I 2 S(O F*~ Economic Development Institute v;;> of The World Bank Enterprise Governance and Investment Funds in Russian Privatization Noritaka Akamatsu EDI WORKING PAPERS *.Number 94 -4 7 !FF COPY STUDIES AND TRAINING DESIGN DIVISION EDI Working Papers are intended to provide an informal means for the preliminary dissemination of ideas with the World Bank and among EDI's partner institutions and others interested in development issues. The backlist of EDI trainingmaterials and publicationsis shown in the annual Catalogof Training Materials which is available from:. Training Materials Resources Center, Room M-Pl-010 Economic Development Institute The World Bank 1818 H Street NW Washington, DC 20433, USA Telephone: (202) 473-6351 Facsimile: (202) 676-1184 Enterprise Governance and Investment Funds in Russian Privatization Noritaka Akamatsu The Economic Development Institute of The World Bank Copyright i 1994 The International Bank for Reconstruction and Development/Thie World Bank 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. The World Bank enjoys copyright under protocol 2 of the Universal Copyright Convention. This material may nonetlheless be copied for research, educational, or scholarly purposes only in the member countries of The World Bank. Material in this series is subject to revision. The findings, interpretations, and conclusionis expressed in this document are entirely those of the author(s) and should not be attributed in any manner to the World Bank, to its affiliated organizations, or the members of its Board of Executive Directors or the countries they represent. If this is reproduced or translated, EDI would appreciate a copy. Foreword This EDI Working Paper will be published as one of 12 chapters in a forthcoming book entitled: Corporate Governance in Transitional Economies: Insider Control and the Role of Banks edited by Masahiko Aoki and Hyung-Ki Kim. The book will have three parts: Part 1: Generic and Comparative Issues: Theory and Policy Implications (chapters 1-3) Part 2: Country Studies in Comparative Perspectives (chapters 4-8) Part 3: Relevance and Lessons of the Japanese and German Experience (chapters 9-12) A list of titles is provided on the inside back cover of this paper. The book presents the results of a research project on corporate governance issues in transitional economies from a new perspective based on comparative institutional analysis. A concern with three issues-the emergent phenomena of insider control, the possible role of banks in corporate governance, and the desirability of the comparative analytic approach-sets the common ground for the research presented in this volume. The coexistence of the alternative models of corporate control in the developed countries suggests that the possible "lessons" for the transitional economies may not be so obvious. It makes little sense to judge the merits of each corporate governance model and its applicability to the transitional economies without taking into account a country's stage of development and the history of its institutions and conventions. In designing corporate governance structures for the transitional economies, economists are required to identify the specific conditions under which each corporate control model (or combination of models) works, the availability of these conditions in the transitional economies, and the most efficient approach to achieve these conditions. By pooling rich individual country studies and cross-examining and comparing their implications, we may be able to avoid premature generalizations or theorizing based on the observation of a single economy. By comparing the workings of diverse systems, we may also be able to uncover latent factors that are conducive to, or constrain, the workability of particular governance structures. Comparative analysis may thus serve in the social sciences as a kind of proxy for laboratory experiments. This work was prepared as part of EDI's multiyear Program for the Study of the Japanese Development Management Experience which is financed by the Policy and Human Resources Development Trust Fund established at the World Bank by the Government of Japan. The Program is managed by the Studies and Training Design Division of the World Bank's Economic Development Institute. Hyung-Ki Kim, Chief Studies and Training Design Division Economic Development Institute Lu 5 Enterprise Governance and Investment Funds in Russian Privatization Noritaka Akamatsu The structure of Russia's industrial sector at the start of reform reflected the most extreme scenario of a planned economy. Production enterprises specialized in production of only a few lines of products, and often in only one line. Trading enterprises carried out only in the distribution of merchandise. So-called "research institutes" had the sole task of developing new products (R&D). At the same time, an "enterprise" consisted of everything necessary for people working in the enterprise, including housing, schools, sports facilities, hospitals, and so forth. In other words, an enterprise in a Russian context made up an entire community. In addition to such functional segmentation and communal integration, many enterprises had monopolistic positions either in their products or services or in the regional market (or in both) in order to take maximum advantage of scale economy in the absence of competition. The monopolistic structure also means that Russian industrial enterprises tend to be huge, and ignore managerial efficiency. Clearly, Russian enterprises require a great deal of restructuring to become efficient and competitive with their Western counterparts. Considering the historical monopolistic position of enterprises, however, competition in the product market will take some time to emerge. The market for skilled managers will not be liquid any time soon because of the scarcity of skilled managers. Although many gigantic enterprises will need to downsize, it does not mean that managers' positions (rather than workers') will become contested. The stock market is unlikely to gain significant liquidity in the near future because investment demand for shares is driven by desire to gain control rather than return, and because an efficient payments system and centralized securities depositories and share registrars will take some time to develop. Takeover threats will not be a function of underpricing in the market because there are no meaningful market prices of shares without active share trading and sufficient disclosure of reliable business information. Enterprises do not have a sense of the cost of equity capital because the primary market of shares is not functioning. It will not function properly unless the secondary market gains significant liquidity. All in all, competition in the factor markets will likely be the result of further reform, and control and monitoring by owners and creditors thus seem to be the only sensible means of managerial discipline for the majority of Russian enterprises today. The driving force behind the design of Russia's privatization scheme is the scarcity of two critical resources: financial means and skilled management. A system of postprivatization governance must make optimal use of the limited resources available. This need is quietly overriding the political and social factors in determining the course of Russia's economic reform. Russia' privatization scheme can be characterized as a combination of management-employee buyouts (MEBO) and voucher-based mass privatization. The MEBO aspect of the scheme has made the incumbent work force (both managers and employees) the largest group of shareholders. Incumbent managers have gained strong control over their enterprises as "owner-managers. " At the same time, the voucher-based mass privatization scheme, which was adopted after the Czech model, enabled voucher investment funds (VIFs) to become another group of significant shareholders. Commercial banks are also placed to exercise significant influence on 1 enterprise govemnance and management. With their universal status, not only can they monitor operations of the borrower enterprises, but also, as owners or agents of owners, have direct "say" about management of the enterprises. Further, as creditors, they have the power to determine the fate of enterprises at risk of bankruptcy. Foreign strategic investors are also emerging as a potential major player in this game. Construction of a legal and regulatory framework is under way. It represents rules of the game among the potential "governors" of enterprises, and consists of human resources (software) such as corporate lawyers, prosecutors, and judges, and of infrastructure (hardware) such as written law and regulations and court systems. Russia's Company Law specifies a two-tier structure of enterprise governance board, as does the German law. Power of extemnal shareholders, however, is significantly limited in comparison with the German case, not to mention the Czech arrangement. Central European experiences would be a good reference for Russia in her effort to press forward with the economic reform. In the Czech Republic, where voucher investment funds have become a superpower in governing enterprises, created a situation in which all leading voucher investment funds are controlled by major commercial banks. Russia's legal framework needs to structure ownership relationships among potential governors of enterprises with care in order to avoid an excessive agency problem and conflict of interest. Development of a corporate governance structure in a transition economy is a dynamic process that must respond to the needs of different stages of the transition. Russia has gone through the stages of corporatization and privatization of state enterprises, and is now faced with a need to press forward the postprivatization restructuring of the enterprises. The crucial questions are who has the ability to: (a) restructure the enterprises; (b) finance the restructuring; and (c) run the restructured companies. The party that restructures and runs a company should have: (a) strong incentives; (b) the necessary skills; (c) the necessary resources; and (d) access to relevant information. Major investors and creditors would satisfy these criteria. Traditionally minded incumbent management groups with vested interests often have not proved to possess these requirements. It is hoped that foreign strategic investors, who can bring in both financial and managerial resources, will play a direct and important role in restructuring the enterprises. The New Privatization Program reflects that the rule of the governance gamne among domestic institutions is shifting toward mobilization of the power of the voucher investment funds as major outside shareholders in disciplining incumbent managers. At the same time, the program tries to restrict emerging anticompetitive powers-such as commnercial banks with universal status, holding companies, and emerging "financial-industrial groups "-although they now have stronger control over enterprises. This chapter analyzes the dynamic emergence of a corporate governance structure in Russia's privatization and postprivatization restructuring process. The key players of the game are the incumbent work force of the enterprises, commercial banks, institutional investors, and strategic investors. This chapter pays particular attention to one group of institutional investors-voucher investment fuinds (VIFs)-and to the dynamic interaction amnong the key players in response to the emerging legal and regulatory structure and the underlying politics. Should voucher investment funds be involved in restructuring? How capable are the voucher investment fuinds of restructuring enterprises, or how can they be made capable? In what areas could they be more effective than incumbent management, creditor banks, or even potential strategic investors? Russian reformers need to keep asking these questions in order to press forward with their reform efforts. ;aRussia's Privatization Scheme and the Power of Incumbent Management From the initiation of Russia's First Privatization Program in the beginning of 1992 to the completion of the program on June 31, 1994, 70 percent of Russia's industrial sector had been transferred into private hands. This impressive speed was achieved through the following steps: initiation of privatization, 2 development of a privatization plan, and implementation of the privatization plan. Each step deserves further attention in order to analyze the way this speed was achieved and its implication for governance of privatized enterprises. ;bInitiation of Privatization First, incumbent management, incumbent employees with no less than 50 percent endorsement, and potential strategic investors (including related enterprises such as banks and suppliers) could all submit an application for privatization of a particular enterprise to GKI (or a local KI). Upon approval of GKI (or a local KI), the application was passed on to a privatization commission established by GKI (or a local KI) within the enterprise, made up of representatives of the GKI, the local Council of Peoples' Deputies, financial institutions, incumbent management, the work collective, and outside private consultants. ;bDevelopment of a Privatization Plan A privatization commission was to develop a privatization plan for a particular enterprise in which the commission was to specify the method of privatization (that is, a choice among the three options), the starting price (to be sold through an auction or tender), the size of the authorized capital (in case of a joint-stock company), and the recommended form of payments. The plan was then submitted to the local Council of People's Deputies and to the employees of the enterprise for approval. Upon nonrejection of the two bodies, the plan was submitted to the GKI for final approval. The requirement to specify the starting price and the authorized capital necessitated valuation of the enterprise. The valuation was based on the book value of assets, including fixed assets, accounting for depreciation, inventory, work in process, and intangibles. Deduction was made for debts-any monetary resources held in the economic incentive, including the privatization fund that was funded out of profits of the enterprise in order for the incumbent work force to acquire shares of the enterprise.' ;bImplementation of the Privatization Plan Once a privatization plan was approved by the commission, GKI transferred ownership rights to the Russian Federal Property Fund. At this point, an enterprise was made independent from the state or a municipality, and corporatized to form a joint-stock company. The Property Fund was then charged with implementing the privatization plan (that is, divesting from the enterprise). ;bThree Privatization Options In the process of developing a privatization plan, a privatization commission could choose one of three options for the privatization method, which allowed considerable flexibility (see box 5-1). All of the three options can be characterized by a combination of subsidized management-employee buyout (MEBO, that is, a closed sale to the incumbent work force) and public offering of shares, which was mainly done through voucher auctions. The extent of subsidization varied from one option to another. CHOICE OF OPTIONS. All the options strongly favor the incumbent work force. Option 1 is the cheapest investment option for the incumbent work force, but it significantly limits their control of the enterprise.2 In contrast, Option 2 ensures majority ownership for the work force, but at a much higher price. Although GKI openly promoted Option 1, about three-quarters of the enterprises have chosen Option 2 (and most of the rest have chosen Option 1). Only about 2 percent of the enterprises have 3 selected Option 3, suggesting the scarcity of the entrepreneurial endeavor among the management (see table 5-1 for the allocation of shares by privatization option; table 5-2 for distribution of shares).3 LOVE FOR INSIDER CONTROL. The strong preference of the incumbent work force for Option 2 is a clear sign of their desire to retain control of their enterprises rather than to seek a return from the advantageous share investment of Option 1. A determinant in the choice of Option 1 over Option 2 was not the low cost, but the insufficiency of a privatization fund in a particular enterprise. The incumbent work force, which was the largest faction in a privatization commission, generally favored privatization, and thus the privatization could proceed smoothly. The reason for their preference for privatization was not that they wished to