sive receivables, and get enough credits to the lack of a comprehensive soci safety net buy raw matenrials and pay salaries. Aside in the Russian Federation. If a social safety from other fictors weaeing worker influ- net existed and new business development ence, this does not seem tobe fertile gound piked up in Russia, it is unlkly that em- forworker controL ployee ownersh would give workers 138 RussL CREINGPRiAIEENTRTANDEPFIOENTMaR enough control to prevent large reductions Biblography in employment. is woker ownership a teat to outside Blasi, Joseph. 198t Empoye Ownersbip: shareholder rights if the firn is not employ- Reaois or Ripof? NewYr Harper Colins. ee-controiled? Not on the basis of the infor- Blasi, Joseph and Kiuse Douglas. 1992 The New macion obtained in our interviews. On the Owne The Mas Emce of Euploye Orwveushi Wn Plick Copne and Wha 2t contn-ry management entrenchment m MaseoA in &aincC New Mir Han rper enterprises that are legaly majonty Coinns. employee-owned, but not employee con- Blas, Joseph- 1993. An Analyss of Opion 4. trolled, is the major hreat to outside share- listitute of Management and labor Relatons, holder rights. In fact, entrenchment is the Rutgers Universit, New Bnmswic, New major threat to the nghts of insider share- Jers anrd Russian Prvatjat0o1 CMtCr. holders, too. It might be healthier for corpo- AMoscow RussPia Unpublisbed mnanusept The crucial question rategovenane ifempoyeeshaeholers Blasi,josepbhjames Gasaway and Douglas. Knruthe rate gDvernance if employee sharehokldes 1994. Top Mo7gema-n 0=nosbiDp L,Tc U.S. is whlo zall play the could confidentially vote their siare at P19c4Stock Magmet. Owgers UbvrnTieU Nsw shareholder meetings, with the results audit- Brnsick. NJ. Unpublished manuscript roles of core o ers, ed by outside aountants. Employee sbare- Bqycko, Mam, Andrei Shleer, snd Robt W c ital provides, holders might elect outside professionals to Vishnyt August 1993. PriatizEng Russa. Moscow. and monitors of serve as independent monitors of manage- FtussiaRussian Privaftizon Center. Paper pnm- ment on the boards of directors. And it pard for the Brwooigs Instittion Pand on mgangement in the Economnic Artivk September 9-10, 1993. would be healhy for corpoate governance Ox5 resrucurng post- if trusts, holding companies, partnerships, donranca 3BnarM&she=aavcmwrzbe priautizedfirm t? joint stock corporations, and the like are Net Ten Yea- August 1992 Oxford, FngIjnEl used to collect employee shareholder votes OAdirdiAndyca LimiL that could not be voted by top management Rutgais, eiWery Speech to the Confernce on Rather, all votes should be passed hrough Employee Owneship and Privatizaion, the legal entity to the individual employee Supreme Soviet of the Russian Federatiori shareholder September 1993. (Speaker was advisor on em- qc employee ovnership play-d an ployee ownership to Ruslan Khasbulatwv and While employee ownership played an drlafterof tE legislatie prpasat.) important role in providing an incentive for Sm we Cofelegi& naatverionp&ie.) workers to participate in prinatization, the Management of State Property AmmaiREoit. role of employee ownership is not the cen- 1992. Krmlin, Moscow, Russia. tral issue in determining the future develop- State Committee ofthe Russian Federation forthe ment of Russian privatization. The crucial Management of State Property and European question is who wil play the roles of core BankforReconsrmctionandDevelopment.The owners, capital providers, and monitors of Prizzon Mamual, L I and HM 1993. management in the restructuring post-priva- Moscow, Russia The Commission of the tizd frm?Canit ealstiallbe nheite by European Communities. tzed firm? Can it realiscally be inherited by Decrce of the President of the Russian Fedtion existng managers, simply because thry are "On Measures for Seeuring Shareholders' there? While they desire this role, they do Rigs, Number 1769. October 27, 1993. not have the financial means necessary to Kremlin, Moscow, Russin Federation. bankroll theirfirmn Can itbeexternal share- Dece of the Psident of the Russin Federation holers who face daunting resistance by -On The Pnvauzanoa Psogam For 1994-, - - ~~~~~~Numbexr 2284 Deeme 24, 1993. Kelin, managers to their entry into the power struc- N 2 D nr21m. ture, unless picked by management? The Russiant policy challenge now is to assess whether Note thee are any levers to simultaneously en- The author is gratefil to Maxim Boycko, Andrei courage shareholder rights and corporate Shleifer DimitA Vasiev, Johirhan Hay and governance input for outside providers of C fD e ouragement and capital, appropriate rewards for reitting sppor Thanis are also due to the local officials skilled management, and a modicum of rea- of privatization agenaes, and senior managers in sonable employee representation. enterprises for their coopeation. OWNERSHI, GOVERNANCE, AND RESIRUCIURIUG 139 CHAPTERIl Corporate Governance during the Transition to Private Ownership Leroy P Jones and Natalia Tsukanova Who govems Russian enterpnses according complicated ienrchay of state bodies, to whose interests? Prior to 1987 the inter- staffrd b the infamous nomenkLru Their eats of the state were dorninant; aj fifl powcrresided first ofal in thbewrespolsibil The evolution of privatization, the intursts of the sharehold- iqy for appointing the chief executive officers corporate gover- ers should reign supreme. This paper deals (CEOs). This. of course4 is the key corporate nance in Russia is a with the transitional intermediate period, governanceissueand,asaresultthenomen- asking who will control the enterprises in Idkan had grat por over e cisions os five-year story of a the absence of concre policy measures, nsibly in managr ' hands. Other notable remarkable who should exercse that control, ad how po included making invesnezir td transformation can polcy bdge the gap? sions and settmg quantities and pnces under These are important quetcns since the the planned economy system. from one of the perfmance of an economy ultimaly sts rFi mnagers also enjoyed signifcant world's most cen- upon the responses of economic agents to discretion First; tihy exercised operational raliZedgovernanCe their envirOnment. Prvatuon is simply a cotrl over prodcton. Secnd, ty hadt fundament angincorportegoveancte some control over employment and wage structures to one of Since full pvatzaion wi take years under poliqy Fmally they had an information ad- the most decentra- the best of ist nceS the question of vantage over the other parties that provded slized with virtually tansitional governance ais beom them with bargaing power m investment ceta to economic perfmnce. If the paxe andproduction decisions. St, theywere fi complete autonomy of lieraain is a inese funcin of eco- lydepend entonthebranchrninisry bothbe- given to the mana- nomicperformnance-as recent evens gget cause they couid be dismised by the branch sand worke... it is-then transition governance is cntal to andbecause the mnyproidedthemwith gas the whole libaztion efE inpus and efecey bought the outpus. Evolution of corporate governance 1987to 1992 The evoluton of corporate governance m In 1987, the Law on State Enteprse Russia is a five-year story of a remarkable (Association of Enterpris) was passed in transformation from one of the word's accordance with the pmclaimed polic of most centralized governance stmucures (in more democratic socialism. It stated that te 1987) to one of the most decentralized, CEOs'shouldbeelectedbytheconfence with virtually complete autonomy given to of the workers' collectve for a period of five the managers and workers (by 1993). yearsm The appointment then had to be con- firnedbysomehierbody(usuallyabranch The c d Some coporate nfmisty). If an appointment was not con- goverance model firmed then newelections had to take place. While this measure eventualy dramati- The assical Soviet system (pre-1987) iswell cally increased the powers of managers and known. Under Soviet socialim, two partes workers, the process was an evolutionary exercised primary govremance rigt over one. hitially, when workcrs' colectives and state assets: state bureaucats and, to a less- branch ministries disagreed, the bureau- er extent; managers of firms There exsted a crats very often managed to appoint their CORPORATE GVEA CE DUJNG TME h&NsIIONu TO PR1VTE OWNsniP 141 candidates because they still had many vided that all finns were subject to the same levers to pulL Over time, howeve, these taxes and were free to use the rest of the powers eroded and in recent years there is surplus at their discreuon, subject only to virually no evidence of successful attempts control by the State Revenue Service. by higher bodies to appoint or dismiss a There was little room left for the branch CEO. Interviews at dozens of enterprises mnistries incontroloverthedistribution of revealed only a handfil of managerial surplus. changes and these were all precipitated by In sum, as theministries losttheircontrol death or near banlkuptcy Managers serm rnghts, managrs inceased their powers by to have mastered the art of reappointing default. Some of the control rights were in themselves, theory gained by the workers, but in practice The erosion of control of the ministeal the bulk of essential govermance rights came bureaucrats was manifest in other areas as to be exerised effecively by managers. wdL One of the key functions exercisedby the banch ministries in the classical Soviet Post-1992 Corporaztiaon and model was to provide firms with inputs and pxatration to allocate outputs to customers. This sys- tem collapsed with the disintegration of the In 1992, privatization was introduced, with Soviet Union. Firms were thus forced to as- corporatizaion as a first step. The ultimate sume this role, malcing the period of goal is to shift corporate govemance to an 1990-91 vry difficult, as they sought to de- entrepreneurial class. The critical question velop their own complicated network of re- is how long this wi take. There is room for lat wiith parmers. Though prices were concern on this score because in Russian liberalized in 1992, the centralized alloca- medium-sized and large enterprises, the don of resources was replaced much earLier initial step has, in most cases, only legit- by these quasi-marker mechanism. imized worker and manager control, mere- Control over the distribution of surplus ly converting it from defacto to dejure. also shifted. The ministries used to have al- The initial distibution of shares (after most complete discretion in allocating the corporatization but before tme privatiza- firs' revenues. An attempt to restict the tion) is spelled out in the 1992 privatiza- disetion of the ministies was made in don program2 with two primary vanants-3 1987489. Over this period two famous Under option 1, workers and managers re- models called hozraschyot (self-account- ceive 25 percent of the shares for free but ing) and self-managment were developed the shares are nonvoting (preferred type and introduced in most of the Russian in- A). They can also buy up to an additional dustries. According to these models the 15 percent of common shares carrying vot- revenues or profits obtained by the firm ing rights. The balance of the shares is ini- were to be disaibuted according to certin tially held by the governmen, but only 20 fixed norms (percentages). After transfer- percent (of total shares outstanding) will ring a certain percetage of the budget to be votin& with the remainder (40 percent the ministerial fund, the firm was free to if workers and managers take their full 15 use the rest of the money for investmnents percent) being nonvoting (preferred type and wages. One important consequence of B). Accordingly, even where workers and this new order was the transfer of some managers buy all available optional shares, control over investment decisions from the the govemment will have a 57 percent ma- ministries to the firns' managers. At the jority (20 out oE a posslbie 35 percent vot- same time, ministries still tained a lot of ing shares) in the stockholders meetin& control as they were responsible for deter- Option 2 is considerably simpler. Wor- .ng the mentioned norms for each indi- ken and managers buy 51 percent of the vidual enterprise shares, with the balance held by the gov- The 1991-92 "Budget Systenm and emient. Under this scheme allsares are -ix on Profit? laws further eroded the votng from the outset and there are no powers of the branch ministries. These pro- preferred shares. 142 RusswR CRETNA PFrVAm EwNTPrnss MD EFFrEmr MARMS Since die majority of firms chose option In those cases where workers and man- 2, workers and managers will initially have a agers are not the majority, generating a voice majority vote in most corporatized firms. for capital wll require cobbling together a Furthermore, govenment shares are liely majority coalition between government and to be sold for vouchers, thereby further re- private shares. This, in tum depends upon ducing the government share under option the ability of private shareholders to con- 2 on a one for one basis. Under option 1, centrate their voice. In other Eastem however, voucher sales come firom the pre- Euompean privatization plans, this has been ferred type B stock (which becomes com- accomplishedthroug the vehicle of mut- mon on saIe) and thus dlutes both worker al funds or their equivalent. By combining and manager and government voting rights. their votes into a single voice, individual For example, if 10 percent of the shares are shareholders can achieve the economics of sold to voucherholders, voting rights would scale necesary to make it worthwhile to in- be: goverment 44 percent (20 out of 45 vest in acquiring the infomuation required percent); workers/managers 33 percent (15 to play a significant role in govemance. In out of 45 percent); and voucher-holders 22 Russa, this role has been attenuated by a percent (10 out of 45 percent). provision limiting such oooling to 10 per- iL sum, shorty after corporatizaton, cent of thevoting shaesof any one compa- managers and workes have a majority of nyby any one imvestmentfindc Still, several ihares in the vast majority of enterprises. suchfundscouldaccumulatetoasigniScant The only exception is where firms which voice. have chosen option 1 and either fewer fhan Unfortunately the eperience of vouch- 5 percent of the shares go to voucherhold- er auctions to date suggest that this may be ers or larger voucher sales are offset by a futile hope in many cases. Asurveyofauc- workers and managers taking up less tha tion consequences in seven provinces is ihe the maxuinum 15 percent of common stock only hard evidence available, and it is dis- Even in cases when they do not hold a couraging. The typical pattem is for an op- majorty of shares, workers and managers uon 2 fian to offer twenty-nne percent of w1i stil control the board of directors, its shares for sale at auction with the r which consists of the general ditor (wih maimng 20 percent of nonworker or man- two votes), representatives of wrkers, an agershares remainingingovermenthands. appropnate legislative body and a relevant The result has generally been that workers property fund (with one vote each). and managers buy up to 80 perent of the Shareholder percentages are irrelvant un- shares sokl bo the extent that this sudy is ti, for example, a vote needing a three- representative, voucher sales have thus not quarters of the common sbares arises (such diminishel worker and manager control, as a vote to change the charer to some oth- but enhanced it. arboardcomposition).4Thiswiil bedifficult The scope for a voice for capital is fur- to obtain, but is at least mathematicaly pos- ther reduced by the efforts of almost eve sible under option 1? However; this chage industry to create a hoding company for must be approved by a two-thirds vote of shares of privatized members of that indus- the wokers holding typeA prefewred stock, nt The phenomenon was so wide-spread and this is unlikely Accordingly workers that GK[ had to developaspecificpolito- and managers wil control tbree-ffths of the vards such proposals. As a result, some of board under most foreseeable cirum- the holdings were created with the perrnis- stances. Leaving the legislative vote aside as sion of the GKI, some of the plans wer re- an unpredictable swing vote, any vote for jected and never implemented; and, in capital via the board must be exercised cerain cases, holding companies wer through the single vote from the property formed evenwithout GEl approvaL fimd appointee or the general director The An additional corporate govemance latrerisappointedbytheshareolder,who, problem occurs for dtose enterprises that as already noted, are the managers and are not subject to privatization. This is by workers themselves in most cases. no mans an insubstantial EsLt he 1992 CORPORATE GOERNAc DURING 1E srAnoN Tro PrvmE OwNnRsH 143 privatization plan identifies three categores actvities remain outside the current priva- of firns that are not to be privatized or that tization process. The more important ones are to be privadzed sdecaively The follow- may be broadly characterized as public util- ing list gives some of the more economically ides or naural monopolies. irnportant entries in each category. Whathashappenedtocorporategover- nance in the firms forwhich privatization is 1. Enteprises not to be privatized in 1992 not mandatory? As with enterprises sched- * Energy enterprises and facilities uled for prvatization, there has been con- * Pipeline enterprises and facilities siderable devolution of power to managers * Water-use and amelioration systems as the enterpnses lnve taken advantage of and structures the 1987 and 1988 laws to form au- * Television and radio broadcasting cen- tonornous legal entities. Compared to the ters others, however, parent ministres retain * Por facilities largr governance rights. * Electricity thermal energy, and gas supply Whyworry? 2. Enterprises to be privatized only with government decision Are there any reasons to be concermed with * Mining enterprses legitimizingworker and manager control? - Fuel and cnecrgy enterprises (coal, oil, and gas) Avoteforcapitd - Communications enterprises - Commercial banks The first reason has to do with providing a 3. Enterprises to be privatie onlywith GKI voice for capital. Left to their own devices, decision rationalworkes and managers will be mo- * Enterprses induded in the Registr tivated by sdEf-interest to extract a main- of Monopolies mum of surplus in the form of higher - Large enterprises with more than wages and benefits, and pass a minim 10,O00workersandmore than200 omil- through to profit where it is subject to lion mbles in assets double leakage from taxes and dividends. * Radroad, air, maritime, and rver The arithmetic is simple: 100 rubles of tasport enterprses benefits taken above the line is worth 100 - Medical equipment and phamaetcals rubles to managers and workers; for 100 - Alcohol, liquor, wine, and tobacco rubles ofbenefits taken below the line, 32 enterprises rubles leaks to corporate taxes and 33 rubles to the govenment shareholder as It is important to note that list 3 is re- dividends. Unless Russian workers and stricted primarily on the demand (for pri- managers are narow-minded-which vatizadion) side rather than the supply side they are not-they will rn the company so because in practice, Gfl has encouraged they get the full 100 rubles rather an the privatization wherever possiblec Being on residual 35 rubles. the list does have two important effects, Rational workers and managrs will, of however. First, because of the importance course, pass some surplus through to prof- of such enterprises, GICI pays more atten- it since some retained earnings wil be nec- tion to proposals from them. Second, there essary for investment to maintain the is much less pressure on such enterprises to company in the long run. However, this in- be forthcoming with proposals. Still, some vestmentvwil stilbe suboptimal because of very important list 2 and 3 enterprises have the first ound leakage to taxes and because alrcady been privatized by mid-1993. The future chags in corporate governance oil industry and the huge Uralmash (heavy may be expected to reduce their ability to equipment) and Zil (automobiles) con- pay high wages and thus firther dimiish cerns are promnent examples. None- heir share of futre returns to the current theless, many economically imporant sacrifce required for investment If work- 144 Russt CREANG PmVA&m ENRmIusES AND EFCENrICa AXS ea are irrational, the situation is consider- of nonemployee shares. Thus far, this paper ably worse. A number of managers whom has assumed that the Coase Theorem6 we intevwed arued that workers were holds and that ifworers and managers can short-sighted and would not undertake approiate the bulk of the surplus, they even the (already suboptimal) level of in- wil act to maximize the suplus to be so ap- vestnent required by self-interest. propriated. Sadly, there is considerble rea- The first evil of inuction, then, is an in- son to believe that this does not hold in appropriate functional distribution of val- Russia,atleastintheshorttomediummen. uc added. Too much will goto workers and As is azaued below, managers and workers too litde to govermnent and capital. Ile have in fact been in this position for sever- result will be too low levels of government al years, and the response of the state sec- services, savings, and investment. Sincewe tor to market forces has thus far been are talking about enterprises which consti- considerably less than dramatic. -.. the first task tute well over half of the Russian economy, To understand what is going on, it is Of corporate the resulting macreconoiic impact useul to consider the results of one de- would be devastating to the gowth tailed available study of enterprse re- govence during prospects of the economy. Note that this sponse. One of many puzzles in Moscow the trasition is to wil ultimately harm the working class as a today is the prolifetion of street-side provide a vote for whole as low investment precludes the cre- kiosks which provide an abundance of war- ation of real jobs and the capital accuniu- ied consmer goods. The question is, why Iation that make real wages rise. have these reafl outlets prospered in com- Accordingly, the first task of corporate petition with established former state govenance during the transition is tO pro- stores which have been privatized? More vide a vote for capitaL Without pressure genecaLry, why have other privatized small for return to capital,ehe whole economy estblishments in Moscow-notably will suffer. restaurants-exhibited so little entrepre- neuial response after privatization? At A votefor mangeral chnge least part of the answer is suggested by a fascinating study of 452 establshments in A case can be made that the foregoing evil seven cities. The study confirms the lack of is no great evl because the real problem in response in Moscowbut finds considerable Russia today is to get entprses to gener- response in the other cities. The difference ate surpluses in the first place. If this can be is attributable to the method of privatiz- sccomphishedbygiingthebulkof theben- tion. In Moscow, enterprises were simply efits to workers and managers, then the ef- tumed over to the previous workers, 'ho ficiency goal will have been reached and continued to do things the same old way fnional distribution is a second-order In the other cites, auctions were used, queston. There are two classes of response which resulted in control