metadata: authors: 0: author: Anderson,Robert E.
count: Slovak Republic,Czechia
docna: 0: docna: Voucher funds in transitional economies :
            the Czech and Slovak experience
docty: Policy Research Working Paper
subtopic: Taxation & Subsidies,Multinational & Corporate Governance,Corporate Governance,State Owned Enterprise Reform,Public Sector Administrative & Civil
            Service Reform,Legal Institutions of the Market Economy,Capital Markets and Capital Flows,Non Bank Financial Institutions,Capital Flows,Privatization,Energy Privatization,Mutual Funds,Civic Participation and Corporate Governance,Democratic Government,Economics and Finance of Public
            Institution Development,Public Sector Administrative and Civil
            Service Reform,De Facto Governments
teratopic: Finance and Financial Sector Development
abstracts: cdata!: Voucher funds have arisen in the
            transitional economies of Eastern and Central Europe that
            have used voucher privatization. These funds collect
            vouchers from citizens and use them to buy shares in
            enterprises. In the Czech and Slovak Republics, voucher
            funds are typically organized as corporations owned by the
            citizens who contributed their vouchers. Recently, they have
            also been organized as unit trusts (either open-ended or
            closed). A management company manages the funds under a
            contract that specifies the management fee. The management
            company is typically owned by the initial sponsor of the
            fund - for example, a bank. Voucher funds can give owners a
            diversified and professionally managed portfolio. More
            important, the funds select who sits on an enterprise's
            governance boards (which oversee management and
            profitability). Although experience is limited, the funds in
            these two countries have probably stopped most fraud and
            self-serving by enterprise mangers and are beginning to
            encourage the restructuring needed for profitability. A few
            funds have replaced poorly performing or dishonest managers;
            more often, because qualified replacements are few, they
            encourage managers to improve performance. There have been
            complaints about funds' performance. Some have made
            unrealistic promises to voucher holders and have appointed
            poorly qualified members to management boards. There is
            concern about conflicts of interest in the bank-sponsored
            funds and excessive control of enterprises. Funds typically
            lack capital or expertise to undertake restructuring - but
            few other potential owners are likely to be better
            qualified. The author examines 27 regulations that have been
            proposed for funds. Regulations in transitional economies,
            unlike regulations in most western countries, should
            encourage funds to play a strong role in corporate
            governance, he contends, as few potential owners have this
            ability. Most important, regulations should require that
            funds disclose information about their operations so their
            owners can monitor and control fund managers. The regulatory
            regime, the author says, should discourage monopolies and
            anticompetitive behavior; create incentives for fund
            managers to improve fund performance; discourage
            self-serving or fraudulent behavior by fund managers, and
            conflicts of interest; and eliminate high-risk investments
            unacceptable to fund owners. Because there is so little
            experience with these funds, the regulatory regime should
            not be unduly restrictive. As problems arise, regulations to
            deal with them can be added.
geo_reg_key: 517208,517190,517191
repnme: repnme: Voucher funds in transitional economies :
            the Czech and Slovak experience
display_title: Voucher funds in transitional
            economies : the Czech and Slovak experience
listing_relative_url: /research/1994/07/698192/voucher-funds-transitional-economies-czech-slovak-experience
topicv3: Corporate Governance m1326968 417,Mutual Funds m1326970 2180,Privatization m1327236 1283,Vouchers m1504820 3553,Financial Institutions m1505015 3797
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Development Economics and Chief Economist
no_of_pages: 54
author_keys: 0: author_key: 96207
model_extractions: PoLIcY RESEARCH WORKING PAPER 1324

# Summary findings

Voucher funds have arisen in the transitional economies of Eastern and Central Europe that have used voucher privatization. These funds collect vouchers from citizens and use them to buy shares in enterprises.

In the Czech and Slovak Republics, voucher funds arc typically organized as corporations owned by the citizens who contributed their vouchersm Recently, they have also been organized as unit trusts (cither open-ended or closed). A management company manages the funds under a contract that specifies the managemcnt fee. The management company is typically owned by the initial - sponsor of the fund for example, a bank. Voucher funds can give owners a diversified and professionally managed portfolio. More important, the funds select who sirs on an enterprise's governance boards (which oversee management and profitability).

Although experience is limited, the funds in these two countries have probably stopped most fraud and selfserving by enterprise managers and are beginning to encourage the restructuring needed for profitability. A few funds have replaced poorly performing or dishonest managers; more often, because qualified replacements are few, they encourage managers to improve performance.

There have been complaints about funds' performance. Some have made unrealistic promises to voucher holders and have appointed poorly qualified members to management boards. There is concern about conflicts of interest in bank-sponsored funds and excessive control of enterprises. Funds typically lack capital or expertise to - undertake restructuring but few other potential owners are likely to be better qualified.

Anderson examines 27 regulations that have been proposed for funds. Regulations in transitional economies, unlike regulations in most westem countries, should encourage funds to play a strong role in corporate governance, he contends, as few potential owners have this ability.

Most importan, regulations should require that funds disclose information about their operations so their owners can monitor and control fund managers.