commercialize themselves to adapt to the new environment, however, but because they could become independent from state or municipal control. The choice of Option 2 clearly showed that they did not favor any outsider control of their enterprises. The intention of incumbent managers was to maintain the status quo rather than to restructure the enterprises into more efficient forms. TIE BETWEEN MANAGEMENT AND EMPLOYEES. Within the incumbent work force, management, rather than employees, was the group that wished to retain the control. In order for the management to make insider control effective, they needed to collude with the employees. The majority of employees also preferred control by the incumbent management over that by Russian outsiders and foreigners, at least initially. In some cases, management established an ESOP-like structure, as a legal entity controlled by the management. By having employees participate in the structure, the management can control participating employees' voting rights. The nature of the tie between management and employees was generally a function of the size of the enterprise-the larger the enterprise, the weaker the tie. The government prohibits imposition of any limits preventing employees from selling their shares freely to outsiders.4 Nevertheless, management has come up with direct and indirect ways to prevent or control employees' sale of shares to outsiders. SWIFT PRIVATIZATION. With a privatization scheme that strongly favored the insider, the Russian reformers cunningly depoliticized the reform process. This "success" significantly contributed to speeding-up the privatization process, and thus to cost reduction making the reform process irreversible. Although this allowed a priority objective to be achieved at an early stage of the reform, it also created the unavoidable problem of excessive insider domination in governing the privatized enterprises. The voucher-based mass privatization scheme was designed to counter-balance the power of the incumbent work force. ;aVoucher-Based Mass Privatization and the Emergence of Voucher Investment Funds Russia employed vouchers as a means of mass privatization, as did the Czech Republic.5 A voucher with a par value of 10,000 rubles was distributed to every one of Russia's 150 million citizens. A presidential decree, "On The Creation And Regulation Of Specialized Voucher Funds" (hereafter the Investment Company Law) was signed on October 7, 1992, and voucher investment funds (VIFs) were initiated in the beginning of 1993.6 Since then VIFs have mushroomed to number over 650. Individuals could invest their vouchers directly into shares of enterprises at voucher auctions or into those of VIFs that would invest the collected vouchers in enterprise shares on behalf of their investors. VIFs have proven to be effective "privatization intermediaries" that facilitate individual participation in the mass 4 Box 5-1. Three Options of the Russian Privatization Scheme Option 1 Work force. The work force will receive nonvoting shares up to 25 percent of the capital of the enterprises for free (each employee can receive a maximum of twenty times the minimum salary, and the work collectives decide the distribution of the shares among employees). Workers can purchase up to 10 percent of voting shares at 30 percent of the book value (workers are entitled to receive 10 percent of proceeds from the sale of the enterprise into a privatization fund; the sum is set aside from the enterprise's profit to purchase shares in the enterprise for the work force). Employees cannot resell these shares for three years. Also, some restrictions apply to the methods of payment while vouchers can be used. Acquisition of shares in the open market is not restricted for employees. Managers (part of work force). Managers can purchase an additional 5 percent of the shares at par value. Furthermore, 10 percent of shares are deposited in a development fund (FARP), which is established by enterprises to retain part of their earnings for investment in restructuring. The remainder. The remaining shares, 50 percent, are held in the property funds and can be sold through auction and competitive tender. Option 2 Work force. The work force can purchase 51 percent through a closed subscription at 170 percent of the 1992 book value on the approval of privatization. Without them, most individual investors would possess neither sufficient information to choose appropriate enterprise shares nor enough resources to diversify the risk widely. At the same time, the reputation of VIFs has hit a low point because of fraud and an inability to pay the high dividends they promised to their investors. (See table 5-3 for VIF statistics.) ;bVoucher Auction and Valuation of a Voucher Voucher auctions against shares of privatizing enterprises were completed on June 30, 1994.7 Every month, 400 to 500 voucher auctions were held across the country. Because Russia's privatization scheme auctions enterprises one by one, 400 to 500 enterprises were privatized every month.8 Out of approximately 150 million vouchers distributed to the Russian citizenry, about 45 million vouchers have been collected by VIFs, and over 27 million of those have been invested into shares (as of April 30, 1994). It is estimated that over 60 million citizens out of a total population of 150 million had participated in the mass privatization by the end of the program, and that there are about 30 million individual Russian shareholders through VIFs. 5 two-thirds of the work force. Vouchers can be used to pay up to 50 per-cent of the purchase, but some restrictions apply to the methods of installment payment. An additional 5 percent can be deposited in FARP. The remainder. The 44-49 percent remaining is sold through voucher auctions or competitive tender. Option 3 Option 3 is a rather pure case of MEBO, applicable only for enterprises with more than 200 employees and assets valued at 1-50 million rubles at 1991 prices. Work force. By the approval of a general meeting of two-thirds of the workers, a group of workers is given the power to purchase 20 percent of shares at par value on the condition that the group accept responsibility for implementing the privatization plan and for the solvency of the enterprise, and signs a one-year contract specifying the obligations of the group. The group must make a security deposit of 200 monthly minimum wages for each member of the group. In addition, workers can purchase 20 percent of shares at 70 percent of book value (up to a maximum of twenty times the minimum wage of each employee). Some restrictions apply to the methods of installment payment, although full payment can be made in vouchers. FARP retains 10 percent of shares, but those can be bought by employees after auctioning/tendering the remaining 50 percent of shares. The remainder. The remaining 50 percent of shares is to be sold through voucher auctions/competitive tenders. Vouchers were exchanged for shares according to a price determined in each auction. The initial value of an enterprise (shares) in auction was evaluated based on book value of its assets in rubles. A sale price of an enterprise, however, was determined by the number of vouchers successfully bid.9 Therefore, the initial value was nothing more than a reference price to start an auction.'" At a voucher auction, investors could acquire shares only with vouchers, but not with cash. " Prior to the summer of 1993, lack of an interregional network of voucher depositories required VIF managers or their agent broker-dealers to carry a large number of voucher documents to an auction center. They had to do so without knowing whether their bids would be successful,'2 which was a costly and risky thing to do, especially in the case of interregional investment. As a result, each voucher auction was initially regionalized by participating investors, and so were the portfolios of many VIFs. Establishment of an interregional network of voucher depositories in the summer of 1993 enabled VIF managers to bid without physically presenting voucher documents."3 This substantially facilitated interregional investment of vouchers, although VIF managers or their agents still had to visit local auction centers to participate in auctions." 6 Table 5-1. Allocation of Shares under Privatization Options 1-3 (percentage) Description Option 1 Option 2 Option 3 Free to employees 25 Sold to employees at a 30% discount (cash or vouchers) 10 20 Sold to employees at 1.7 index of nominal value (cash or vouchers) 51 Sold to management at nominal value (cash or vouchers) 5 Sold to employee group committed to fulfilling the privatization plan and managing the enterprise at nominal value after one year (cash only) 30 Sold to Enterprise Employees' Shareholder Fund (EESF) with 2-year right to purchase (cash only) 10 5 10 Subtotal retained by enterprise 50 56 60 Voucher auction (minimum percent by law) 29 29 29 Investment tender/retained by government/other 21 15 11 Subtotal available to investors/ government 50 44 40 Total 100 100 100 Source: Price Waterhouse 1994. 7 Table 5-2. Distribution of Shares for Selected Russian Enterprises (percentage) Saransk Company name ZEL Factory Orbita Amurenergo (semi- (electric util- conductor ities and Principal Industry (automobiles) devices) thermal power) Privatization option 1 1 1 Internal Placement Preferred stock placement for employees (Option 1 only) 25.00 25.00 18.53 Closed subscription of common stock for employees 10.00 10.00 5.56 Common stock placement for managers (Option 1 only) 5.00 3.60 5.00 Enterprise employees' share- holding fund 10.00 10.00 10.00 Total Internal Placement 50.00 48.60 39.09 External Placement Voucher auctions 35.00 29.00 11.91 Retained by government or holding company 13.00 20.00 49.00 Distribution to the Far North Population and employees of the oil transportation companies and/or subcontractors 0.00 0.00 0.00 Investment tenders 0.00 0.00 0.00 Cash sale 2.00 2.40 0.00 Total external placement 50.00 51.40 60.91 Total shares 100.00 100.00 100.00 Source: Price Waterhouse 1994. 8 Lukoil- Krasnoyarsk Tomsk Kogalim- Tire Krasnoyarsk Neftekhimichesky neftegas Factory TsBK Tekstilmash Factory Oil Drilling Cellulose, and Paper and Textile Oil-based Gas Extraction Tires Cardboard Looms Chemicals 1 2 2 2 2 18.60 0.00 0.00 0.00 0.00 10.00 51.00 51.00 51.00 51.00 5.00 0.00 0.00 0.00 0.00 0.00 5.00 0.50 0.00 5.00 33.60 56.00 51.50 51.00 56.00 17.30 29.00 29.00 29.00 44.00 38.00 15.00 19.50 20.00 0.00 9.70 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1.40 0.00 0.00 0.00 0.00 66.40 44.00 48.50 49.00 44.00 100.00 100.00 100.00 100.00 100.00 9 Table 5-3. Statistics on Voucher Investment Funds in Russia Date Category 28.05.93 30.06.93 31.07.93 31.08.93 Funds Regions polled 5 26 69 52 Percentage of all regions 5.6 29.2 77.5 58.4 Funds licensed by Kls 85 211 370 435 Funds licensed by GKI 42 62 77 80 Total number of licensed VIFs in FMU database 127 273 447 515 Percentage increasing NA 115.0 63.7 15.2 Vouchers Number of funds polled 50 87 145 256 Percentage of total number of funds 39.4 31.9 32.4 49.7 Number of vouchers accumulated 2,619,381 5,819,874 8,598,714 12,224,618 Number of vouchers accumulated per fund 52,388 66,895 59,301 47,752 Total number of vouchers' 6,653,228 18,262,363 26,507,760 24,592,493 Number of vouchers invested 842,467 1,612,420 2,886,178 4,808,718 Number of vouchers invested per fund 16,849 18,534 19,905 18,784 Total number of vouchers invested' 2,139,866 5,059,663 8,897,390 9,673,788 Percentage of vouchers invested 32.2 27.7 33.6 39.3 Shareholders Number of funds with share- holder's data NA NA 76 181 Percentage of total number of funds NA NA 17.0 35.1 Number of shareholders NA NA 3,400,950 5,387,116 Number of shareholders per fund NA NA 44,749 29,763 Number of vouchers NA NA 5,992,588 10,355,267 Number of vouchers per shareholder NA NA 1.76 1.92 Total number of shareholders in Russia NA 8,000,000 15,000,000 15,327,982 Percentage of the total population NA 5.4 10.1 10.3 a. FMU estimations. Source: Capital Market Surveilance Unit (formerly, Fund Monitoring Unit) of GKI. 10 Date 30.09.93 30.10.93 30.11.93 15.12.93 31.01.94 28.02.94 31.03.94 30.04.94 57 63 71 71 71 72 75 75 64.0 70.8 79.8 79.8 79.8 80.9 84.3 84.3 482 498 514 515 518 521 535 538 84 102 117 117 117 119 121 121 566 600 631 632 637 640 656 659 9.9 6.0 5.2 0.2 0.8 0.5 2.5 0.5 307 370 421 428 450 466 492 505 54.2 61.7 66.7 67.7 70.6 72.8 75.0 76.6 18,196,624 23,022,418 26,158,309 27,839,694 29,625,642 30,317,824 31,961,326 34,678,461 59,272 62,223 62,134 65,046 65,835 65,060 64,962 68,670 33,548,173 37,333,651 39,206,397 41,109,081 41,936,742 41,638,213 42,615,101 45,253,675 8,425,031 12,404,011 15,182,382 15,714,755 18,231,302 19,212,205 20,600,187 21,135,704 27,443 33,524 36,063 36,717 40,514 41,228 41,870 41,853 15,532,793 20,114,612 22,755,542 23,204,965 25,807,421 26,385,861 27,466,916 27,581,047 46.3 53.9 58.0 56.4 61.5 63.4 64.5 60.9 223 290 371 378 406 420 445 457 39.4 48.3 58.8 59.8 63.7 65.6 67.8 69.3 8,937,555 11,852,655 14,384,240 14,784,086 14,100,959 14,502,364 14,796,164 14,352,798 40,079 40,871 38,772 39,111 34,731 34,529 33,250 31,407 15,120,334 20,437,761 24,140,393 25,816,640 28,336,330 28,829,243 30,302,664 33,093,186 1.69 1.72 1.68 1.75 2.01 1.99 2.05 2.31 22,684,557 24,522,734 24,464,839 24,718,366 22,123,918 22,098,840 21,811,873 20,696,923 15.3 16.5 16.5 16.6 14.9 14.9 14.7 13.9 11 ;bClassification of VIFs by Size and Regional Coverage As of April 30, 1994, there were 659 licensed VIFs."5 They can be classified by size and area of geographic coverage as listed in table 5-4. The top fifty own about 50 percent of the industry's assets. ;bLegal Form of VIFs Although investment funds in Russia include both VIFs and cash investment funds (CIFs), almost all investment funds are VIFs.'6 The majority of Russian citizens, with limited savings, were unable or unwilling to invest rubles on a long-term basis, especially in the presence of vouchers. A distinction between VIFs and CIFs remains in licensing bodies and regulatory matters, even though VIFs completed the conversion of vouchers into enterprise shares. VIFs have been licensed and regulated by GKI. 7 They took a form of "open joint-stock company" defined under the Company Law."8 Since a VIF was a "company," investment certificates issued by a VIF are "equity shares," and investors of those shares are "owners" of a VIF. 9 In that sense, they are similar to mutual funds in the United States or investment funds in the United Kingdom.20 Unlike mutual funds, however, the Russian VIFs are required to be "closed-end" funds by the Investment Company Law.2' This requirement reflects the GKI's commitment to press forward with privatization by making the investment with vouchers irreversible. At the same time, open-end funds would be impossible in the illiquid Russian stock market of today. Table 54. VIFs by Size and Regional Coverage Number Regional Number of Type of VIF of VIFs coverage shareholders Asset size Large, nationwide 5 Nationwide 1-3 million $25-50 million Interregional 50 5-30 regions 40,000-250,000 $1-10 million Regional 50 One 50,000-300,000 $1.5-12 million Small, regional 500 One 1,000-10,000 $20,000-300,000 ;bAggressive Advertisement VIFs have grown in number through aggressive advertisement promising unrealistically high return or dividends on their shares, as happened in the Czech Republic. Unfortunately, most VIFs could not pay enough dividends in spring 1994, if they paid dividends at all, which disappointed their investors. As a result, public confidence in the VIFs is now at a low ebb. Promising return is illegal in the West, and it has been made illegal under the Investment Company Law in Russia as well. Advertising is also restricted financially by the law.22 Nevertheless, one VIF "promised" up to 700 percent in dividends, and while it actually paid this amount, it went to only a select few. A weakness of the present legislation is a lack of effective punitive actions and enforcement. It cannot be denied, however, that the mass privatization might not have been launched successfully if such aggressive advertisement were strictly prohibited.23 ;bCapital Income Taxation 12 Although VIFs have mushroomed to number over 600, one-third of them were said to not be in operating condition. The most serious obstacle for the growth of the VIFs was Russia's system of capital income taxation. Return on investment in investment funds was taxed three times: first as a corporate income, second as dividend income to the VIFs, and third as personal income to the VIF investors. The triple taxation seriously discouraged investment in VIFs, and