being shifted to to this argument. The first is that some en- an entrepreneur who was both capable of terpnrses (particularly those imvolved in re- initiating change, and motivated to do so source extraction for export) are already as welL Eventually, control of the Moscow very profitable. For acample, the average estalishments vill be transfemred to true monthly wage m mmining in SvedUosk in entrepreneurs through bankrptcy or am- June 1992 was 40,000 rubles, compared to ple recognition of the self-interest of cur- an average wage in the region of 6,000. rent owners. Until then, however, inertia Why shuld the surpluses of mining be dominates, with patternns established over used for consumption by wel-placed min- seventy years of socialism triumphing over ea rather dtan for investment wich bene- the profit opportunities provided byprop- fits the working class as a whole? erty rights in markets. The second dss of response isfar more The same phenomenon is occuring in important, because it questions whehr many of the larger state enterprs. To be the desired increase in efficiency and sur- sure, there is wide variety in managerial plus will in fact take pace without the vote response, at least as ehited in interviews. CoIIMR GOvERNA DllRING THE INmoN TO PanvE O0ruw 145 Some managers are aggressively pursuing transition a signficant poaron of the shar new business opportuinities, but many- in many companieswill be in the possession perhaps most-seem merely to be bewail- of voucherholders and other smal in- ing their fates and crying for goverment to vestors. Because these shares wrll be wide- bail them out. The point is that enterprise ly desired, small investors wil not be able reform requires management to profound- to bring their collective voice to bear on the ly change its ways, ?nd many mnges are operation of the enterprise. Their interests not ready or able to do so. Some wil have canbeprotectedonlybythevote of the sin- to be fired and other wl have to face a re- gle large strategic investor-the govern- al tireat of being fired before widespread ment. In the absence of such a role for the change occurs. This has not happened to govemment shares, Russin citizens are any signifcant extent thus far, and is un- likely to receive litde return from their For the health of likely to happen soon with continued con- vouchers and will be rightfully disenchant- the enterpries and trl by manages and workers. One edwith the privatization program? the economy, distingaished observer of the Russian econ- omyhas arguedthatgiven achoicebetween The bomom e protection for the massive infusions of new capital with exist- interests of capital ig manages and no capital with new man- None of this should be taken as an attack must be addedt agers,hewouldpredictahighergrowthrate on managers and workers. Their interests with the latter This may be something of an are fundamental and mustbe promotedvig- ovestatement, but the sentiment should be orously. The point, however, is that in a mar- applauded. Thus, we have a scond and ket econom, an enterprise must be mn to ciical role to be played by corporate gov- benefit the providers of both capital and la- ernance-ta use the hiring and fring and boar If either is neglected, the enterprisewi incentive power of the shareholders to en- dedinc Some wokers and manger- sure that managers either change or are raised under seventy years of socilism- changed. may not fi* appreciate tbis point at first, but in the long rim their interest is inextn- A vote for ex* cably linked to that of capitaL An enterprse that does not protect the interests of capital The third evil of inaction is straight-for- will not attract capital, and without capital wardL In a market economy firms that out- the productivity gains wiAch raise real wages live their usefulness must die. If they are to are not possible. The curret system pro- die, sooner is better to avoid wastng addi- tects only labor interests. For the health of tional resources. The interst of wodrers the enterprses and the economy, protection and managers do not promote this end. for the interests of capita must be added. They would prefer to suck every lst re- To are that goverance coid be in- sourcefromthefirxnanditscreditorsinthe proved is not to say it wil be improed. form of wages and benefits. Once again, Refornming corporate govemance in a way their wage gains outweigh their dividend which reimposes the old form of state con- losses and their role as employees domi- trol in a new guise will not be a step for- nates their role as owners. The interest of wardI Thus far we have only argued that capital does promote this end, since a time- there is room for considerable improve- ly shut-down can at least preserve some of merit in corporate goverance. It remains the assets or preclude additional losses be- to be seen whether there is a scheme for ac- fore more and more money is pouredin.A complishing this wichislikelyto do more voice for capital is teefore required to en- good than harm sume appropriate exit rates. Policies to improve corporate A voteor the smal shaeholder governance Anotherperspectiveonthe evils of inaction The arguments thus far may be succincty is provided by recognizing that during the summarizedi 146 Russ1A C{TsNG PwaVxE ENmmEUS AND EFFIcENr MAFxEmS * Empirically, the period 1987 to 1993 fimn the budgetthrough sales to the gov- saw a revolution in corporate gover- emnent rather than through sales to a nance as dt bulk of powers were de- market, and the goods are produced by centralized from state organs to the unly one or a few suppliers so supply is managers and workers of largely au- not competitive. tonomous enterprises. 2. Uilities, and otber senrices who sell to * Normatively the change was undoubt- consumers and pmducers. There is lit- ecly a major step forward for both stat- tle actual or potential competition in ic and dynamic efficiency. their core markets and, therefore, they * Nonethless, serious governance prob- may be expected to remain in govern- lems remain. In the context of monop- ment hands for some period of time. olyoutputnmarkets andnearmonopsony In contrast, the last two regimes pro- in the provision of (largely state) credit, duce for markets that are actually or po- The challenge... is manager and worker control results in tentially faced with competitiVe pressures, to develop measures an madequate voice for capical change, whether rmm domestic or foreign sources. and efficienct They are distnguished as folows: that promote beter Tlis analysis is hardly unique. Within 3.Tranuidoal fis are those slated for management and Russia, there are many who share at least privatization, but for whom the process finanial disciline some of the major tenets. A distinguished is not complete r - in a Commission under Professor Yasin has re- 4 Mird evapises are those where cQpo- eneTSe a cently compiled a draft report on Basic ratizaton has bem completed, but in manner that is Provisions of Ste Entespnse Refonm. They wich the government rains significant ositet With... saythatatpresent, theenterprises are"con- shearehold ins. trolledneitherbythemarketwhichhasnot Notethatthlastdefinirionisconsiderably the transition to a been put in place,... nor by the State as the broader than the official Russian definition market economy. ownecr Rather than looking to markets for which dlassifies an enterpnse as prnvate if revenues, these entities "put pressure on the governmentes share is less than 25 per- the Government wih a view to receving cent8 The govemment defnition is useful privieges and subsidies....? because it encourages firms to go through The halenge, then, is to develop mea- voucher auctons to achieve special prmi- sures that promote better minagment and leges accorded to those who pass the 25 per- financial discipline of enterpises in a man- centtrip wire. One such pdvilege is theright ner that is consistent with, and that hastens to bid for and hold shares of odter compa- ratherhan rards, the transition to a mar- nies, induding the ight to pariicipate in ket economy. The balance of this paper asks voucher auctions. Passing this threshold is, how tis might be accomplished. therefore, necessary for achieving the for- mation of holding cmpanies. Governance gime Nonetheless, for reasons explained above, it is clear that even a 245 perfent A useful first step in this direction is taken govement shareholding could be so vot- by the commission in abandoning the hope ed to improve the efficiency of the firm. of having a single governance regime for all Therefore, regime 4 has conscously been enterprse and instead identifying differ- defined as including mixed (public and pr- ent structures as apprpriate for different vate) firms rather tan only those that are types of enterpnses. This paper follows this not officially privatized. lead, but extends it, identifying four (rather Table 11.1 provides a matrxlinldng gov- than their three) regimes. Thee regimes ernanceregimes (the olumns, representing are specfied based upon the nature of the types of enterprses) with the essential markets in which they operate and the last definig characteristics of each regime (the is subdivided according to progress on pri- rows). As such, it provides both a summary vaiaion. Biefly, the regimes arc: of recommendations and a disciplning an- I.Mznopoly goennm swppie who de alyticdevicewhich ensuresthatmajorissues rive the bk of their operatng revenues are not left unreolved for particular types. CORPOWRAE GovERACE DUPING THE TION To PNvs OwNa0sw 147 Regime 1: Monopoly government supplies ble for true enterprises. Further, structring them as independent entities does not suf- Pure government suppliers include stuch list fice to create a maket, for they are then 1 organizations as the National Archives; monopolists facing a monopsonist, but the assets of the Armed Forces (geological and monopsonist is in control because it has the meteorological surveys); agencies con- money. cerned with hygiene, epidemiology, and E such entities are indis uile plant protection; and patent, standards, from govemment, to the extent that market and machine testing facilities. It is difficult mechanisms do not operate, then there is to distinguish such entities from the gov- nogreatharmintreatingthemaspartofthe emmient itselL Like the governmcnt, they goverment apparatus. That is, they are produce important public goods, whose parr of a hierarchical chain of command, value is impossible to determine in any their employees are state employees, and practical way. One can therefore not con- they are funded as part of the regular bud- duct the sort of cost-benefit calculus possi- get proces. Table 11.1 Corporate governance regimes of different ldnds of enterprises Govnment suppliers Uliie, and otier servim Transtonal Mxedpubkleand private Exampns Weapons research and Railways. telecmmunica- Enterprises undergoing Consumers and producers; design institutes, patents tions. electric utilities, corporateation actual and potential and standards; metorology pipeline operators domestic and imports competition Market (rain buyer-of Government near- Consumers and producers; Consumers and producers; All companies that have ou ; compe monoporistic or strategk little potential core compe- actual and potential undergore corporatization con ditd) industries tition domesfic and import but are still party competition govemment-owned Role of government Dominant Carefully selected and Sdeeed finance for restruc- Prohibited (reliant on capi- finance structured subsidies and turing in antidpation of tal market) credit guarantees prvatizaton Corporatiza!ion No Yes Ongoing-to be expedited Done Prnatiation Not now Not necessarily now (but Ongoing-to be expedited Done tess than 50 percent encouraged where feasible) govemrnment-owned) or partially done (more than 50 percent governnent- owned) Legal form Departmental enterprise Joint stock company (or Existng laWs loint stdck company (state law and public public corporation with employees) special law) Board None State-controlled majority; None According toshares minority representation of workers, experts. banks. and so on En*ityappointing CEO Government Supervisory board, with Workers collecive Shareholders board approval of interdepart- mental commission Control devces to mirnic Competitive bidding proce- Performance contract care- None None markets dures to be developed fully designed and signed where multiple suppliers by interdepartmnental com- exist mission Prsetter Government Autonomous commission Market Market for each industry Encouraged wherever tech- None into regime, free into Free Enny Restriced nically feasible industry Exit Expicit governent policy From industry, policy; from Expricit govemment policy Free needed rgime, okay needed 148 Russx; CRaTG PRvAmE ENTE7RRE AND FFIcNTMAJxmS An intermediate category of enterprises Ilustratively; but most importancly is occurs in industries where economies of the status of workers. If they are state scale are such that many suppliers are pos- employees, then management is re- sible. Now the govermment monopsonist stricted in hirng, firing, and promoting can use competitive bidding procedures according to the needs of the enterprise among government-owned firms in strate- and the consumer rather than according gic industres and bidding among private to ditates of law. Forexample, most en- suppliers in nonstrategic sectors. Anma- terprises need trained cost accountants, ments may fit in the first category and pro- a commodity that is in scarce supply in ducers of stamps, state insignia, and the Russia and available only at a premium like in the second. The former could, and wage beyond government standards. should, in the long run, be placed in regime Managers must be given the freedom to 2, and the latter in regime 4. manage in response to market condi- tions and this is almost impossible un- Regime 2: Utilies der state regulations. Direct skte satus inbits the im7fion. How should utlites and other services be Russian utilities have extremely large govemed? There are three options. First, capital needs. Multilateral and bilateral they could be managed like regime 1 orga- lending and grant-giving institutions, to nizations. Second, they could be managed say nothing of privre bankers and in- using the fiduciary mechanisms described vestors, are highly v 'ikely to provide above. Third, they could be run along the fiudstodirectstates -res. Further- lines of public enterprises in mixed more, corporatizatoi .acllitates economies. This paper rejects the first op- privatization in the lon-: - *1 com- dion but sees some merits in both of the petitive restructuring (f anpleI pc- other two alternatives. vatizing electrical generation while Intemational experience demonstrates maintaining apublic grid) in the short to convincngly that direct government control medium rmn. is not appropriate. Instead, utilities should In sum, regime 2 is much more like be corporatized as semi-autonomous bod- regime 4 than regime 1, because both serve ices. Reasons include the following: independent customers rather than the • Conwner needs should dominte. government This similarity is reflected in antagement of suh enterprises should the fact that many of the enterprises in be psychologically oriented to look first regime 2 are already well into the planning to the market for policy guidance and suge for privatization (communications, then to ministries. Direct govemment airlines, and ports). There can be no ques- control reverses this orientat:on. Quality tion that regime 1 mechanisms of direct of service and effciency suffer as a re- state control are simply not appropriate. suLt. Managers must be given a com- The choice between the remainimg two mercial orientation, meaning they look mechanisms, however, is not so simple. first to the market for solutions to their In addition to the obvious definitional problems. Retuming them to direct distinction based on the share of govem- state control encourages the traditional ment ownership, regime 2 differs from menaity; corporatization helps trans- regime 4 in two princpal ways: form that mentality and fosters a new L*imted competion. Regime 4firms face market orientation. actual or potential competiive markets. • Government n&rarrehineible. Manage- This competition may be from domestic ment of such enterrises must be free to production or imports (once a modicum respond quickly and effectively to of stabilization is achieved, the dolar changing market conditions. They must ceases to be a store of value, and the ex- also be able to quicddy acquire necessary change rate falls). Regime 2 fms, in con- inputs at market prices without cum- trast, largly produce nontradales bersome administrative requirements. which are natural monopolies in at least CORPORTE GovEANE DURING THE TRANSION TO PRiAIE OWNEsR 149 their core activities. The number of such term and, if this is the case, we examine two activities is smaller than generally alternativre control mechanisms. thought, and competitive restructuring Under both options, there will need to can reduce the realm still fhrther, but be an independent authority or authorities there remains a core of activities for to regulate prices. This subject will be left which prices will have to be regulated. for others to elaborate, but there is an im- Finance. As an instrument of social pol- mense volume of international experience icy the govermment may want to subsi- to be tapped. dize consumption of some regime 2 In an earlier memo on this subject for commodities in a selective and Gfl, Robert Anderson surveyed intema- carefully-structured fashion. To meet tionalexperiencewithcontrollingpublicen- their capital needs the government may, terprises and identified two broad patterns: on a case-by-case basis, decide to pro- * Infomal contrd via board of diredorm vide additional equity capital or guar- Following the pattern of private enter- antee loans. No such facility should be prises, shareholders appoint a board of available to regime 4 firms. capable and experienced individuals Thc above reasons have led the rmajori- who then represent shareholders, pur- ty of the world's mixed economies to run suing their interests through whatever these activities, as public enterprses owned means seem appropriate to the board and controlled by the government. In these given the crcumstances of the company countries the public enterprisc sector gen- * Formal conetl via performance contracts erally generates around 10 percent of GDP Other countries judge that part-time The United States and followers such as the boards are an imperfect control on fult- Philippines have, however, largely followed time managers. They rely instead on the alternative approach of regulated pdi- formal performance contracts with vate operation. Here, the public enterprise management which specify goals to be sector amounts to only about 3 percent of achieved and provide explicit monetary GDP. In the presence of monopoly, both incentives varying with the degree of forms of governance have proven higbly attainment. imperfct However, during the 1980s the If the first mnechanism is chosen, how- weight of world preference clearly swung ever, there is a rnajor danger to be avoided. towards regulated private enterprises. In most countries where the board method 'Wholesale privatizations in the United has been attempted, board members are Kingdom, Chile, Mexico, andArgentina, as part-time political appointees who have well as partial privatization (selling minori- neither the time nor the expeience to ef- ty shares to diversified shareholders) in fectively contribute to governance. Stereo- Japan, and small-scale privatizations in nu- typicaly, they receive a packet of material a merous other countries clearly illustrate few days before the meeting, and peruse it this change. It must be noted, however, that in the limousine on the way to the meeting. despite pronouncements to the contray, In such circumstances the enterprise plays privatization has been of significant magni- them like a fiddle and, except as a check on tacde (reducing the sector by more than 10 the more egregious forms of managerial percent) in only a handfiul of mixed malfeasance, the enterprise is controlled by economies. Furthermore, these have all the CEO. been the more advanced mied economies, If the board method is chosen, there- characterized by developed capital markets fore, the private fiduciary method recom- and legal institutions. Which governance mended below for regime 4 should be mechanism is the lesser evfl for Russia at adopted. This provides the essential incen- this stage isatoughcall, as thechoiceis be- tives for the fiduciary to do his or her job tween two highly imperfect alternatives9 welL We confess a fondness for the sym- Whichever choice is made in the long run, metry of thus privatizing the fiduciary role, many of these activites will remain in gov- but recognize that it may not prove feasible emnent hands for the short to medium on a wide enough scale to cover al applic- 150 Russ>: CxamNG P'nvm EyEnwsEsnD EmaFF rc1t,Wrs able firms. Accordingly, we go on to con- * Preparation and commissioning of de- sider the altemative. tailed studies on governance issues with While perfonrnance contracting is central attendant policy recommendations. to the proposed regime 2 governance, it is by * Development of computerized data- no means the only element. The broad ques- bases developed on a priority basis with tion is what should the government share- attention first to critical information holder do when it controls a majority of the (for example, subsidies) on the largest shares? As an aid to answering this question, firms using readily available data.10 This it is useful to begin with a distillation of the would evolve over time into a more literature on multidivisional or multination- comprehensive performance informa- al firms, which face the same dass of hierar- tion system. chical problemr Lessons from this literature - Negotiation, monitoring and evaluating suggest that the head office should: the performance contract system for 1.Appoint the General Director; regime 2 where this method is adopted. 2.Provide resources (including realloca- ' Recommending appointment and reas- tion of surplus and major investment signment ofmanagers in regime 2 based decisions); on assessments of performance. 