The regulatory regime, he says, should discourage monopolies and anticompetitive behavior; create incentives for fund managers to improve fund performance; discouragc self-serving or fraudulent behavior by fund managers, and conflicts of interest; and eliminate high-risk investments unacceptable to fund owners.

Because there is so litde experience with these funds, the regulatory regime should not be unduly restrictive. As problems arise, regulations to deal with them can be added.

This paper is a product of the Europe and Central Asia and Middle East and North Africa Regions Technical Department, Private Sector and FinanceTeam. Copies of thie paper are available free from the World Bank, 1818 H Street NW, Washington DC 20433. Please contact Faten Hatab, room HS-087, extension 35835 (47 pages). July 1994.

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# Voucher Funds in the Transition Economies The Czech and Slovak Experience

## Robert E. Anderson

Technical Depadment ECA/MNA Regios
S.

# CONTENTS

|1.|D~escriptionof Funds..........................<br>1<br>¶Typesof Funds<br>.<br>..<br>..<br>.<br>...<br>..................<br>2|
|---|---|
||Strctr<br>of Funds<br>.<br>3|
|2.|Funct:osofVoucherFunds<br>.<br>_5_<br>|
||Porttflio Diversfilcation.<br>. .........<br>........<br>_S_<br>|
||I?rttblo Se,.<br>.....<br>.<br>.<br>_6_<br>|
||Cor1poate Govirenigce...................<br>_9_|
|3.|MvodlelsofCorporateGovernance..<br>................<br>_9_|
||DispOersedOw<br>nershi.<br>10|
||InstitationalOwncrship<br>.'.<br>11|
||Holding Companies....................<br>11|
|4.|Governance in the Czech ai'd Slovak Republics .<br>...........<br>13|
||Governance Boards.....................14|
||Owvnership Structure..................<br>17|
||<br>Comparison with, Other Countries .<br>..............<br>18|
||,icperiencetoDate<br>..<br>19|
|_5._|T1'bxeEnterprise,CaseStudies..<br>...............<br>23|
||SUCCCSSfbl<br>CoMpany .........<br>..........<br>23<br>S<br>|
||Avrd<br>Conipaiy....................<br>24<br> <br> <br><br> <br>RecommedatifionS.4|
||F<br>gCompany.........................<br>25|
|_6._|Fund Be<br>h<br>aioor<br>26|
||Shirking........................27|
||SelfIDeaing ......................<br>28|
||THghRisk investments ...................<br>29|
|7.|Cpticn for Regulation....................<br>30|
||Promote Competition....................32|
||ReqireGreterDisclosure..................33|
||Ices<br>Rights of Fund Ownes..34|
||ContmolFund Operations..................38|
||TLimitFund nv;stmn<br>..<br>40|

References .. 47
~- -

|TermGlossa<br>'~ --<br>Term|ry<br>of Terms<br> <br>Definition<br>_|
|---|---|
|Cash Fund|A mutual fund in which the members contibute cash. The<br>fimd uses this cash fund to buy enterprse shares.|
|Voucher Fund|A muual fundinwhich the members contribute vouchers. The<br>fumd uses these vouchers to buy enterprise shares in voucher<br>auctions.|
|Enterpie Share|Shares issued by former Statowned enterprises now held by<br>various owners including voucher funds.|
|Entpse<br>Sharehoid-<br>ers|The holders of entepise shares and thus the owners of<br>entpses.<br>Major shareholders may be the voucher funds.|
|Fund Shares|Shares issued by the voucher funds to their own shareholdes.|
|Fund Shareholders|The holders of fimd aes and thus the owners of the funds.|
|Board of Superviors|The senior governance board in those companis wit a two tier<br>board.|
|Management Board|The junior govemance board sometimes called the Board of<br>Directors in Germany or E:xecutive Board in the Czech and<br>Slovak Republics|
|invastnent Company|A type of voucher fund established as a corporation. The<br>mers<br>are shareholders of the fimd.|
|Unit Trust|A type of voucher fimd established as a contractual trusL The<br>members are holders of partcipation units.|
|Open End Fund|A type of cash or voucher fund that Permits its members to<br>redeem their shares/units from the fimd for its net asset value.|
|Closed End Fund|A type of cash or voucher fund that Permits its membes to sell<br>their shares or partaion<br>units to other investors but not to<br>redeen theirshares/unitsfrom the fund for cash.|
|Management Company|A company that is hired to manage a find. Somcimes referred<br>to as investment companies.|
|Sponsor|An individual or a company such as a bank tat establishes the<br>fund and initially hires the management company for the fund.|
|Privately-Sponsored<br>Fund|Avoucherfund whosesponsoris a pnvate individualorcom-<br>pany.|
|Government-Sponsore<br>Fund|d A voucher fund whose sponsor is the government|
# **Voucher Funds in the Transition Economies: The Czech and Slovak Examples**

## **Robert E. Anderson'** THE WORLD BANK

## 1. Description of Funds

1.1 This paper analyzes the role of the new voucher funds th have arise in those Central and Eastern European countres dtat have implemented voucher privatization. These funds have been given different names in different **countries,** but their functions are similar. Such funds are similar to Western mutual funds except their members buy shares in the fund using vouchers, and the fimds then use the vouchers to buy sha in enterprises. The term "voucher fiad' is used rather than mutual fund or investment fund to make it clear that the partcipants contibute vouchers rather than cash to these funds.