small VIFs were unable to collect vouchers.24 Two-thirds of the existing VIFs are expected to go under if the triple taxation remains. This means that one-third of the VIFs that are actually functioning would go under.' GKI has so far come up with three solutions to this problem. First, GKI promoted consolidation of the VIFs by allowing them to purchase one another's shares, an action that was previously prohibited. As a result, there have recently been a growing number of M&As among the VIFs. The number of VIFs increased toward the end of voucher privatization on June 30, 1994, which was due to the second solution. In January 1994, a VIF tax privilege was made effective, allowing them to be exempted from tax on dividends received during the first two years of their establishment. A number of industrial enterprises established new VIFs to take advantage of this new privilege. The irony is that this privilege does not apply to the dividend income received prior to January 1994; the better- established VIFs were created around the end of 1992 and will celebrate their second anniversary by the end of 1994. Therefore, the established VIFs will not benefit very much from the privilege, and it contributed much more to the creation of new VIFs, mainly for a purpose of tax avoidance. The other solution is creation of a contractual form of funds (trust funds) that is not subject to corporate income tax, thus eliminating an effect of the triple taxation.27 A concept of "trust" was introduced in December 1993 by the presidential decree on trust. Investors in an existing VIF would not have to pay extra tax if the VIF transforms itself into a "trust fund." Such a transformation, however, requires the following steps: (a) establishment of trust funds as new organizations, (b) transfer of the VIF's assets into the trust funds, and (c) dissolution of the old VIF structure. At this moment, the VIFs cannot carry out this transformation because the Investment Company Law prohibits the voluntary liquidation of VIFs for three years from their establishment. According to the regulation, their reorganization within the three years also requires approval of GKI.28 If the triple taxation should remain after the first three years, there will be a massive transformation of VIFs from a company form into a trust form, which would be socially costly, with little benefit. More generally, the triple taxation would distort the financing patterns of enterprises in favor of short-term debt financing, leaving enterprises in a weak capital structure. Enterprises would tend to rely on bank financing,29 and capital market development would be hindered. Such a lack of "neutrality" in the tax regime would also entail effectiveness of taxation and the government's fiscal financing. Therefore, amendment of the triple taxation is necessary.30 ;bValuation of Shares and Research Capacity of VIFs Disclosure of financial information by enterprises has not been effectively enforced. Accounting based on Western financial accounting principles is little practiced, although the new form of Russia's financial statements and the underlying accounting principles required by law do resemble a Western form.3" There are no regulations (including the Company Law) that specify disclosure requirements in detail.32 Out of the 5,000 enterprises privatized, about 100 publish financial statements. Their balance sheets, however, consist of three lines on the assets and two lines on the liabilities, without footnotes, which is just nonsense. Enterprise managers do not wish to go public, and therefore there is no incentive for the managers to disclose. 13 In the current environment, where valuation based on income or cash flow is ineffective,33 VIFs are concentrating on asset valuation techniques. Major VIFs also carry out intraindustry analysis. Their industry analysts look at the relevant industry branch and make intraindustry comparisons. There tends to be a wide range of differences among enterprises in a single industry branch. Some enterprises are clearly better than others, and good ones often have equipment that can be valued in hard currency. Accounting for depreciation with age, the analysts estimate replacement value of major equipment. Marketing research is also carried out by the analysts. They analyze an enterprise's relations with suppliers and their reliability, superiority of products, and sales network relative to those of other enterprises, and estimate resulting market share, growth potential, and cost structure. They also try to analyze the experience and ability of management.34 These analyses and judgments are largely based on the analysts' experience, on-site observation, and interviews with management, and are age-old practices performed by the Western securities analysts as well. Taking this into account, the valuation efforts made by leading Russian VIFs seem reasonable, given the current circumstances. In any case, well-established methods of valuation certainly do not seem to exist, and even a naive method such as the above is limited to some leading VIFs. Macroeconomic analysis35 in the present environment is not useful because the problems that many enterprises are faced with seem to come much more from the payment system failure than the apparent macroeconomic slump. The evaluation of an enterprise hinges on the ability of the management and their success in collecting payments. Popular shares have been in oil, gas and minerals, construction, tourism and hotels, and consumer products. Generally speaking, enterprises with a monopolistic position in a regional market and with producers of finished goods are considered attractive, and industrial giants (probably with the exception of oil, gas, and minerals) and Moscow-based enterprises are found unattractive by some fund managers. Oil, gas, and minerals generally have a good export market. Local monopolists tend to have stable demand and revenue, and producers of finished goods (or consumer goods) usually have few payment collection problems. At the same time, gigantic industrial enterprises, particularly producers of intermediate products, tend to bear high bankruptcy risks and are difficult targets for the acquisition of controlling stakes for VIFs, even through collusion. Moscow-based enterprises (hotels, department stores, and the like) can be expensive because they are well known, and therefore are popular investment targets.36 Share prices have also been pushed up after public exposure of some major VIFs' plans to place bids on particular enterprises (signaling effect of credible bidders). It was, therefore, critically important for major VIFs to disguise their participation in an auction. ;bVIF Associations and Self-Regulation Leading VIFs try to promote as well as govern themselves through participation in industry associations. There are three major associations of VIFs-the Association of Investment Funds,37 the League of Assistance to Investment Funds,38 and the Moscow Public Shareholders' Rights Committee.39 The League is acting as a self-regulatory organization (SRO)' of the VIF industry, although SRO status is not yet official and will be defined in the securities law now being drafted. Jointly with the Committee, the League has recently produced a code of conduct and fiduciary duties of investment fund managers. Three of them also publicize good and bad practices of managers of VIFs as well as enterprises. ;bVIFs' Sources of Income 14 VIFs' sources of income have been dividends from enterprises," voucher trading, and enterprise share trading.42 Because of the recent poor business performance, however, most enterprises are unable to pay significant dividends, if they can pay dividends at all.43 In addition, VIFs have been prohibited from trading vouchers collected in exchange for their shares. Besides, most vouchers disappeared as the voucher privatization was completed on June 30, 1994. Therefore, trading of enterprise shares has become the only source of immediate income. OTC share trading has been active, particularly after a voucher auction. VIFs acquired as many shares as possible at each voucher auction and sold the shares as a bloc at a higher price.' Broker/dealers (B/Ds) also have been buying up shares (dealership operation) from individuals and selling those as blocs.45 Such bloc sales by VIFs and B/Ds have been made to strategic investors who sought control of the enterprise. ;bNature of the Present Stock Market The Russian stock market has been predominantly a market for "control" rather than return, although some sign of change is slowly emerging. The motive behind most investment has been to gain or retain control of the enterprises. Except for the case of dealership operation of B/Ds, therefore, block trading is very common.46 Certain groups of sellers and buyers of shares can be clearly identified as follows. A manor group of sellers includes employees of privatized enterprises who obtained shares cheaply through the work force allocation part of the privatization program. B/Ds acquire shares from such individuals, bundle them in blocs, and sell the blocs to control-seeking buyers. A major group of domestic buyers is incumbent managers of the enterprises and their potential group companies, which are in many cases purchasers of the products sold by the target enterprises. Foreign strategic investors are another group of buyers that is steadily increasing its importance. Exchange trading is limited, and OTC trading accounts for over 90 percent. The market is segmented and illiquid because of the atomized asset registrars and lack of depositories while shares are dematerialized.4' ;aStructure of VIF Groups and Their Involvement in Enterprise Governance Because the Russian privatization has so far taken the form of subsidized MEBOs, almost all enterprises are controlled by the incumbent management. Management generally tries to buy back shares from their own employees and VIFs through direct and indirect means, attempting to assure their controlling power. VIFs often have no choice but to accept these deals (if management offers a good price) because of their need to realize a return on the investment in the illiquid stock market in order to pay dividends and to meet the portfolio diversification requirement of the Investment Company Law. Therefore, the illiquidity in the secondary market is not only a result of the control-oriented market, but also made control-driven investment inevitable for VIFs.48 Employee share-ownership is not proving to be an effective control mechanism because employees of smaller enterprises, where the relationship between management and the employees is close, almost always vote for incumbent management. Employees of a large enterprise compete to cash out their holdings. ;bProblems with Manager Ownership 15 The enterprise managers' love of control stems from their desire to maintain their position and vested interest. Many managers appear to think that the enterprises are theirs and that using assets of the enterprises for their personal interest is justified. Many do not recognize the difference between debt and equity capital and, therefore, do not honor shareholders' rights. More serious is their intentional theft of enterprise assets. Some managers have established and became the owners of a new company (or joint venture), transferred quality assets from their former enterprise into the new company, and let the old enterprise go bankrupt. This suggests that there is a good potential for quick-and-easy efficiency gains in enterprises without a sophisticated and expensive restructuring workout if the excessive controlling power of the incumbent management is challenged by outsiders. ;bRole of VIFs in Enterprise Governance The role of VIFs in privatized enterprises is primarily to "contest" the positions of incumbent managers. VIFs can also cooperate with the managers to enhance efficiency of the enterprises. Recognizing the potential role of VIFs in counterbalancing the power of incumbent managers, the New Privatization Program has lifted the portfolio diversification requirement of VIFs from 10 percent to 25 percent. The 25 percent represents a critical level of share ownership that gives the VIFs veto power over major corporate decisions, including liquidation and restructuring. The deregulation was packaged with tighter regulation on shareholding by commercial banks, to a maximum of 10 percent, and on formation of holding companies and financial-industrial groups. The tighter regulation indicates GKI's cautious attitude toward emergence of anticompetitive power, while the deregulation promotes governance by independent outside shareholders. ;bClassification of VIFs by Founder VIFs are managed by 538 fund managers, including 346 individuals and 192 legal entities (see table 5- 5).49 A founder of a VIF first establishes a fund manager/management company, which in turn organizes a VIF(s). When a VIF is invested sufficiently by voucher holders, the voucher investors become the new owners of the VIF. VIFs are founded by several different kinds of institutions and individuals as listed below. * 1. Broker/dealers andfinancial consultingfirms are involved in professional funds with a variety of investment strategies. Most of the leading VIFs belong to this category. * 2. Major banks (only a few) collected vouchers of the banks' individual clients and employees of institutional clients, and made conservative, long-term investment in the banks' client enterprises for control. They initiated no aggressive marketing and advertising. * 3. Industrial enterprises collected vouchers of their employees or employees of their group enterprises to buy their own shares and shares of the same or a related industrial sector for control (that is, sector VIFs). * 4. Local authorities-associated entities collected vouchers of regional residents and invested in shares of regional businesses for control (that is, regional VIFs). * 5. Individuals and nonfinancial private companies generally included small regional VIFs, most of which did or will not survive (amateur VIFs). Some disappeared with collected vouchers (fraud VIFs). In a Western context, the new owners should be empowered to choose any new fund manager/management company to separate the founder's interest from the VIF. In Russia today, however, 16 structures of the VIFs' business and the nature of their investment strategies differs distinctively depending on the category of founder. That is because voucher investors themselves are often closely associated with the founders. Such VIFs would inevitably be subject to a serious agency problem in governing VIF investment activities. ;bInvestment Strategies of VIFs Few VIFs specified their investment strategies in the beginning and consistently followed them, as is commonly done in the West. Most VIFs changed strategies in response to the changing environment. Nevertheless, several characteristic strategies can be found in the extent of the diversification of portfolios and the investment time horizon. VIFs founded by enterprises of a particular industry often first invested heavily in the founders' industrial branch. This group mainly includes 1 and 3 of the founders listed above. Their portfolios now consist of healthy enterprises thanks to the industry knowledge from the founder enterprises. These VIFs, however, will face tough competition from more professional VIFs in the future, constrained by an agency problem. Most regional VIFs diversified their portfolios widely by investing in a large number (70-240) of smaller enterprises. A main component of this group is founder 4 in the above listing. These VIFs are now burdened by the need to monitor closely the management of many enterprises because the smaller the enterprises are, the more easily their performance is damaged by management misbehavior. ;bSpeculative VIFs Among the more independent VIFs, some concentrated on voucher trading and speculation on the immediate resale opportunities of acquired shares. This kind of VIF includes many of the amateur VIFs of 5 in the listing and part of the professional VIFs of category 1. They acquired vouchers from the public and shares from voucher auctions and employees of the enterprises in the hope of selling them in a bloc to incumbent managers of the enterprises or their groups, or to external strategic investors. Incumbent managers often used money of the enterprises to acquire the shares. Although the speculation was profitable, the speculators did not always successfully unload the shares because the opportunities to resell were not sure ones. As a result, some VIFs, particularly amateurs in category 5, are now loaded with illiquid shares of poor performance. In addition, their asset size is usually too small to survive as collective investment vehicles that have to pay fees to their funds managers, custodian banks, transfer agents, lawyers, and the like. Amateur VIFs are now in the process of consolidation. They either are merging among themselves, being acquired by larger VIFs, or disappearing. 