3.Set objectives; a Selecting and monitoring regime 4 4.Monitor performance according to fiduciaries. those objectives; The other important govemrnce fuic- 5.Reward or penalize according to tion is finance and while the capstone insti- achievement of those objectives; tution should be involved in this activity, its 6.Plan and coordinate across subsidiary princpal locus should probably be else- units; and where in the government. The creation of a 7.Do nothing else. new and independent body to carry out Performance contracting is carrying out these activities is urgendy needed. This in- activities 3, 4, and 5. It is essential to pro- stitution Mwould require both a senior policy viding motivation and guidance in its own board and a secrecadat to provide inLrma- nght, but is also essential if the other func- tion and analysis and carry out day-to-day tons are to be carried out. Perhaps the activities. Further, the secretariat must be most essential item on the list is the pre- autonomous from government rules and scription 'Do nothing else.' However, if regulations so that it can attract the rneces- the government does not set targets and in- sary highly qualified staff centivize performance, then managers are likely to pursue their own set of interests. It Regime 3: Tranritionalfims makes sense for the government to look over theirshoulders on day-to-day activities Regime 3 is for transitional enterprises. to prevent abuses. In short, if the govern- Inclusion in this sector is precisely as de- ment does not control results through per- fined in the asin Report, namely: formnance contracting, then the alternative is to control the processes through which ... enterprises in Federal ownership results are achieved. Performance contract- which were not included in Type I and ingis thus central to the governance of pub- for that or some other reason did not lic enterprises. South Korea provides a undergo corporatization or privatiza- model of positive experience to be tapped tion, but which are capable of operat- if this option is adopted. ing in the market independendy on a A capstone governance institution is commercial basis. neded to carry out governance activities on behalf of the state. Ihis could most effi- To promote interim efficiency in this ciently be done by maling it responsible for sector it can be argued that they should be both regimes 2 and 4. The general structure subject to the governance structure wbich of its responsibflities was given above. we will propose for regime 2. There are Prority activities ildude the following: dear benefits associated witi this idea. CoaPoRnm Gov1ERCE DURING THE IANsrmloN iro PRIvATE OwNEns 151 There are, however, also two offsetting ment has minority status, the impact will be costs to this approach, both of which im- limited to the sort of informed lobbying pre- pede the speed of transition to a market viously descibed for the board. In cases economy. where the government shares constitute a • Conversion to the new form of gover- controlling majoty, or where such a major- nance will consume considerable scarce ity can be had in conjunction with the prox- human resources at both the enterprise ies of private shareholders, considerably and govemment levels. These resources more can be accomplished. How can these could be better employed in developing votes be exercised effectively? We propose means to adapt to market forces. priVatizing the governance function through * Psychologically, it will reorient man- the use of private fiducaries. agers to look backward to the state, The people are the principal-the ulti- The property rather than forward to the market for mate owner of the shares in question. The funds and Gac solutions to their problems. The pace at problem is how to get the ultimate agent- which regime 3 withers away will ac- the enterprise-to act in the interest of tls share a fiundamental cordingly be attenuated. principal. The people are a rather diffuse limitation on their The costs of building a new governance group, and consequently one or more it- ability to exercise structure greatly outweigh the benefits." termediate agents must represent their in- Governance for the transitional enterprises terests. As we have seen, one such the corporate should therefore be status quo. There is no intermediary will be some representative of government escape from their current plight other than the RSFSR, institutionaized in the proper- finction. privatization. In an effort to put further tyfund, GKI, or perhaps othcr bodies. But, pressure on these firms to privatize expedi- one additional layer is needed to act in the tiously, the state should not render any fi- default capaity. nancial assistance to the enterprises of Who is the default agent? It is widely regime 3, except in the context of a con- recognized that after a company's corpora- crete restracmrg plan leading to pnvati- iization and prnvatizmatn by GK[, govem- zation. In sum, the transitional regime ment shares are transferred to the should be just what its name implies. All appropriate federal, regional, or municipal policies towards enterprises in this regime property fund, making them the default should be explicidy designed to minimize agent. What is not so widely recognized is the transition peiod. that the GKI is entitled to keep controlling blocks of shares for up to three years in lare Regime 4: Mixed enerpnises enterprises, enterprises that dominate mar- nets, or those engaged in natural resource- How can a voice for capital and change be based activities (list 2 and list 3 finns). introduced in regime 4 enterprises? Given The propertyfunds andGKI share afun- the crppled board and minority status of damental limitation on their ability to exer- outside shareholders, the scope seems hm- cise the corporate government function. ited indeed. Most observers. therefore write Both are subject to limitations on salaries these finns off as a done-deal. Before aban- which make it impossible for them to at- doning the board, however, we shouid note tract-or at least keep-the highly skilled that it is only crippled and not quadriplegic. people necessarv to do a sophisticated job. Even one board member can make a diffecr- There are other limitatons as well, inlving ence if he is trained to ask the right ques- the bureaucratic inheritance of the old sys- tions. People are willing to do some tings tem, but the salary consraint alone is suffi- in prvate but not in public, and a board dent to indicate that the goverance member can get things discussed and thus functon should be delegated to some au- put in the public record of dhe meetings. If tonomous body or bodies not subject tobu- well-qualified, the same person could pre- reaucratic constaints. sumably perform the same function as the Forunaty, this seems to be a noncon- governments minonty representative to the troves concuusion. Representatives of shareholders meeting. Where the goven- the Federal Property Fund assert that, with 152 Russ>: CREA1INGP RBvA ErNnixsEs Am EFAcmNr MAms only eighty employees and no plans to hire usual constraint on cartel behavior (self-in- more, they intend not to exercise the gov- trest of members in cheating on their pro- ernance function, but to deegate it. The duction quotas) would be precluded by the same principle lies behindthe joint decision holding company's power to appoint and of the property fund and GIG to form the reward the general directors. The leaders of Russian Privatization Center (RPC) to ex- the associations are smnart enough to assure ercise privatization functions. The same interviewers that tiey have no intention of sort of thing needs to be done for the gov- doing any such thing, but would encourage ernance function. competition among their member firms. We shall refer to this third party or par- They are also smart enough to know that in ties as a fiduciary, to emphasize that it is act- such a situation itwould be contryto their ingonbehalfofthepropertyfundandGKI, self-interest to do so and that in a market who in turn are acting on behalf of the sstem the prmary guiding light is that of Russian people. Who should the fiduciay self interest. or fiduciaries be? Another major goal is the promotion of The most obvious candidates for the change-Would the old leadership force the fiduciary role are the old branch ministries replacement of incompetent management and their off-spring associations and apex upon the enterprises? Would their response corporations. As we saw above, there is to poor performance be to expedite change considerable support among the industrial- or delay it through cross-subsidization of ists for the branch ninistries to be the pri- losing enterprises trough transfer pricing mary fiduciaries, and, in some cases (such and the use of captive banks? Similarly, as oil), they have already been empowered would they promote the goal of pomoting in that role. They have one powerfil asset exit, or delay it out of (expensive) loyak to knowledge The a=ex organs are reposito- old friends? ries of information about the industry and TIhe answers to al these questions are its managers, technology, suppliers, and self evident to those whose self-intert is buyers (especially in former CIS republics notinvoved, and acccrdinglythe oldbranch and EAstern Europe). These strengths can ministries should be reected as fiduciares. and should be utilized, at least in the form It would be the same old people doing the of consulting fims, selling their services to same old things. These individuals should be autonomous members of the industry ac- encourgedtousetheircritclowledgeas cording to the needs perceived by au- consutanrstotheindustries,butwiththere- tonomous enterprises in light of alternative lationships intermediated by mardets rather means of providing such services (whether than hierarchies. internal or extemal). Another possibility is to appoint inde- Anoher issue is whether or not they pendent private financial or magement should also be given shareholder rights specialists as fiduciaries. Their interest over the associated firms putting them in a would be linked to that of the nation hierarchical position of dominance. There through an appropnately structured set of are a number of ways of answering this incentives to be described in the next sec- question. One is to look at the list of jobs tion. In essence, this would mean privatiz- to be done (evils to be avoided) bythe fidu- ing the govemment's corporate govemance ciary as laid out above. The goal of provid- function in addition to privatizing the com- ing a vote for capital would be promoted pany itseld by this structure, since their income would Who might these fiduciaries be? At partially be a function of the dividends of one extreme-perhaps representing wishful the subsidiaries. With regard to the other tiking-iy s Singapore Airlines (a public en- goals, however, the picure is less sanguine. terprise and arguably the worlds best airline) The job of avoiding consumer exploita- as tustee forAerofiot shares. Such a trustee tion would not only not be accomplished would not only vote the shares, but provide but would be retarded. One vvould essen- n cons lting srvices and play an tialy be creating a super-cartl where the aciverole inthesearchforapnvatebuyer or CoRLoxa GovERNNcE DDuRNG THE NITON TO PRIVATE Ouw 153 partnerfordte enterpriseAAtthe opposite ex- difficly spedfying an incentive scheme treme, a purely domestc financialmanage that adequately links the interests of the mea compary might take on a pornilio of tusteee to toe of the nation. Most impor- smaler companies, but play the tnimalis tantl, it will take time to find and contract role of appointing the general directors- tsees, nd corporate goverance wil still signing incentive conats with them that have to be exercised in the ine promote the trustees' interests (and there- Accordingly, iis imperative to establish a fore, because of the trustee incentives, pro- fduiary of last resort (FIR) to take on all mote the public interest) and taking one seat trust not dispensed using the above scheme. on the boards to monitor and promote per- There are two critica distinctions. First, the formance. May intermediate possibiities FIR would be a publicl-Owned body while emst A particualy apaling one involves a the trustees of first resort would be pivare. partnership between domestic and foreign Secmnd, the FLRwould notbe compensated financial-management consultants. primaly through a share in the profits ofthe How would such a trustee be selected? firns whose shares it Was voting. Rathec, it Competitve bidling is the obvious market- wouldbeanautonomousbodywhollyowned based answer, with the award going to the by the state and compensated primarily by bidder willing to accept the lowest pay- fixed payments (idea with funds provided ment* to do the job. However, the lowest by some interational or foreign donor). bidder might simply be the least intelligent Performance incentives could and shouldbe orthe one leastable to dothe job. To avoid provided, butthesewoudnotbetheprima- this, two things would have to be done. ry form of funding, precisdy becuse the First, bidders would be prequalied (in bulkofthefirmsinvohvedwouldbethsefor terms of their ability to do the job). Second, which suic incentives were deemed inade- each would submit both a price and a plan quate by the markeL as to how they would exercise their fiducia- What we have in mind is somethng ry rponslbility. The selecton commmiee stucUy equivalent to the Russian would consider the quality of the plan and Privatization Center (RPG), which is joint- the bidders' ability to implement it, in addi- ly owned and operated by the Federa non to the price in deatemining the winner. Property Fund and GKI with foreign fimd- This scheme has considerable merit in g4 In fact, since the property fund and that it uses market mecaisms and is thus GE[ are the concerned shareholders, the consistent with the curret rceform phioso- RPC (or its twin) would be a prime candi- pby and that it also places the shres in the date for the FIR role. Wherever it is locat- hands ofthosewith the skills most needed in ed, it would have two functions: first, it Russia today. The enterprses have consider- would select and monitor the fiduciaries of able engineering and techical skills, but are first resort; second, it would appoint, tain woefully ladking in the entrpreneuria, fi- and supevise those selected to vote the nancial, and madet management areas. govermment shares in residual enterprises. The critical question, of course, is whether or not there is a potential supply of The urgency of govenance reform such tustees. This will depend in part on the incentives to be offered. First, howev- Many informed observers-both Rausian er,we consider cases where no private fidu- and foreign-believe that reform of corpD- ciary is forthcoming. rate govermance is not a prioty TheiLr ar- Even under the most optimistic assump- guments may be summarzed as follows: tmns it is doubthu that the supply of trustees v At this critical juncture in Russian histo- will be suffcient to handle all of the impor- ry, the govnment simply has too many tant regime 4 entities. Most significantl itis hier priority concers (democracy unl&iely to work when govenment and pri- macroeconomic stilization, privatiza- vate shareholders are in a minority. Some tion) and too few skilled economi man- firms may have such blak prospects that no agers to divert resources to another trustee will take them on. Others may have difficlt and controve reform 154 RuSSrL CQRcG PIUVME EmNTERPs MND EFCINT MAnM Any attempt at reforming corporate ity, but vould suggest that getting a governancc would slow down the priva- GDP boost of approximatel-y 5 percent tization program as the possibility of an annually would seem to warrant alternative governance structure would expenditure of scarce resources. redluce the pressure an many enterpris- To minimize the impact on the pace of es to privatize quiddyc privatization, two features would be *Any reform effort would be likely to necessary. Frst, a quick and definitive reimpose a semblance of the old state decision would have to be made assign- govecnance structure. This would be ing a limited number of enterprises to worse than the current evils of pure regime 2. Second, nothing should be worker and management controL done with regime 3, and they should not There is much wisdom in these arguments be eligible for cven the limited financial and any proposed reform must explictly assistance which might be accorded to address these concerns. regime 4. The counter-argument rests on two To avoid returning control to the old propositions: state smures, the apex organization * The state sector is going to remain large of the new governance regimes would for severd years. For the sake of mus- have to be outside of those structures. tration, assume that regime 2 enterpris- A new and autonomous body would es will account for 20 percent of GDPD have to be created to exercise stricdy Assume further that regime 4 enterpris- limited fuictions (specified in the sec- esw ll produce another30 percent. tion above) for regime 2 finms and to • Corporate governance can make a dif- appoint and monitor fiduciaries for ference, most importantly, by providing regime 4. avoiceforchangingmanagers.Aguinby Whether or not these counter-arguments -way of illustration, assume that it can carry sfficient weight can only be decided produce a 5 percent annual increment at the highest levels of the Russian govern- in efficiency (defined simply as the ratio ment. If, and when they are accepted, then of real outputs to real intermediate in- this paper has provided some preliminary puts). suggestions on howthe reform of corporate If these premises are accepted, then imple- govemance might proceed. mentaton of corporate governance reform will add 55 pecent to the annual growth Conclusion rate of GDP. The calculation is smple. If the relevant enterprises produce 50 percent Since this paper was written in 1993, the ofvalue added, then teir output will be on GM has made extraordinary progress in the order of 120 percent of GDR completing privatization tunsactions. The Increasing this by five percent whle hold- questionhereishowquicdlytbisremarkable ing inputs constant wil then make real change in structure will translate into GDP 5.5 percent (05 multiplied by 120) changes inbehavior.Itis ofcourse muchtoo higher than it would have been without re- soon for definitive conclusions, but the use- form. These numbers of course only repre- fulpapersbyBlasiandbyWebsterintbisvol- sent broad orders of magnitude Note, ume provide some fascinating insights On however, that they are conservative in at the question of who controls the enterprise, least one citical respecL They assume that Blasi reports two resdts which will not sur- the only gain is in static operating effiden- prise readers of the foregoing first, insiders cy and ignore the dynamic impact on in- dominate outsiders in tenns of board repre- vestment and innovation. sentation ard decisionmaking power and If some variant of the foregoing aigu- second, among insiders, managers over- mcnt is accepted, then how are the three whelmingly dominate workers'3 This coae- earlier objections to be met? sponds to our earlier observation that the * We are not in a position to assess the ex- immediate impact of privatization would be tent of limited economic reform capac- conversion of defacso manageral control to COm'OaniE GoVNANm DUmI nc fANSMON To PRuv OwWNERn' 155 de jue. How has the resilting managerial percent had speific discussions about joint control ben exercsed? ventures, and 15 percent were alredy in- Of particular importnce is the observa- volved in joint ventures.?3 This is ceainly tion that "Since 1991. post-priAtized finns en but one needs to know how have cut employment by 21 percent"14 If many of these contacts will be brought to this were the result of concrete actions by fruition.llingaboutdoingtngsisbettr manags it would be impressive evidence than not taLking, but actually implementing that tbey were capable of rapid change and them is something entirely different were pursuing the interests of capital and Similarly, in interpreting the 15 percent in- not merely labor. There is room for concern vlved in actual joint ventures, one wonders as to whether this is the correct interpreta- howmanywerebegunpriortoprivatization. tion. Consider Uralmash, the famed heavy In sum, there are two exteme carica- In sum, there equipment producer in Yekaterinburg. In mres ofRussimanager. One says that the are two extreme 1991 it had 62,000 employees, but at the bestpeople roseto the topintheoldsystem time of ourvisit in 1992 it was down to only and the capabilities leamed there wil allow caricatures of 48,000. Further enquiry reuealed that none them to excelin the new market economy as Russian managers. of this was due to layoffs or restrucuring- welL The other extre says that the capa- all had been voluntay deparures for better biities necessary to succeed in a bureaucrat- opportunities elsewhere As of 1994, em- ic system are totally different from those ployment had been further reduced to only requdin amarket stmandtuechange 23,000 workers and only 3,000 of this de- wil come only when mnagmet is cline represented action by management changed. The truth is presumably some- (subsidiaries hived off in the process of pri- where in between. If experience reveals that vatization). Voluntary departures of such the latter extrme is loser to the mark, then magnitude are ofcoursewonderfil news for real change in the lage and medium-sized proponents of rapid eorm because it industry sctsinRussiawfllcomeonlywith shows the creaton of many new jobs in the fiuher changes in corporate govenmance. prvate sector. As evidence of changes in managerial behavior; however, they are less Notes than convincing. How much of the 21 per- cent average reduction was voluntary (as in This is a condensed version of a mnh longer pa- Urmnash), how much wa active labor- pt Copies of dte complete paper are available shedding by management> Our own inter- fi the authos suggesut diit, atcast dhrough 1993 1. Artide 6 of the Law, passed by in USSR views~ ~ ~ ~ ~ ~~~~urs sugsShtotlas hog 93 onJune 3D, 1987. The procedure voluntary departures dominated. Until fur- S Soie wajune 3 elaboaedite of eetions was further elabmed in the ther evidence is in, one should not euate Regulation of the Cecual Conae of the cuts in the labor force-with management-in- Communist Party and the Coundi ofMinistiesof duced restructuring. February 8, 1988. It has also been reported that after pri- 2 Reuion of the Supreme Soviet of the vatization, management was changed in Russian dration Ni2 980-1, Swte Zn. of about 10 percent of the cases. To the exent PIN ,O of Ste sd Mwiim4 Quad E qoue f a 5c Rrsui &&tn 19 92, June this represents the ascendancy of moder 11, 19929 market-oriented management, this is im- 3. A third opton is avuabi but has bee pressive. However, some part of it presum- senbyrisfrewtup andis bearefomthece ably reflects the retirement or death of 4. Followed by anoher vote to actually Si the old-style managers and their replacement newly apportioned seamvia a simple majoniyvoe by like-minded fellows Lering how of common iareholders. much of the 10 percert falls in each cate- 5 Foreimple,chnWoldbepossibleifvoc- gory is crucial to interpretation. cm and nanags buy only 6S pecet of tbk rp- Survey evidence for active restructuring i amdslsoomtifXkessmdndmabuytdefiA iustrates that 58 percent of managers en- 1S percent, but govem ses al its preferd gaged in new product development, 58 per- shae to indentvestors who are induced to cent had contacts with foreign investos, 33 vote with the govemen (2D*40W75=.sol. 156 Russm CREATNG PRIvATE ENTEu r AND ErcNxmiTARL rs 6. As long as someone has the propertyights, it not object strunuously to there being five evis of doesn't matter who. inaction, we are content with foz; which seem 7- Some would argue that there is a fifth evil of more than sufficient to justify our condusion. inaction, namedycontinued manageial uraton 8. Article No. 9 of the Law of Russian Federa- of surplus and assets through a variey oF swee- tion "On Privatization of State and Municipl heart deals with private companies which wic Enteprises?" back a percentage to the managers' accounts. 