1.2 The fllowing primarily analyzes the experience of the Czech and Slovak Republics though some compansons are made with other transiton countries in the region. The two _key_ issues are:

dthe success of voucher fnds in monitoring and supevsing the enterpises in which the finds have purchased shares in order to improve performance and profitabiity of these nterprises, in other words, the role of voucher funds in -corporate govenance"; and

* deign of a regulatory famework that encourages funds to play a positive rle in the development of the economy and limits any undesirable or harmfiu activities of funds.

1.3 The analysis is based on discussions with government officials in these two republics, intiews with three funds in the Slovak Republic and six finds in the Czech Republic, and inteviews with six enterprises in the Czech Republic and four enteprises in the Slovak Republic that are now primarily owned by the voucher fumds3. The analysis also draws on

,The findings, interpretons, and conlusions expressed in this paper are endrely the **aushors** and should not be attribed to the World Bank, im Board of Directors, its management, or any of its member counties.

> 2The author was accoed in some of the interviews in the Czech Republic by Mitchell Orenstein and Karla Brom of fte European Studies Center of the Institute for EastWest Sudies in Prague. They have used the results of these interviews as well as others to prepare a report on the new private sector in the (continued...)
R. Anderson 2 several papers prsted at a conference on voucher finds sponsored by the Certral and Easern Euren Pivatton Network (CEEPN) held in Prague on Octber 29-30, 1993.

# Types of Funds

1.4 Voucher funds in transition economies can be divided into two tpes according to their sponsors. In some counties, fimds were founded almost exclusively by private individuals, companies, or institutions. These coun **:s** include the Czech Republic, Slovakia, Russia, and Lithuania. In other countres, however, the government plans to create the funds or has already done so though the inenton is to eventually transfer these funds to private owneship. These countries include Rumania and Poland. This report will primadly analyze the experience with pivately-sponsored funds, though some conclusions are also applicable to government-sponsored hmd.

_1.5_ Privatey-sponsored voucher funds have arisen in those countries that are seling Stae-owned enterises for vouchers (coupons) rat han cash. Such vouchers are prvided free or for a nominal charge to all citizens. Two distnct types of voucher auctions have been used:

- (i) a centralized auctian (the Czech and Slovak Republics) in which the shares of many enterprs are sold simultaneously in a single auction; and

- (H) enterprise by entepise auctions (Russia, Lithuania, and Mongolia) in which each enterprise is sold over time independenty of the others.

Vario theoretical and practcal arguments can be made in favor of each type of auction. The _type_ of auctin used, however, does not significanty change the role of the funds.

1.6 Privately-sponsored funds have been founded by both domestic and foreign entities including banks, insurance companies, entripnses, and individual businessmen. Citizens then tumed over their vouchers to the new finds in exchange for shares in the funds themselves. The funds used the accumulatd vouchers to bid for shares in the auctions of enterpses. In the end, the funds acquied a portfolio of shares in former State-owned enterprses on behalf of their own s ldes.

1.7 Because the funds themselves are usually corporatims that issue sha to their owners, there is often confusion when the tms "share, -shareholder," or "owner" is used. Do these tms refer to the former Stat-owned entepnses that are now private companies or to the voucher funds that are themselves private companies? HEreaftr, the terms "enterprse _shar"_

> 2 ( ..coe)

Czech Republic and their analysi **s** upplements and in certain cases expands on the issues dealt with in this paper. See Brom and Orenstn (1993).
3 Voucher Funds in the Transtion Economies and 'enterpse saebolder (owne)" rer to shar issued by the forner State-owned enterprises because of priva aon nd now held by a variety of owners including voucher fimds. The terms 'fund share and 'fund saeholder (owner)' refer to the shares issued by the funds and now held by the owners of the funds, namely, the former voucher holders who gave.their vouchers to the fimds. Fund shares may be traded on the stock mariet along with the enterprise shares though the value of fund shares obviously depends on the underlying value of the enrpise shares owned by the funds.

# Structure of Funds

1.8 As noted above, funds are typically cor ions and ths are subject to general legal provisions concerning the organitio and structure of such companies. Some countres, however, have instituted a special legal framework for funds that include rirements not applied to other corporations. As discussed below, funds may also be established as unit trusts, but most of the analysis in this report assumes that funds are established as corporations. The structu and organization of funds will depend on the particula legal e in each country.

Fig. 1

1.9 The structre and tion Of the funds in many transition counties are sinilar to that in the Czech and Sloak Republics. Using these two countries as examples, it is necesary todistinguish between three legal entities assocated with a fund (see FLg. 1). These are: (i) the fimd itself, (ii) the snsor of the fund, and (iii) the management company for the fund. These three enftties are sometimes not clearly distinguishied and often collectively called the 'fund.'

