corporate governance and agency

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April 2007

PED401. Applications and Cases in International Development

Teaching Notes

1

Corporate governance and agencyproblems consequences forefficiency and equity

This case concerns questions of the organization of the corporate sector. In the past, wehave often focused on how credit and insurance market failures can be particularly costly

for smaller-scale and poorer groups, and how this can lead to adverse efficiency, equity

and poverty effects. For example, microfinance uses a set of contractual and

organizational innovations to deal with market failures. But this focus on the bottom of

the firm (or firm-household) distribution does not imply that all is well at the top of the

distribution. In fact, there are a whole set of issues around how the corporate sector is

organized and how this interacts with both capital and insurance market failures.

As in other areas we have looked at, theory helps analyze the nature of the potential

problems, including insights from contract theory. A central focus of the session will be

on the potential costs of family-controlled and pyramidal corporate structures. A stark

example of an agency problem is tunneling, the transfer of resources between firms in

the pyramid that favors controlling groups at the expense of minority shareholders. This

is a form of moral hazard (see below.) But note that theory is often ambiguous. For

example, the net effects on efficiency of a pyramidal structure depend on the balance

between incentives to expropriate minority shareholders, and the potential of such

pyramidal structures to compensate for credit and insurance market failures.

This topic will also illustrate two other themes of the course: how there can be

interactions between inefficiency and inequity; and how unequal power can shape

institutional design. In particular, the potential for economic entrenchment ofcorporate elites is a potentially pernicious source of inefficient and inequitable

development paths.

1These notes were prepared by Michael Walton and are solely for teaching purposes.


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Finally the case discusses how design of legal and regulatory systems can countervail

concentrated corporate power, and shape corporate structures. This will focus on a

contrast between the Czech Republic and Poland in the 1990s that it is suggested has

features of a natural experiment. These were not cases of entrenched economic elites, but

are of interest precisely because of the fluidity of institution in their transitions.

Analytical context

Agency theory is relevant to many aspects of corporations, from the fundamental

question of why firms exist at all to questions of corporate structure.

The boundaries of the firm

If markets are such efficient mechanisms for allocating resources, why do firms exist at

all? The huge amount of market activity in mergers and acquisitions and in spinning off

parts of complex firms suggest that this is an issue of genuine economic importance, withcontinual experimentation in finding out what boundaries are most profitable. This is not

the primary concern of this case, but we highlight a few of the points in Holmstrn and

Roberts (1998) to provide some broader context.

Coases classic answer to why so much economic activity occurs within organizations is

in terms of transactions costs in a world of imperfect information. Where the costs of

transactions are high, it can be optimal to undertake those within an organization rather

than at arms-length. This was later developed in the work of Williamson, who structured

the issue of the frequency, uncertainty and asset specificity of transactions: with higher

levels of uncertainty and asset specificity, contracting is more complex, and hierarchical

management within a company can be more efficient.

A related argument in the property rights school is based on the classic hold-up problem.

Where a transaction involves relationship-specific investments, one party can hold up the

other after the investment has been made, this will be anticipated and the level of

investment will be suboptimal. This would predict that transactions for which hold-up is

potentially large would occur inside firms; others would occur at arms-length, exploiting

the efficiency gains from the market.

As in many areas we have looked at, this is only part of the story. A theme of Holmstrn

and Roberts survey is that we need a richer account of the reasons to understand why

boundaries form in particular ways. For example:

! In some cases inter-firm transactions with high levels of relationship-specificinvestment appear to successfully avoid hold-up problems. An example is the

traditional relationship between Japanese automobile manufacturers and their parts

suppliers. Firms such as Toyota developed relationships with small numbers of

suppliers that form one element of their very high levels of efficiency. Hold-up


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problems are attenuated by the repeated nature of the interaction, substantial

information-sharing and (for Toyota) the possibility of benchmark competition by

having more than one supplier.

! There are also other reasons for boundaries forming along particular lines, that canalso be illuminated by agency theory. An example is the optimal level for

incentives for cost control. Garages commonly involve franchises, for whichoperators pay a rent, and so are residual claimants of profits. Supermarkets are

more commonly run by the owners. An explanation for this is that the primary

margin for better cost control and service for garages lies within the garage itself,

whereas for supermarkets it is primarily in inventory management and

warehousing. Firm boundaries are associated with the role of organizational

knowledge and learning.