17 Table 5-5. Groups of Interests with VIF Participation Region Fund Manager Participants and activities Archangelsk Fund Severa Andrey Butakov SR Bashkortostan Vostok Rafis Kadyrov Bank "Vostok," depository Vladimir PIK-Invest Sergey Konin Concern PIK, depository "Deposit-reserve," insurance company "Unico," trade house "Trans-market," activities in transport, informational systems, and poligraphia Volgograd Tsaritsa Alexey Morozov Holding: commodity trade, brokerage, investment company, industrial production Vologda Vologda- Commercial Bank, agriculture machine- Agroprom- bank building, technical service invest VaskBank Ivanovo Activ-center Investment Bank "Ivanovskiye sitsy," Shiit company Trust company "Trust-TK," trust company "Kon-Trust" Garant Fondovy center Investor Boris Zalutovsky Depository Promyshlenny, SR, bank license exist Kaliningrad Zapadny Anatoly Sablin Bank, brokerage firm, insurance company, depository Kirov Lepse-check Stanislav Depository, brokerage firm, Gorokhov plant Krasnodar Invest- Klimenty Kotov Bank Kubinbank, depository, servise-1 brokerage firm; Mr. Kotov is the president of an investment company, connected with the bank Marij-El Zemlya- Vitaliy SR, commodity trade Invest Kuznetsov 18 Region Fund Manager Participants and activities Nizhny Pervy Nizhegorodskaya Pension fund, brokerage, Novgorod Obraztsovy Fondovaya commodity trade, construction Nizhegorod- Company skaya Yarmarka Novosibirsk Ermak Company Ermak Depository, bank, industrial production Omsk Vysokii Sibirsky Depository, brokerage firm, Technologii Capital-Manager commodity trade Sibirsky Capital Khiminvest Perm Narodny Investment Bank BIS-Credit, pension fund company BIS BIS-Garant, trust and intermediary service by the company BIS Primorsky Pasific-Invest IPK Fedgi Brokerage firm, commodity Kraj trade, technological investment, realty Rostov Rosif Company PIF Brokerage firm, depository Tyumen Sodeystviye Investment Realty, brokerage firm, company Olim commodity trade Udmurtia Certralny Company Depository, investment in Upravlyayushaya technologies Gruppa Khabarovsk Kholder Petr Sukhanosov Brokerage firm, consulting, commodity trade Moscow Alpha-Capital Company Bank, enterprise Bolshevichka, Apha-Capital a number of food enterprises in Nizhny Novgorod MMM-Invest Alexander Bank, commodity trade, realty Bychkov Eximer Constantin Consulting, trade, service, Korenevsky technical equipment 19 Region Fund Manager Participants and activities Moscow Germes Yury Anisov Oil trade, commodity trade, (cont.) securitites operations, bank, exchanges, service, leather production, money market operations LLD-fund Self-managed Bank, insurance, brokerage, SR, realty, commodity trade Fintrust Company Credobank, audit, consulting, 100 + 1 Marion-Invest insurance, industrial production Equipage Realty, trust, banks, brokerage, commodity trade Yamal Center Relations with Gasprom Moscovskiye Finansy RPB Company Russian food exchange, bank, Fondoby Dom insurance, commodity trade, Agroprom structure, brokerage 20 Table 5-5 (concluded) Region Fund Manager Participants and activities MN-fund Trade House Bank, realty, brokerage Simpex Incomfund Nataly INCOMBANK group Roslyakova Pervy Mikhail Pension fund Voucherny Chebotarev Grant-Invest Company INIT SR Kapsula Shahtyor (Rostovsky region) Neft-Almaz- Company Margo-bank Invest Delta VPK (??) Self-managed VPIK-military production and service MIF (??) MIF-LTD Banks, Moscow governmental structure, gold production Note: Information as of March 30, 1994. Source: Capital Market Surveilance Unit (formerly, Fund Monitoring Unit) of GKI. 21 ;bSpeculation Plus Venture Capital VIFs Many smaller speculators have been engaged in venture capital business in addition to participating in the privatization. Venture capital business, however, required a significantly larger amount of funds than the VIFs of moderate size with illiquid assets could generate. This led such VIFs and fund managers to establish new financial institutions to form financial groups. Thirty to forty pension funds were established as a part of such groups to raise capital for the venture business. This implies that the pension funds are actually venture capital and engaged in quite risky investment. These pension funds should be distinguished from more professional pension funds designed to serve employees of large enterprises, their groups, and other social organs. ;bLong-Term Portfolio Plus Venture Capital VIFs The most successful kind of VIF combined long-term portfolio investment and venture capital business. Their portfolios consist of shares of following three kinds of enterprises: strategic enterprises that the VIFs try to participate in restructuring, nonstrategic enterprises that they hold for income gain and liquidity,50 and venture businesses. Managers of these VIFs try to participate in restructuring of strategic enterprises in their portfolio, while also developing venture investment projects. This form of VIF also closely monitors behavior of managers of nonstrategic enterprises. Managers of these VIFs carefully selected shares based on investment quality rather than short-term speculative potential. They avoided explicitly promising unrealistically high returns in a short period of time. This kind of VIF has the healthiest financial position among all categories of VIFs and are involved actively in restructuring and governance of enterprises. ;bGoverning Power of Long-Term Portfolio VIFs Poorly performing amateur VIFs are going bankrupt because they are unable to cover their costs, while less poorly performing groups are merging among themselves or being acquired by major VIFs.5 The long-term portfolio VIFs will grow further through acquisition of some or part of the amateur VIFs. In addition, they are acquiring a number of smaller banks that are losing in the recent environment of positive real interest rates. VIFs with a long-term orientation try to acquire controlling shares of privatized enterprises. Although they often own more than the stipulated maximum of 25 percent of an enterprise, they can obtain the controlling share in two principal ways. One is through their group structure, and the other is by colluding among VIFs. Their group structure generally includes a private founder company (or a holding company), a fund management company, a broker/dealer, and a bank.52 When they collude, a VIF that holds the largest share tends to assume leadership in syndicating the stake and pressuring the enterprise managers by their collective voting power. Such VIFs often send their managers to the board of directors of enterprises. ;bResistance by Enterprise Managers Many enterprises do not appreciate managerial intervention of this kind. Enterprise managers think that VIFs have served as intermediaries of privatization, simply reallocating ownership of the existing assets, and have not brought any financial or managerial resources into the enterprises. Therefore, they believe that VIFs' intervention is irresponsible, without necessary capacity, and thus unacceptable. Some VIFs are using "a carrot and a stick" approach in dealing with enterprise managers. For the carrot, for 22 example, VIFs usually try to convince enterprise managers that they can offer quality service (for example, attract good foreign investors, arrange competitive loans, underwrite new share issues and marketing, and so forth). For a stick, as a major shareholder some VIFs have taken an enterprise to court for their violation of shareholders' rights." ;bGovernance by Sector VIFs Sector VIFs do not actively manage their portfolios, but act more like holding companies. This kind of VIF is often considered a group company by the enterprises, and their intervention is more accepted. Thanks to the industry knowledge from their founder companies, they are often capable of providing managerial resources and control over the companies in the portfolio. Because they were founded by an enterprise in a given industry in which they have invested, however, they are subject to an agency problem. Founder enterprises created such VIFs to control the invested enterprises in the particular manner the founder desired. Shareholders' interest to maximize the value of the portfolio does not necessarily coincide with the objective of managers of the VIFs. This kind of VIF may well become subject to close monitoring by the State Anti-Monopoly Committee. ;bGovernance by Regional VIFs Many regional VIFs, which hold diversified portfolios of many small regional enterprises, are bound to monitor closely the behavior of the enterprises' managers. This is because the smaller an enterprise is, the more severely the company's performance will be affected by the misbehavior of its managers. In outer regions, the domination of the commercial banks is much less strong than it is in Moscow or St. Petersburg. Some leading regional VIFs that invested vouchers of regional residents into many regional companies are often considered as representatives of the regions' residents. Managers of such VIFs are respected and viewed as if they were "mayors" of the regions. Invested enterprises often invite managers of such VIFs to their board as directors. Monitoring closely many small companies is a costly process for VIFs of this category. It needs to be emphasized that, except for the holding company form of VIF, an ultimate objective of VIFs is not to manage the enterprises but to maximize the value of their portfolios. Many VIFs would happily remain "silent" investors if some other outside strategic investors (likely to be foreigners) invest in the enterprises and improve their profitability. Incumbent enterprise managers initially tried to keep the control of their enterprises in their own hands. Having succeeded, largely because of the subsidized MEBO part of the privatization scheme, they are now at sea, loaded with poorly performing enterprises. Most of the managers are now quite willing to give up the control if capable strategic investors approach them with investment proposals and some acceptable conditions, such as security of the managers' employment and the like. ;aStructure of the Enterprise Governance Board and the Power of Outside Owners The governing power of a particular interest group over an enterprise is determined by two factors. One is a legal structure of enterprise governance defined in the company law, provided that the law is honored. The other is an actual shareholding structure of the company in question. Chapter XVIII of the Regulations Governing the Activity of Joint-Stock Companies54 (the Company Law hereafter) defines the legal governance structure of a Russian company. 23 ;bRussia's Company Law 1: SHAREHOLDERS' MEETING. According to the law, the general meeting of shareholders, which is to be held annually, is the highest governing body. In particular, election of directors and reorganization or liquidation of the company are within its jurisdiction. The meeting is deemed valid if attended by shareholders or their legal representatives who represent at least half of the total number of the company's outstanding shares. Any decisions at a meeting are to be made by voting (one share, one vote)." A resolution about the reorganization or liquidation of the company must be passed by 75 percent of the total votes cast by the shareholders present at the meeting. All other matters, including approval of the appointment of directors, is decided by a simple majority of the attending shareholders. 2: BOARD OF DIRECTORS. In the intervals between general shareholders' meetings, the highest governing body of the company is its board of directors.56 The number of directors is to be determined by a shareholders' meeting, but should be an uneven number and no fewer than five in an open company.57 Only a shareholder or a representative of a shareholder who has the number of shares specified in the charter has the right to become a director. Directors are to be elected for a two-year term, and may be re-elected an unlimited number of times. A shareholders' meeting can increase the number of directors and elect additional directors to fulfill certain functions. Nevertheless, a shareholders' meeting cannot remove a director before the expiration of his term of office. Directors are to elect a chairperson and deputy chairpersons of the board for a period of two years. A quorum requires the presence of two-thirds of the members of the board, and the board is to meet at least once a month. 3: PRESIDENT AND THE MANAGEMENT. A shareholders' meeting directly appoints a president out of the members of the board of directors. The president submits the composition of the management of the company, and the board of directors approves it. In the intervals between board and shareholders' meetings, the management directs all the company's activities, and meetings of management are to be held as required. The president presides over the meetings of management and organizes the keeping of minutes at the meetings, which are to be open for inspection by shareholders at any time. 4: AUDITING COMMISSION. The general shareholders' meeting elects an auditing commission among shareholders who are not directors. The commission is to oversee the financial and economic activities of the company by carrying out audits: (a) on instructions from a general shareholders' meeting, (b) on its own initiative, or (c) on the demand of the shareholders with more than a 10 percent holding. It can demand production and submission of all required documents and personal explanations by company officers. The results of the audits are to be presented to a shareholders' meeting. In the absence of auditors, the auditing commission draws up balance sheets and income statements and submits these to a shareholders' meeting for approval. Members of the auditing commission can call an extraordinary meeting of the shareholders should they believe that the shareholders' interest may be jeopardized. ;bThe U.S. and the German Models Governance structures of U.S. and the German companies contrast well with the Russian structure, and one another. A U.S. company has only one governance board, which is a board of directors, and the members are elected at the annual shareholders' meeting. The highly dispersed ownership structure of a large U.S. corporation, however, limits the power of each shareholder. Generally, 50 percent of a big U.S. company is owned by a large number of individuals, and a good part of the rest is owned by 24 institutional investors, each of whom owns a maximum of a few percent and tends to be a "silent" shareholder.8 Management plays a major role in selecting members of the board through its control over the voting process at the annual shareholders' meeting. Naturally, management elects itself to the board, and also nominates outside directors to the shareholders for their approval. Employees do not have an automatic right to be represented on the board unless they are significant shareholders. As a result, the board is dominated and controlled by the incumbent managers, who often put their self-interest ahead of the shareholders', creating an agency problem. In contrast, a German company has a two-tier governance system. Shareholders are represented on the supervisory board, while management is represented on the management board. Banks and other companies often own and/or represent significant shares in a large German company and elect their representatives, as well as outside members who represent minority shareholders, to the supervisory board. Employees are entitled to elect one-half of the members of the supervisory board, which in turn appoints senior managers to a management board. The supervisory board sets broad corporate policy, while the management board is in charge of the day-to-day implementation of that policy. The German system of corporate governance, therefore, mobilizes participation of a wider range of parties in governing the company and reduces an agency problem. ;bPower of Major Shareholders in a Russian Company Russia's Company Law defines a two-tier structure of a corporate governance board, as is the case in the German company. Russia's Company Law, however, does not allow outsiders who do not represent the interests of major shareholders into the board of directors. Neither does it automatically allow representatives of insiders, such as managers or workers, into the board unless they are at the same time significant shareholders or their legal representatives. A shareholders' meeting directly appoints a president,59 a head of the management board, out of the members of a board of directors and elects members of an auditing commission from among nondirector shareholders. The auditing committee, as a supervisory body, is also appointed directly by shareholders. The governance structure of a Russian company is, therefore, to be strongly dominated by major shareholders. This is one reason the Russian stock market has so far been strongly driven by the desire to gain controlling shares. ;bActual Shareholding Structure and Dominance of Owner-Managers When a Russian enterprise was registered as a joint-stock company, the first board of directors consisted of the president, a representative of the labor collective, a representative of either the Property Fund or GKI (or an appointed representative), and a representative of the local Soviet. This assured the majority voting shares of the incumbent work force, and it dominated the governance structure until the first shareholders' meeting. A president was simultaneously a chairperson of a board of directors, almost without exception. Members of an auditing commission were often part of the incumbent work force, middle-managers reporting to senior managers who are members of the board of directors. Furthermore, employees, an important group of the owner work force, tended to limit voluntarily their participation in managerial issues to only the smallest, least significant range of decisions in running the enterprises, while the manager would undertake to keep as many people employed as possible.' In this situation, there has been little managerial discipline imposed on the incumbent management. 