9. Tb avoid misunderstmnding, note that this While agreing that this is a pmrolem, we do not statement applies only to the last 10 percet orso see it as one whose primary solution lies in actions of GDP World eperience convincingly demon- by the government as shareholder- There is a much strates that privatizing the other 90 percent is un- more direct sdlution rdying on a third partywhich equivocally a good thins has both the slf-interest and potentiaflybetter in- 1Q lWe undertand that the first steps in tbis di- formation, namely the workers. In the previous rection are underway at the Ministry of Fmance. cases, the interests of workers and manages over- 11. There rmay be an exception for a very smal lapped and goveanment acton was essentiaL In number ofvery large entprises which itis impos- this case, their interests diverge, since any diver- sible to privatize for a very long time. If so, thq sion tO mnagers is in large part at the expense of should be placed in regime 2 wrkers. According the most efficient solution is 12 The xe in the incentive scheme descib3ed to educate workers to the potential for abuse and belo. perhaps provide them easy acces to a recmedy 13Joseph Blasi, "Ownership. Governance, and (perhaps a regional ombudsman). Ihe govern- Rcstrucuring" (this volume, pp. 125-139) ment representative on the board might also play 14. Ibid. a mle here, but this is rnot centraL Whle we vould 15. Ibid. CORPORAMC GOvEANnC DURING THE TNsmoN To PnAxE OwN)tsHm 157 CHAPnER 12 Restructuring Large Enterprises in Preparation for Privatization: A Case Study H5kanJ. Wlson The essence of transition, fiom planning to prvatzantion, and it went through the the market, is that Russian enterprise must voucher aucuon process in early 1994. change and adapt to a newr and continu- From 1992 on, a French imnesment ously changing environment Much has group and an imvestment bank (referred to been accomplishedin privatization, but it is henceforth as Invesuent Bank) worked the sucs (or faflure) of enterprise re- with management to create joint venres structuring that will uimately detennine with intenational firnh Some global com- the speed of transiton to a market econo- petitorswereinterestedin cooperatingwith my This case study illusmrates the daunting Enterppnse anda Krean multmationalpro- difficultis faing le manufacturng en- Mded sophistcated technology and ma- terpnses in Russia, what remedial actons chiery for more advanced production. are needed, and how they can be carried Wih more than 250 product groups, a out The objective of the chapter is to pre- weaking military demand, uncertaint sent the measures necessary fir successfil over potential partner objectives, and a restructuring. rapidly deterorating economy, manage- ment found it increasing difficlt to iden- Background tify a corporate direction with which it could fed confident Management also rec- The chapter draws from an actual case of ognized the need for restrucring to deal enterprise restrcturing but some specific with the complexity of Enterprise's struc- enterprise information is concealed for ture, with inevitable layoffii, and to crate a competive reasons and to provide anony- legal structure to allow for joint venures at mity to participants. The firm wil be re- the subsidiay lev ferred to as "Enterprise.? Enterprise was Consultants (a management consulting created in the 1950s as an amalgamtion of firm) and Investment Bank were hired to six separate nu enterprises, assist Enterprse in assessing its strategc some of which datedback to the 1920s. In positon, and to undertake necessary re- 1990, the company had 32,000 employees stcturing. Investment Banks interestwas and made a range of products for both the to create and financially support ajointven- military sector and civilian industries. It had ture, take an equity position in the compa- developedconsumer productstobalanceits ny or both. To this end, Investment Bank military order book and to eploit its tech- would help finance new investments, if nologies. Due to its strategic importance to guaranteed an equity stake and if selected the nullary, Enterprise was not explicidy for financing a future deaL Consulants re- targetedforprivatizationin 1991, butanew cently decided to expand their European managementteamandstrongforeigninter- operation outside the United Kingdom, est came at a time when the oompany faced and were willing to invs both in learning an uncertain future as a military contractor. and inbuiding a reputation in Russia. Thbey Thus, it took the oppormnity to identify vi- wcre financed partly by Investment Bank able :;.rategic directions, induding how to and pardy by themselves Later in the pro- privatize quickly In mid-1993, Enterpise jecc, Bilateral Donor woould come in and succeeded in getting cabinet approval for provide additional financial supporL RsmrcrmnG ILAE EN5pmEs iN PREPARAlION 10o1 PMVnzAION: A CE S-rum 159 Snarl owenizadon und! 1991 development, pmtotypes, prepartion for seial production, development of produc- In the early 1990s, Enterprise's productive tion tools, and maintenance. Roughly 6,000 capacity was split more or less equally be- employees worked in this departmnent (in- tween miltary and civilian production. On duding over 2,000 sklled engineers in re- the militay side, the development and pro- search and development). Production of duction of a small series of specialized ap- individual parts, processes, and assmibly plications was dominant. Most civilian was allocated to individual production production was based on the same tech- units. Assembly would always go to those nology but had been developed separately units responsible for assembly of similar There were three main nonmilitary prod- products. The marketing and supply de- ucts and the most important end-users partmenr obtaned extemal raw materials were indusries, hospitals, and schools. and parts. Specially tailored components Recently, some products had been devel- were produced by the components parts oped to target the consumer market. unit in the technical department. Altogethers there were more than 250 Producton unit 76 was an exception. It product groups, ranging from toys to ad- assembled rwo of the more profitable non- vanced miliary hardware. Many civiian nilitary products, and provided parts and products were made only by order (areflec- processes to other units. Unit 76 was also tion of how militayr production operated). responsible for elements of product devel- Moreover, there were many development opment, production preparation, mainte- projects in the pipeline, originating both in nance, and supply. All production units, the cental research and development de- including 76, reported direcdy to the direc- partment and in individual production unts tor general, who, in addition to other du- or complexes- ties, assumed direct responsibility for To meet the requirements of 250 pmd- production, partly because he had been uct groups, the organizational smucture manager of 76 during its creation, before emphxaszed specialization according to being promoted to director generaL Over- fLnctional expertise (figure 12.1). Al, the production units employed almost The technical department had been re- 16,000 workers and engneers. Production sponsible for applied research and product and development decisions were taken by the management group-that is, the direc- Figure 12.1 Existing organization tors of the central units. I Shareholders 1The department of economy served I oDmsi*ionltrMplitarAhijs individal units, as well as the whole cor- poration, -with accounting and cost calcli- Management Group tions. Costs for complete pmducts or parts - Director-General were calculated based on the use of re- sources, estmated when the product was originally developed, and current resource SI- Emcy o, *l o social ' costs; inventory accounting was based on _U Ifh2 ? f n the first-in, first-out method. With lmited wnsoemo s .d _md & P - computercapacity, bookkeeping and cost ---A4 faf I l a if and accountingwere done manually, employing sWkt "F"Vllan d td ti wod |. li es f. SW- several hundred economists. in a7Itup'e heafticare The department of marketing and sup- and dir edit ply handled the major and difficult task of of:1fdal scuring inputs. Marketing (to the extent prductim Ithat it was done) was carried out through *|~ - l contacts with govemment-controlled dis- DCie_GUW ap- Yllt7 twoembro tributors in the former Soviet UniorL Two ing asl q 8 od f mast *'Z(af31 busi units L.....E.J p'ductionunbs sin no exceptions were the stores in the city in miTmry vwhich Enteprise was located and in 160 RUJS5TA CREAmNG PRIaEMas AND E cr ENTEmnm Moscow, wher consumer products were documentation. For example, Enterprise sold and some industrial pmducs ordered. staff working with Consulants had con- The two scores also provided minor repair tracts drawn up to establish their terms of services and sewved as reception and deliv- reference and guaranteethem theirold jobs ery points for products to be repaired at the at the end of the project main factory. There were major gaps in the functions The personnel department notonly cOy- performed because, for decades, directive ered mangement of 32,000 employees, but fromMoscowhad largelyreplacedthe need also supported the wodre' council and in- for market information. Basic research was temnu security. The finance and innovation provided by central laboratories in department, which had been created in MsOcW. SL Petersburg, and in the city of 1992, oversaw financing and cash-flow is- Entriprise, and the mflitary took an active sues, as well as directed investments to part in supevising the deveopment of mi- promising developments. It also attempted itaryapplications. Supplywasorganizedna- to function as an intemral touble shooter or tionallx and some key supplies came fron wnsulting service. other monopoly suppliers and from other Fmall, die social department, employ- republics in the UJnion (figure 12-2) ing 5,000 workers, provided housing kin- The most critical deficiencies were in dergarten, lmite d health services, and basic marketing, sales, distribution, and after- food and grocenes at the company cafete- sales senice. Enterpnse had almor. no con- rias and stores (produced at a nearby farm). tact with end-users, and did not have real It also offered sports facilities near the fac- marketing, sales, or service capabilities, nor tory and two dacda for employee vaca- itsowndistnbution channelso Llated from tions-one next to the farm outside the city strategic desions on production and prod- and one in Crimea. uct development and from customer access and contact, Enterprise, in the early 1990s, .Flow of i4nnfaon was a large, centralized, overstaffed, in- credily complex, bureaucratic production There ee two distinct information and employment organization. flows-bottom up, from individual units to production units (or from central depart- Struucural changes in the ealy 1990s ments) up to management and top down, from management (or individual dirctors) The shocks experienced by the Russian to departments, production units, individ- economy from the eady 19 80s on are com- ual units, or ven to individual employees. mon kmowledge. Less well-known were the The first flow (bottom up) provided basic performance data-production volumes, resourceuse, worker attendance, cost of in- g s outs, maintenance needs, development re- Market Research and Supply Production Marketing Sales and After-sates sults, and so on. The second flow (top research development distribution sence down) provided decisions-on product mix and production targets, resource Peromed by Enterprise: allocation, amnel, suppliers, inputs, Emphasis an Extensive - Production Limited TWO Sakes hin sales allocation, personnd suppliersw inputs, * organa- pmitairaangunant fice in St ofikes(or maintenance, developrment, schedules, and - ontionto of fer Mrt lemur m reaiu - applications xEcure aXWts. or ifD sent tot so on. Even trivial decsions were often re * deveopment supptes andpduc- a LiAied facyin , , , @ ~~~~~~~~~~~~~~~produsbo n 6an chin- 5 ferred upward, as senior management di- machin ery %=dib- rected all aspects of the operation. As5 bon Performed exdernal to Enterprins This resukeed in a centralized organiza- Direeives Bau7r& a anizd AlMocted tion with rigid operating procedures.Major cramby central ss and ,, ~~~~~~~~~~~~minist es duiancecydir d disrbudio decisions were communicated through ex- cedra r Swecv CD"- ecutve memorandums from the director U.S general, and all decisions required formal direc RsmcaNG LA GE iENrmsEs m Pmnnnn FOR P miAomN: A CASE STun 161 effects of the shocks on an oranization ical input, labor, also experienced drastic such as Enterprise. They had a huge influ- changes as many skiled and entrepreneurial ence on the need for the scope and pace of workers and engineers either left fir beter restructuring The external shocls most rel- opportunities or spent their timc at Enter- evant to Enterprise were a drastic al inc dce- prise working for themselves. Those who re- mand for military products, the political mained became dissatisfied with their chaos combined with the disintegration of shinking real wages and reduced benefits. the Soviet Union, hyperinflation, dimina- Idle capacity, caused by reduced and tion of central planning, drasc reducton of shiftng demand and limited avaiability of soft credits or subsidies, foreign competi- key inputs, was further aggravated by in- tion, and privatization ofboth suppliers and creased competition. For example, the customers (figue 12.3). transistor radio market was an easy target The external shocks These external shocks led to significant for cheap Far Eastern and Chinese con- most relevant to changes in the industrial structure in which sumer products. While some imports did Enterprise operated. Miitay orders, rep- not offer the same technical quality, their Enterprise were a resenting half of tumover, dropped rapidly, designs were more attractive, and dLey drastic fall in whereas industial and medical demand for rapidly gained market share. demand of military core products remained relatively stable. Enterprise's hospital products, on the products, the With inceasigy independent and cost- other hand, were in a rapidly grwing seg- conscious consumers, demand became ment of the increasinyimportant medical political chaos more quality- and service-oriented. Con- equipment industry This relatively new combined with the sumers also seized the opportunity to buy product group offered good-quality prod- newly available foreign products, and, as a ucts to both hospitals and patients, with disintegration of result, Enterprise's consumer goods fared lower costs to alL A few big international the Soviet Union, badly with their old design and limited fea- companies had come to dominate the hyperinflation tures To make matters worse, the payment world marketandmanymorewantedtoen- elimination ofsystem proved inadequate to absorb the ter. The Russian market was quicldy be- elimination of rapid increase of transactions. It was not coming important, and Enteprise, among central plannin& unusua for cash payments (from customer a few local suppliers, became a target for drastic reduction of to their local bank to Enterprise's bank in acquisiton itself the City to Enterprise) to take 60-90 days. Structural changes adversely affected so>ft credits or Inflation and an increasingly hard budget the performance of Enterprise. By the ear- subsidies, foreign caused further poblems for Enteprise, its ly 1990s, Enterprise experienced severe competition, and clients, and suppliers. And for die first time supply shortages and a marked deparure in Enterprise's history, customers would from its healthy financial position during privatization of sometimes default on payments. the iate 1980s. Although the situation was both suppliers and Enteprise experienced important kept under control through soft credits customers. changes in both up- and downstream sup- from Moscow, it was becoming more and pies. As pnvatization gained momentum, more difficult to obtain these subsidized many traditional suppliers changed their loans Neverdless, there were some prod- product mix, volumes, customer base, and ucts that were highly profitable, especidaly prices. In particula, energy prices rapidly the few export eamers. The trend toward a approached world market levds, and the lo- streamlined product range aleviated some cal energy supplier quiddy evolved into the problems, but the shift in product miix and largest provider of medium and long-term volumes was painstakingly slow. finance Limited and irregular availability of Further aggravation was caused by the key supplies reduced capacity utilzation, lack of internal financial informaton, even for goods stil in demand. Moreove, especaly short-term cash-flow analysis. downstream acvies suffered severe dis- Accounting could not provide rlevant and ruptions. Local distaibution oganizations timely information m a changing environ- quiddy went through privatization, and ment wnth high inflation. Consequently, al- Enterpse suddenly had to deal with many though the books may have ba3anced, there profit-onented private firms The most cnt- were fequent liquidity cnses caused by the 162 Russr& CEANG PRVAnE Ms AND E NaIniTENpmiSs volatdle payment system, defaulting cus- Restructuring tomers, changes in demand, and sudden in- put price increases. The joint effort to retructure Enterprise Operationally, all this had three major began at the end of 1992 with discussions effects. First, inventory of less attractive between management, Investment Bank, product groups was piling up quickly, and and Consultants It was agreed that Cons- production could not adjust accordingly. ultants would field a team starting January Second, at the same time, many workers 1993 to perform a diagnosis and generate were underutilized, causing poor morale preiminary recommendations. Enterprise and lower product quality Many qualified would fiu-ther strengthen the team by workers left And third, due to lack of adding its own members as needed. Given fimds, lower overall activty, and a sense of positive results, the agreement would be ex- lebargy, the deterioration of the machine tendedbeyondtheinitialdtree months.The park and buildings accelerated. first task for the consulting team was to get These developments prompted sub- to know the client. There was litde infor- stantialchangesinconductbyEnterprise- mation available on Enterprise or its mar- and by its increasingly private and active kets, merely brochures for some civilian competition. Enterprise reacted to the fall products. The consulting team had four in demand by reducing its work force from objectives: 32,000 to 25,000 by the end of 1992, part- * To make a rough assessmrent of the fun- ly though rDrement and resignations- damental viabilty of Entesprise, its Moreover, there was a stronger emphasis products, markets, and capabilities on revenue-generating products and on re- * lb assess managementes willingness to search and development focused on con- change and its ability to implement sumer goods, both of which had further tough recommendations cost-cutting effects. * To build trust and a relationslip with To retain key staff and survive in this client team members and key managers new environment, Enterprise began to pay and be accepted by the organization important employees better, increasing the * To create a common platform for gener- salary spread considerably. The company atingpreliminaryrecommdationsand also began to delegate greater authority to managers and to create units to handle the Figure 12.3 Structural change early 1990s missing finctions. Forexample, production I unl3it 76, with its small product-develop External i _ dChanges in Changes in Changes in unit 76,withitssmallproduct-devel-shocks structure conduct peformane ment, economy, and sales functions, was an attempt to create the embryo of a strategic F udimaiicr Demand Effiency Proltability -Etiminatkm of central - Drastic drop hin -Fo3ised product: -larg aidations kV business unit plamning pwciasing power rman consm product profit nur- -Drsic reduction of bugtlo;ins products gins Externally, Enterprise began to link up soft credit a demand -Drasak cost cuning -Negat ar brak- . s s . ~~~~~~~~~~~~~,Raic ent b^ry s Rof =rlneinconsurner =thryoffhs. even perxaX .. _c with key suppliers (fornally and informal- el?omrpetiSon e e7w,cont Zproducaon, oll ly). Upstream, the company secured long- -tZationof demandpatt tonswkith suppMs i rn term contracts witi some parts suppliers by cus 5ners paynetnd cmcit -spead to mkey rete indltion providing some financing as an incentive. fnd war stn -?w-upe rpte Negati cash flb addrastic fall 51812* ofSMI ad oISbte Downstream, the race was on for control in demand for *oisruption in supply bu "ess A, ients, iad over distribution channels. Established 1iticalhaos Mrexomp7no and sales afeumt riqLdrty contacts allowed Enterprise to continue to soldeiewegeator Valf intpatlon 0c - -n pmup nhostile and capacity -Build-up ofla use much of the existing distnbution net- Ofages* in 54pply ilnsta eofess works, but this did not provde the neces- sr distribution (for enmpl no sary direct ustomer contact The texbiook so td _ o id runderutilized solution would be to create a new distrlbu- Rapid entrycf reasedletora. tion set-up, but Enterprises intemational vice * buftin competitors vere already working on this Compedtion in the service-intensive hospital-product - Rapd enuyof lir- market. ip aeors RasRucrURG LARGE ENTERPIES iN PREPARATiON FoR PRiivATifnoN: A CASE SnTr 163 to agree on a detaled work plan, scope simple and focused, four key areas of analy- of the engagement, and time frame sis were identified (figure 12.4). A mock annual report was drawn up, and the team set about designing draft or- Financial situation ganization charts to be filled in based on in- fornation generated by the client team The firstctical need was to understand the members. This initial six-week exercise al- short-termrfinancialsituationof Enterprist so served to demonstrate the effort and Was there need for immediate defensive ac- quality of infonmation requied to perfom tions to sustain the company in die short a fact-based restructurin& run, or was cash-flow positive? The answer Was the restructuring of Russian enter- was inconclusive. The emphasis was on prises qualitatively different from that of cash only and the team took great pains to The first crtical typical western clients? Clearly, the histury eliminate revenues not readily available to need Was to under- and tradition of Enterprise were different the company. It seemed that there was stand the short- fiom those ofanywestern company, as were enough liquidity to meet short-term de- the degree and the types of external shocks mand, but even this was uncertain. Some term fina al it faced. On the other hand, the mandate soft creditswere also anticipated, butitwas situation of was to help transform this company to a unclear whether they would materialize. Enterpfise. profitable busness competing direcdlywnth The analysis revealed that pricing did not Enterpwrise. large multinational corporatons in a mar- reflect cash production costs. and that a set ket economy The obvious cnclusion: re- of price changes and production stops strucaming is much more complex for a would improve liquidity. The short-term Russian enterprise, given the greatEr effort cash issue resurfaced several times in 1993, required, power of old habits, and cultural causing much turbulence for Enterprise sensitivity. But basic business conditions and the project team. still apply. Having successfully created the mock Pmducas, ogankagon, and parnrs annual repor the team designed a struc- tnual approach to help Enterprise become Second, it was thought that product analy- sustainably competitive?' To keep matters sis would identify winners and losers among Enterprise's products