The overall message from Holmstrn and Roberts is that we need a more complex

account of boundaries, that would include, but go beyond the relationship between hold-

up and investment.

Corporate structure: dispersed ownership and pyramidal structures

The traditional analysis of firm behavior is concerned with potential principal-agent

problems between managers and owners, with the latter typified by individual and family

shareholders. In this view, a corporation is widely held, in that its ownership is

dispersed across a large number of small public shareholders, and freestanding, in that

listed companies generally do not control other listed companies. (Morck, Wolfenzon

and Yeung, henceforth MWY, p.660). In fact, this ownership pattern, characteristics of

the UK and the US, is relatively rare in the world. Of particular interest is who controls a

firm, and control is often conferred by levels of ownership of 10 or 20 percent of votingstakes. A number of studies have sought to categorize whether the major corporations in

countries are widely held or family controlled: Table 1, taken from MWY provides a

summary. Note that in the developing countries family-held firms are typically much

more important than widely held companies, including in Argentina, Indonesia, Korea,

Mexico, the Philippines, Taiwan, and Thailand. And this also applies to many developed

countries, such as France, Germany (on some definitions) and Sweden.


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Table 1 Patterns of control of corporations in various countries.

Source: Morck, Wolfenzon and Yeung, 2005

Family ownership is one feature of the corporate sectors of much of the world. But of

perhaps greater importance is that this is typically associated with pyramidal structures of

ownership. In its simplest form this means that an apex firm owns shares with second

tier firms, that in turn own shares in third tier firms, and so on. This is illustrated inFigure 1. In practice this will be more complex, with cross-holdings of shares within the

pyramidal structure. What is interesting about this is that controlover lower-tier firms by

the apex family group can be conferred with substantially lower levels of underlying

cashflow rights. Thus even if we assume that control requires more than 50% of shares,

the family controls the fourth tier firms in Figure 1 with only 12.5% ownership. Where

control is conferred by 20% or even 10% of ownershipor via crossholdingsthe


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divergence between ownership and control can be much greater. In many countries a

relatively small number of wealth families control a substantial part of the large-scale

corporate sector.

Figure 1 A schematic account of a pyramidal ownership structure.


While the most common form of extensive control is via the family-based pyramidalstructure, there are also other forms of business group. In Germany, banksthemselves

widely heldown shares in a wide range of corporations with extensive control rights.

German banks play an important role in monitoring corporate performance. In Japan,

there are extensive cross-holdings within business groups known askeiretsu, that confers

substantial control the managers of the group.

Potential consequences

The general principal-agent problem

Why should we care about the family-held pyramidal structure? Because agencyproblems are likely to be significantly different from a freestanding family firm. For

freestanding family-owned firms, the classical agency problem emphasized in the

literature (of divergence of interests between utility-maximizing managers and dispersed

owners) is likely to be reduced or eliminatedthe interests of owners and managers will

be aligned. But this is unlikely to be the case with pyramidal structures. There is likely

to be a divergence of interest between the minority shareholders (here the principals) and


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controlling interests (as their agents), in any area where there are private benefits of

control. A particular concern is that of entrenchment, where controlling interests can

maintain in power their favored managers, often from the family: this can include honest

but inept insiders as well as clever self-serving insiders an egregiously incompetent,

but power-hungry son or even the most efficient thief, who is willing to pay most for a

control block (MWY pps. 677-678)

Tunneling.

Tunneling is an important example of the agency problems created in a control

pyramid. This termcoined in the context of interpretations of the experience in the

Czech Republic that we will discuss in classmeans the transfer of resources between

related firms that benefit individuals or groups with control rights. It can be illegal or

legal (Johnson et al. 2000, document a number of individual cases that occurred legally in

developed countries.) Note that tunneling is (often) a form of moral hazard. Given the

divergence between control and cash flow rights, it is optimal for controlling owners to

(partially) expropriate the minority public shareholdersin a pyramid typically from a

lower tier to higher tier firm. This can take many forms: value can be transferred

between controlled firms via transfer pricing, the provision of capital at artificial prices;

or via inflated payments for intangibles, brand names, and insurance (MWY p. 678).