<!-- Start of picture text --> FUND STRUCTURE<br>En p<br>Sponsor<br>_n t oo<br>con trc Ftd<br>contra<br>/I 1 \<br>Fund Owne<br><!-- End of picture text -->

1.10 As a corporation, the fund is owned by its s o namely, citizs who tansferred their vouchers to the fimd. At the annual meet- **Fund** Owne ing, these shareholders elect the governance boards (for example, Board of Supervisors or Managment Board) that are responsible for the managment of te fund between the annual meetings. As discussed in more detail below, the number, functions, and structure of these boards depend on the specific corporate law in each country. Like other corporations, the funds in the Czech and Slovak Republics have both a Supevisory Board and a Magement Board.
It: -:

**R.** Anderson

4

1.11 The sponsor of the _fund_ may be any legal entity or individual that organized and established a management company that in tum organized and established the fund. The management company is usually a corporation itself The sponsor typically will continue to be the owner of the management company, but neither the sponsor nor the management company is the pemanent owner of the fund.

L 12 The management company established by the sponsor, however, is likely to be the initial but temporary owner of the fund until the fund shares ae distributed to the voucher holders. The m ment company also provides the initial operating expenses for the fund until the fund obtains its own sources of ime, for example, dividends from shares in its portfolio or from selling shares. The funds in the Czech and Slovak Republics have been pleased to see the lare incease in share prices on the Prague stock exchange over the last few months because the can more easily sel some shares to cover ther operatng expenses. The sponsor also expects that the man cet company will continue to advise the fund on the management of its potfolio and carry out most of the other activities of the fund under a management contract The fund typically pays a management fee to the management company statd as some percentage of the value of the fund's assets. As discussed below, counties with voucher fimds often regulate the size and structre of this fee. This use of management compamies is copied from the stucture of muual funds in the United States and Western Europe. In theory, however, there is noreasoc why a fund likeany other corporation could not benmanaged by its own staff rather than a management company.

1.13 After the voucher holders become the owners of the fimd, they have complete legl authority to select another management company and sever any connecton with the sponsor of the fund. Until the annual meetngs of fund shareholders have occurred, however, it is not clear whether shareholders will exercise this right. An important test of the ability of the thousands of fiund shareholders to control the funds will be whether they can change management companies and thus place pressure on the sponsors and their management companies to better manage the funds. Alternatively, funds may become similar to many large companies in the United States with widely dispesed ownership, and as a result incumbent managers effectively control the companies.

1.14 The income of the fund wiR cornefrom dividends paid by companies in which the fund _owns_ shares and from selling shares _from_ its portfoho. The fund can then use his income for three purposes: (i) paying dmidends to its own shareholders, (iH) paying the expeses of the fund, for example, the fee paid to the management company, or (iii) puchaing additional shares of companes. This income cotuld become a new source of capital for enterprses if the fnd decides to invest in newly issued shares of enteprses rather hn pay diidends to the fimd's shareholds. This does not appear to have happened yet to any great extent in the Czech and Slovak Republics, at least in part, because funds have received only a small amount of dividend payments from companies in their portfolios.
Voucher Funds in the Transition Economies 5

1.15 An important isue is the taxation of the income of the funds that is related to the tLaxaio _Of_ coprtosin thee coutrbies in genewal. If allcroaia including funds ave required to paymacorporate income tax, this could lead to "double tandont of the income of entrprses Duble txation would aris in the following situation. Fhirst supp osetha enteqirse must pay a corporate income tax on thidr earnings and then pay dividends to their tadeord from after-tax income. Next, suppose that the dividends pai by the enterprse to the fands is also considered income. for tax purposes on which the funds must pay the coroatem incme tax Thus, this tax is paid a secon time on the sane income. Thnis _could_ greaty discourage part ficiptio in voucher funds because doing so would double the taxes that voucher hodWers would have to py on their futur income from owning shares.

1.16 There are avariety of waysof avoiding this double taxtion. One exmplecopiedfrom the U.S. would be to allow voucher funds to deduct from their taxable income all divideds -i to thir own shar s hus if the voucher funds -i dividends equal to the dividends they receive from enterprisea **s** well as income from selling share (called "capital gains*),, they would not have to pay corporate income taxes? Tik-s, however, would discourage fluids from reinvesting their income back into the enterprise and instead would encourage them to pay all of thir income as divdends to their own

# 2. Functions of Voucher Funds

2.1 Voucher fnds can ha three major functi that can contribute to the success of vouce piaizto and eownomic reform in general. Voucher holders decding whethe to entrut their vouchers to a particular fund must make some judgement as to the ability of tha fund to carry out these functions. The following disuses ach of these functions.