and deter- Figure 12L4 Structural approach to restructuring -mine the future of its product portfolio. The -annual report" oudined Enter- knear-tenn Is*real et incone prise's products and estimated the volume financial IEa- - Positiave b of production. With an improved under- posifive standing of the econoniic importance of the Am.producs atactie and bmader product groups to Enterprise, the Ispouct 1a7n uDo revenuesnmeet producion consulting team bruinstormed with man- offeing ao s agdment to determine where production competitie? VWil products be attracivw and Are prduct develpments copetitive7 should be focused. Based on existing in- PolCenidallcompetitivi Wil netvalueofrevn uestmeet dustund ersng, supported by west- Can dient developmen, wesnt, and becomea_ production csts em market information, the team and viable Doesstructureake Is relevat inforrmation readily management decided to concentrate on bkorgarizaion nources effetively? Are inceti in Ene with dient tWo industial products as the most promis- (and s Itm objective?7 ladspr) g ing business areas and also look dosely at effective and ~~~~~~Is araizalian appropriatel dfxiden Doesrergaizati seuffedr?tonap one consuener product (becausc of its rela- effiden? orqaidadnyeivr~ and efidenfl gainst dedo7 s organization posse sut- tive importance to Enterprise). Should business sponsibt be nzational anass aim at creating 'S5hould ownion be deWegat? a stcture to support the production and (Gien need*> = 9"no'a Ca- atmu coeii Should diet be . gaps? sale of the most promising products. The .eet market Is cient naturl owner of eiisbng goal was to change the organization from situation? jhouM product offering products? bechwxgeo7 ShouW devldopn.emt be monorithic and centralzecd otne, to a set of red dede product-oriented business units wth dele- 164 Russw Cna G Pin sv Mm=rs AND EFfrcImEmNmusrs gated authority and profit responsibility understanding of both former Soviet and Another important objective was to reduce inernational markets. Since international the complexity of the organization, as well market information was readily available, as to train managers and workers to close the issue was how to analyze the domestic skills gaps. markets. It tumrned out that Enterprise's The assessment of potential partners managers and engineers had a wealth of in- was based on the strategic position of each formation on other producers in the former sub-anit and its investment needs (in sys- Soviet Union because of their previous con- tems, skills, and capabilities, as wel as cap- tacts. The team was able to put this infor- ital). It also perceived partner aspirations mation to use and suggest a marketing and the value to both parties (Enterprise strategy. For example, the research and de- and partner) of cooperation. The assess- velopment department had rough segmen- ment covered direct competitors with coin- tations of end-user markets, which the team . -.top management plete business systems and world market broke down by purchasing power and geo- was still inclined to presence, suppliers of key functions, and graphic location to identify test groups. capabilities in important markets only. Data were then collected through in-depth cross-subsidize and interviews with representatives of the test continue making Progrs groups, and some information as available products judged from GOSPLAN in Moscow. This provid- pr tant to The initial diagnosis began in January 1993 ed a deeper understnding of market size mportant to and took about three months, with an ad- and share, the development of competitor soCiety"... ditional three months to generate prelimi- products and distribution, and Enterprise nary recommendations. The plan was that product attibutes. management had to accept the results and As better-quality infornation and analy- be wiling to push ahead before the team ses became available, Consultants began to could continue. Initally, the Consultants spend considerable time with management expected to move more quicwdy and either implementing the improvement plan. Not finish the engagemnt by late summer 1993 surprisingy, as soon as one problem mas or increase the scope of the project. In re- solved, new obstacles and questions would ality, it took longer, for three reasons. First, arise For example, the need to merge profit the process was expected to be a series of responsibflity with key business systems iterations-starting broadlM then gradually highligted the concern of top management zeroing in on key issues. But lack of infor- that it would lose controL Would sub-unit mation and the inevitable unanticipated sit- managers perform as expected, or would uations caused delays. Second, as trust they retain the benefits at their units? started to develop and personal relations Corporate govemance had to be dearly de- were built, Consultants and management fined and control mechanisms put in place engaged in time-consuming, but produc- If sub-units were organized around good tive and frank technical discussions. Third, products only how would the rest of the management asked for assistance on items product groups be organized? The obvious not indaded in the original terms of refer- answe, to eliminate most of the product ence. Managers, induding the director gen- range, met considerable resistance n the eml, increasingly requested day-to-day help consultants' view, it was reasonable to insu- with operational issues. late viable products from loss-makers, but By eirly spring 1993, the team had top management was sdll indcined to cross- achieved a rough understanding of Enter- subsidize and continue making products pnse, its products, its capabilities and the judged "important to society" if only to re- market situation and had devised a prelim- tain the option to produce these products at inary strategic plan for product focus, busi- a later stage when the economy had devel- ness unit organiion, and joint venture oped. Eventually new, more business- angements. The team then began imple- oriented sub-unit managers would force the menting and modifying the plan. A major issue, and as privatization became a red pos- effort was made to increase knowledge and sibility top managers increly empha- RmsmucruRN LAuGE ENmuD;ss. IN P1EPARAnON roR PIVAZPIort A CAs! STuDY 165 sized profit generation over societal commit- groups reported fequently to top manage- ments and questionable long-termoptions. ment and to each other. After a short Discussions on how to organize compa- teething period, the working groups gener- ny-wide support functions focused on three ated momentum that quickly pushed elements. Firs, inanagers pointed to solu- changes through. The change process, how- tions of internr anal competitors, especial- ever, caused tension tu build between es- ly those with centralized research and tablished operations and the proposed development. It could not easily be shown changes until it I tcame dear that a resolu- that those companies had gone through a tion was required. The conclusion was that period of decentralized research. It was on- gradual transition was not only cosdy (as lywhen synergies of central research and de- products were eliminated without subse- velopment outweighed the cost of removing quent layoffs and asset reductions), but direct control from profit centers that it could actually jeopardize the whole re- made sense. The concdusion was that the re- structuring program. Management decided turns from investment on research were in- to give itself one month to create a func- significant (for the time being) compared tional new organization while temporarily with the value of insiling market behavior. shutting down operations, giving all A second discussion centered on how to nonessential staff leave. An important by- deal with social units. The social commit- product of this month was the identifica- mcnt to workers and their families was tion of the staff (and resource) needs of deeply ingrained in top management, and eachbusinessunit,based onprojected sales they only reluctantly agreed to divest these of profitable products. services. The third discussion concerned the In the final analysis, that one month of links between functions. The team spent concentrated implementation of the pro- considerable effort describing to manage- posed changes proved critical to the success ment how information could and should of the transition. The clear deadline pro- fiow, how decisions couldbe made, and how vided top management and consultants future units would interact The proposed with a sense of now-or-never and pushed sub-unit managers became invaluable allies, them to a massive effort to finalize key andmanyworthwhileideasweredeveloped pieces. By the end of the month, the new and tested in the two pilot business units. As organization was more or less in place-re- the new organization and core products suting in theimmediateelimination of over were established, the focus of the consult- 10,000 workers.1 The new, redimensioned ing service shifted to implementation. product market sub-units had the ball and The transition phase was the most were starting to run with it taxing-both for enterprise employees and for consultants. The emphais of the work Results shifted from analysis to process, and the pressure on individual team members and There were five concrete results from the managers intensified. One reason was that restructuring project: many middle managers got involved as the * The nonmilitary product range was cut focus shifted from strategic design to im- from well over 100 to 3 core groups, plementation. The team was thus tern- representing more than a 50 percent porarfly augmenlted and two consultants (and increasing) share of turnover, 80 were assigned to each pilot sub-unit man- percent of profit, and 45 percent of em- agrament unit while the project manager ployment (direct and indirect). Of the and another consultant supported the di- original 250 product groups, only 90 re- rector general and corporate center. mained, and those were mainly in the Groups were set up to work out details of military sectoL the structure and functions ofthe corporate * The new orgmaization is considerably center and sub-unit organizations, indud- smaller and simpler; and the size of the ing staffing resource needs, transfer pric- organization contines to decrease as ing, and myriad other details. he working more products are judged nonviable or 166 Russx& C:Am.n PaxvnTE Man AND EncIN4rflmlmEs unsuitable for Enterpnse. The new sub- controlled or ignored. A gradual under- units have not yet begun to expand their standing has emerged that the decisions staffs, but are likely to as output and of these consumers, rather than the de- product sophisation increases. There cisio t of a few bureaucrats in Moscow, has been some limited recruitment to fill determine the fate of the Enterprise. key functional gaps, but die emphasis has been on fEning suitable staff m:.er- Conclusions nally and retraining them. The present ccrporate structure is that of a holding Corporate remouvtoing reqdes much ef- company, with incorporated strategic fortandlime, often years ofintensive, sin- business units to stress formal account- gle-minded concentration of resources. abiity, to increase flexibility ad to facil- It cannot be imposed successully rom itate foreign investments (figure 12.5). the outside (by shareholders, govern- Corporate • Enterprise was successfully privatized in ments, or the public). It can only be inst- rest rcturin a voucher auction in November 1993, gaed fios uiShn by managen able to g wnth strong interest from Moscow- carry the organization'with themL Any it- requtres mucb effort based investors and brokerage firms. structuring must therefore be undertak- and time, often Almost all workers, incuding those ter- en with full cooperation of management yeanr of intensive, minated, invested their vouchers in the and the understanding of employees, company. Once privatized, Enterprise customers, and suppliers. Restructuring Single-nmnded was free to pursue an equity injection intheformerSovietUnioniscertainlyno concentration of from Investment Bank in two of the less difEcult than it is elsewhere, and resources, [and] can business units, or subsidiaries. probably more demanding in intensity • Due to lower costs, concentration on vi- and quality of efforL After one year only be instigated ableproducts, andimp wed marketing, this particular restructuring effort had from within by distrbution, and sales tanctions, Enter- stopped the financial bleeding of Enter- managers able to prise has returned to positive net earn- prse and set the stage for implementing ings in 1994. More important, cash-flow a new cororate stratW It wl be an- Cay the organiza- is positive, and the company has begun other two to three years before Entr- tion with them. to reduce its debts to the energy corn- prise is fillyrestrnctured. pany. In adldition, with hard-curenyin- * Basic buess practices still apply. The jections in two business units, these basic advice provided by consultants sub-units have begun to invest ia three advising management in Russia was the areas-equipment (to improve quality and process control), emnployee trining, and creation of computer-supported Figure 12.5 Organizational change management information and account- Director General Director General ing mtcms. * The wolking mode of Enterprise [as pr X}arat Eoadgla changed dramatically. The orientation . and skills of both managers and work- dsrl-4jnsi _ ers have already improved considerably, as measured by output and more quali- tative assessments, and there is gmater Ctrproes Centerimplt-its CuIpOU mit. Carpoamte code and is grea ~~restarch and salecstrkbibmtio. P¶*d strategc pa idwaggre- emphasis on borizontal interaction for d nd n - zrkt iZjZs - prmkpU p , p-sonne,socad fin ncig, enqhc information and decsions. Aciities ration, * arnd tam- entdcadbl . , . _ , pann~~~oming, fimm accourntg and pennam *unc- are mcreasingly dven by profit, and rq,.'dresurce tauryfunctiom - n customers are, if not paramount, con- . et_ siderably more important an ever be- MaOd R Sup*Pn Mrn fore. When mentioned (and they are Iftwu d ro:.1ducdtn lru duction sL mentioned often), they represent not I Luits I units I units l s abstractend-usersorintermediariesbut important individuals who cannot be RStucruGaIa LRGa ENT CsEs IN PREPARAN FOR PRavAn oN: A CAs SEw 167 same as anywhere else. Given the limit- Moreover, the diagnosis provides a ed time available to management and foundation for tmst-based relation- lack of long-term capital, it is important ships, without which advisors cannot that te advisorsfcus on thefundamental help management accept and imple- aspects of the business, with a view to ment difficult changes. changes that are sef-sustainhsg and that * hat must be clearly emphasized is that create a momentum ofcontinouspositive managers in formerly socialist countries change. Rather than fine-tuning market find themselves in uncharted waters. strategies, which istime-consumning and Not only is the transition to a market requires considerable local knowledge, economy new and confusing but the in- concentrate on getting the basics right teraction with intemational organiza- • Two key limiting factors that must be ad- tions, financiers, donors, and advisors dressed early on: the complexiy of lare can give rise to misunderstandings and ftmncaioalorganiaioubsand &elackofrel- suspicion. The value of panence and euantskilfsfora market-based ecnomy and long-term perspective on behalf of for- profit-driven oraniaton. Both factors are eign parties cannot be overstated. to a large degree a function of the orga- Pinners mus know that retrns on in- nizationalsrrtiucreofLypicalSoviet-sryle vesnmens, evme 4potentaly sign4¶cant enterprises. This complexity can be re- wil take time to matail*v-and often duced only trugh drastic reorganiza- uill not Participation in restrcturing tdon, simplification, and down-sizing. could wel be viewed as a long-term op- The greaest lever for self-sustainable and tion, and valued accordingly Equally, bi- continuous building of skills isto create a laternt donors mut permit advis and new structure for which both manges management sucnt ime to tumn the and workers are responsible that gives company around and greatfreedom of op- them authority over cost and revenues, erationz Most important, however, advi- quality and product decisions, produc- son shou not expect any substatl tion, sourcng and marketing inpact utl trust has been established be- • At the outset of a restuuing effort, adi- tween dte consltant ad the managers, son andinanciers should permm a qzuic another aspect of the process that will diagnosis of the enterprise focusing on its take time. The ingredients of a mnust- current financial status and the attitudes based relationship are no differentin the of management. The ailites and will- former Soviet Union dtan elsewhere, ingness of top managers to change, only more pronounced. Honesty, in- which will decide the outcome of the tegriy, longterm perspective, personal project, canbe assessedonlybyworking relationships, and high international direcdy with them. Equally important is standards of quality-these are every- to evaluate the potential viability of the where the building blocks of cbange. company, the attractiveness of products, The restructuring effort will often the cost situation over time, and the change direction during the project, competitve structure of the market in pardy due towhat the consultants learn, which it operates. No doubt there wil but also as the client develops an un- be many basket cases (and only a few derstandingof the company's situation. shining stars). fmawngers are unwilng Although much hard strategic thinking or unabl to implment tough changes, or and analysis are required, there will be if the compay is nor potentialy viabk, substantial tactical elements in working conudant should withdrawfrom thesitu- with managers. Often, the biggest dis- ation. In addition, it makes good sense cussionwill centernotonrthe strategyor tobegintheusmdywithananalysisofthe even the orgaizational structure re- current financial situation. Often, cash- quired, but on the less tangible interac- flow will be negative and immediate at- tion between units in the organization. tendon must be given to near-tenm The topics of debate wil inclde any- solutions of the liquidity crs. thing from suppliers, customers, tech- 168 Russz CEwAnNG PMm Wm=S AND ERmoarENnhsEs nology changes, competitors, and mar- The soluton was to retaithe delimnatedl woers ket behavioz to the soft link between on a sepate paoll wine they would receive utnits and functions witi Units, ijn their current (nominal) wage indeitey With in- tive sctemes, tion flows, and flaton. the cast of this payroll bill wold soon be n a.ddition, management assumed a dedsionmaking in a rapidly diangitng great deal of rsponsibility to actively outpace maket environment. In the final anly- workers. In many instances, exneploys would sis,this iswheredte success or failure of acquireorevenbe ,nividuaasset.andcon- restucturing will be deternnined. tinue to supply Entmprise and odie companies as subontractrs Others would receive shotm Note training for other employment opporatnities Some would be employed in private companies of 1. Even though workcrs were immediately em- top managers. Man, howevre would have to fend inaed, lgpy dtey could not be fired that quicdy for themselves. RESiICnJWIuN LARGE ENTSPES iN PREPARhION R PMImoN: A CASE SumD 169 CHAPTER 13 Newly-Privatized Enterprises: A Survey Leila Webster with Juergen Franz, Igor Artemiev, and Harold Wackman Projct objectives combined population of 8.4 million (6 per- cent of the Russia's total population). The primary objecinve of the survey was to The survey was carred out from document the characteristics, problems, October 18-28,1993 by a team of Western and needs of medium-sized and large pri- and Russian interviewe Two-person str- vatized enterprses in Russia. The survey vey teams spent two to three hours with each was crried out during tie preparation and enterprise manager, completing a question- pre-appraisal of an enterprise restructuring naire made up of quantitative and qualita- operation. Findings from the survey were tive questions and visiting their fictories utiized in the design of a subsequent oper- when possible ation. Specific areas of interest includedc The sample was based on lists of all pri- * The characteristics of medium-sized varzedfirrnsprovidedbytheoblastproperty and large pivatized firms as regards funds in Vladimir and Moscow (table 13.1). ownership, govence, labor and capi- In each oblast, two lis we obtained one tmanagement, finance, post-privata- for enterprises privaized throu the mass uon behavior, and futu strategies, privatization program (MPP) and one for * Firns' main problems in demand, in- pivadzed leasehold companies (PLCs). puts, finance, and labor; Firms were to be evenly distributed be- - Fnms' potential demand for cedit in tween the two oblasts. Half were to be pri- terms of use (working capit or inest- vatized leasehold companes and half ment), nature (debt or equity), term should have come through the MPP. In ad- (short medium, or long), currencies (ru- dition, half of the sample firms were larger bles or foreign); and their relationships then the average privatzed Russian firm with major actors in the financial system (which has 1,100 workres) and the other (banks, domestic and foreign investors); half smaller Small firms with fewer than * Technical assisance requirements and 250 workers were exduded if possible. The potential design of this assistance; sectoral distribution was to focus mainly on * Firms' general capacity to stay afloat in manufacturing with 70 percent of sample the near term, undertake necessary re- firms drawn from manuficmrers and 10 strucuring in the medium term, and percent each from construction, services, evolve into viable companies in the and transport (table 13.2). future The final sample wa fairly representa- tive of prvatized firms in the two oblasts Method Two oblasts dose to Russia's c Table 13.1 Privatized firms by oblast and origin selected for sampling-Moscow oblast Mas. PWtzed (which exdudes the cty of Moscow) and orogam companies otal Perent Vladimir oblast (located about 200 kilome- Moscow ablest 105 351 456 51 ters from Moscow). The total area of the Vladimir oblest 194 96 290 39 two oblasts is 75,000 square kilometers Total 299 447 746 100 (twice the area of the Netherlands) with a (percentage (40) (60) (100) NEwLPRNATzE ENTERSES: A SURvEY 171 with two erceptions. Because the survey in- shares, 10 percent of shares were held back duded numerous large finns, the average by the property funds for later sale to work- sample finn size is amost twice that of the ers and managers, and the remaining 39 average firm in the population. Stratification percent were sold to the public through by sector also resuted in a disproportionate voucher auctions and investment tenders. number of manufactrers in the sample. Managers owned an average of 17 per- cent of their finns, 21 percent in leasebolds The firms and 13 percent in MPP firms. On avenge, employees owned 61 percent of shares, 75 Half of the firms moved into the private percent among leaseholds and 50 percent sector in bits and pieces under leaseholds amongmass-privatizedfirms.Amonglease- and half came through the mass privatiza- holds, the small portion of shares not yet tion program. In both cases, there was little purchased belonged to the Russian state. evidence that managers had sorted trough Among mass privatized finms, owners oth- assets, chosen the best, and discarded un- er than managers and workers were oblast wanted parts. This was particularly surpris- pmperty funds (average 20 percent), insti- ing for privatized leaseholds where it wras tutionarinvestors (average 19 percent), and thought that these managers have been ac- individuals (averagelO percent). tive in asset stripping. More than 60 per- The average labor force was 1,518 em- cent of the finns had been private for over ployces, but the medianwas 752, reflecuing a year and only 5 percent had bee priva- a duster at the small end and rdativelyfew tized in the previous six months. firms with more than 2,500 workers. Aver- AAlmost all former leaseholds wera ei- age monthly sales in Septemberwere $1.04 ther cosed joint stock or limited liability million but the median ($266,000) was companies and, as requiredby law, alUmass considerably less, again due to a duster of prnvatization enterprises were open joint firms at the small end. At an average of stock co,mpanies. Among mass privatized $400,000, sales of former leaseholds were firms, a quarter had chosen option 1, a tiird the size of mass privatization firms. whereby workers could claim 25 percent of Sectors wit ie highest sales mduded fab- shares free ofcharge with the option of pur- rcated metal products and paper prod- dhasing an additional 10 percent at a price ucts, the lowest sales were in services and established by GKL Managers could pur- construction. chase 5 percent of shares, and the remain- Minufactu ng s operated in all ma- ing 60 percent vere to be sold to the public jor sectors. Sixty percent were producing through voucher auctions and investment basic consumer goods. Nonbasic consumer tenders. Almost three-quarters chose op- goods such as porceain and art products iion 2, wherein workers and managers were the main products for 10 percent of Lould collectively purchase 51 percent of firms. Twenty percent manufactured non- Table 13.2 Characteristics of the sample consumer goods such as electric cables, wa- ter pumps, and locomotives, and 10 percent Population Ojective Actuasanse, produced construction materials. Forty-five Number of finrms 746 100 92 firms denved all revenues from one activiu:t Moscow (percent) 61 50 52 Among those that had diersified, thiry- Vladimir (percent) 39 S0 48 mass privatization program (percen) 40 50 48 twobepn manuficmangasecondproduat Pivatized leasehold companies (percent) 60 50 52 ten started up trading activities, sixteen Number of employes wer ivolved with servnces (usuaRy repar), Less than 250 (percent) 51 few 1 2 wruulyrpi) Less than ,1100 (percent 89 50 58 and four took on minor leasing activities. In More than 1,100 (percent) 1 1 50 42 general, enterprses diversified to make up Mean 880 - 1.518 Median 280 1,100 752 for shortfills in revenues. For example, a Sector number of specialized construction compa- Manufacturing (percent) 48 70 76 Construction (percent) 18 10 10 nra broadened their scope to all forms of Transport (percent) 13 10 5 consuction. Manufac of auto-parts Services (percent) 20 10 7 offered repair svices. 