25 ;bPotential for Changes in Power Balance For management ownership to act as an effective governance device in the large and medium-size enterprises, managers must have a reasonably high ownership stake, and yet not be completely entrenched, so that outsider investors can force them out when they fail to maximize profits. The New Privatization Program stipulated a limitation on the absolute control of the management over the privatized enterprises. In particular, incumbent work force (including management) participation in the board of directors has been limited to one-third of the board members. Deregulation of VIF shareholding in one enterprise from 10 percent to 25 percent is a significant move to mobilize outside shareholders' control, because with a 25 percent shareholding, one VIF can have veto power over decisions related to reorganization and liquidation of an enterprise. In addition to the regulatory factor, there are two other principal ways that incumbent management's dominance may be challenged. One is an emergence of outsider shareholders, either by acquisition of existing shares or by making a fresh strategic investment, and the other is a control by creditors over enterprises in financial distress. Both of these possibilities are now materializing in Russia. The tie between management and employees is weaker in large enterprises. It is also being weakened in many medium-size enterprises whose profit performances have been poor and whose wages have been kept low. Few managers view employee shareholding as an impediment to laying off the workers, although a labor collective is often a major shareholder and represented on the board of directors. Employees are now selling out their holding of shares, as happened in postwar Japan. Broker-dealers offer attractive prices for shares in which they expect foreign investment. Bankruptcy is now to be enforced with state-owned enterprises. As inflation is coming down and the real interest rate has become positive, some privatized enterprises are also exposed to considerable bankruptcy risk. ;bEnforcement of Shareholders' Rights The first shareholders' meeting is required to be held within twelve months after registration of the company as a joint-stock company. Many were held toward the beginning of 1994, but with some irregularities to obstruct participation of outside shareholders. In some cases, management required shareholders' representatives to have authorized certificates to participate in the meetings as an excuse to exclude sham shareholders, and to have those certificates validated by notaries. In other cases, the voting at the meeting was counted on the basis of "one person one vote" rather than "one share one vote."6' To begin with, over 10,000 enterprises issuing shares planned to have annual shareholders' meetings at about the same time, making it impossible for multiple shareholders such as VIFs to attend most of the meetings.62 The Company Law defines rights of shareholders, but their enforcement is another issue. An effective way to enhance enterprise governance is to promote awareness of public shareholders about their rights to the profit of the enterprises they own. The Moscow Public Shareholders' Rights Committee was established by an initiative from the VIF industry to promote public awareness.63 The committee publishes periodicals and publicizes practices in violation of shareholders' rights, as well as good practices by managers of enterprises and VIFs. As shareholders become educated about their rights (and the procedures for claiming them), enforcing the law will become less of a problem. Now the inadequacy of the court system itself is being highlighted in the fight to enforce laws and regulations.64 ;aPower of Commercial Banks, and Foreign Investors and their Relationship with VIFs 26 ;bCommercial Banking Sector Russia's private commercial banking sector started in 1989, while VIFs emerged at the end of 1992. Although many purely private banks started from nothing, they have shown an impressive growth in the past five years, and commercial banks number about 2,000 in Russia today. Moscow has attracted nearly 600 bank headquarters, which include most of Russia's leading commercial banks. Major commercial banks are currently better placed to influence corporate control than any other financial and investment institutions, including VIFs. First, banks have been able to provide financial resources to enterprises, which VIFs have not. Second, former state banks (for example, Promstroibank) have traditionally strong ties with former state enterprises, and purely private banks have worked together with private enterprises from the beginning of their establishment. Third, the universal banking status gives a capacity to the Russian banks to control enterprises.65 ;CSOURCE OF BANKS' GOVERNING POWER ;dMedium-term loans and loan provisions. Leading banks are trying to strengthen their relationships with client enterprises and recently started medium-term (1-3 year), hard currency lending.' In the current inflationary environment, hard-currency credit is the only way to provide medium-term financing, while such credit can only be provided to reliable hard-currency earners. Furthermore, medium-term credit can only be given to a borrower who has a stable, long-term revenue base. As a result, long-term credit has been concentrated in resource-based, export-oriented project financing. The banks' loan provisions when granting such credit include imposition of ceilings on additional borrowing and dividend payments of the borrowers, and a requirement to channel set minimum amounts of the export revenues through them. If a borrower fails to meet such provisions, the bank may undertake a wide range of possible actions. Today, Moscow-based major banks claim to have about 20 percent of their assets in this kind of lending. As an enterprise becomes dependent on a particular bank, a threat to withdraw credit becomes a powerful tool. Share custody and registrar. Russia's commercial banks are considered as universal banks because they are allowed to engage in securities business. Commercial banks' direct investment in equity, however, is generally not a very significant source of corporate control because of bank regulations such as capital adequacy requirements and the single-risk exposure restriction. Nevertheless, banks' share custody business, which often gives proxy voting rights to the banks, is another potential source of governance power. A number of banks playing the role of custodian are affiliated to major VIFs, however, and do not play an independent role as proxy voters. VIF managers vote by themselves most of the time. More independent custodians are major banks with trust, brokerage, and/or registrar operations but without affiliation with major VIFs. Aiming to be a full-scale universal bank, Inkombank, for example, is said to control 20 percent of the shares of all the enterprises in St. Petersburg. It achieves that level of control by the proxy voting power gained through its custodial business. Inkombank operates a leading independent registrar in St. Petersburg, and the registrar can assure proper registration of shareholders and hence their rights, such as the right to receive dividends, to vote at the shareholders' meetings, and the like.6' Because Inkombank also offers custody service, investors of companies registered at the bank's registrar tend to prefer to use the bank's custody service. ENTERPRISE GOVERNANCE BY BANKS. Whether or not the Russian banks will play a significant role in corporate governance-as their German or Japanese counterparts do-remains to be seen. The strong ties between major commercial banks and enterprises raised a concern in GKI about their potentially anticompetitive nature and led to tightening of the regulation on the banks' enterprise shareholding. The 27 New Privatization Program announced by GKI in December 1993 stipulates that commercial banks are limited to a holding of a 10 percent of equity share in each enterprise.68'69 So far, banks' involvement in privatization and governance of privatized enterprises has been limited.70 One reason is that the controlling power of the incumbent work force was much greater than expected in the beginning of the privatization. Except for the hard-currency project lending, banks are not providing long-term credit to enterprises. Even in the case of the hard-currency project lending, foreign investors and financial institutions tend to take a major stake. In such a case, the governing power of the Russian banks would be limited. In addition, major banks have recently become increasingly conservative and lost interest in equity investment and trading as the real interest rate has become positive. In the recent environment of positive real interest rates, with inflation and nominal interest rates falling steadily, the most sensible way to manage bank assets is to invest in fixed income instruments of longer duration and high creditworthiness.7' T-bills are an ideal instrument for this purpose and, therefore, have recently been increasingly popular among major banks. In contrast, smaller commercial banks were engaged in risky investment.72 Small banks have tried to attract deposits by offering high rates because they needed to have greater liabilities to take advantage of scale economy in financial intermediation. On the asset side, however, this forced them to be engaged in high-risk, high-return business (moral hazard). Small banks continued to speculate in foreign exchange and interest rates and to be engaged in equity investment and trading. However, the ruble did not depreciate much more as inflation cooled, and interest rates in hard-currency deposits have come down with competition. Property and equity do not appreciate as real interest rates become positive with falling inflation. It is speculated that a large number of smaller commercial banks will go under by the end of 1994.73 Such smaller banks are now trying to sell themselves to leading VIFs. SIZE OF COMMERCIAL BANKS AND BANKING SECTOR STRUCTURE. In order for Russian banks to play an active role in enterprise governance, they would have to be able to contribute significantly to financing the enterprises. While provision of short-term working capital serves to monitor the activities of the client enterprises, banks should also be able to provide longer-term financing in order to participate in the enterprises' strategic business planning. The requirement of a significant financial contribution means that the banks have to be large enough relative to the size of a client enterprise.74 At present, even leading Russian banks are still small if compared with the gigantic Russian industrial enterprises, such as the oil and gas. Commercial banks will have to syndicate loans among themselves to meet the financing needs of such industrial giants." In order for individual Russian banks to be larger, the banking system would have to be relatively concentrated. The banking sector would need to have a two-tier structure, with a limited number of large commercial banks with extensive, nationwide branch networks in the first tier, and a large number of smaller regional banks in the second tier. Although Moscow-based leading banks are significantly larger and more sophisticated than other regional banks, emergence of such a banking system is still at a beginning stage.76 Major banks have expanded their branch networks to gain a competitive position in correspondent banking to consummate interregional payments.7" They did so both by establishing new branches and by acquiring small local banks. VIF-BANK RELATIONSHIP. As of July 1993, about 16 percent of the banks had VIFs managed by their affiliated fund management companies.7 The relationships between leading VIFs and major commercial banks, however, appear to be quite independent from each other. In general, it is much more likely that a group involving a major VIF has a commercial bank as a member than that a major commercial bank controls a VIF through its affiliated fund management company. When a leading VIF has a commercial 28 bank in its group, the bank's core activity tends to assist the operation of the VIF, especially in the provision of services of share custody and payment for dividends and settlement of share trading. In other words, financial groups involving leading VIFs often have VIF business in their core, and commercial banking operations as a supplement. In contrast, VIFs controlled by leading commercial banks collected vouchers from the bank's depositors and employees of the bank's client enterprises and invested in the client enterprises for control. Such VIFs act more like holding companies, and their marketing strategies have been conservative.79 There are only a few VIFs of this kind, and they are likely to be subject to close monitoring by the Anti-Competition Committee. Commercial banks are not necessarily the dominant financial institutions in the outer regions of Russia. There are a number of regions where only a few VIFs exist and banks are small. Some VIFs in such regions collected vouchers from the majority of the residents of the regions and are viewed as "representatives" of the citizens who are workers in the region's enterprises. The president of such a VIF resembles a regional mayor. Enterprises in such a region often invite representatives from the VIF to be members of their boards of directors. Such VIFs claim no difficulty in competing with the commercial banks of their regions. In general, Russian banks and VIFs maintain a rather competitive relationship with each other, although a competitive advantage clearly lies with commercial banks at the moment.80 ;bSubsidiaries of Foreign Banks Several foreign investment banks and commercial banks have established subsidiaries or joint ventures in Russia. They are serving as the catalyst for foreign investment in three different ways. First, they are the agents for foreign strategic investors in cross-border acquisitions."8 The foreign banks then work with VIFs and B/Ds in the acquisition of shares of target enterprises. With their "well-capitalized position" with vouchers, VIFs acquired shares of a target enterprise and sold them as a bloc to a foreign investor through a foreign investment bank.82 Some VIFs profited significantly from this operation. Second, they served as advisors for joint ventures between foreign investors and privatized Russian enterprises. Third, they have been custodians for foreign portfolio investors. Naturally, the investment banks are stronger in the first two areas,83 and the commercial banks are stronger in the last. ;bRole of Foreign Investment A common perception of foreign investment in Russia is that it would be insignificant compared with the resources needed to restructure the huge Russian industrial sector. Contrary to this perception, the importance of the role of foreign investment has received increasing recognition. Foreign strategic (that is, direct) investment provides confidence to the target Russian enterprise, and thus helps mobilize domestic investment and financing as well. Foreign portfolio investment, which has recently become noticeable, accelerated the increasing trend of foreign investment," a response to the undervaluing of Russian enterprise shares relative to the value of their assets.85 Long-term investment, whether strategic or portfolio, is quite limited in Russia today, and within that limited investment, foreign investment comprises a substantial part. It is generally the foreign investor with a large amount of long-term funds who has the capacity to take short-term risks for long-term strategy and return in the present risky business environment of Russia. 