Vol. 17 No. 2 (February, 2007) pp.153-161

CORPORATE GOVERNANCE LESSONS FROM TRANSITION ECONOMY REFORMS, by Merritt B. Fox and Michael A. Heller (eds). Princeton: Princeton University Press, 2006, 408 pp. Hardback. $45.00/£29.95. ISBN: 0691125619.

Reviewed by Basak Kus, Department of Sociology, University of California at Berkeley.  Email: basak [at] berkeley.edu.

Over the past 15 years corporate governance has become a front-and-center topic in academic research. Of course, bodies of literature in law and social sciences have always considered political and social factors as fundamental to firms and economic growth (Fligstein and Choo, 2005). The structural changes that took place in the world’s political economy during the 1980s and 1990s, however, made it even more imperative to examine carefully how social and legal arrangements affect firms, markets and economic growth across nations. Technological progress and opening up of financial markets have complicated the allocation and monitoring of capital within and across nations. Privatization has brought forth questions of the role, rights and duties of owners, managers and shareholders in sectors that were previously in the hands of the state (Claessens 2006, at 95). As Claessens explains, the wave of financial crises in 1998 in the Russian Federation, Asia and Brazil demonstrated how deficiencies in corporate governance may endanger the stability of the global economic system as a whole. And just a few years later, confidence in the corporate sector was shattered by corporate governance scandals in the US and Europe, which triggered some of the largest insolvencies in history. In this context, Claessens articulates, not only has the phrase corporate governance become a household term, but academics, the corporate world and policymakers everywhere have begun to realize fully the potential macro-economic consequences of weak corporate governance systems (p.91). This realization has given birth to increasingly interdisciplinary efforts by academics to understand how social and legal arrangements affect firms, markets and economic growth.

Edited by two prominent legal scholars, Merritt B. Fox and Michael A. Heller, CORPORATE GOVERNANCE LESSONS FROM TRANSITION ECONOMY REFORMS is an outstanding example of this kind of endeavor. Drawing on in-depth studies of market transition reforms in Russia and Central/Eastern Europe, authors address questions that remain central to the comparative/historical study of corporate governance, including what constitutes good corporate governance, the role and limits of law’s relationship to economic change, the effect of ownership structures on corporate performance, and the relationship between securities regulation and privatization outcomes.

This book has three important merits that should be acknowledged from the start. To begin with, as Fox and Heller state in their introduction, our theories of corporate governance rely heavily on the limited experience of advanced market [*154] economies, and are not necessarily generally applicable to the rest of the world. The volume’s emphasis on the transition experience “points the way toward a broader conception of corporate governance, one with timely implications even for wealthier countries” (p.vii). Second, about 15 years after market reforms began, the volume offers a timely assessment of the different forms of institutional change that have taken place in transition economies. The study of post-socialist transitions became a growing academic field in the late1980s; yet, as the book shows, many of the assumptions and prejudgments that were made at the start of the transition regarding the reform process have proved to be fallacious. Today we have more data with which to analyze comprehensively the reform process, and to draw robust conclusions about various elements of corporate governance. CORPORATE GOVERNANCE LESSONS offers many good examples of this nuanced scholarship. Third, most of the chapters tackle corporate governance questions from a comparative and historical perspective, allowing the reader to observe cross-national and time-series variations.

CORPORATE GOVERNANCE LESSONS is divided into five parts. The first part, which consists of one chapter by the editors, offers a conceptual framework for studying corporate governance. Following this theoretical chapter are seven empirical chapters organized into three parts (Parts 2, 3 and 4), each focusing on a specific element of corporate governance (law, owners and managers, and stock markets, respectively). The volume concludes with a single chapter in Part 5, in which editors Fox and Heller offer a discussion on how the experiences of corporate governance in Transition countries discussed in the preceding chapters contribute to our theories of corporate governance.