172 RUSSLe CuIAmG PanEs EmnnaSS AND EFRCIENT MNA Sonm cross-investment was apparent. hoped to resume former leves of produc- Among the two-thirds of firms that invested don in which case they would need what in at least one other business, most bought tthey had. shares in a bankl Other investments wer mainly in trading companies, raw material Finance suppliers, and odter manufacturing compa- nies. One in five PLCs made other invest- Working capito. Managers reported ments, compared with onie in ten of mass that inadequate workig capital was thi privatized fimLs. Forty-five percent of large biggest problem with financng. Problems firms owned shares in three ormore compa- mainly were due to deayed payments from nies compared with 7 percent of medium- customers and high interest rates. Mana- sized and 8 percent of small companies. gers could not get paid by their cusomers The major problems affecting business- and could not bormw to cover gaps at a The major es were delayed payments from customers, price they considered reasonable. Reve- problems affecting high taxes (maagers claimed they were nues were criticaly influenced by demand paying profits taxes of 80-90 percent), in- uncertainties and input and payment prob- snesses were sufficient ,woring capital, weak demand lems. More spedficaIly cash flow reported- delayed payments and falling orders, inadequate funds for in- ly did not cover operating costs (inputs, from customers, vestment, and inflation (table 13.3). These salaries, overhead, interest and taxes) in 35 h L S * problems were inter-related. Wordng capi- percent of enterpnses. Compansons across tal was eroded by high taxes, falling orders, firn groupings yield a profile of firms with insufficient working and inflation. Delayed payments, particu- the mmst severe problems coverng dteir apital weak lady with high inflaion, exacerbated the operating costs. These tended to be: p v problem Manags were hamstrung in Producers of goods such as plastics, demaznd and falling their efforts to move into new, more prof- glass, fabricated metal parts, and some orders, inadequate itable products by lack ofresidual fiunds for textles (68 percent of all sample firms funds for invest- investment. Few managrs complained of producing intermediate producs) more problems associated with government reg- so than producers of finished goods (13 ment, and infation. ulations, except for tax. percent of al such firms). Construction firms (five out of a sample Grpal total of six) and nufaturers produc- ing constuction materials (four of nine). Fixed aati Most firms (95 percent) *Mass-privatizaton firms (47 percent) owned all of their buildings and equip- more frequently dan among leaseholds ment. Former leaseholds purchased their (21 percent). assets in stages over the previous 3 to 4 *Fairly equaly distributed by size, with years and mass privatzation firms bought about a third each of small, medium- them as part of the privatization package. sized, and large firms failing to cover Ownership of land was less dear because their costu. Among large firms, one in of legal uncertainties. Half of managers five adequately covered costs, com- said that they had a long-term lease from paredwithonlyoneintwenrty-foursmall the state, 27 pecent were simply using the firms ancd one in fourteen medium firms. land with no legal agreements, and 20 per- cent claimed they owned the land and had Paymena. Receivables were up to date fornal tide to it. (or late by 30 days or less) in about half of Forty percent of enterprises had sold firms,butlate by90daysormoreinaquar- (mostly old) macinery or budings in the Table 13.3 Largest problem affecting sample firms previous 12 months to new private firms. entage of fims) Most manufacturers, however, were hesi- * ,, * * ~~~~~Delayed /nsuh;iet Weak No f'imd s for tant to sell off unused equipmentt cven paymrent High taxes wking capital demand invment Inflaton Oher though much was idle. Some wanted to hold on to teir equipment because,in 13 12 1Z 10 10 10 33 their view, its value was rsing daily; others more: Manages were asked to name thir three largest problems in order of importance. NEwIsPRVAm ENTEnPRP: A StUREY 173 ter of companies. Half of receivables fiom A few banks dominated in both oblasts: priae firms were up to date, compared Unicom Bank m Moscow oblast and with a quarter of receivables from state en- Moscow Inutial Bank and Rosselh- trpre. For tasport and construction bank in Vladimir oblast. On average, enter- companies with mainly in-state customers, prises paid nominal interest rates of about almost all receivables were late. The worst 190 percnt, with a range of 150 to 250 per- offenders were in other CIS countries. cent. Short-term loans were used mainly to Managers had little formal recourse against pay for inputs (69 percent of fimis) and em- those who delayed payments, and most re- ployces' salaries (23 percent). Among the lied on informal means of colecton. relatively few manager who had difficulty Personal harassment, including persistent obtaining short-tenn loans, the main prob- telephoning and threats to cut off or can- lens were reportedly that thirbanks didn't Obaining a short- cel) further shipments, was the most com- have enough money to lend or they pre- term lon from a mon approach. Only 15 percent of firms ferred favored clients with large acaunts. filed rsims in courts-a procedure that Only 12 percent of enterprises received bank was eas.. took 6 to a months during which time no long-term loans (onger tan 12 months) in interest was paid on the debL Extaing the preious year. Most long-term loans payments fiom large, powerful customers, were soft loans fiom the govemment, some upon whom many managers relied for fu- through association with agricultural con- tare contracts, was difficult. cems and others in the name of reconstruc- tion or immunent bankruptcy Almost all Prepaymeat Requiring advance pay- had been obtained more than 6 months ments with orders was a widespread prac- previously, and managers had litle expec- ice. This approach did appear to lower taton of receiving addidonal soft loans. arrears, and may also have dampened de- nand in the mdustial sector as managers ReLationb&s wiuth banks Forty percent delayed pmduction until they could obtam of managers had no problems with their prepayments from customers, which wer banks. Those who did, complained about needed for prepayments to suppliers. delays in transactions between different Others bad the opposite problem wherein banks and different cities and across the customers paid in advance (at current network of former republics. Many man- prices) whbe producer, who could not af- agers daimed that banks delayed financial ford to stock raw materials, ended up pay- transfers intentionally to maximize their ing higher input prices due to ddays in earnings. Otherwidespread complaints in- procunng their raw mateials. Textile and cluded lack of confidentiality, focus on clothing producers who pre-paid for sup- short-tem profits, and high fees for routine plies of cotton from Uzbeldsrn were par- services such as cash withdrawals, opeing ticularly disadvantaged. Locating solvent of new accounts, and exchange of foreign customers and exrActing payment from currency them was an important key to success. Some managers described improve- ments in banking practices over the previ- Us of intiwionu cdi±t Obtaining a ous year Firms were reportedly no longer short-term loan from a bank was easy, and required to conduct all transactions 77 percent of sample firms obtained one or through the banks. Accountholders were more loans with terms of fewer than 12 free to ithdraw unlimited cash from their months in the previous year. Many ob- acnts if they had a good explanation for tained four or five such loans, typically with its use, their bank had sufficient funds on terms of three months or less Loans were hand, and they were willig to wait a few secured with equipment and inventones. days for delivery Intermediating transac- Managers of smaUer firms demonstrated a tionsacossthebordersof formerrepublics greatr reluctance to take loans (62 per- was a prominent area inwich financial ser- cent, compared with 83 percent of medi- vices worsened. Managers reported waiting um-sized and large firms). months for payments, unable to ascertain 174 Russu: CIWI PuVmE E Nxsr AMD EmCaNr MArRS whedter the delay was the fault of the cus- payment-both in the context of a dens- tomer or of the respective bank tating recession. Keeping cnterprises afloat Two-tids of firms owned shares in depen.ded far less on lobbying ministry of- banks, usually 1 percent or less in the local ficials for subsidies than on making profits branch. Not surprising, the larger the firm, in the marketplace-after paying numer- the more likely it was to be a shareholder in ous high taxes. Provision ofbasic soial ser- a bank (87 percent of large firms, 44 per- vices for workers became problematic for cent of small ones). Ownership appeared to manymanagers, mostofwhomwere caught confer several advantages, including rela- in the dilemma of feeing responsible for ively easy access to short-term credit fadl- these services but recognizing that they ities, marginally lower interest rates; and could no longer afford them. ongoing relationships between managers The data suggest a strong netwcrk and bankers. among managers of privatized firms. More Most managers than half belonged to at least one industry wer middle-aged Mmnaget associaton, many of which were descen- dants of sectoral ministries that formey well-edlCed men Mostmanagerswere middle-aged,well-edu- coordinated production among state enter- with long cated men with long management histories. prises. Typically orgaized as joint stock ?xUgemm1 The youngest were in their early thirties and companies, these organizations offered their the oldest were in their early sixtes, with an shareholders and members bulk purchasing hlstories. average age offorty-nine. Only l6perentof of raw materials, assstance wit disrbu- managers were under 40. FuRly 85 percnt tion, technical information, and a voice in had uniersity degrees and an additional 9 Moscow politics in change for equity percent had post-univey education. The Forty-five percent of enterpises invested in continity ofmanagement from pre- to post- odter companies (almost 20 percenc in dree privatizauion periods was dear from the fiac or more companies) conveyig dhe impres- that half of the managers interviewed had sion of a faidy dense netwrk of coss-in- been general mangrs and 30 percent had vestment. Many managem continued to rely been managers of techical departments in heavily on former suppliers and customers their enterprses before privatizaion.m Estimates were that about forty of the Labor ninerty-two firms surveyed were led by high- ly competent managers who appeared able The average and median numbers of work- to bring their firms through the uansition ers per firm in October 1993 were 1,518 successfully-assuming the business envi- and 752, respectively, down from an aver- ronment did not entirdy hobble their ef- age of 1,591 and a median of 800 twelve fons. Nineteen managers vere judged to months previously (a 6 percent drop). Most be poody-prepared to make the transition, managers reported their employees were and the remainder were rated as average worlking full-time; although about 15 per- with a mix of srengths and wealmesses. cent said part-time workwas often cutback Many managers maintained their pow6- due to falling orders and insufficient cash erful positions with privatization, but inter- flow for payrolls. views made it dear that the combination of Sixy percent of managers had laid off economic crisis in Russia and the speed of workers in the previous 12 monds-on av- privatzation radically altered the content erage, lopercent of their labor foc Three- of managers' jobs. The difficulty of acquir- quarters of enterprises engaged in ing scarce raw mateials had been replaced constuction, chemical prducts, and textiles by the difficulty of paying for inputs in the laid off wonkers, reflectng the swvere de- context of high inflation and falling rev- mand problem fiaced in these sectos A enues. Production quotas were gone, but in quarter of firms had not made signifcant their place had come pressures to find mar- cbanges in the size of their labor force; and kets where production could be sold and 15 percent of finns hired addional work- strategies formuated by which to co3lect ea!-onaverage,8peracntofthelaborforci NEWY.PiuvAJE EurnIREs: A Su&r 175 More layoffs can be expected, pardci- of sample firms provided housing for most larly among large firms. Just over 40 of their employees. Fiy-seven percent percent of managers acknowledged they maintained ownership of the housing fcili- had more workers than they needed. ties, with 28 percent transferred to munici- Moreaver, fewer large firms laid off work- pal governments, and 14 percenttransferred ers than snall and medium-sized ones, and to employees. But regardless of owner- lae firmswere more likelyto report excess ship-even where employees purchased labor than other firms-particulady in the their flats-the financial burden of main- nonmetallic minerals and the fabricated taining housing facilities and providing utli- metals sectors. ties remained with the enterprises. Nonetheless, over half of the managers said they had difficulties holding on to their Production and saks Sixty percent of skilled workers, in part because of their in- managers had laid ability to pay competitive wages. In some Average monthly sales in Septembere cases, the most talented employees left to $1-04 milion with a median of $266,000. Off workers in the work independently as private entrepre- Forty-seven percrent of firms had montbly previous 12 months neurs in their own companies. The ex ±p- sales below $417,000 (annual sales of $5 -on average, 10 don was among companies in small towns million). On average, the highest sales were in which they were the primary employers fiund among enterpnses involked in heavy percent of their in the area. These shad nolost work- industry for example, fabrcated metl labor force. en because their employees had few other products ($2.4 million per monti) and pa- optons. Most managers were taking actve per products ($12 million), and the small- measures to hold on to their best employ- est among services firms, such as business ces. Some icitiatedbinding, long-term con- and household services ($150,000) and tracts. One firm selected a few of its transaon ($108,000). Sales in two- employees for contracts, offering them ac- tids of firms were constrained by lack of cess to low-priced cars at the end of two demand or orders for their products, and in years if their performance was good. In an- one third by an inability to fill more orders other, 20 out of 1,300 employees had been than they currently had. Forty percent re- sngled out for dividual contracts. Many ported mountng inventones. managers took steps to raise labor produc- Almost a third of managers (31 percent) tivity by inkng employees' salaries and reported th at least one of their prmay performances more losel4 products was subject to pnce controls or The average monthly salary for a skilled profit marns Some controls were associat- worker was 110,442 rubles ($90) in edwithsectorforexample,petroleumprod- September, 1993, up from 26,374 rubles in ucts, agdrclulue, andwholesale trade. Afew January 1993-an increase of 420 percent wee subject to pnce controls because the in the nine-month period. Monthly salaries firms were registered as monopolies. Most for unskilled workers grew from an average price controls, however, originated with of 12,208 rubles inJanuary 1993, to 42,529 committees andassociationsthatdescended rubles in September 1993-an increase of from the former sectral ministies. 350 percent. Thus, the ratio of average Just under 60 peremt of managers said salaries of skilled and unsdiled workers that production had been stable or had in- changed from 1 to 22 to 1 to 2.6 in the first creased over the last few months. Sectoral 9 months of 1993. Moreover, almost all en- differences were prominent: 60 percent of terpnses (89 percent) offered social ser- firms producig textles and clothing and vices to their employees, tpically a mix of 50 percent of constution firms reported housing and associated utilities, health and declining production, whereas 78 percent child care facilities, vacation locations, of funiture manufacters and 73 percent transportation, and farming plots. of transportation firms reported increasing Provision of housing represented by far volumes. Over half of maws privatization the most crtical and knotty problem in the firms reported dedines in production com- area of social services. Eighty-seven percent pared widL a third of PLC firms. 176 Russi ClNG PBN ENuII AND EmcENT MAnSm Just under 60 percent of firms con- tion. Specifically half sold most output on firmed orders for only the following t-ree national markets, just under 40 percent months, but a third had orders that would sold locally and in nearby towns, and about keep them busy for the next six. Large in- 10 percent sold elsewhere in Central dustrial firms producing metal and plastic Europe. Only 2 percent of managers re- products more frequently had long-term ported that they faced any regulations con- orders; small firms maling consumer goods ceiing distrbution. were likely to have short-term work plans. A quarter of managers said they had Again, mass privatization firms were less no competitors in their main markets; 40 likely to have confirmed orders for the fu- percent had fewer than ten. The slow de- ture than were PLC firis. velopment of competitive markets was a Most enterprises had easy access to in- bit surprising given that most firms were termediate inputs. Access was maintained, producing basic consumer and intermedi- The main barrier to in most cases, by the continued presence of ate goods where competition typically is entering e aort the former network of suppliers (many now greatesL The highest levels of compet- privatized), although some managers com- tion were reported by managers in trans- markets was lack of plained that markets had become chaotic port and furniture companies. Among information about -with former suppliers changing product firms that did have competitors, the main potential trading lines and charging monopoly prics. One source of competition was other large, producerdescriedasituationwhereamo- private firms-again confirming the de- panttes, the nopoly scrap metal supplier cut off all de- gree to which the economy had been pri- strcture of liveries for a month to increase prices. vatized. The fact that only 11 percent of demamd in foreign Of the 20 percent of managers who had managers cited state enterprises as their problems obtaining needed inputs, three- main competitors dispels notions chat the marke, and quartas relied mainly on suppliers in other existing state sector is crowding out pni- required product CIS countries. These firms typically tied up vate firns or at least the newly privatized quality and large amounts of scarce working capital for sector. lTe almost nonexistent level of long periods as theywaited for slow and er- foreign penetration was evident in that pcck43ng mtic deliveries. They described chronic dif- only 2 percent of managers said that their ficulties in dealing with bureaucratic and main competitors were imports, and none unpredictable cross-republic quotas, cus- named joint ventures or foreign firms as toms regations, payment systems, and competitors. transport arrangements- Just under half of firms were exportng Just under two-thirds of managers cited some production (20 percent on average). other private (mainly privatized) firms as Two-thirds of those who exported sold di- theirmain customers. State enterprises and recdly to buyers; the remaining third sold to newly-privatized state companies offered intermediaries. Most exports were sold in large contracts and the built-in advantages Ukraine and Belarus, with only a few firms of an existing personal network. but they seling in foreign marcets outside of CIS were much slower to pay for goods and ser- countries. vices. Private firms pait: their bils faster, The main barrier to entering export but orders were too small to sustain sample markets was lack of information about