# Portfolo Diversification

2.2 The first funcion is portfolio dieificatio. By tnsferring fteir vouchers to a fumd, voucher hldes can obtain a p io ownership of a lge dversfid potolio of shar **in** many enterpr. Since the value of a voucher is typicaly small, an ididual voucher hokler can buy only a few shame in one or two companies. For example, in the f wave of t

> 5Ano&er more technical problem for voucher fumds is how to calcula **t** e he inome received by a hand wham, it sells shares, commony referred to as capital -an income. Capitd aln- _is usualy_ mseasred - the diffe betweolen price at which the fund sold oae from its portfolio and the price itai r The sharesoriginay. if tpri hasgoneup, the fundois said to a cap lgan fthe price hs gone down, the fol is said to have a fcapita loss!' The problem is that the fouas did at pay a caih - for shares in thir initial portfolios. They boughmh shares using vouchers. Thu it uncle wha **t** he initial purchase price fDr these shares should be for purposes ofcculating capia gains and los. For exmple, should a pice of zero be used or the nmnal Cpar _vaW)_ of th sha which was se at 1,000 cns for al swa sold in the voucher aucton.
6 Ri. Anderson the Czech and Slovak voucher aucions, a typical enterprise share was initially priced at 33 points per share. Thus, a single voucher worth 1,000 points could be used to purchase only about 30 shuas at tis p-ice. Owning part of a diversified portfolio reduces risk for the voucher holder snce the futue value of Shares in any one company is likely to flurtuate much more an a diverified portfolio composeci of shares in many companes. The ultimate in a diversified portfolio is a so called "inde,xed" fund that owns a fmcon of the shares of a large number of enterprises.<sup>4</sup> No fund in the Czech or Slovak Republics appars to have advertised itsdf as an index fund, but regulatons in those countnes requir that all finds invest in at least 10 enterpses. Larger funds invested in many more than the minimum, sometimes as many as 100 or 200 enteprises.

# Portfolio Selection

2.3 The second function is portfolio selection. The sponsor of a fund and the management company hired to manage the fund may be better able to choose enterpise shar in which to invest compared to an individual voucher holder. Lt ote words, voucher holders may taser thei vouchers to a fund beause they bdieve that the fund can 'pick winners' from the large number of enteprises being offered in the voucher auctions. In voucher auctions, being able to pick winners does not mean simply choosing those enterprises that are likely to be more proftable than others. It means picking enterprises whose prices quoted in the auction are low compared to their estimated futre earnings. Like; any investor in the stock market, the management company of a fund will try to select 'undervalued' companie and avoid 'overvalued' compaiesm.

2.4 In Western stock markets, a body of financial theory says that it is not possible to pick undervalued cmpanes because the markets in these counties are 'efficiet"<sup>5</sup> An efficient maret is one in which pries of Sha instantly adjust to reflect all of ffie available informatin about each particular enterprise. Thus in such a market it is not possible to find an undervalued company or an overvalued company, and the market price of each company's shares accurately reflects everythng hat. is curently known about its future earings potentiaL An 'efficient' market does not mean, however, that curret estimates of futr earnings are always correct Because of events that no one could anticipate, future eamings may be higher or lower than now predicted, and the futre pnce of shares may nse or fall from cunent levels. There is no reason to believe, however, that the probability is higher that the price will rise or that the - Will falL 'Such a fund is called an 'indexedj' d because the value of its portfolio is designed to track closely one of te popular inderces of overal stock mariet value. To do this, the fimd includes in its portfolio shares of each enterie that is covered by the selected stock maket index. 5 For a nn-tehical description of the theory of an "efficient stock market, m Maldel (1990) pp. 130211.
Voucher Funds in the Transition Economies 7 2.5 Bocaus of th lack of generally avwilable financial nd othe infomaon about enterpises sold in voucher aucdons, one can reasonably doubt whether the vouher aucion market in the Czech and Slovak Republcs or in other ansto economies would be an "efficient" market in which the voucher funds could not find undervalued companies. In any event, it is liky that voucher holders felt that funds could pick undervalued companies thus contributing to the popularity of these fiuds. In the Czech and Slovak Republics, the most popular funds were those managed by banks. On thc one hand, this may have bee due simply to the fact that these ban were widey k:nown and had the resources to advrtie. On the other hand, individuals may have believed that banks had iside or better information about fth future eangs potential of enwrprs. Thes banks were the major lenders to entepises and thus peraps in a better poston to pick undervalued companies and avoid overvaued companies in the voucher aucdons.

2.6 There i inadequate information now to judge whether the funds in the Czech and Slovak Republics could pick undervalued compan. Funds did typically buy sha in those entises that had a high price compared to their book value.' In odher words, the funds wer more likely to buy shares m those companies tat had an above average earnings potentaL This does not mean tat such enterpris shares were undervalued, however. In fact, the pces paid for the shares in ihes **e** nteises could have been too high compared to their futur earigs potential, and the fiids might have been better off choosing lowe pced shares. The ultimate test will be whether the pices of the sbais bought by the funds rie fister in the secondary market than other sbares. As other vestos realize that the funds wer able to pick undervaued shares, the prices of shares held by funds should ise bster than other shares.