We think of moral hazard as involving unobservable action, and this is indeed often the

case and is highly relevant to the policy discussion below. Note, however, that this is not

necessarily so: in some cases, including those documented in Johnson et al (2000), the

transfers were carefully documented, but still judged to be legal.

Interactions with capital markets and dynamic processespotential positive

and negative effects of pyramids

While we are emphasizing the agency problems and associated adverse efficiency (and

equity) effects of pyramids, note that in theory pyramids can have either positive or

negative effects. Where credit and insurance markets are imperfect, a pyramid can help

solve financing problems through inter-firm transfers, both for investment purposes and

to help otherwise efficient firms manage shocks. MWY cite work by Tarun Khanna that

argues that Indias Tata group has been an important source of relatively efficient internal

investment finance, compensating for highly imperfect credit markets.

But there can also be negative effects on capital allocation: even if there is more efficient

capital allocation within a business group, there is a wedge between the internal costs ofcapital and that of outsider firms. This wedge is likely to be increased when relationship-

based lending with banks is salientand especially when banks form part of the business

groups.

There are also likely to be effects on innovation. Pyamidal structures may resist the

Schumpeterian process of creation and destruction that is central to innovation, when this

new activities hurt the profits of other firms within the group. On the other hand they


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may be able to use the rents they enjoy to finance innovationespecially if markets for

venture capital are weak in a country.

Political economy

A broader, and potentially more important, concern, concerns the role of concentrated

corporate wealth in the shaping of policies and institutions. MWY argue that under

oligarchic capitalism, typified by widespread corporate control by relative few wealthy

families, the oligarchs will have an interest in lobbying for limited public investors

rights, restrictions on entry, less international competition and a narrower capital market.

This, for example, was a feature of the analysis of Mexico discussed in an earlier case,

where the resolution of the credibility problem was via theselectiveprovision of property

rights to a narrow group of insiders. This helped solve the investment problem, but at the

cost of efficiency, dynamism and innovation. It is still seen today in the widespread

regulatory capture and legacy of a narrow, concentrated banking system in Mexico (as in

many countries.)

The role of judicial and regulatory approaches: Coase versus the Coasians

Can regulation make a difference? Glaeser, Johnson and Shleifer (2001, henceforth GJS)

argue that it can. They distinguish between a Coasian view of the world (though not

one held by Coase himself), that has high levels of confidence that securities transactions

can be efficiently managed using the wide range of contracting possibilities open to the

sophisticated buyers and sellers, which can then be adjudicated in the courts. By contrast

advocates of greater regulation emphasize the market failures (noted above), that could

allow issuers of securities to expropriate investors, and so increase the cost of external

funds. This implies the need for specialized laws and regulators are needed.GJS develop a model that that explores the contrast between an active regulatory

approach to securities markets, and a Coasian view that relies on the normal working of

the judicial system. Underlying this are two sets of considerations:

! The zeal of the enforcer, that is judged to be greater for a (non-captured) specializedregulator than for a judgeone who has higher powered incentives for finding and

punishing offenders.

! The extent of specialized information and investor protection requirementsespecially for minority shareholdersthat is embodied in company and securities

laws.

There is a tradeoff here: a zealous regulator will more vigorously protect minority

shareholder rights, but at a cost for the corporate system, in terms of punishing the

innocent and the cost of information provision. Greater information requirements will

lower the search costs for the investigator, and so make more observable the actions of

agents, reducing moral hazard. Where a country wants to locate itself on this tradeoff

depends on the depth of the agency problems. GJS argue that active regulation backed by


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specialized laws protecting minority shareholders is desirableand use the comparison

between the Czech Republic and Poland to support this.

Of course, if the political economy view of the world sees all policies and institutions as

endogenous to the underlying structure of power, then this is not very interesting. In

practice, power structures and potential coalitions typically provide some room formanoeuvre. Assessing what is politically feasible in policy and institutional design, is

central to the art of development practice!