In their opening chapter, entitled, “What is Good Corporate Governance?” Fox and Heller argue that corporate governance is best defined by looking at the firm’s economic functions, rather than any particular set of national or corporate laws (p.4). From this perspective, “firms exhibit good corporate governance when they both maximize the firm’s residuals – the wealth generated by the real operations of the firm – and, in the case of investor-owned firms, distribute the wealth so generated to shareholders in a pro rata fashion” (p.4). Bad corporate governance manifests itself in a firm’s failure to meet one or both of these conditions. Building from this definition, and using Russia’s transition experience as a model, Fox and Heller develop a typology that shows the channels through which bad corporate governance can damage a nation’s economy. According to this typology, non-maximization of residuals can occur due to five types of pathological conditions (p.5): 1. unreformable value-destroying firms failing to close; 2. viable firms failing to use existing capacity efficiently; 3. firms misinvesting internally generated cash – flows; 4. firms failing to implement positive net present value (NPV) projects; and 5. firms failing to identify positive NPV projects. Non-pro rata distributions, on the [*155] other hand, can happen for two reasons: 1. firms failing to prevent diversion of claims; and 2. firms failing to prevent diversion of assets. According to Fox and Heller, it makes more sense for students of corporate governance to judge its quality in a given context by the degree to which these pathologies exist than by other factors. I sympathize with this argument.

The literature generally defines corporate governance as an assemblage of formal laws. The inquiries focus on how these laws (corporate laws, financial market regulations or labor laws) emerged from various cultural, political and economic processes throughout history, and how they affect firm practices and society’s overall performance (see Fig. 1 below).

Taking advanced countries’ experiences as their subject matter, most scholars and policymakers draw general conclusions as to what kinds of laws constitute good corporate governance structures, and prescribe legal changes for countries in transition. Shifting attention to firms’ economic functions (firm practices and corporate performance) in Transition economies might breed two benefits. First, it allows us to see the relationships specified in the below figure in a reverse causal order. It might indeed be rewarding to first look at how firms interacted with their social and legal environment during the transition period (i.e., firm practices), and find out what outcomes (for both firms and the economy) emerged from that process, before drawing conclusions regarding the laws and other institutional arrangements that work best in a given place. Second, focusing on business practices and economic effects, as Fox and Heller suggest, gives “more precision to the often vague notion of corporate governance failures” (p.390). We can thereby specify how poor corporate governance manifests itself, and through what mechanisms.

Figure 1: Study of Corporate Governance

Source: Fligstein, N. and Choo, J. 2005. Annual Review of Sociology, 1: 61-84.

The second part of the volume addresses a set of questions regarding law’s relationship to economic change. In Chapter 2, Pistor uses cross-country formalized indicators to investigate this relationship. Her analysis, based on a sample of 24 countries with data from 1990 to 1998, focuses on the change in shareholder and creditor rights. She compares the level of shareholder versus creditor rights protection at the beginning of the transition process and as of 1998, and analyzes the scope of change in different nations. She presents three major findings. First she convincingly shows that transition economies’ pre-socialist heritage has [*156] little explanatory power for the observed patterns of legal change. As is well known, the literature distinguishes three groups of transition countries in terms of their pre-socialist legal heritage. The first group includes the nations of CEE and the Baltics, namely, Croatia, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, the Slovak Republic and Slovenia, all of which have the German legal heritage. The second group includes countries of Southeastern Europe, namely, Albania, Bosnia, Bulgaria, the Federal Yugoslav Republic of Macedonia and Romania, which used to belong to the Ottoman Empire and received French law when the French legal system was modernized in the mid-19th century. The third group is composed of the former Soviet Socialist Republics excluding the Baltic nations. Pistor shows that these initial differences had little power to explain the observed patterns of legal change, and that lawmakers in transition economies were not seriously constrained by their countries’ historical ties to a particular legal family. To begin with, she notes, the differences in the laws on the books in transition countries are less than initially assumed. Throughout this time period, most countries strongly converged toward a formal legal system driven in part by external parties such as the EU or the US. However, this pattern of overall convergence, Pistor notes, must be qualified somehow because we still can observe some differences in nations’ patterns of legal change. These differences can be explained by several factors according to Pistor. One reason is governments’ policy choices, which affect the scope of legal reform in particular areas of the law (p.64). In nations that pursued a massive privatization strategy, laws regarding creditors’ and shareholders’ rights were improved considerably more than other types of law. The area of securities market regulation, for instance, was neglected in these nations. Another reason might be the particular type of external legal solutions available to a country. The extensive foreign technical assistance received by transition economies was very much responsible for both their degree of change and the general trend toward convergence in these regions. However, the particular group of advisors dominating a given country (US versus EU) might be partly responsible for the difference. Pistor’s final finding is that, in transition countries, legal reform has not initiated economic change but rather has responded to it.