po- pmducers, and large orders were increas- tentialtrading partners, the stuture ofde- ingly hard to come by Enterpnses likely to mand in foreign markets, and required sell maly to orher private firms tended to product qualiy and packaging. Many felt be smaller, produce consamer goods (such that locating a foreign partner who could as clothing and furniture), and to be former inject capital and link the firn with appro- leaseholds Those who relied on state en- priate markets was a prerquisite for suc- tetprises as their main customers were of- ceasfUl exportg. Managers also descrbed ten large, ma privatization firms that formidable logistical problems, including manufactured industrial inputs. payments problems, high exort taxes, dif- Firms' primary markets were in Russia ficultieswith export liceses, and excessive and there wee few problems with distribu- paperwork and fees. Without capital to up- NEW-PIvATmmZED E Ns: A Suzv 177 grade equipment and thereby improve since privatization. Many managers sponta- product quality, most felt unable to com- neously revised this question by saying that pete in foreign markets. Others com- recent changes in their firms resultedmore plained about the share of profits taken by from the economic cisis in Russia-most trading companies that could market their notably the recession that is under way- products abroad. One manager said that than from the shift in ownership. Even so, the overvalued ruble meant th4e could the most important changes were: get better prices on the domestic market; * On average, 90 percent of enterprise another cited quotas and tarffs in foreign ownershio had been transferred to pri- markets. vate hands through privatization pro- Almost all managers equated Lhe state of grams (either MPP or legal buyouts by their technology with the state of equip- keaseholds); Forty-seven percent ment. Virtualy none showed an awareness Ninety-five percent of firms owned all of firms had of temhnology issues such as information their buildings and equipment, and al- systems and the organizaDon ofproduction. most 40 percent sold off some redun- changed their mix Rather, they focused on the need for better dant equlpment; of products in the equipmrentthatwouldproducehigherqual- Fiy-five of the ninety-two firm su- past 12 months, ityoutput Some producuon equipment ap- veyed laid off employees (on average, peared adequate, but much appeared 10 percent of thcir current labor force), typically starting up outdated and rn down Fumitur makers and fourteen hired new employees (on production of new needed higher precision madhines and bet- average, 8 percent of their labor force); products, upgrading ter quality finishing equipment. Texie pro- * Fo.ty-seven percent of firns had 'rodwt quality, ducers needed new kmitting and weaving changed their mix of products in the machines. Plastics manufawturers were past 12 months, ypically staring up and ittroiducing aware that their producton equipment was production of new products, upgrading trade and service inadequate to produce higher-tech plasics product quality, and introducing trade activities... Most nmmagers seemed fuly aware of and service activties; environmental concerns associated with Seventy-seven percent took (and pre- their factones, but actons to ameliorate sumably repaid) short-term loans in the problems were seldom seen. Many report- previous 12 months, almost all frm ed that they were subject to environmental commercial banks at going interest inspections by govenment officials. The rates of 180 to 220 percent a year; most frequently observed problemwas tox- 'Fifty-seven percent of managers ic fumes that affectedworkers. Some man- changed the ways they motivate and re agers said they had improved ventlation in ward workrs-typicaly hlting perfor- their factories, but most admitted that mea- mancewith payment and differentiating sures had been insufficient A number of more between sided and unskied managers said that officials routinely mea- workers; sure the level of pollutants in nearby water * Forty-five percent of firms made invest- sources and fine them if levels are too high, ments in other firms; almost 20 percent but most said they could not afford to build invested in thee or more other firms; recamation or water purifcation plants to * Fift-eight perent offirnms relied on oth- solve the problem. The impression was that er private firms (some privatized former environmental assessments probablywould customersandsomenew) aspimarycas- reveal fairly serious problems with pollu- tomers rather than on the state sector tion and worker safety m many firms. Despite the magnitude of aggregate changes undertaken over the previous 12 Sttategies for the fiture months, firm-level response was highly het- erogeneous. Firms fial into three groups- Firm-level dange those wno resisted making changes, those who made marginal changes, and those Entrepreneurs were asked to identify who embraced the new eavironment and chaanges that had taken place in their firms reshaped enterprises as quiky as possible. 178 Russv CREArNG PrawnsvA ENTPmE ID EFFnmrrMnicn The first group (25 to 30 percent of ecepttootherworkersandthenonly with firms) was clinging to die staus quo, pro- permission of the collectv In another 46 ducing the same products for the same c- percent of firms, shareholders were free to tomers, and strling to hold on to their sell hares but none had done so. Share- labor force in the face of filling orders and holders sold shares in only 20 percent of incresingly inadequate workig capitaL firms, and most reportedly sold few. Except for firms with monopoly power. Boardsofd wrshadbeen established these firms were among the weakest firms in in most firms, but were dominated by man- the sample. The second group (50 to 60 per- agems. Formal membership typically was still cent of finns) typically made small changes the one prescbed in the corporatization in their product mix in the direction of oDn- legislation-that is, one representative each sumer demand, laid off small numbers of from managers, workers, the propert bfimd, workers, ventured into new markets on a and the municpal govemment Newcorpo- Boards met once or limited basis, and began to think about di- rate charters, to which enterprises vwe en- twice a year to versification. The third group (15 to 25 per- tided folowing privatizaon, had not been cent) were headed by the most competent drawn up. Boards met once or twice a year C q om managers in the sample, and they typically to cnsider questions concerning issuance concerning issuance started up new product lines, downsized, of dividends and management of social as- of dividends and and mitroduced fleible productLon. Sets, but dty appeared to have litte or no invement in decison affeting firmes ma gement of coiporate gozenne opeain social assets, but Without question, coprate goverance of ShaUgWsfor&J ibeute hey appeared to enterpises was in the bands of manages ve litte or no Whenqueriedabouthowthenewownership Mangers' pioih Mnags were involvement in structure wa affecting the dsiing asked to desacbe their strategies and pri- dr4dO af process,mostmanagersexhibitednoqualms orities for the near term. A common an- ei g abo stng they were fully i charge. swer was 'to surve." When pressed, a fir operations. Indeed, 9ainplicdtbargainhereinwcs tird said that ivestment in new cquip- nghts to partiapate in a selected, narrow ment and a quarter said that finding new ranofdecisions andtoreceivedidendsin markets was their first priorty. More for- exchange for manages' tang reponsiW ward-looking managrs in the sample also forkeepingasmanypeopleemployedaspos- tended to indudce improving financial sible had been acnowldged. Maintenance management and marketing silkls and en- of the labor faice and delivezy of social ser- twing export markces. vices was fekt as an etiical and wegh re- Managers' emphasis on pocumet of sponsibility by most manager new equipment was difficult to evaluate. Most managers flfilled the formal re- Most manags showed lited awareness that qunrements regardng governance that theycouldbringaboutsubstandialimprve- came with privatization. Almost 90 percent ments in production other than dtrugh held shareholders meetings (usual sched- new equipment Indeed, stratgies for in- uled annually), and over 90 percent had aeasingproductionefficiencyusingarent shareholder registers. Many managers re- capita stockwet seldom raised. Strategies ported that shareholders made important suchasimprovingthelay-ottofproduction, decisions at the shareholders' meetings, inventory mianagement product desig, most focusing on the disposition of social and wores' skills took a back seat to ac- assets. Only about a third issued share cer- quisiton of new equipment. On the other dficates and paid dividends; most reported hand, some enterpnses were at a compet- they would soon do botbt dve disadvantage using outated macbin- Few shares had been traded. In a third erX and their abiliy to compete depended of firms-alnost all leaseholds that con- ritically on acquirg new pment. verted tO closed joint stdck companies- Managers'emphasisondevelopingnew workers were not albwed to sel shares products and finding new marelts reflect- NEwLYPwvATniD ENThus: A Suxv 179 ed falling orders fr-mn established cus. foreign cxdhange risk, and most managers tomers. This was the ±.st priority for large seemed to understand whit was involved. firms as they struggled to maintain working Many managers said that they would have capital andlaborforcesinthefaceoffung aninerest insuchloans, butwould haveto orders from their old customers. But as understand the terms thorougly before seen elsewhere in Eas-ten and Central making a commitment European enterpnse, managers often were stymied without the necessary market Tecbnical asstnce. Some manager said information or marketing sklls. they had no need for technical asistance (M). Most were unclear about what kinds Exematl fine g. 'When asked how of options might be available. The first pri- they planned to finance future investment, ort among those who acknowledged TA ...managen stressed 43 percent of managers said that they needs was for assistance with markting, that most useful would use business profits; 25 percent said followed by technology and financial man- assistance avoids they would take long-term loans from agement. Many explained that they had banl when available; and 21 percent said never before needed to market products conceptual realms that they would rely on equity from foreign and that the services used in effective mafr- and focuses on investors. The fact that most managers as- keting (advertising, t , cndfonv seyi on l sumed they would be able to finance in- marktng firms, and so on) were totaUy conveying praacticl vestment costs from business profits lacing in Russia. Assistance in financial how-to information reflected their doubts about accessing ex- managemet also seemed to be a priort in key areas of temal finance and an optimism about the Survival of many enterprses depended cn buin future of the Russian economy and of teir heir abflit to diversif and in the view of enterprises. Most manags felt their busi- resers, many could have used assis- management. nesseswould performbetteroncethe econ- tance in strategic planning before imvest- omy stabilized. Many spoke readily about ments m new prduct areas were made. the desirability of locating a foreig partner Managers were divided as to the best and preference for equity financing, but format for technical assistance. A third few had made tangible stps mainly be- each thought that TA programs should be cause tiey did not know how to proceed. pacaged as short-term consultancies, Demand for extral finance was diffi- study tours abroad, and short couses cult to assess. Managers clearly had access Almost allwho wanted consultants wanted to and made use of short-term, ruble aed- foreign consutants, with few requests for its from commercial banks. When queried Russian expet. Viewsw ere mixed on the about potential demand for long-term subject of study tours. Some managers loans, most managers indicated they would were clear that they would benefit greaty have numerous uses for investment credits fiom actually seeing foreg firms in simi- but, with few exceptions, they were uriill- larindustries atwodr, andothers dismissed ingto take on the risks associated with long- this approach by saying tIat conditions in term loans in rubles at cmrrt domestic Russia were sufficiendy diffrent to render interest rates (even if avilable). The gener- Aisits abroad irrelevant al impression was that most managers were There was little disagrem t about the risk averse as regards taking on debt-even levl atwhich technical assistance shoold be though debt to equity ratios were low and delvered or about the kinds of people man- ownehip of budis and equipment pro- agers felt were best-suited to delive vided enteprses with collateraL ithhout excepton, managers stressed that The single credit package inwhich man- most useful assistance avoids conceptul agers did express an interest was mid-term realms and focuses on conveying practical (2 to 3 years) hard-curencyloans. Many in- how-to infornation in key areas of business quired about potential interest rates of managemnt. Along these Ines, managers hard-currency loans and how the foreign recomended t those who deliver TA exchange risk might be handled. Inter- programs dsould be drawn from the ranks viewers explained the basics of assumng of privte, intematonal consultants, prefer- 180 RuSs £CwA2GPzMvENrmwasANEnIciraMuTs ably people with personal backgrounds in had a few years headstart as partially private firtns with lke actvities. Many thought that businesses. Lack of investment capital and intemational assistance organizations and chronic difficulties reading an unstable mar- the Russian government should take re- ket were their pimary constraints. sponsibility for the organization of such pro- A quarter of firms are likely to fail, bar- grams-but not the actual delivery. ring substantal restructuring and large infiu- When asked whether they would be sions of capital. They were operating at a willing to pay part of the costs of technical lossunable to find solvent customers, cut assistance for their firms, most managers costs, downsize, and reorient their product responded affirmatively. Most, however, lines toward profitable markets. Ofthe medi- said that they would only do so if they felt um-size and large firns that came through the price was reasonable and the assistance the mass privatization program, most were was of the highest quality. This qualification associated with heavy industry and almost all Staying afloat will reflected a general wariness among many were highly depzndent on the declining state depend critically on managers about the true value of consul- sector for their sales. Notable exceptions to tancies and training programs. this characterization were found among a series of factors, some largefims thatwere able to exploit mo- such as firms Conclusions nopolypositionsanLinelastiitiesofdemand ability to maintain for their products. Perfonnnce By implication, the most fruitful strategy adequate working might be to focus assistance efforts on the capital; managers' Prospects for enterprises induded in this large numbers of firms that are 'surviving,' skills in making survey were mixed. About half of the enter- under the assumption that the strongest en- prises were sunviving," struggling to find terpises wil achieve sccess without assis- strategically correct solvent customers and to caver their oper- tance and in spite of external difficulties,and choices about pro- ating costs. Staying afloat will depend criti- the weakest firms are unlikely to survive ducts and markets; cally on a series of factors, such as firms' even with assistance. ability to maintain adequate working capi- the degree of free- tal; managers' skills in making strategically Rernctung dom managers can correct choices about products and mar- exercise in down- kets; the degree of freedom managers can Seriousrestrucmringhadyettobegininmost -sizing in aasuc exercse in downsizing in areas such as labor finims, despite the relavly high percentages sizing in areas such and social assets; the speed with which ex- of enterprises that laid off workers and as labor and social temal competition stikes; and in the longer changed their mix ofproducts. Most ofthese a&-sets; the speed term, the availability of capital for restruc- changes were marginal and probably are in- turing. Underpinning all of these factors is suflcient for the mid- to long-term. Obvious with which exernal the rate at which the economy as a whole needs for restructuring to reduce cxpendi- competition strikes; stabilizes. Each step deeper into recession tuaes induded downsizing cf operations, and in the longer diminishes these firms' chances of survival adoption of cost-cutting measures, and elim- as does each percentage point of inflation. ination of nanviable activities in favor of term the avail- About a quarter of firms showred promising ones. Restructuring for competi- ability of capital for promise andwere easy to spot. Allwere cov- tiveness wil call for strategic re-onientation in restructuring. ering their costs and many were opeaating at the direction of consumer demand, develop- a profit lTcir managrs were maling strate- ment ofmarketingcapabilities, and attention gic shifts in their operations, cutting back on to environmental pollution problersr When loss-rnaking activities and expanding into foreign competition enters the madretplace, profitable private-sector markets where most enterprises wil be faced with the addi- they were less dogged by payments proW tonal necessity of modernizing thir plants, lms These firms mainly produced goods includig upgrading technologies. and services for consumers, and their man- Some enterprises can and will restruc- agers were focusing on improving product ture on their own as the market settles and quality These better firms were found more capital becomes available. Others will need frequently among leasehold companies that incentives and financial and technical sup- NEwLY-PRInVA ENTER s: A Suxvzr 181 port A third group should be aulowed. to fail nominal rates were exorbitant and that without attempts to resuscitate them The commitment to long-term debt payment challenge for those involved mn delivering re- was untenabie given the uncertain future. structuring services will be to distigh The cxception might be medium-term dearly between the three ypes of enterpris- loans (2 to 3 years) denorminated in foreign es. As noted in this report, researchers locat- crrency Managen were interested in ed large numbers ofmanagers who appeated loans of this sort because interest rates wel-qualified for their jobs and receptive tO would be fixed (even though they would as- new approaches-a finding that bodes well sumne the foreign exchange risk) and be- for implementation of assistace programs. cause the term is long enough to finance some capital investments but not so long as Labor to incur unacceptable risL Over time, markets in enterprise shares Asigpificantnewincreaseinunemployment Govemance will develop, is coming, not only from business failure and attdtion, but also from financially- Private corporate behavior is begining, corporate takeovers induced workfo:'ce reductions. Forty per- but true shareholder control is still nascent and strategic invest- cent of fim saw themsdlves as ovesaffed, Shareholder meetings had ben initiated ments will ensue, ~on average bN 17 percent. ThirLy-five per- and boards of directors constituted, but it ments will ensue, cent of managers reported theywere unable was dear that mnnagers exercised control board management to cover their operating costs, a large share over almost all aspects of enterprises. The will change, and of which goes for salaries. Pressures to re- few areas where manages may no' have structure and establish firm-level viability dominated included the disposition of so- managerial will engender tremendous conflict for the cial assets and payment of dividends-both behavior will many managers who have a strong sense of left for workers to decide in many firms. it respond to share- responsiltyilir for their employee&s Creating wil take time for shareholdes to begin to bolder pressure. job opporunities for those laid off may be exercise thei- power and see the connection bholderpressul-re. central to successfil restructring efforts, between corpomte performance and divi- given the strong oUligation managers feel to dend payment Over time, markets in en- their employees. terprise shares will develop, corporate A fledgling labor market was observed takeovers and strategic investments wil en- in the growing discrimination between sue, board management will change, and slilled and unskiled workers, and in re- managcrial behavior will respond to share- ported movement of the most silledwork- holder pressure. ers to private firms of their own. Linked wvth these developments, greater social Soci dset tension can be expected as less-skilled workers lose jobs and skilled workers' Social sevices, including housing and asso- salaries increasingly lag. Social safety nets cated atilities, medical and educational ser- and measure to facilitate labor mobility are vices, and vacation ficilities were provided aucial, and some firms mayneed assistance by most firms to significant numbers of in labor restructuring. workers. Continued provision of social ser- vices, mainly housing and utilities, beame a Lwerement large financial burden for many managers, but few altematives were apparent Ik some Managers were anxious to obta financng cases, ownersbip of some social assets re- for new investment, but few were willing to verted to municipa governments at the time take the risk under current conditions. of privatzation, but enterpises generaly Most had taken short-term loaus to cover continued to pay large sums for utilities and working capital shortfalls, but few had tak- maintenance costs, particlrly for housn en or wolid take lonterm loans (which Asmallnumberofenterprisesfoundso- were not available in any case). Despite lotions to some problems associated with negative interest rates, managers fek that sociaasses, suci as privatizing some hous- 182 Rusg&: CaIsQ PianuE ENriwmmsANDEcIaWNrMA=rs ing and instituting worker-wned kinder- all expressed doubts as to its usefulness. gartens. Most need assistance sorting Areas where assistance was requested in- through the knotty social and financial eluded marketing, general management, problems associated with divestiture of so- financial management, and technology. cial assets. Inprovements in housing and The preference, voiced by virally all who labor markets could have positive effects in requested technical assistance, was for ex- this area. perienced Westerners with product-spe- cific knowledge and a practical, 'how-to' Tecbnical assitance approach. Most were willing to pay part of the costs so long as the assistance offered Most managers needed and wanted tech- was of high quality and useful for their nical assistance. At the same time, almost putposes. NEWThPMVAIIZENDEwuxs : ASuRVE 183 Part Four THE EMERGING PRIVATE SECTOR: CONSTRAINTS AND REGULATIONS CHAPTER 14 Constraints to Private Enterprise in the FSU: Approach and Application to Russia Marie Sheppard The purpose of this paper is to describe the compliance if conditions continue to make constraints that restrict the formation and it more rational for entrepreneurs to renege