Some illustrative empirical patterns

Control pyramids effectively entrust the corporate governance of the greater part of the

corporate sectors of many countries to a handful of elite, established families, who can

quite reasonably be described as oligarchs. (MWY p.693) To the extent this is true,

does it matter? As noted in the selected review of theory, effects of pyramidal corporate

structures are theoretically ambiguous, so the issue is empirical. While there is not thespace to review the literature here (see MWY), we highlight a few results.

First, to motivate interest, there are some suggestive associations between billionaire

wealth and various measures of development performance. Billionaire wealth is

measured by the ratio of Forbes estimates of total wealth to GDP. When this is added to

simple cross-country growth regressions, measures of self-made billionaire wealth have

a positive relationship with growth in per capita income, while measures of inherited

billionaire wealth have a negative relationship (Table 2). This holds for a variety of

definitions of whether billionaires are self-made or rich because of inheritance or political

connections. It is not possible to infer causation, for all the usual reasons, and there may

in particular be problems of omitted variables: something about a societys economic or

political institutions may be good for both major business entrepreneurs and overall

growth, and vice versa. But it is at least consistent with the view that entrenched familial

wealth may be associated with structures that are bad for growth. (Similar associations

hold for other development outcomes, such as health status.)


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Table 2. The association between growth in real per capita GDP and self-made andinherited billionaire wealth


A rather different and also highly suggestive result comes from measures of the premium

the market grants to the value of control rights. It is possible to distinguish purchases that

confer control over a firm, such as blocks of shares. These often have a higher price than

regular purchases, indicated that the market attributes private value to controls.


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Table 3. Some evidence on the value of control rights


A number of studies have found evidence of tunneling, in countries ranging from Korea,

Central and Eastern Europe, India and in Europe, and this is a growing area of empirical

research.

But it is also true that pyramidal/familial structures have existed in countries that have by

most standards of economic development been extraordinarily successful: Korea and

Sweden are examples, as are many of the East Asian miracle countries. How do we

interpret this? Is it because the gains from pyramidal structures (from solving creditmarket failures) offset the costs? Did other parts of the institutional context offset the

worse costs of pyramidal structures in these cases? Or would the pattern of growth been

more efficient and equitable than actually occurred? These are important questions for

future work and policy design.


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The Czech Republic and Poland

Czech Republics Vaclav Klaus: We knew we had to liberalize, deregulate, privatize ata very early stage in the transformation process, even if we might be confronted withweak and ..not fully efficient markets.Conceptually...all you had to do was apply the

economic philosophy of the University of Chicago. 1995

Polands Leszek Balcerowitz. The capacity of the state to deal with various problemsvaries, mainly because of varying informational requirements 1995

(cited in Glaeser, Johnson and Shleifer. 2001)

A natural experiment in institutional design?

The discussion of theory has emphasized the potential for entrenchment of patterns of

control via both economic and political channels. The case we will look involves a very

different setting, of the Czech Republic and Poland, both societies in an unusually highdegree of flux, owing to the ruptures associated with the political transition from

communist control. Apart from the intrinsic interest of their experiences, they illuminate

the issues we are concerned with, both because of the institutional fluidity, and because

contrasting policy and institutional changes were adopted in a form of natural

experiment.

As has been discussed in the quantitative courses, to assess the effect of an intervention,

we want to compare the effect of the treatment on an individual, household, community

or country with what would have happened if everything else was the same except the

treatment. This can never be observed, and so we are always looking for information that

is close to this structure. Well-designed randomized experiments are about as good asyou can get, and quasi-experimental methods seek to approximate the ideal, with varying

degrees of success. When the comparison is between just two countries, there is of

course no possibility of undertaking any statistical tests, but it is worth thinking of the

structure of the problem through a similar prism.

The hypothesis is that the Czech Republic and Poland were similar in relevant respects

except choices over institutional design that we are interested in, so this allows us to

explore the consequences of the design choices. In 1989 both led the transition from

communism in Central and Eastern Europe, after 40 years under communist rule. Both

were fully industrialized under Soviet-style central planned. The Czech Republic wassomewhat richer in 1989, and Poland had a larger agricultural sector. Then both

undertook a quite rapid process of liberalization. To quote Glaeser, Johnson and Shleifer

(2001):

Both countries initiated economic reforms immediately after shedding

communism. In Poland critical legislation on liberalization was passed in the fall

of 1989, and the key measures came into effect on January 1, 1990. Small-scale


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privatization began in May 1990, although large-scale privatization started with a

whisper in 1991, ran into political obstacles, and spread over most of the 1990s.