2.7 The efforts of the funds in evaluating companies did help to bring about a more efficient market, and individual voucher holders receved in some sense a free ride on the efforf of teh funds. If the flmds did discover undervalued companies, these funds would rush to buy such sha and thus bid up their pnces. Similarly, the fiuds would avoid buying shares in overvalued companies thus forcing down their prices. The irony is that the effort of the fnds to find undervalued shares led to a more efficient market in which fewer shares we undervalued or overvalued.

2.8 As the voucher auctions became more wefflcientC due to the effrts of the funds, voucher holders who did not entrust ffieir vouchers to a fund could do remasonably wdl by pickdng shares simply at andor. In other words, individual investos could not make a sero mistake in buying shares no matter which shares they purchased because no shares were overvalued. All share prices rwghly reflected the future earnings potential of the companies than at least parially to the efforts of the fimds. Individual vwolher holders may not have bee able to invest in a diverified portfolio witiout transferring their vouchers to a fund, but they are unlikely to have paid an excessively hi price for tie shares they did purchase Thus it can be 0 Shafil (1993), p. 34.
R. Anderson 8 arguwed that all investo in the auctions wer trated with rough justice at least in part due to the effort of the funds to cvaluate Companies.<sup>7</sup> 2.9 lust as imporant as buying shares for the fund's portfolio is the selling of shams from the portfolio. The selling of shares by a fund allows the ownership of an enterpis to pass to another investor, for example, a forign company _opatng_ in the same industry, who may be better able to s vse and control the enteprise and thus ince its efficiency and profitability. This is sometimes called the market for corpoate control.

2.10 Those who oppose voucher pivaization ague that the government instead ought to sell an enterprise to larg fo or domestic investors who can bring both additional capil and expertise to the management of the enterprise. They argue that voucher funds have neither uthe purpose of this paper is not to evalua alternative types of voucher programs, the type of voucher auction used does unpact on whether the **resulting** market for shares is **"efficientw** and whether participants are aed fairly. The tpe of voucher auction used in the Czech and Slovak Republics had one fature that made it less likely to be "efficient and thus arguably detracted fmm the firness of the program. hi feature ws that the aucton method forced some voucher holders to invest in shares dtht wer overpriced and thus receved less value for their vouchers relative to other voucher holders. The general approach used in these auctions was to have multiple roads of bidding with prices adjusting fom rund to round to bring about a balance between supply and demand for the shares of each antprise. For exmple, if the in price for the share of an enterprise resulted in excess dmand, the prce was raised in subsequent rounds. Ihe exception to this general approach was that shares in some companies were sold at the current pnce even though they were under-subscribed. In these cases, the general view of the market was that the curet quoted price for these enteprises was too bigh and thus demand was less than supply. Those voucher holders, however, who did make an of.r at that price were forced to buy the shares at that price. The unsold shares were offered again t! later rounds at a lower price to attract more buyers. In these cases, the market was clearly not _efficienf_ since the e actually paid by some participants did not reflect all of the information about the enterprise avaHable to the other participants. Those who were forced to buy under-subscnibed and thus overvalued shares were in some sense not treated fairly.

The auction system used in Russia and some other counties is even less likely to approximate an effcient market and the inequities are even greater. This is becmse the Russian system sells enterpnses one by one independently of each other rather than simulteously as in the Czech and Slovak aucto. A bidder in a Russian auction has no way of knowing what the prices will be for shares in other enterpse or even what enteprs will eventally be offered for sale. In the Czech and Slovak auctions, a bidder codd evahate whether an enterprise was undervalued or overvalued compared to other enterprises and thus choose an enterprise that seemed to offer the best ratio of price to fiture earin potential. This is simply not possible in the Russian type of auction. Thus such an auction can not even remotely resemble an 'efficient" market, and the value of the shares purchased is likely tD vary much more from inividual to indda n in the Czech and Slovak auctions. Russian government officas recognized these theoretical weakness but chose that type of auction becmse of vaious practil cosiderations.
Voucher Funds in fth Transition Economies 9 capital nor expertise to carry out neededretuuin of th enterprise. Those who support voucher prvtzto, however, argue that the funds will be willing to sell their shares to a lare investor if the investor could do a better job of managing the enterprise. Voucher priatzatondoes not preclude the later sale by the funds to a large investor if such an investor is interested. The reason the vorhJer funds would be willing to sell is that the investr should be willng to pay an attractive price for the shares of the company. Because the investor has a better plan to improve efficiency and profitability, this investor can afford to py a higher price than now quoted on the stock market. Such sales should be encouraged because the overall efficiency of the economy would be improved.

