Emerging Owners, Eclipsing Markets? Corporate Governance in Transition
by Erik Berglof and Anete Pajuste

In the transition economies, ownership and control will probably remain concentrated for the foreseeable future. Regulatory intervention should focus on eliminating outright fraud while maintaining the incentives for entrepreneurship and large shareholder monitoring. The transparency of emerging control structures—and of what controlling owners do—is of the utmost importance.

New comparable data on ownership, control, and financing patterns show that the emerging capitalist systems in Central and Eastern Europe share many features. While the extent of remaining government ownership differs from one country to another, private ownership dominates everywhere. Ownership and control are becoming increasingly concentrated, with the emergence of corporate groupings and significant foreign owners in most countries. As firms grow, ownership and control are separated. Most firms in the CEE countries are, however, still owner managed, but professional management is becoming more common. Nevertheless, even in those that employ professional managers, controlling shareholders play a critical role. Moreover, for better or worse, large shareholders also play, and most likely will continue to play, a role beyond their immediate mandate and influence the course of politics, in particular, in shaping the rules related to corporate governance and financial sector development.

The emerging ownership and control structures have important implications for corporate governance. In owner-managed firms the fundamental trade-off is between providing incentives for entrepreneurship and protecting minority investors. The data and rich anecdotal evidence from the CEE countries suggest that strengthening minority protection is of paramount importance in combating fraud and bringing down financing costs. This policy priority has its drawbacks, however, when selling companies, because excessive protection of minority shareholders may discourage strategic investors and prevent badly needed restructuring in these countries. The mandatory bid rule that requires new owners who acquire large controlling stakes to buy out remaining shareholders (thereby providing an exit possibility for the minority stakeholders in case they are unhappy with the new owners) could induce firms to withdraw from the stock market, and these de-listings could undermine the sustainability of the fledgling capital markets.

As controlling owners gradually distance themselves from day-to-day management in favor of professional managers, the nature of the corporate governance problem changes. Managers must be monitored, and only controlling owners have sufficient incentives to perform this task. Even in these firms, controlling owners and minority investors could turn against each other, unless controlling owners are provided with sufficient incentives to monitor and protect the latter. In the medium term, the increasing involvement of lending banks may provide some monitoring. Over time, enhanced financing opportunities can increase competition in the market for corporate control and help improve contestability. As countries’ legal environments improve, especially with respect to enforcement, litigation could also contribute to better corporate governance.

The regulatory response to the emerging ownership and control structures has largely been determined by the EU accession process. Regulators have emulated existing institutions in current member states, and to some extent have anticipated possible regulation at the EU level. As a result, the CEE countries have adopted regulations that on paper have stronger minority protection than in most EU countries; however, the CEE countries are less forceful when it comes to implementation. For example, the interpretation of the mandatory bid rule appears to be lax in several countries, leaving more possibilities for a control premium and facilitating block trades.

Regulators must recognize that holders of large blocks of shares are an important feature of the corporate governance system once ownership and management split. Controlling shareholders are a second-best response to weak legal institutions. Efforts to get rid of large holdings would lead to more managerial discretion in an environment where few other disciplining mechanisms exist and where elements of a specific stakeholder culture may obfuscate corporate goals. Moreover, such attempts would most likely lead to further de-listings and increased opaqueness. The market for corporate control is critical to promote transfers of controlling blocks, but given the high ownership concentration, these transactions are unlikely to take place against the wishes of the controlling shareholders and managers. Strict enforcement of mandatory bid rules would essentially shut down the market for corporate control and further entrench incumbent management and controlling owners.

Erik Berglöf is the director of SITE. Anete Pajuste is a Ph.D. candidate at the Stockholm School of Economics. This article is based on their paper "Emerging Owners, Eclipsing Markets? Corporate Governance in Transition," to be published in the forthcoming volume Corporate Governance and Capital Flows in a Global Economy, edited by Peter K. Cornelius and Bruce Kogut (Oxford University Press).