29 ;aBankruptcy, the Power of Creditors, and the Role of VIFs ;bBankruptcy and the Power of Creditor Banks As a debtor falls into financial distress, the voices of creditors become louder. Enforcement of bankruptcy law strengthens the governing power of creditor banks, which comes to supersede that of shareholders. The governing power of commercial banks over a debtor in financial distress would be determined by two principal factors. One is the legal power given to creditors in bankruptcy law,86 and the other is the extent to which the commercial banks are creditors of the enterprises. If the commnercial banks were not lending extensively to enterprises, the banks would not be in a position to command strong legal power over the debtor. If the banks were financing enterprises extensively, their voice would be stronger. At the same time, however, a large-scale bankruptcy of enterprises would seriously hurt the soundness of the banks and the banking system. ;bRussia's Bankruptcy Law Russia's Bankruptcy Law was revised in December 1993, and the Federal Agency of Bankruptcy was established simultaneously to administer enforcement of the law.8' In May 1994, a presidential decree set up specific criteria for recognition of bankruptcy. Further, on June 2, 1994, President Yeltsin signed a decree "On the Sale of Debt-Owing State Enterprises." This decree established a normative base for bringing insolvent enterprises out of crisis. The general structure of the law is similar to those of most Western bankruptcy laws, and it describes court and out-of-court procedures, reorganization, and voluntary and involuntary liquidation. Russia's bankruptcy law is designed with greater similarity to the U.K. or the German law than to the U.S. law, in that its reorganization procedures are not as permissive with the debtor as is Chapter 11 of the U.S. law (see table 5-6).88 Liquidation of a debtor under the Russian law would leave nothing to govern afterward, although it gives foremost power to the creditors in the recovery of the credit. Reorganization is, therefore, the matter of more relevance in considering the issue of enterprise governance in Russia. ;bOpening Bankruptcy Cases According to Russia's Bankruptcy Law, a creditor (as well as the debtor, the owner, or a public prosecutor) can file a petition to open a bankruptcy case to the Court of Arbitration, with a prior notice to the debtor, if a payment becomes overdue by more than three months.89 The petition can include a request for reorganization. With the attendance of representatives of the debtor, the owner,' the creditor, the local financial agencies, and the work collective, the Court of Arbitration is responsible for reviewing the case and deciding whether to accept the petitions. The court first considers whether to recognize the debtor as bankrupt and institute bankruptcy proceedings (liquidation). If it decides not to recognize bankruptcy, and the petition includes a request for reorganization, the court also reviews that possibility and decides on an appropriate action to be taken. ;bReorganization and the Power of Creditors The legal concept of enterprise reorganization consists of two principal components-outside management of a debtor's property and rehabilitation. Outside management of a debtor's property includes the organizational procedures ordered by the court upon receiving a petition and are designed to sustain an 30 enterprise's activities by transferring the functions of managing the debtor enterprise to the arbitration manager. An arbitration manager works out a restructuring plan that is to be effected through merger, division, detachment, takeover, or transformation.91 Rehabilitation aims at recovery of a debtor enterprise and consists of financial aid administered to the debtor enterprise by the owner, creditors, or third parties. Table 5-6. Bankruptcy Reorganization: The United States and the United Kingdom United Kingdom United States Administrative receivershipa/ Chapter 11 administration Debtor in possession Debtor loses control Process dominated by management Process dominated by (secured) creditors Easier to raise financeb creditors Finance usually from secured creditors More costly because it takes longer Lower costs Deferred liquidation Premature liquidation a. Appointed by the court. b. Any new loans given to the firm for reorganization are considered "preferred credit," which is higher in seniority than existing debt. Source: Atiyas 1994. ;bOutside Management of a Debtor's Property To institute outside management of a debtor's property, the debtor and creditors can nominate candidates for arbitration manager, and the court endorses the nomination or tenders the position on a competitive basis if more than one candidate is nominated. The law requires that an arbitration manager not be a staff member of the debtor or the creditors.' A meeting of creditors has numerous powers, including: 1) establishment of a creditors' committee, which is entitled to request information and explanations from the arbitration manager; 2) endorsement or amendment of an outside management plan made by the arbit- ration manager; and 3) establishment of the amount of remuneration the arbitration manager will receive, which is to be approved by the court. Within three months of its appointment, the arbitration manager must obtain an endorsement from a creditors' meeting for a plan for outside management. If an outside management plan is not endorsed by representation of two-thirds of all creditors' claims, the court may revoke its judgment on outside management of the debtor's property or leave the decision in force but replace the arbitration manager. Any creditor (or owner) can also file a petition with the court for a review of the outside management plan by an arbitration manager if it finds the plan to be detrimental to its interest. If the outside management should be terminated for reasons of its ineffectiveness or incompletion within eighteen months, the court may declare the debtor bankrupt and begin bankruptcy proceedings . 31 ;bRehabilitation The priority right to participate in rehabilitation belongs to the creditor, the owner, and members of the work force.94 If the owner and the creditors agree, however, the court may call an open tender for participation in the rehabilitation. If no one wishes to participate, the court may revoke its rehabilitation decision. The participants in rehabilitation must perform their assumed obligations to creditors in full and are collectively liable for their fulfillment. The creditors (as well as the owner or the work force) can complain to the court about the ineffectiveness of the reorganization, and the court may then take an appropriate action, including termination of the rehabilitation. At least 40 percent of the combined amount of creditors' claims must be met in order of seniority within twelve months, and the duration of rehabilitation should not exceed eighteen months.' There are several other restrictions on the duration of procedures to carry out rehabilitation in order to ensure swift and cost-effective actions. If rehabilitation is terminated for reasons of its ineffectiveness, incompletion, or failure to satisfy requirements, the court declares the debtor bankrupt and begins bankruptcy proceedings. The court may not decide on rehabilitation if the case of bankruptcy is to be reopened within three years. ;bRussian Banks' Exposure to Enterprise Financing In light of Russia's Bankruptcy Law, creditors are given considerable power and control to protect their interest in the process of enterprise reorganization. Russian banks' enterprise financing, however, has so far been limited. Unlike many of the Central European countries, Russia has employed a decentralized approach to promote development of a competitive banking sector.96 The commercially minded Russian banks of today do not easily lend to risky Russian enterprises, except for companies in their groups. In addition, long-term investment credit was traditionally provided directly by the government, and therefore traditional business ties between banks and enterprises are generally not strong compared with those in many Central European countries. Furthermore, inflation has wiped out past debt of the enterprises. Therefore, it seems unlikely that the Russian banks will be faced with a phenomenal nonperforming loan problem, which has been a common problem in formerly planned economies that employed a centralized approach to develop their banking sector. At the same time, it is also unlikely that banks will develop a widely encompassing governing power over the enterprise sector through the process of enterprise bankruptcy. ;bStatus of Enterprise Bankruptcy According to the Federal Agency of Bankruptcy, there are said to be over 1,000 state-owned enterprises that have filed for bankruptcy either voluntarily or involuntarily. They comprise a third of enterprises in which the government still owns over 25 percent of the shares, and 250 have already been recognized formally as bankrupt. Some of those enterprises are now being sold into private hands. In addition, inter- enterprise arrears have shown phenomenal growth, to amount to over 70 trillion rubles,9 suggesting a possible domino bankruptcy of enterprises. Many enterprises seem to have continued to produce and deliver products as has been done in the past, but without the assurance of payments. Inflation is now being cooled off steadily, and the real interest rate has become positive in the gradually tighter monetary environment, while the payments system remains inefficient. All this implies that more bankruptcy may be realized with private or privatized enterprises, which now comprise about 70 percent of all the Russian enterprises. It is beyond the scope of this chapter to forecast whether the seemingly bottomed-out recession will help enterprises escape from a grand-scale bankruptcy.9' 32 It needs to be mentioned, however, that an incentive to evade tax is generating a lot of sham insolvency. Enterprises can easily hide transactions and profit in reality by barter, by cash payments with no transaction records, and by manipulating transfer pricing, particularly within their corporate groups. By hiding transactions, an enterprise can disguise revenues and manipulate taxable profit while evading turnover tax.99 In particular, the incentive to evade turnover tax encourages barter transactions and growth of interenterprise arrears.'° In these circumstances, some credible threat to enforce the bankruptcy law may be effective in forcing enterprises to disclose their real performance and pay taxes. Asset registrars are now developing, and private land ownership is now legally defined. Nevertheless, the authorities and the legal system have so far not been very successful in enforcing the law because they lack understanding of enterprise valuation and restructuring. ;bPotential Role of VIFs in Debt Restructuring One way for VIFs to deal with creditor banks and enterprises is to buy nonperforming loans from banks at discount and engage in debt-equity swaps with the debtor enterprises. This can be a mutually beneficial business among VIFs, banks, and potentially viable enterprises. In addition, it will reduce the government's fiscal burden by having the private sector shoulder the cost of restructuring. This will also help avoid development of excessive cross-shareholding relationships between banks and enterprises through direct debt-equity swaps.'°l Bills of exchange have been introduced to carve out the uncontrolled growth of interenterprise arrears. The introduction of bills of exchange is expected to accelerate growth of a secondary market for enterprise debt, which will be a good foundation for VIFs to acquire those debt instruments and engage in debt-equity swap transactions. Currently there is said to be an obstacle against debt-equity swap transactions. The current Russian law seems to stipulate that the par value of shares be written against the value of fixed assets on the book. Under the current law, debt equity swaps are considered as issues of new equity shares with par value against nothing tangible and, therefore, not permissible. The authorities, however, recognize such regulation to be an obstacle to promoting restructuring of enterprises. VIFs are lobbying for revision of this regulation in order to be able to engage in debt-equity swaps, particularly in the capacity of distressed restructuring. ;aConcluding Summary Russian enterprises currently are controlled by incumbent management. The strength of insider control stems not from the legal structure of the enterprise governance but from the actual shareholding structure of the enterprises. A majority of the management, however, has not been successful in restructuring and improving the enterprises to adjust to the new market environment. Positions in enterprise management need to be made competitive so that incumbent management is pressured to do a better job, or to leave the position in one way or another. The role of outside shareholders, creditors, and potential investors is thus critically important in Russia today. Commercial banks have some governance power as creditors, especially over enterprises of moderate size with a close business or group relationship. Nevertheless, their governing power does not reach widely over the huge Russian industrial sector. Operation of leading banks is becoming increasingly conservative as they become established and the real interest rate becomes positive with cooling inflation. Public trust in VIFs is generally low following several examples of fraud, nonpayment of promised dividends, and the failure of VIFs to provide financial resources for enterprises. Nevertheless, the importance and capacity of VIFs should not be underestimated, for four reasons. 