This is a fascinating article that is theoretically interesting and empirically rigorous. Its author offers a balanced analysis that shows how and why convergence takes place and where we can see path dependence. When interpreting the article’s findings, however, it should be kept in mind that the author focuses on shareholders’ and creditors’ rights. If the inquiry had focused on other areas of law, then conclusions regarding convergence and path dependency might have turned out differently.

The third chapter, by Mahoney, entitled “The Common Law and Economic Growth” also tests quantitatively the role and limits of law’s relationship to economic change. A bulk of literature suggests that countries with common [*157] law systems have more developed financial systems than do civil law countries, and presents this is as the cause of their economic growth performance. Mahoney reconsiders this reported difference in corporate governance between common law and civil law countries. He examines differences in nations’ average annual growth in real per capita GDP from 1960 to 1992 (sample size: 102). He agrees that legal origin affects economic growth; however, he argues that finance (more specifically, rules of investor protection) is not the sole or principal challenge through which legal origin affects growth. Rather, he presents evidence favoring a Hayekian argument that the difference between common law and civil law countries stems from each system’s different philosophies of government. He argues (p.85), “Legal origin does not affect economic growth solely, or even principally, through its effect on financial markets. The major families of legal systems were created as a consequence of debates about government structure, not merely about the rules that should govern particular transactions. A country’s legal system accordingly reflects, albeit remotely and indirectly, a set of prior choices about the role of the state and the private sector in responding to change.” In short, according to Mahoney, common law countries experienced higher growth during those years because common law is associated with fewer governmental restrictions on liberty, more judicial power, and more secure property and contract rights (p.84).

The third part of the volume deals with the role that owners and managers played in determining corporate outcomes in the period of transition.  Chapter 4, the longest chapter in the volume, by Black, Kraakman and Trassova, focuses on the dynamics and outcomes of mass privatization in Russia between 1992 and 1994. In its authors’ words, “the chapter joins an emerging literature that questions whether rapid mass privatization of large firms is an important element of the transition from central planning to a market economy” (p.114).

At the onset of Russia’s privatization efforts in the early 1990s, it was widely believed that privatization would lead to more efficiency and profitability at the firm level and more growth in the real economy. Instead, privatization in Russia led to massive self-dealing by managers and controlling shareholders; it has improved neither firms’ productivity nor growth. Enterprises were sold below their worth to corrupt economic actors, who then further increased their wealth and used their power to block reforms.  In Chapter 4, using the Czech Republic as a comparative case, the authors offer an analysis of why Russia’s experience has not developed as anticipated and offer a general theory of what conditions privatization requires to be undertaken successfully and to produce desirable outcomes.