# Corporate Governance

2.11 The thin andperhaps most important function of the funds isto governthose enptepise in which they own shares. Though the firs two functions of funds (portfolio diversification and selection) are iliportant, they primarily involve issues of equity or fairess, in other words, how individuals are treated in the, voucher auction system. Whether an individual can obtain a diversfifed portfolio or whether thevralue of his or her portfolio is high or low does not greaty affect the general functioning of the economy in general or enterprse in particular. 2.12 When voucher privatization was first proposed, the most seriou criticism was that it would not result in "good" owners who would take. an active interes in the future ef ficienc and profitability of enterprises. In particular, it was feared that shares of enterprise would be dispersed among millions of voucher holders who could not influence or control the enterprise that they owned. Though not anticipated in the initiakl planning for the Czech and Slovak voucher program, the spontaneous creaio of funds by privat individuals and insdtittions has at least partially elimninated this weaknes of voucher privatization. 2.13 Doubts about fthe effect ivenes of pxriately-sponsored funds in governing enterprse, however, have led some countries, most notably Poland, to creat government-sponsorefun **d** s. In these case, the government would choose the maaeetcompany for each fund, establish the terms of the maaeetcontract, and select the portfolio of enterpise that each fund would own. The goal is that the ownership of suck funds would be Iransferre eventually to the citizes of the country and thus be privatized.

## 3. Models of Corporate Govemance

3.1 The debate over the role of funds and whether privately-sponsored or government-sponsored funds are best in trasition economies stems in part from differences in views about the role of owners of large compxanies. To illustrate thee differences,, the following presents three different models for corporate, governance that are applicable to trAnsition economnies. Table 1 lists the thre models and the likely percentage of shares owned by fth largest investor in each model.
10 R. Anderson Table 1

# Dispersed Ownership

3.2 In the first model, ownership of l public corporations is widely dispersed wit no angle owner or even a coalition of owners having a stong voice in the goverance of the entprise. The largest mivdua shareholder has less than 10 percent vi the dojn shar and does not have a r tative on the govemance boards of the entrpises.

|ModelsofCorp<br>|orate Govenance<br>|
|---|---|
||Ownershipby<br>Largest Investor|
|Died|lesstIan10%|
||10 to50%|
|Holg<br>Company|51to100%|

3.3 Most lrge companies in the United Stat are example of dispased ownership. In the U.S., small individual investos own about half the hares. Though the other half the shares are owned by financ instituons such as mutual funds, peon funds, and insurance companes, each institution only owns a smal ftion of the shares in a partculr company. For example, the five largest sharholde in l-are U.S. companie typically own in total less tha five percent of all shares.' Thus, even the lagest shareholdes usually play a passive role in corporate govenance.

3.4 Government gulation and tax laws limit the ability of financial institutio to play an active role. For example in the United States, the GlassSteagall Act of 1933 and the Bank Holding Company Act of 1956 restrict bans firom owing share in entprises or sposoring mutnul funds. C ueny, the govenance board that offcially represents the intrest of shareholdes in U.S. companies (the Board of Directors) is often under the control of managemet and may only intervene m manemnat of _the_ ny n aordi circumstances. As opposed to direct pressure from the owners, indirect pressure on mangement o impre prnce comes from market competiton, the quoted stock maret pice, the threat of take overs, oveght by lenders such as banks, debt ratings by such institutions as Moodys and Stndard and Poors, and thret of bankruptcy.

3.5 It is q ble whe these indire pressures on management work well even in the United States. Complaints are often made that managers i the United States pay themselves excessive saries though their company is peforming badly, oppose a new own buying a controlling block of sh in teir company because they ar cncered about losing theirjobs (so call whostile taewers because existing management is hostile to the new owner), and squander the fnancial resources of the conmpany on new investments and expansio plans that increase the prestige and salaries of the manags but prvide a low rate of return to the shareholder. In any event, these _indirect_ pressures are even weaker i many transition economies, and thus the model of disprsed ownerhip is probably not well suied to these counuies.

i Brims, Buxaumm, and Hopt (1993), p. 28.
**Voucher Fwnds in the Transition Economies**

**1**

# **Institutional Ownership**

3.6 In thie second model, financial institutions such as banks, pension funds, or mutual funds are the dominant shareholders. Several of these institutions would each typically own somewhere betwee 10 and _50_ percent of the shares. Thbus they have an incentive to closely supervise and monitor the performance of maaeetand to demand representation on the goverance boards for that purpose.

3.7 This model is exemplified by Germany what the banks play a dominant role in corporate govenace. Gedran banks often control a large proportion of the shares of the largest enterprises.' The shares controlled by these banks consist of shares owned directly by the banks, sa held by the banks for individual ins vstors who purchased the shamr thoaugh the banks since banks are also the largest brokes in Germany, and shares i affiiated mutual funds. in the Czech and Slovak Republics, large banks are the sponsors of the largest voucher funds and thus probably can control the shares owned by these funds. 3.8 In spite of the general pattern of widespread and passive share ownership in the United S3tas, insitutional investors in that country have begun to play a lairger role n corporate goverance. This trend is sometimes called "relationshlp investing' because the large institutional shareholder wants to influence the manaers toDimprove the pormance of the company and thus enhance the return on the large shareholders investment in the company. The most cited exmple of such an institution is the Californiia Public Employees Retirement System (Calpers), a large public pension fund. Some mutal funds have also adopted this philosophy.1 3.9 Institutional owners monitor perorace, but are not themselves experts in the management of any particuWl business or industry. The owners review and approve business and financial plans for the enterpise prepared by managem but do not typically develop the plans or arage for financng themselves If the managers are incapable of developing appropiate plans and strateies for improving efdficiency and profitabiity, the response of the large instittionalowners typicaly would be to replace the managers rather man carry out the duties and responsibilities of the full-time managers.