In Czechoslovakia reforms were also initiated in early 1990, with the devaluation

of the currency, budget cuts, and banking reform. The formal reform package,

including price increases, started on January 1, 1991. The law on large-scale

privatization was adopted on February 1, 1991. Privatization through voucherstook place in two waves: in 1992 (completed in mid-1993) and 1993 (completed

in 1994). Most rules of privatization, including those on Investment Privatization

Funds, were developed in 1991 Moreover, both countries were virtually

finished with these basic reforms by 1994. They received virtually identical scores

on every World Bank indicator of the pace of transition.. (pp. 865-866)

Table 4 Comparative indicators for the Czech Republic and Poland

Czech Republic Poland

Years under communism 40 40

Transition 1989 1989

Per capita income, 1989 (1995US$)

5730 3045

Private sector share of GDP,1997

75% 65%

Privatization indicesLarge-scaleSmall-scale

44+

3+4+

Price liberalization index 3 3

Banking reform/liberalization 3 3

Legal environment 4 4

Source: Glaeser, Johnson and Shleifer. 2001

Some of the similarities are given in Table 4. However, there were also differences in

both the approach to privatization and the choice of regulatory regime for the newly

created corporate sector. The Czech Republic was more Coasian in the sense that it

chose to rapidly transfer state-owned property to private citizens, and then chose a lighterregulatory regime, trusting more in the newly created property rights, private contracting

and the judicial system. Poland selected a more gradual approach to privatization of

large-scale enterprises, using a variety of methods, including direct sales and share

transfers to mutual funds. It backed this with a more active regulatory regime, with

stronger protections to minority shareholders. Now the classic evaluation question is

whether this policy difference was driven by some unobservable characteristics that


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would also explain subsequent differences in outcomes. Here the hypothesis is that the

primary driver was differences in the ideology and preferences of the leadership, captured

in the quotes at the beginning of this section. Both had strong economic leaders

committed to the transition to capitalism, but while the Czech Republics Vaclav Klaus

was a fierce proponent of the power of free markets, Polands Leszek Balcerowitz was

more concerned with the need to nurture the states capacity to manage capitaliststructures in the context of market failures.

The differences in design choices

The first difference concerned the design of privatization. The Czech Republics

privatization gave all Czech citizens rights to purchase booklets of voucher points at a

modest prices; these could then be used exclusively for purchase of shares in state owned

companies put up for sale. There was, however, awareness that atomistic owners would

be in a weak position to monitor the performance of their firms (in what was referred to

above as the classic agency problem under dispersed ownership). So free entry was

allowed to Investment Privatization Funds (IPFs) as both a means of providing

information to citizens and aggregating bids, and as a mechanism of corporate

governance of the newly formed private firms (Coffee, 1996). As already noted, Poland

chose a more gradual and managed route.

Note that voucher privatization had apparently attractive efficiency, equity and political

economy characteristics: it could swiftly transfer ownership to true owners; gave rights

to participate to all citizens; and could lock in the transition swiftly vis--vis either old

state managers or new insiders.

The second difference concerned the regulatory stance. Here the Czech Republics

legislation on company and securities was much laxer than Polands with respect to a

whole series of requirements on protections for minority shareholders and information

disclosure (see examples in Tables 5 and 6, all from GJS). Moreover, regulatory action

in the Czech Republic resided in a division within the Ministry of Finance, while Poland

created a powerful, independent regulator.


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Table 5. Indicators of differences in policy stance


Company law: degreeof protection against

expropriation ofminority shareholders

Moderate to low:overall rating of 2 out

of 6 on

Moderate protection:overall rating of 3 out

of 6

Securities law Supervision in anoffice within theMinistry of Finance

Weak licensing, anddisclosurerequirements

IndependentSecuritiesCommission

Strong licensing anddisclosurerequirements


Table 5. Indicators of differences in securities laws


Required to engage in honesttrading

No Yes

Brokerage enterprises:Regulator has right ofinspection of brokers

Must report who has more than5% of voting rights

No

No

Yes

Yes

Investment advisersLicensed by regulator No Yes

Stock marketsTrading must take place on astock exchange

No Yes


Outcomes

What were the outcomes? The Czech Republics privatization was much more rapid.