According to the authors, three factors seem to have prepared Russia’s privatization failure. First, the government, which lacked the capacity to force privatization on unwilling managers of state enterprises, sought to buy managers’ allegiance and support [*158] for reforms by granting them cheap shares. This strategy led to an ownership structure characterized by managers’ control of most enterprises. Managers who did not know how to run a company in a market economy made bad decisions and engaged in self-dealing. In the early 1990s Russia lacked the institutional structure to control self-dealing by managers of private firms. Basic commercial and capital markets law did not exist; an independent, well trained and honest judiciary was not available; and enforcement infrastructure was non-existent. The second factor was the hostile business environment. The punitive tax system, official corruption, organized crime, unfriendly bureaucracy, and a business culture in which skirting the law was seen as normal, even necessary, behavior made it impossible to restructure privatized enterprises and create new businesses. Finally, because corrupt officials and company insiders joined forces to resist them, potential improvements that might have emerged from future reforms were compromised. Based on this analysis, the authors contend that institutions matter more and privatization matters less; institutions must precede privatization.

This chapter, written by scholars who have firsthand knowledge of Russian privatization, presents a lot of information that is quite useful for students of Russia. The article is written in a descriptive and somewhat informal manner, however. The authors make many arguments, some of which are not substantiated by systematic evidence and read instead like ad hoc observations. It also is not clear what the Czech case contributes to this analysis. The authors contend that the Czech comparison “can help isolate which aspects of the Russian experience with rapid mass privatization were unique to Russia, and which may reflect deeper problems that arise when privatization precedes development of legal and institutional controls on self-dealing” (p.162). The Czech case remains, in many ways, a replica of the Russian case, however. Yes, the Czech Republic fared better in terms of the quality of its business environment but, lacking necessary controls, it also fell prey to self-dealing. The point of adding the Czech case to the analysis, then, is to emphasize that without strong controls on insider self-dealing, large scale privatization cannot succeed. In a small-N comparison such as this, however, it would make more sense to find a comparative case with institutional factors that, according to the authors, would have prevented the Russian privatization failure (such as strong controls on self-dealing), and whose outcome was successful.

Chapter 5, by Frydman, Hessel and Rapaczynski, focuses on entrepreneurship and restructuring of enterprises in Central Europe. This chapter adds to the debate on the relationship between ownership and corporate performance in nations with market transitions. While most literature on the subject discusses the difference between state and private ownership, this chapter shows that different types of private ownership matter also. The authors’ central question is whether firms controlled by certain types of private owners are more successful in restructuring than others. [*159]

Based on a survey of 506 mid-sized manufacturing firms in the Czech Republic, Hungary and Poland conducted in the fall of 1994, the authors examine the link between ownership and performance (revenue and cost performance, in particular). They find that firms controlled by outside investors outperform those controlled by corporate insiders. Then they elaborate what causes the positive impact of outside ownership. From their perspective, this impact is caused by the entrepreneurial attitudes of outside investors – in other words, their greater readiness to take risks, and a lesser need to defend and account for their managerial decisions.

This article deals with a very interesting question, and convincingly establishes the difference between two types of private owners (outside investors and corporate insiders). However, the authors’ explanation of the cause of this difference is not quite convincing. It is not clear from their analysis why the greater readiness to take risks, and lesser need to defend and account for managerial decisions, would make outside investors more successful.

Chapter 6, by Miwa and Ramseyer, draws comparisons between modern transition economies and the prewar Japanese economy. The logic of comparison is that structural factors, such as dysfunctional courts, nascent markets, non-existent statutes, and firms controlled by communist hacks which, for many observers characterize modern transition economies, existed in prewar Japan as well. For firms in these kinds of environments, the authors explain, observers often prescribe concentrated finance – that is, raising capital from a few sources and relying heavily on bank debt, rather than relying on broadly dispersed shareholdings. The reason for this is that it is generally believed that only large-block shareholders and banks effectively constrain managers in weak legal environments.

Miwa’s and Ramseyer’s study of Japan suggests otherwise, however. They examine the largest sector in prewar Japan – cotton spinning – to find out what capital and governance structures the more successful firms in the industry adopted. They find that the most successful firms relied on equity rather than bank debt, and raised it from many shareholders so that a few powerful ones would not intervene. The article argues that dominant shareholders, if corrupt or incompetent, can seriously impair corporate performance.