growth of private enterprise in Russia and on commitments and renegotiate at every to suggest an approach for alleviatingthem. step in the process. Such laws are only ef- When desigAing a strategy for private-sec- fective if accompanied by other conditions, tor development (PSD), a prerequisite is to (such as penalies, enforcement prctices or identi binding constraints. A PSD strate- ethical codes of conduct) that render com- gy also requires some method for deciding pliance to a rational business decision. which constrits to target and What types of remedial programs are lkely to be most Property and ownerbip cost-effective. This paper is organized into four sec- Vgue ownership and property rights in lions. The first reviews the recent develop- Russia increase risk, impede investment, ment of private business in Russia. The next and limit economic growth in both the pri- section proposes a typology of business con- vate and public sectors. During the Iuperial smints. The third section focuses on the penod, the tsar or tsarna owned everything most binding constraints to Russian busi- and his or her approval was required for all nesses. The final section describes an ap- contracts. Property rights began to develop proach for alleviating constraints to business before the revolution, but following it, pri- development and applies this approach to vate property was virtuay abolished. This some bindig constraints in Russia. did not, however, equate to making enter- prses property of the state. State enterpris- The context es were legal entities that controlled assets, but the right to dispose of these assets and Count Wrtte, a Russian Imperial Prime other concrete resources was never clearly Minister at the end of the last century wrome defined. This left enterprise directors in a that his country was different from the rest difficult position; even actions that clearly of the worlid Russians had 'no sense of increasedefficiencycouldbeusedbyahigh- property or legality" Wile the uncertainty er political authority as an examnple of mis- regarding property rights is pre-revolution- use of state property Hence, enterprise ary, the Soviet period reinforced it by abol- directors had a disincentive to make re- ishing most forms of private property source-related decisions that might result in Despite the collapse of the Party ownership productinity gains. and pmperty rights reain ambiguous and To answer this dilemma and icrease there is still no market ifinastructure and productvity, perestoika introduced the few incentives (or penalties) which encour- first non-state enterprises. Until 1987, the age market-oriented behavior only legal foLn's of economic activty were Simply importing missing elements of a state enterpises, colective farms, and agi- market system will have limited effect if cultur production on fmily plots (usually there is no institutional infrastucture to less than 1 hectare). Gorbachev introduced supporttheinAsoundbodyofcontractlaw, two new management systems-cooper- for instance, will not lead to contractual tives (in 1988) and leases. Cooperatives ConsmNrs To PIWA EN N THE FSU: Anan mND APPLUCAnON TO Russ5A 187 were the first legal non-state enterprse, and cial forces intertwined into a stable state all kinds of entrepreneurs flodced to regis- system that looked after each member of ter teir businesses as oopertives". the society and provided a strong sense of The legal foundation for the current en- security. terprise structures was essentially complet- The collapse of this systm imvokes ed by 1990, when it became possible to have ambivalent reactions. Market reforms have a 100 percent privately owned business.' created coundess opportunities for entrpre- During this same period, market liberaliza- nears who are providing servces and better tion began. Thus Perestroika increased the qualitygoods.Theyarequicktocapirlizeon autonomy of the public sector as wll as op- opportuities cated by the transiion. pormnities for the private sectox process. Exploitng temporay feaure such Reforms, however, focused more on as gaps between state and market pices Tellingly, Russians ownership than on property rights. So far, (cornplemented by the fluid legal and reg- often refer to the while property can be owned, itcan seldom latory environment) creates huge a*rage privat sbe considered semre. Most enterprises rents and enables business people to gener- privatesectoras th7e (state or private) possess propertytitles that ate vast profits invy shot peiods of ime? nonstate sector. are less than absolute. On the other hand, market-driven Uncerainty surrounding propery forces cannot immeiatdey fill gaps left by rights is exacerbated by the political situa- the retreat of the state sstemL Individuals tion. The coUapse of the Soviet and com- fear an immediate worsening of living con- munist systems created a power vacuum ditioni, and not being able to afford the that has largdy been flled by local govcrn- most important servces (housing health, ments. The distribution of power varies and education). It is not surprising that widely across and within oblasts, and this most ofthe population continues todepend layering of jurisdictions (often with over- on the old system for jobs, along with the lapping mandates) creates confusion, am- package of housing, goods, and services. biuity and opportunism amongst both Most Russian families have ties to both officials and entrepreneurs. the state and nonstate sectors, wih at least Whie prnvate enterpnses appear more one member moonlighting or engaged in autonomous with regard to property than nonstate economic activity Officialjobs are state enteprises, there is ample opportuni- kept tosecure housing, goods, and services, ty for outsiders to meddle in their opera- but many people eam more money in the tions. Leasing arrangements (primarily of non-sate sector Thus ana engineer paints premises) and continuing control over apartments on weekends, a research scien- sources of supply (despite some apparent tist dabbles in a small tl company, and monetarization) guarantee that the direc- an accountant at a state enterpise keeps Table 14.1 Russian private tive features of the Soviet system continue the books for small companies. Because enterprise in mid-1993 to function. Indeed, business people con- the.epeoplekeeprheirjobsinthesmtesec- Number of tinue to depend on it, and this reinforces tor; employment figures are relatively sta- Owrershipsbtruct companies the power of the old system. Entrepreneurs ble. But the bulk of their income may be Partnerships 440.00 wil not be willing to break these links until generated from prvate activity individual private there is an altemative system for resource enterprise 2Z10000 allocation-one n which property nghts The prwe seator Cooperaive 165.000 Joint stock companies 110,000 are dearly defined and enforced. Associations. consortia 15.000 As of mid-1993, the official non-state sec- ltal 950.000 Ititdoxs and atttudes tor acoDunted for roughly a- tenth of the Aote: these figures idude those cnom- economy in resources and production. p- t haw been pdized. Telliy, Russians often refer to the private Roughly 950,000 new enterpises had been Partnerhips and inividual peate sector as the nonstate sector From the registemd(table14.1).Though' pie (iaoounrig for 385~ o etrasrgseed(al 41.Tog ipeie rse ect independent stat-ups and 1920s to the 1980s, important resources these figures indicate some growth in pri- wkcl OWaimi. Joint stodc ZopaniesindudefiZnspZZizedwde (food, housin4 healt, education, and vate ecoomic actvity and this reflects the the -an i2atik prOWt work) were allocatedthrougb top-down de- impact of prvatization. But, the pace of 19 73a sionmalning. Economic, political, and so- change is not enough to avoid t-he threat of 188 RussiA CRnMGm PAm ENTEnnn AND EFFzmEwTMAnNErs serous soc disruption should mass un- ing and margins are squeezed. The other is employment materialize. Nor is it sufficient the rent seeking opporunist, cashing in on to compensate for the drop in productivity connections and making a quick ruble whi in the state sector. the opportunity las; once "rents" are no While an increasing number of Russian longer there to be captured, many of these businesses are wholly private, their daily traders will disappear. operations seldom reflect this? Comma- The second group is equally quik to cial enterprises are dependent on state en- pounce on cash-rch opportunities, but tities as customers and suppliers, but that these entrepreneurs are using cash-flow dependence vares by ownership type and from trading to build an asset base. Manu- by line of business. Purely private compa- facmring profits are volatile and are driven nies (26 percent) depend less on the state by value added and by imbalances in pnrces than do other types of companies (47 per- of input/output markets. The latter is a While an increasing cent)- The greatest dependence is among transitionary feature that creates both ob- share of Russian manufacturers; 60 percent declared them- stacles and opportunities for manufactur- selves 'largely dependent" for supplies. em. Vluable assets can be obtained from bunesses is wholly The state sector wields tight control state enterprises and used to build manu- private, their daily over rubles, resources, and information. facturing capacity for the future. operations seldom Allocation of these resources is highly de- For instance, a common phenomenoon is centralized, but depends on individuals an imbalancebetween thecost of raw mate- reflect this. scattered throughout government and ials-world market-and the pnrce for across state-owned enterprises, which finished goods can be sold-localev- As the old system crumbles, opportuni- el-that makes manufacurng seem like a ties to capture value abound. In fact, a losing proposition. Many entrepreneurs in- unique feature of the transition period is novate around this constrait by adopting that these opportunities (usually i trading) complicated resource reallocaton schemes far outnumber those for value creation. with state enterprises. In essence, the prvate There is a tendency amongst Russians enterprise purchases mputs from state en- to lump this army of speculators" into a terprises at subsidized prices, some portion single category that can then be castigated ofwhichisin cash. Thesubsidies reciveedby forreaping benefits from Russia's hardship. state enterprises an: only in credit, and be- In reality many of these entrepreneurs are cause state-owned enterpises (SOEs) can- providing a useful function in commerce, not survive without cash, the SOE forgoes manufacturing or botL These business the potential profit it could theoretically people share one trait that is common make (by selling at a maket price) in order amongst entrepreneurs wodmwide. a desire to recei cash. The pnvate trader uthen col- for independence. Strategies for adhk'v5ng lects the difference between the subsidized that independence fall into two general cat- prce and the market pnce. If the cmpany egones entrepreneurs for whom trading is uses these inputs to manuacur a product, their end business and entrepreneurs that their margin might be squeezed, but thiy use trade as a means to accumulate capital will be able to produce goods-something market knowledge and other resources the company without access to the subsi- needed to build a sustainable production or ded inputs cannot do at all. service-oriented business. Most oampanies, no matter the size, en- Enuepreneurs in both categDries are gageinseveralactMitiessukaneousl).One quick to exploit busiess opportunities cre- characteristic of the transitional environ- ated by the transition; the difference lies in ment is the seed with which business op- tbeirlongterxn strategies.Whleboth groups portunities emerge and evaporate. A use trade to generate cash-flow, for one common coping strategy is diversification. group, this is enough. Wthin is first group Most companies perform a combination of of traders, there are two subcategories. One mancti services and trading. By is leaming commerce and will continue to maintainig a flexible stntegy, entepre- trade long after the market starts functon- neurs try to keep enough of a presence to CONSM S TO PmVAE EmsWus w Tm FSU: A oAaiMD AAUCIMON TO RUs 189 build on should an opportunity open up and most start up businesses do) or through fi- iinimize exposure to any single activity. nancial institutions (common for estab- While this flexible strategy helps firms tosur- lished companies) depends on both the nve, it also inhibsinvtsn,ent and growth. state of the financial markets and on the There are no black and white distnctions manager's tenacity and performance. between the state and prvate sectors. There A business can innovate around sys- are degrees of 'statenesse and pateness temic constraints, but it cannot cbange in all ventures. The task is to encourage busi- them. For example, entrepreneurs can ex- nessts and individuals to behave increasing- ploit tax loopholes, and so, reduce taxes ly in a market-oriented manner. To do this, payable, but government is the entity re- conditions must be created and supported sponsible for semng razes and rules. where marker behavior is possible and ratio- In environments such as Russ's, where nal-by removng constraints, creating in- systemic risks abound, entrepreneurs tend cenives, and providing means. to increase the range of business activities (and reduce the depth) to manage expo- Syem a opertionalonsraint sure. In many market economies, govern- ments strive to improve the business Constraints inhibit economic activity by in- environment by targeting systemic con- creasing (perceived) costs of statingor op- straints; the undedlying premise being that erating a company They heighten business less systemie risk i enable entrpreneurs risk and are a disincentive to enrepreneur- to take on more operational risk, wich ship and investment. The greater the con- yields higher returns. Two common strae- straints, the slower the rate of enterprise gics are to reduce the real cost (lower infla- formation, investment, and grwdL tion, streamlined regitration, efficient and There are two broad types of con- equitable arbitration mechanisms and so straints-sysremic and operationaL The en- on), and to maintain a constant legal, regu- trepreneur has no control over systemic latory, and macro environment constraints, but has some capacity to con- trol operatng constraints. Product quaity Constraints to Russian enterpise can be improved through management de- cisions, such as better inputs or processing Of all the problems faced by Russian busi- techniques1 The constraints can be thought nesses, systemic constraints are the most of as a continuum, ith systemic constraints acute. Foremost is the volatile poliical and at one end and operational constraints at economic environment, particularly infla- the iher. Wile some constraints can be tion (figure 14.1). A businessman from clASy positioned at either tcnd, others can Perm encapsulated the general sentiment, be a little of both. Obtaining capital, "iflation, ruble instabilty and unpre- whether through savings and friends (as dictable price rises all leadto the absence of any idea of what tomorrow brings and an in- Figure 14.1 Constraints to private sector ability to plan for the future." development (a continuum) Regulatory constraints also rank high and the most cosdy is taxation. Others are sources of commercial proper3y, access to infonmation, dispute resolution, and busi- - - ness registration. Interestingly few entre- preneurs consider lack of'- management U - o o * skills a constuaint. :0 i O oWnat follows is a brief descrption of .1 ... so F CM 8 m4;: _ imercial property information, dispute res- - X *~ ioluton and business registoation. 190 RUSSLV CIANG PmvsE 1.Umpms AND 3EEaENT MAxc Wsxdon Novembr 1, 1992. Although it was not en- acted unfil February 1, 1993, dte authorities Russa's tax system is a major impediment required that companies pay the tax from to business growh and to transparency of November 1. Those companies that pro- the prriate sector. Problems are recog- tested were fined until they conformed. nized by both the private and public sec- The second example is the mechanism trs. For businesses, the cost of the tax used to collect overdue taxes across the system includes mbles paid for taxes and country. Atthe taxinspector's request, fines for 'services" rendered to appease tax au- for late payment are automatically with- thorities; time taken to understand the drawn from a company's bank account complex system; and the uncertainty gern- wiiout even informing the company This erated by constantly changing laws and in- not only allows the govemment to impinge consistent administration. Tax authorities on property nghts, but encourages cx- The average Russian themselves are overwhelmed by the com- ploitative behavior of governent officials. ;ompany m plexity of the system. Govemment receives only a fraction of its dues because of am- infobmation gaps. Most businesses la-ck comply with biguities in the regulations and increased the information they need to comply with fourteen federal, informal activity. the tax regulations. So do some tax author- four oblast, and ities. For example, when some business Ti legksAwo Tax regulations are cum- people from Tonsk asked for clarification up to tWemty-tWo bersome and confusing The aveage Russian on how to complywith a recent change in local taxes. cmpanymust comply with fourteen federaL tax codes, local authorities were at a loss to four oblast, and up to twenty-two local taxes provide answers. While admitting that thry The number of taxes is constantly changing did not understand the new tax regulation, manynewraxes areapplied reroctvely and - the tax authorities insisted that businesses repomrng procdures are seldom standard- comply and fined those that refused. zxe This can also resut in duplication. There is no streamlined communmca- 'Witne the profits tax (at 32 percent) and tion between the federal, oblast, and mu- the recently recommended enterprise in- nicipal tax authorities or between the come tat Indeed, taxesadd up to more an authonties and businesses. Due to the two-thirds of profis. complexity and malleability of the tax code, it is often impossible for businesses Xx admMiuraton The drving forces to independendy ascertain whether they behind the tax administration, which is in- are complying with the law. Many respon- efficient and frequently regarded as preda- dents claimed that tax authorities monop- tory, seem to be the numerous and varied olize what information they have, and this locations of tax authorities and the control enables them to in-terpret ambiguities to systems that undermine those authonties. their own advantage. No public body is ac- lTx authorities lack accountability and cre- countable for providing taxation informna- dibilit Few have training and most do not tion to brsinesses on a timely basis, and possess the informadon needed to admin- while some tax consultants are taking on ister taxes according to the law. The wide- this role, few businesses are willing or able spread complaints of incompetent officials to purchase their servces. and lack of integity simply underlines this broader problem. Impact. The dilemma faciog the Russian Tax authorities, moreover, are perceived government is how to increase tax revenue ashav ingbroadcdiscretonarypowers,which and simultaneously encourage investment they frequently use. It is necessary however To a large extent, it seems that Russia has to distinguish between sheer exploitative adopted a short-term strategy ofgenerating behavior of individuals and the blunt in- revenue by hiking up tax rates.Whethere struments the system requires them to use have been some attempts to use tax policy Take two examples, tax inspectors in lbmsk to stimulate sectoral development, most of expected a Fedeal tax to be introduced on the tax breaks have been cdums conflict- CoNSTINm1T mO PR=VAE EERPsE IN THE FSTT: ArpmoAOr ND Ap nT RuspA 191 ing, and unattractive.Just when it is citical Sozwe offinance to take along-term strategy that encourages business fonnation, fosters investment, Entrepreneurs across the board were quick and broadens the tax base, the government to articulate their financing constraints, and appears to be choking business develop- the list of finance related problems was ex- ment through high tax rates, a complicated tensive-ranging from the cost of credit, to code, and abusive enforcement. corrupt bankers. However, when ranked The net effect is that the tax base is against other constraints, finance was not eroded and faud is rampant Many enter- the highest priority. prises evade taxes or remain informal Whereas most western start-ups are fi- Some 'companies" do not register, have no nanced from personal savings, in Russia in- official bank account, and conduct all flation has eroded this option. The transactions in cash. This is not limited to dominant source of funds is trading activity, the kiosk traders or govemment stores which generated more than 60 percent of which now have 'commercial sectionsn total financing (figure 142). As the market running similar operations. Other 'compa- develops and margins are squeez=d, howev- nies" appear and disappear quicddy, usually er, this will become less viable. by agreement with the authorities that are supposed to control diem. This has given The bkng system. From slow pay- rise to the cliche, 'Paying taxes is stupid, ments to poor adminisration the banling but paying bribes is vital" system is rife with problems. In fact, care- Most companies use legal and semi-legal fully selecting a bank seems to be the most means to avoid taxes. Some also inform on effcient way firms can alleviate bank-relat- caupetitors to tax authorities. Avoidance ex- ed constraints and sourcing credit. The pri- tends right through the economy. "Under- mary reason for this is institutionaL gound" producton companies bave been Govemment uses banks to control private operating for years. Most started to become businesses. The 1992 decree, for instance, legal, but were driven back underground by obliges all enterprises to deposit money at the tax regime. Now, they employ various a bank and use that bank for all transac- means to evade taxes, induding creating un- tions (unless prevIously agreed with the prxfitable subsidiaries and false charitable bank). Goverfnment can also withdraw tax finds. Government experts estimate the un- fines from a company's bank account and delivered revenues at more than a tillion restrict the use of deposits when the client rubles, hamstongtng investnent programs is considered behind on accounts payable. and fueling inflation. Because bank managers have much dis- cretion over these matters, the most im- portant critera in choosing a bank is the Figure 14.2 Sources of finance: average perfinn entrepreneur'srelationshipwithbankman- agement and staff Given the importance of Fhreign i nvesb n ent (1 %) good banking connections, it is not surpris- Loansfromrfends(%) ing that entrepreneurs using bank credit were more likely to have been managers of / A/ \ BBak (15%} state-owned enterprises (46 percent) and less likely to be women (35 percent). ~~~ / ~~~~Partner (2%) P. ff! (62X) -Other (not. spefied) (4%)- Bank fince Compared to past prac- -er (no suppliecrfed)t (20 ) ces (for example, restictions on multiple Suppli-er.-\ \ \.ei Familym s(2%) bank accounts), it now seems relatively easy Family means X37 for entrepreneurs to open bank accounts. --- \