Indeed, by end-1994 over 80% of Czech citizens had become shareholders in privatized

companies and 65-90% of all assets had become privately owned (Coffee, 1996). But a

highly concentrated ownership structure was created, with IPFs playing a central role in

holding multiple companies.


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Then, in 1996 and 1997 there was a sequence of scandals, involving asset-stripping, the

collapse of some financial institutions and allegations of embezzlement (ibid.) The term

tunneling was coined in descriptions of this experience. Moreover, ..during the mid-

1990s, the heyday of tunneling in the Czech Republic, the regulators did very little to

stop it. Part of the problem was the weakness of the laws. But equally important was

probably the lack of interest in securities regulators combined with judicialineffectiveness. (GJS)

By contrast when financial scandals occurred in Poland, they were widely reported, and

vigorously pursued by the regulator, making use of the legal rules designed to protect

investors.

There were markedly different effects on the evolution of stock markets. The Czech

stock market initially grew much faster than the Polish market, but then the pattern

reversed: Figure 2 illustrates for stocks listed in the IFC investable index, that is limited

to stocks liquid enough for foreign investors to take positions. Even more striking is the

differing abilities of firms to raise capital. While no Czech company sold equity for cash

in an initial public offering between 1991 and 1998, 136 nonprivatizing companies had

done so in Poland.

Figure 2. Market capitalization of stocks in IFC Investable Index.



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Table 6. Initial public offerings for cash, 1991-1998


The above evidence is only indicative. An alternative interpretation of the Czech

experience is a Darwinian one: it effectively went for an upfront floating of all

companies, and then the market weeded out the least fit firms, with the least market-

friendly charters. GJS argue that this was unlikely to be the case, on the grounds that

the survival of theft-proof firms is not an efficient mechanisms of economic selection.

Tunneling could be used to strip assets of good or bad firms alike. They argue that the

key difference was in the design of regulation, and that well-designed laws and couldindeed have effectively regulated the IPFs and related intermediaries.

Policy questions

It is 1990 in either the Czech Republic or Poland. There is intense interest in the design

of the transition to private ownership. You are part of a planning group assessing

alternative design options. There are debates over the pace and design of privatization

itself, the role and sequencing of regulation, alternative mechanisms for monitoring of

corporate performance and the importance of the overall political context. You are

familiar with debates over corporate governance in rich countries, and the high risk ofagency problems under both dispersed and concentrated forms of ownership. You are

particularly interested in what form of regulatory framework would make sense

conditional on the choice of privatization approach (fast or slow, voucher or managed

etc.) What do you recommend?


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Alternatively, you may wish to consider the question of whether regulatory choices can

be useful to tackle problems of entrenched family-based structures of corporate

ownership in a country with which you are familiar and have information.

References

Coffee, John. 1996. "Institutional Investors in Transitional Economies. Lessons from the

Czech Experience." in Roman Frydman, Cheryl, Gray and Andrzej Rapaczynski

Corporate Governance in Central Europe & Russia: Volume I: Banks, Funds and

Foreign Investors.New York: Oxford University Press.

Cull, Robert, Jana Matesova, and Mary Shirley. 2002. Ownership and the Temptationto Loot: Evidence from Privatized Firms in the Czech Republic. Journal ofComparative Economics,30:1-24.

Glaeser, Edward L., Simon Johnson, and Andrei Shleifer. 2001. "Coase versus the

Coasians." Quarterly Journal of Economics,116(3):85399.

Friedman, Eric, Simon Johnson, and Todd Mitton. 2003. Propping and Tunneling.Journal of Comparative Economics,31(4):732-50.

Holmstrm, Bengt and John Roberts. 1998. The Boundaries of the Firm Revisited.

Journal of Economic Perspectives,12(4): 73-94

Johnson, Simon, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer. 2000.Tunneling. American Economic Review, 90(2):22-7.

Morck, Randall, Daniel Wolfenzon, and Bernard Yeung. 2004. Corporate Governance,

Economic Entrenchment and Growth. Journal of Economic Literature, XLII,

655-720.


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