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The East: Changes Needed In Corporate Governance, Says EBRD

Prague, 3 November 1997 (RFE/RL) -- A new phase of economic transition is necessary in Eastern Europe and the former Soviet republics to counteract a legacy of communist-era managers who still retain control over many former state firms. This next stage of transition requires new forms of corporate governance that allow shareholders to sack managers who are incompetent or corrupt.

That's the assessment being made today by the European Bank for Reconstruction and Development (EBRD) in its Transition Report for 1997.

The report urges governments across the former communist world to create new laws and market institutions that boost competition and crack down on corruption.

Characterizing old state managers as "insiders," the EBRD report says that outside investors -- including small share holders as well as strategic investors -- must have more control over the bosses of newly privatized firms in order to improve corporate performance.

In industrialized market economies, shareholders generally let managers run medium and large-sized companies. But when the financial performance of a firm becomes unsatisfactory, the structure of a western corporation allows shareholders to press for changes -- including the sacking of its managers.

The EBRD says this kind of corporate governance has not yet evolved in former communist countries.

Further, the EBRD says privatizations in most of the CIS, as well as in the former Yugoslavia and Poland, have primarily benefited the old state managers and other "insiders" who remain largely in control.

Russia is singled out by the EBRD as a country that has sold off the entire spectrum of companies' operations to incumbent managers and employees. It says that Russian managers quite often seek to control employees' shares, as well.

As a result, the EBRD says incompetent or corrupt managers are becoming entrenched in what would otherwise be good firms. And the desire of these managers to retain their control is causing many potentially profitable companies to miss out on investment from external sources.

The trend not only constrains the growth of the newly privatized firms. The widescale nature of the problem also is hurting the overall macroeconomic performance of eastern countries. In fact, the EBRD says the whole reason for conducting privatization programs in the first place -- to bring about economic growth and stability by strengthening the performance of former state firms -- is being sacrificed in many states.

Competitive market pressures are considered as one strong influence on the performance of insider-controlled companies. This raises the need for laws and institutions that foster a competitive marketplace.

But the EBRD warns that continued government subsidies to firms with incompetent managers is preventing the emergence of new private firms that could prove to be more efficient. The benefits of competition also are being squelched by arbitrary bureaucratic hurdles on the part of governments, another legacy of the communist era that is making it difficult for new firms to enter the marketplace.

The EBRD says the rise of financial-industrial groups in countries like Russia and Ukraine could be a challenge to the insider domination of industry. The Transition Report says such groups could eventually evolve into effective agents of corporate governance and restructuring. But the EBRD warns that if financial-industrial groups are not properly regulated, they could also recreate the kind of industrial or regional monopolies that prevailed under communism. The Bank urges for effective competition policies to keep the powers of the financial-industrial groups in check.

Even in the Czech Republic, where private investment funds played a vital role in the success of voucher coupon privatization, the EBRD is warning about lax corporate governance. The EBRD says the system of cross-ownership among state-owned banks and the investment funds has insulated Czech fund managers from external control. A lack of transparency when shares were concentrated after the voucher process also is depriving minority shareholders of rights that would, in the west, be considered part of the fair value of share ownership.

Independent agencies are needed that monitor and control emerging capital markets. The EBRD says the ultimate goal should be a stock market system that allows both the ownership and control rights of companies to change hands.

Another way to break up insider control is to gradually increase outside ownership through the provisions of outside financing. This process appears to be slowly taking hold in Russia.

A last-resort approach to corporate governance is the threat of bankruptcy. This mechanism is considered important in countries like Bulgaria, where insider privatization has led to the draining of most state firms, and where banks and capital markets are considered weak.