33 * They were intermediaries in privatization and, therefore, are politically supported by the powerful GKI. The failure of VIFs would mean failure of privatization, which GKI would try to avoid as much as possible. * Leading VIFs have become a group of significant enterprise shareholders, and thus have a significant governing power over enterprises. Currently, privatized enterprises are controlled by incumbent owner-managers who are in many cases unwilling or unable to restructure their enterprises to adjust to the new environment. Governance by outside owners such as VIFs is an important source of managerial discipline for the enterprises. * Because they are completely new entities without any roots in a communist organization of the past, many VIFs and fund management companies are run by an innovative new generation of Russians. The managerial capacity and entrepreneurship of the management of leading fund management companies is particularly noteworthy. * If the liquidity of the stock market increases, and stock prices start reflecting the true value of the enterprises, the net asset value of leading VIFs will likely increase dramatically to a level beyond that of commercial banks. Infrastructure to support generation of liquidity is now being worked out. Some long-term-oriented VIFs are involved directly in the governance of invested enterprises. Their ultimate objective, however, is not to manage the enterprises, but to earn a higher return. They would be happy to remain silent investors if strategic investors come in and restructure the enterprises. Leading Russian banks, VIFs, and B/Ds cooperate with foreign investment and commercial banks with operations in Russia. These foreign banks are acting as a catalyst for foreign strategic and portfolio investment. By using well-capitalized positions with vouchers, some VIFs are playing the role of subagent for the foreign banks. Foreign investment is increasing its importance, and it also encourages domestic investment by giving confidence to the domestic investors. VIFs' role in enterprise governance seems to lie in intermediation of strategic investment through which they solicit managerial resources while, in the interim period, keeping the management position contested. As they go through that process, they are expected to become long-term portfolio investors, much like mutual funds in the United States. VIFs also have the potential to play a role in restructuring of distressed enterprises and assisting banks and creditor enterprises in dealing with nonperforming credits. If VIFs buy the bad credit and carry out debt-equity swaps with the issuing enterprises, they may gain substantial influence over enterprise governance. So far, the relationship between major VIFs and major banks in Russia is rather independent, especially compared with that in the Czech Republic, and thus it is unlikely that an agency problem will be a serious impediment in coordinating among VIFs, banks, and enterprises. Development of a secondary market of bad credit with an introduction of a bill of exchange is an encouraging sign that such debt-equity swap deals will be possible, although an obstacle seems to be Russia's accounting regulation. While the banking system has been playing a leading role in enterprise financing and governance, the capital markets also have the potential to grow into large-scale markets because of the massive privatization of industrial assets. The mixture of a German-style banking system and an Anglo-American model for capital markets may well result in the Japanese model. The Japanese financial system is characterized by the following three factors: 1) Article 65 of Securities and Exchange Law (equivalent to the Glass-Steagall Act of the United States), prohibiting securities business by the banking institutions; 2) the Banking Law, allowing banks' corporate equity holding on their investment accounts; and 3) a relatively concentrated financial sector. A compromise between 1) and 2) is made through the Anti-Trust Law, which limits the banks' corporate equity holding to 5 percent in any company. Some Central European countries have also been driven to a system similar to the Japanese model as a result of the tug-of-war between the German-style banking system and the Anglo-American model of capital markets. In the New Privatization Program, the GKI 34 restricted banks' enterprise shareholding to 10 percent, which is similar to Japan's antimonopoly regulation on banks. 35 ;aBibliography Akamatsu, Noritaka. 1993. "Privatization and the Role of Investment Funds. " Finance and Private Sector Development Division, Economic Development Institute, The World Bank, Washington, D.C. Anderson, Robert E. 1994. "Voucher Funds in the Transition Economies: The Czech and Slovak Examples." Draft paper, The World Bank. Atiyas, Izak. 1994. Bankruptcy Policies. Washington, D.C.: World Bank. Boycho, Maxim, Andrei Shleifer, and Robert W. Vishny. 1993. "Privatizing Russia." Paper presented at the Brookings Institution Panel on Economic Activity, Washington, D.C., September 9-10. Jensen, Michael C. 1991. "Corporate Control and the Politics of Finance." Journal of Applied Corporate Finance, summer. Klebnikov, Paul. 1994. "Russia-The Ultimate Emerging Market." Forbes, February 14. KPMG Management Consulting and the Centre for Economic Reform and Transformation, Heriot-Watt University and SovEcon. 1993. "A Study of The Russian Privatization Process-Changing Enterprise Behaviour." Price Waterhouse. 1994. "Techniques of Mass Privatization-Russia's Voucher Auction Program, October 1992 to June 1994." Working Paper, International Privatization Group. Russia. 1992. The RSFSR Law on Insolvency (Bankruptcy) of Enterprises. . 1993a. Presidential Decree No. 2284. December 24. "On the State Program of Privatization of State and Municipal Enterprises in the Russian Federation" (The Second Privatization Program). . 1993b. Presidential Decree No. 2296. December 24. "On Trust." U.S.S.R. 1990a. The RSFSR Law On Enterprises and Entrepreneurship. . 1990b. Regulations Governing the Activity of Joint Stock Companies (RSFSR). Vasiliev, Dimitry, John Erickson, and Mark St. Giles. 1992. "The Progress of the Privatization Programme (The First Privatization Program)." Codogan Management Ltd., Credit Commercial de France, and White and Case. Volgin, Andrei. 1994. "Voucher Investment Funds in Russia." Paper presented at the World Bank Conference, "Privatization and the Emerging Private Sector in Russia," Washington, D.C., June 20-21. 36 Footnotes-Chapter 5 This paper is a preliminary draft for the joint research project, "Corporate Governance in Transition Economies: Insider Control and Role of Banks," undertaken under the auspices of the World Bank EDI Program for the Study of Japan's Development Management Experience and the Economy of Japan Program at the Center for Economic Policy Research of Stanford University. This paper represents the views of the author and not those of the sponsoring institutions. 1. The hyperinflation necessitated periodic revaluation of the book-value-based value with a coefficient set by the government. 2. Option 1 was amended later, and now the nonvoting shares have been made convertible into voting shares at some cost. 3. But if there are entrepreneur-managers, they would have found it very difficult to run their enterprises in the new environment with the tied contract with the rest of the work force. In that sense, Option 3 seems to carry ill-structured incentives. 4. Not only employees, but any shareholder should not be restricted from selling their shares freely under Russia's privatization program. 5. An important difference is that the Czech privatization program weighed the pass privatization much more heavily than the Russian program did. As a result, VIFs in the Czech Republic hold a very large portion of enterprises shares and, generally speaking, are much more powerful than their Russian counterpart. 6. A few VIFs existed in 1992, even before the decree was issued. 7. The city of Moscow will continue to allow use of vouchers to participate in the privatization of the city's assets until the end of 1994. 8. Compared with the collective auction systems found in the Central and Eastern European countries, this system makes it very difficult, often impossible, for investors to make cross-enterprise comparisons of value in making investment decisions. 37 9. There are two ways to bid with vouchers: a noncompetitive bid (Type 1) and a competitive bid (Type 2). A noncompetitive bid assures success of the bid, while the bidder has to be a "price taker." Competitive bids specify a price (in number of vouchers) the bidder is willing to pay to obtain a share. If a clearing price of an auction turns out to be higher than the price specified, then the bid is considered "unsuccessful," and the competitive bidder will receive no shares. 10. A consequence is that the market price of a voucher at a given time reflected the demand for shares of a particular enterprise that was coming into auction soon. Therefore, a market price of a voucher has been volatile, although it proved to be an inflation and ruble devaluation hedge, showing a general upward trend in dollars. 11. Investors can buy vouchers in commodity exchanges and then participate in voucher auctions with the vouchers. 12. That is, if they are not determined to make a noncompetitive bid. See footnote 9 for "noncompetitive bids." 13. With financial and technical assistance from USAID and Deloitte & Touche, the Cash Union, a Moscow-based depository, was established and linked with other regional depositories. 14. The network of depositories also facilitated interregional voucher trading, although settlement of payments was still a major obstacle, and therefore terms of the voucher delivery and the payment settlement have influenced the price of a voucher in a particular voucher trading deal. VIFs could trade vouchers they bought with cash while they were prohibited from trading vouchers they collected in exchange for VIF shares because of their special role in privatization. Many VIF managers seem to have been engaged in trading of collected vouchers anyway, because voucher trading has been an important source of income for VIFs. Some anecdotal evidence also shows that short sale of vouchers was common, despite the illegality of short-sale of securities in Russia. The network of depositories is a key infrastructure to support the practice of short sale. Vouchers were easy to trade because they were homogeneous, bearer securities. 15. Of the 659 VIFs, over 130 are in Moscow, and about 45 in St. Petersburg. Major VIFs include First Voucher Privatization Fund, Alfa Capital, Privatization Program, Moscow Real Estate Fund (MN), and so forth. 16. There was only one CIF licensed by the Ministry of Finance, but it has gone under, unable to attract enough funds to be economically feasible. VIFs in aggregate have received less than 1 percent of their assets in cash. 38 17. CIFs are licensed and regulated by the Ministry of Finance. 18. An "open joint-stock company" means a "public" company in Western terms. It should not be confused with an "open-end fund." A public company is a company with shares widely held among the public. A company may be legally considered as a public company if it has more than 50 shareholders, for example. Of significance in being a public company in the West is that it is subject to disclosure requirements set up by appropriate authorities. 19. General characteristics of an investment fund: An investment fund usually has no employees of its own and is operated by external agents such as fund managers, broker/dealers, principal underwriters, transfer agents, and custodians. It is governed by its board of directors, who are to be "independent" (particularly its fund manager and underwriter) and "prudent." A fund management company establishes investment funds and contracts with them for managing the funds. A fund manager, as fiduciary of the investors, selects a portfolio in accordance with the objectives and policies specified in each fund's registration statement (for example, trust deed), places orders with broker/dealers, and makes sure that transactions are executed at the best price and cost. A bank normally acts as a custodian to safekeep the securities of the fund and makes sure that delivery of cash or securities is done only for specified transactions and according to proper instructions received from officers of the fund. Banks, brokers, and/or nominees having shares of the fund registered in their names normally act as proxy of the shareholders in voting at shareholders' meetings of the fund. 20. "Unit trusts" were not suitable for the lengthy privatization process, and thus do not exist in Russia today. 21. A closed-end fund does not redeem its shares at investors' requests. Closed-end funds are, therefore, traded in the market. Russias CIFs can be either open-end or closed-end funds. Open-end funds must stand ready to redeem their shares for the net asset value of the share at the request of their investors. 22. Annual management expenses of an IF, including the cost of advertising, is restricted to a maximum of 10 percent of the VIF's net assets. This seems completely out of the Western standard, which is normally around 1 percent for a closed-end fund. The hyperinflation, lack of an appropriate NAV accounting, and the costly operational environment, however, seem to make this level of management expenses inevitable. 23. Lack of liquidity in the stock market is a major impediment for VIFs to grow into professional mutual funds. Regional share depositories and registrars will be in operation by early autumn 1994 to enable speedy and reliable trading of shares, at least on an intraregional basis. While voucher auctions were completed on June 30, however, this improvement of market infrastructure has proven to come a little too late. 39 24. As described in footnote 9, setting up and operating a fund is a complex and costly process involving a number of external agents for which fees must be paid. Therefore, a fund must attain a certain asset size in a relatively short period of time to be economically viable. In the United States, for example, the size required is said to be $50 to $100 million. 25. In addition, interest expense on long-term debt is not deductible from taxable income. The heavy turnover tax on enterprises also encourages cash payments, tax evasion, and vertical integration of industry to create industrial-financial groups. Russia's capital income taxation system discourages long- term financing and investment and promotes speculative trade practices and inflation. 26. Article 9.4, the New Privatization Program. 27. In the past, commercial banks seem to have acted not only as custodians, but also as share trusts for investors without having separate trust accounts. Depositors in the banks and investors in relevant VIFs could have fallen into conflict with each other in case of bank failure unless the Banking Law and the Investment Company Law were mutually consistent in protecting the interest of depositors and investors. 28. CIFs are subject to such a restriction neither for liquidation nor for reorganization. 29. Original regulations in the Investment Company Law prohibit VIFs' investment in nongovernmental debt securities. VIFs should also not acquire more than 15 percent of the debt of the single issuer. 30. The neutrality in the regime of capital income taxation is such that the tax system does not favor a particular means of investment financing, especially among the following three option: borrowing, new share issues, and reinvestment of retained earnings. This means that a neutral system of capital income taxation should provide the same effective net tax burden on interest income, dividend income, and capital gains. 31. A critical remaining difference is that the income statement is based on cash accounting and the balance sheet is based on accrual accounting. Because of the use of cash accounting for the income statement, there is no statement of cash flow in the present set of the Russian financial statements. 32. There is no securities law or securities exchange law, which often specify disclosure requirements in detail, especially in civil law regime countries. 33. Inflation and the inefficient payment system make those techniques ineffective. 40 34. Information sources are: a) VIF's broker/dealers; b) State Property Funds; c) State Committee on Statistics of Russia and other statistical organizations; d) research institutes; e) commercial information sources; f) data banks; and g) personal connections. 35. That is, stock picking and portfolio management based on recognition of an economic cycle (boom and recession) and a pattern of industrial linkage. 36. In Moscow oblast, the number of vouchers invested in shares has exceeded the number of vouchers issued there. This means that there has been a considerable net inflow of vouchers from outer regions into Moscow oblast. Moscow-based leading VIFs have a substantial brokerage network either through their own network or through affiliated brokers or bank branches. 37. The members include medium-size VIFs, other financial and investment service companies, and some production and trading companies. 38. The members include fifty-three major VIFs (but not Alfa Capital), which hold 50 percent of the VIF industry's assets. 39. Established by Mr. Andrei Vogin, President of Adamant Financial Corporation, a fund management company for Derzhava Investment Fund, a Moscow-based, major VIF. 40. It was modeled after ASD of the United States and CIDA of Canada. 41. Interest income would also be earned if a VIF manages its liquid assets in T-bills or bank deposits. 42. IF management companies also have fee business, such as brokerage and management consulting. The consulting department of the management companies handles the restructuring of enterprises. 43. The poor business performance is largely the result of the payment of enterprises. 44. If a VIF honors regulations by GKI, it had to sell excess holdings to meet the portfolio diversification requirement of the Investment Company Law at the time of quarterly reporting to GKI. VIFs must meet two portfolio diversification tests. One is that a VIF should not hold more than 10 percent of outstanding shares of an enterprise, and the other is that a VIF should not invest more than 5 percent of its assets into shares of one enterprise. The first of these was relaxed from 10 percent to 25 percent in December 1994, which has a significant implication for enterprise governance structure. 