In Chapter 7 Coffee compares the Polish and Czech privatization experiences and argues that inadequate securities regulation primarily explains privatization failures. The Polish and Czech cases are similar in terms of their historical and cultural background, but they have displayed very different approaches to privatization. Viewing continued state ownership as a great danger, Czech authorities rushed into privatization in the early 1990s, with regulatory controls developed later in response to a series of crises and scandals. In contrast, Poland moved slowly and implemented a limited privatization program. Rather than assuming that a secondary market would develop spontaneously, Poland designed voucher investment funds as a [*160] mechanism to solve the individual’s perceived powerlessness in a massive privatization program. This way, Poland effectively substituted state-created monitors (in which citizens could invest) for direct state ownership.

The comparison of Poland and the Czech Republic constitutes an interesting puzzle for scholars who emphasize the importance of substantive corporate law. As Coffee explains, the corporate laws of Poland and the Czech Republic were largely the same: they each had a corporate law based heavily on the German civil law structure. Yet, their privatization experiences were different. According to Coffee, this is because these countries imposed different levels of regulation on their securities markets. Although both had corporate law based on German civil law, in its approach to securities regulations Poland remained closer to the British and American common law model. Poland imposed high disclosure standards from the beginning, created an SEC-like agency, and endorsed British style takeover regulations.

According to Coffee, the difference between the Czech and Polish privatization experiences also informs us on the question of why common law systems outperform civil law systems. According to Coffee, the reason for this lies not in the corporate law of common law countries but in their shared system of securities regulation. Common law systems endorse a style of securities regulation that discourages rent-seeking behavior through high disclosure standards, enforcement of transparency and minority protection, which lead to better performance.

In Chapter 8, Morck, Yeung and Yu add to the debate on the role of stock market structures in transition outcomes with an article that examines synchronicity in stock returns. They first report an interesting finding: stock returns are more synchronous in poor economies than in developed economies. That is, stock prices in emerging economies tend to move up or down together. In contrast, developed countries see a low degree of co-movement. The authors show that this difference is explained by measures of property rights protection. Less respect for private property by government is associated with more synchronous stock price movements. These results, according to the authors, also imply that stock markets in emerging economies may be less useful indicators of business practices and economic information than in advanced nations.

The question this article deals with is important, and the authors use rigorous methodology to present their argument. However, the reader expects more theoretical discussion, especially on two matters: one is the relationship between stock synchronicity and corporate governance. How does this relationship matter for our theories of corporate governance? What kinds of policy implications does it embody? And two, what is the theoretical link between private property protection and stock movements? The authors offer a two-page discussion on this question (pp.342-344), which suggests that poor property rights protection might deter [*161] risk arbitrage and create space for noise traders. Yet, as the authors themselves acknowledge, this interpretation is not altogether satisfying, and it is still not clear how and why this would lead to more synchronicity.

In the volume’s final chapter the editors, Fox and Heller, revisit the Russian experience to re-emphasize some of their theoretical claims. This chapter shows that the Russian experience is unique in the sense that “no other place in the world offers such ample and creative corporate governance pathologies” (p.391). Yet, at the same, being the closest example of an ideal-typical corporate governance failure, Russia’s experience informs us on various aspects of corporate governance.

On the whole, CORPORATE GOVERNANCE LESSONS FROM TRANSITION ECONOMY REFORMS is an excellent collection of essays that will surely become a “must-read” in both the post-socialist transitions and the corporate governance literatures.

REFERENCES:

Fligstein, N. and Choo, J. 2005. “Law and Corporate Governance.”  1 ANNAUAL REVIEW OF SOCIOLOGY 61-84.

Claessens, Stijn. 2006. “Corporate Governance and Development.” 21 THE WORLD BANK RESEARCH OBSERVER 91-122.

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© Copyright 2007 by the author, Basak Kus.