41 45. Sales of VIF holdings are carried out by fund managers. Fund management companies in Russia often have their own broker/dealer functions, although they also worked with independent broker/dealers as necessary. B/Ds are licensed by the Ministry of Finance, and there are over 2,000 of them in the country today. 46. Between 2 and 3 percent of shares outstanding are commonly traded as a block. 47. A combination of dematerialized shares, an atomized registrar system, and lack of central depositories makes each registrar function as if it is also a depository, a situation that makes the market highly segmented. 48. In this sense, an appropriate name for the Russian VIFs may be "voucher buy-out" (VBO) funds. 49. The 192 fund managing companies include: 1) Pure managing companies (33), 2) Investment companies (55), and 3) Broker/dealers, consulting firms, insurance companies, banks, law firms, individual private firms, trade houses, and production firms (25), and so forth. In addition, 79 (40 percent) do not have a clear profile. The 33 pure fund management companies can further break down as follows: a) companies that have been established only for managing a particular fund; b) companies managing more than one fund; and c) enterprises that concentrate on managing financial assets of companies including VIFs. 50. Many VIFs also hold T-bills for liquidity management. 51. Recently, however, the number of VIFs has not decreased because many industrial firms established VIFs for control in the last minute of voucher privatization to take advantage of the newly introduced tax privilege mentioned above. 52. A share depository also exists and contracts with the VIF for share custody. They all exist under the umbrella of a founder (holding) company, and tend to be located on the same premises. "Fire walls" are, therefore, not at all strict. In addition, VIF management companies have a brokerage function within. There is no "Chinese wall" between the underwriting (or investment) operation and the trading operation of an IF management company. Therefore, the current structure of the IF management companies appears to be a perfect source of conflict of interest and agency problems. 53. Alfa Capital bought 25 percent of Bolshevid Biscuit Co. in December 1992. Bolshevik Biscuit, however, did not permit Alfa in their shareholders' meeting. Alfa then took the company to arbitration court for violation of shareholders' rights, but the court had no capacity to judge, lacking experience in this kind of case. Only after Alfa promised foreign money to modernize the factory did the managers allow Alfa in the meeting. 42 54. Decision of the RSFSR Council of Ministers No. 601 of December 25, 1990. 55. If a shareholder fails to attend the meeting, he/she is obliged to delegate his/her vote to the board of directors or his/her proxy, and if no power of attorney is presented, the shareholder is to be deemed not to have participated in the voting. 56. Extraordinary meetings of shareholders to discuss special issues can also be called by the board of directors, the auditing commission, or by the holders of at least 10 percent of the company's shares. 57. No fewer than three in a close company unless the number of founders-shareholders is smaller than that. 58. Some U.S. institutional investors do participate in corporate governance (for example, public employee pension funds such as State of Wisconsin Investment Board, Califomia Public Employees' Retirements System, and so forth). 59. This potentially weakens power of the board of directors to exercise control over the president and the management board. 60. There is anecdotal evidence that the work force has voluntarily restricted (or agreed with the management to restrict) their wages to a low level in order to secure employment. 61. There is an ongoing discussion in academia as to whether "one share, one vote" is the optimal rule of corporate governance. In the Russian system, they have both voting and nonvoting shares. The issue here is not the voting rule itself, however, but the universal enforcement of whatever rule exists. 62. The accounting year ends December 31, and dividends must be paid within sixty days. This means that all the privatized enterprises try to pay out dividends at almost the same time. It may be imagined what a mess this can cause in present-day Russia, with its inefficient payment system. 63. It was established by an initiative of Mr. Andrei Volgin, President of Adamant Financial Corporation, a fund management company for Derzhava Investment Fund, a Moscow-based, major VIF. 64. A bottom line is that the Russian judges, juries, and lawyers do not have any experience in handling private commercial lawsuits and are unable to function effectively in those capacities. 43 65. In asset size, banks are significantly larger than VIFs, and therefore claimed to be more powerful. A comparison of asset value between banks and VIFs under the present illiquid stock market with inflation is not very meaningful in the long run, because net asset values of VIFs are greatly undervalued relative to those of banks under a circumstance that is unlikely to persist in the long run. 66. International Moscow Bank, Tokobank, and Mosbizinesbank are among such banks (see Elena Belyanova and Ivan Rozinsky in this volume). 67. When GKI started promoting establishment of independent registrars, half of individual Russian shareholders were said not to be registered properly and, therefore, often failed to exercise their rights. 68. Prior to the new program, there was no automatic restriction on banks' shareholdings, unless a banking law regulation on single-risk exposure also applies to equity shareholdings. The only explicit restriction was that banks' acquisition of beyond 35 percent of shares required approval of the State Anti- Competition Committee. More general rules of significant share acquisitions are: 1) a purchase on the market of over 15 percent of a companys shares by one party requires the consent of the Ministry of Finance (this provision does not apply to the company's founders) and 2) a purchase of over 50 percent requires consent from the Anti-Competition Committee. 69. Total value of equity shareholding by a bank was also restricted to maximum of 5 percent of the banks' assets. This, however, is rather a matter of prudential operation of banks and, therefore, a concern of the Banking Law rather than the Anti-Competition Law. 70. Only 3 percent of enterprises surveyed by The Russian Economic Barometer in November 1993 indicated that the banks' representatives became members of the board of directors (see Elena Belyanova and Ivan Rozinsky in this volume). 71. T-bills are discount instruments; therefore, their duration is as long as their maturity. There are three- and six-month bills being issued today, and an issue of one-year bills is planned to start in late 1994. 72. In 1993, banks were said to be responsible for half of trading turnover. 73. Article 11 of Russias Bankruptcy Law stipulates that a petition for insolvency (bankruptcy) of a licensed bank cannot be filed by its creditor and/or a public prosecutor until the Central Bank of Russia suspends the banking license. This is an exception of the enterprise bankruptcy rule applied only to licensed banks. The Central Bank of Russia and commercial banks are now also working on introduction of a deposit insurance scheme and a bank rating system to increase the transparency of the banking system. 44 74. Prudent management of a bank should require diversification of the loan portfolio. This normally materializes in the form of a regulation to limit a bank's lending exposure to a single risk source. 75. Although some major industrial groups have commercial banks as their members, such a "house bank" tends to be too small to satisfy the investment needs of its group enterprises and to specialize in working capital financing and payment services. 76. The World Bank announced loans to strengthen banking institutions on May 19, 1994, which will permit thirty to forty "core banks" to be upgraded to an international standard. 77. Because the payment system of the Central Bank of Russia takes at least two weeks to consummate inter-regional payments in the inflationary environment, demand for a swift payment service has been very strong. A bank with a nationwide branch network could offer an interregional payment service by correspondent banking, which allows the bank to internalize the payments as its free liquidity and, therefore, has been a very profitable business. 78. The Russian Economic Barometer, July 1993. Also, see Elena Belyanova and Ivan Rozinsky in this volume. 79. They do not aggressively advertise their investment performance and dividends to attract individual voucher investors. 80. This contrasts with the situation in the Czech Republic, where the banking system is dominated by a limited number of former state banks. All the major banks own leading fund management companies that manage the ten largest VIFs. As a result, the Czech banks have strong influence on the management of VIFs. Through the VIFs, Czech banks exercise significant governance over enterprises, which creates an agency problem and conflict of interest with investors of such VIFs. 81. The foreign banks take either buy-side or sell-side, depending on the case. In some cases, they seem to have acted as middleman on behalf of both sides, which is unconventional, and often unacceptable, in the Western investment banking practice. 82. If a foreign bank tries to take a sell-side, they visit Russian enterprises individually and identify potentially marketable enterprises. If an identified enterprise seeks foreign investment, the bank arranges for lawyers and accountants to carry out Western-standard due diligence and advise on the minimum restructuring acceptable for foreign investment. At the same time, the bank markets such Russian enterprises and brings in the best Western partner through their international network. They commonly charge the seller a fixed fee plus a success fee as a portion of the capital they successfully solicited from a foreign investor. 45 83. Among them, a subsidiary of Credit Swiss First Boston (CSFB) is the most well-established, active, and successful in Russia. 84. Foreign portfolio investors are particularly concerned about the Russian market's capacity to ensure ownership rights and their sure transfer on a nationwide basis. The system of share custody and company registrar, particularly to ensure swift and sure interregional share trading, needs to be upgraded as soon as possible to give confidence to the domestic as well as the foreign investors. As for an organized trading system, a centralized exchange or a NASDAQ-like networking OTC market needs to be established. To generate liquidity, listing of blue chip enterprises needs to be promoted simultaneously with upgrading of the market infrastructure. 85. In terms of Western securities analysis, price-to-book-value ratio (PBR) of Russian shares, if the book value is adjusted for inflation, tends to be far below 1. 86. Assuming that the law can be enforced, which seems a reasonable assumption in the long run. 87. The agency can also initiate bankruptcy procedures for unprivatized state enterprises. 88. The 1978 U.S. Bankruptcy Law was revised in 1989 as a cautious response to the rise of LBO (leveraged buyout) transactions in 1980s. The revised law has been criticized by academia for giving too much chance to the debtor to reorganize itself, which tends to be a lengthy and costly process, and gives less incentive to restructure (see Jensen 1991). 89. The debtor's petition must be filed by decision by the owner or board of directors of the enterprise, signed by its manager and accompanied by the debtors financial information. The debtor must also send a copy of the petition and the financial information to each of its creditors. The financial information must include a list of its creditors and debtors, a breakdown of payables and receivables, and a balance sheet or substitute financial documents. 90. Including appropriate authorities if the enterprise is still owned by the state or other public bodies. 91. A merger is to be effected by combining controlling interests with subsequent conversion of shares or by the replacement of the shares of one company with the equivalent value of the shares of the other company and by consolidation of balance sheets. A takeover is to be effected by purchasing 100 percent of the company's shares. 92. An arbitration manager must also be either a lawyer or an economist with practical experience and must disclose his/her income and property. 46 93. As a disincentive against an unelaborated rehabilitation attempt for an unviable enterprise by the owner or creditors, the remuneration for the arbitration manager is to be charged to the requester if the court decides to terminate the outside management. 94. If the owner and/or the work force are to participate, the work force must participate in an independent capacity. 95. The court may extend the duration by a maximum of six months upon a request from the participants. 96. The physical size of the country and other political factors necessitated such an approach. 97. The total is 112 trillion rubles, according to the State Statistics Office. 98. In Hungary, strict enforcement of the Bankruptcy Law in a tight monetary environment resulted in the ballooning of nonperforming loans in the banking system for which neither the authority nor the banks were prepared. 99. Russia employs a turnover tax, which is different from the value-added tax (VAT), although both are indirect taxes. Turnover tax is similar to consumption tax and levied thinly on the gross transaction amount, while VAT is levied on value newly added by the enterprise. Therefore, there is a strong incentive to hide transactions, which also often leads to vertical integration of industry. 100. By postponing payments, revenue and profit would not be recognized under Russias cash accounting of profit and loss. Therefore, enterprises do not have to pay income and turnover taxes for such unpaid transactions. 101. This will help banks meet the maximum of 10 percent corporate shareholding restriction on banks. 4-, Working Paper Title Number Author(s) 94-43 Controlling Insider Control: Issues of Corporate Governance in Transition Economies * Masahiko Aoki 94-44 Political Economy Issues of Ownership Transformation in Eastern Europe Gerard Roland 94-45 Corporate Governance in Transition Economies the Theory and Its Policy Implications Erik Berglof 94-46 Corporate Governance, Banks, and Fiscal Reform in Russia John M. Litwack 94-47 Enterprise Governance and Investment Funds in Russian Privatization Noritaka Akamatsu 94-48 Evolution of Commercial Banking in Russia and Implication for Corporate Governance Elena Belyanova and Ivan Rozinsky 94-49 Reforming Corporate Govemance and Finance in China Yingyi Qian 94-50 Centralized Decentralization: Corporate Governance in the East German Economic Transition Ernst L. von Thadden 94-51 Cleaning Up the Balance Sheets: Japanese Experience in the Postwar Reconstruction Period Takeo Hoshi 94-52 The Privatization of Ex-Zaibatsu Holding Stocks and the Emergence of Bank-Centered Corporate Groups in Japan Hideaki Miyajima 94-53 Savings Mobilization and Investment Financing during Japan's Postwar Economic Recovery Juro Teranishi 94-54 Shareholder Voting and Corporate Governance: The German Experience and a New Approach Theodor Baums and Philipp v. Randow The Fcollonilic Development IlistituIte (EDI) was established bv the Worid Banik in 1955 to help piromilote interlnationlal de1 elopml1enlt throuhIl the trainin, of officials fromii developing coutrlies ill planning aid maa-ing their national investmeiits imiore prodcLtively. Al- -. thoughIlt LI is located at the Worltd Bank's headqLuar1ters in VVashington, ID. C., most of its : c tral n in' acti\ ities ar e hleld in member countries in cooperation with regional and national 3 development agencies and trail1in1(, institutiolns. Most of its work is conzduIcted in English, r6 but ELDI also operates in Arabic, Chliniese, Ftrenichi, '1ortugue-Le, RLIssian, and Spanis FIor information on 1)l pubhlicatiolns Write to: Traiining Matel-iaIs Rlesoull-ces Cenltel- Flconomilic Developmen t Ilistituite The Wo\orld Banik 1818 tl Street, NW. Washington, ). C 20433, USA ITe: (21)2)473-(6351 la v 12021)676-1 184 I ele\: MCI 641451 WORLDB3ANK) 4001111111119 ii 400/125 E1944