# **Holding Companies**

3.10 The third model only iosts in a minority of companies in Wester countries, but seems to be the basis for proposals to create govemrment-sponsored funds. This model is the relationshipbetween a holding company and its closely held sub ies Other examples might For example, in 42 of the largest German companies, three bans cotol on avcrage 45 percent of the shares in these companies. ts Bums, Buxbaum, and Hopt (1993), p. v _75._ ob "Corporate Governance Survey," p. 16.
R. Anderson 12 include venture capital fimds and "turn-aroundw funds that specialize in providing management expertise and capital to improve the operations of enterprises in which the funds are the major owner. Ih ts model, the holding company would own at least 51 percent of the shares of the subsidiary and often much more.

3.11 The holding company plays a more direct and acdve role in the day-to-day management of the subsidiary. Representatives of the holding company may be the only members of the govemance boards of the subsidiaries. Managers from the holding company may transfer to positions in the subsidiary companies and vice versa. The subsidiary is expected to provide much more freuent and detailed reports to the holding company than would nonnally be provided to shareholders. The holding company provides maagement and technical expertise to help the subsidiary develop its business plan and improve its operations. The holding company reviews investunt decisions above a certain threshold and may also be responsible for raisin capital for the subsidiary.

3.12 Because the holding company owns most or aU of the shares of the subsidiary, it will reap most or all of the gains in efficiency and profitability of the subsidiary and thus has an incentive to devote a substantial amount of its own resources to improve the operation of the subsidiary. A holding company that owned a smaller percentage of the shares would find that increases in profits and dividends must be shared with other owners of the company. In other words, the other owners would be "free riders" on the efforts of the holding company. This would reduce the incentives for the holding company to devote a large amount of resources, such as scarce managerial talent, to improving the operation of the subsidiary. Also, a large ownership percentage helps to guarantee that the holding company can control the enterse and ensure that its restructuring plan is carried out.

3.13 Those who favor govemment-sponsored funds seem to support the third model of corporate goveance smilar to a holding company strucue with the funds acting like a holding company. In these cases, the government would determine the portfolio of each fimd, appoint the goverance boards for the fund, and select a management company for the fund. Management companies for the funds would be staffed by management and **financial** exrts drawn from intenational consulting firms who can take an active day-to-day involvement in the management of the companies and provide the manageial and technical expertise that may be lacking. Furthermore, a fee stucte would be established for the management companies that will give them a strong financial incentve to improve perfomance of the enteprises owned by the fimds. Supporters of govemment-sponsored funds doubt that private funds will ever have this expertise and insist that only the govemment has the resources to create such funds. Note that a particular fund should then own a large proportion of the shares of a particular enterprise (ceraly more than 50 percent) to create maximum incentives for the fund to invest resources in improving the operation of the enterprise.
13 Voucher Funds in the Transition Economies

**-**

3.14 As an examle, the mass program in Poland is centred on governmentsonsored funds. in this case, however, only 33 percent of the shares of a oDmpany will be owned by a single fund calied the "lead" fund with smaller amounts of share held by other funds. This seems to raise questions about whether the "lead" fund and its management company will have the necessary incentives to improve the efficiency and profitability of enterprises. Incentives may be reduced for the lead fund because over two-thirds of all increa in profits would accrue to other owners of the enterpise, creating a "free nder" problem.

# 4. Governance in the Czech and Slovak Republics

4.1 In the Czech and Slovak Republics, the funds initially assumed the fis model of disperd ownersip. The managers of these funds say that they modeled themselves after mutual funds in the United States and Westem Europe and were primarily interested only in providing a diversified and attactive portfolio of shares for the voucher holders. Some sponsors of funds following Western models even attempted to offer a family of funds, for example, a growth fund, an income fund, a small capitalization fund, sector fiurds, and so forth. Most fund managers did not have any plans initially to play an active role in the goveraace of enterprises.

4.2 These funds, however, realized that the situaton was different at the first annual meeting of the shholders and have adopted the second model of institutional ownership. They discovered that three or four fimds together typically owned a majority of shares in a partcu enterpise, and dtus they had the obligation to elect the members of the Supervisory and Msanagement Boards. Not surprisingly, the funds elected thir own rprsenives to sit on the boards. After tat, the representatives of the funds on the new boards had no choice but to suprvise and monitor the performance of management and to review and approve business and fiancial plans.

4.3 The funds in the Czech and Slovak Republics, however, have not yet adopted the third model of corporate govenance tpical of holding companies. In general, they have not tied tD become the day-to-day managers of the enterprises or take on the responsibility of isi capital fr restructuring or expansion. They have been forced to limit themselves to encourage edsting managers to improve opeations and, if necessary, to replace managers who have proven to be incapable. This may be because the funds simply do not have the expert staff or access to capital necessary to implement the third modeL Also, as discussed in more detail below, any single fund or group of funds with the same management company is prohibited from owning more than 20 percent of the shares of an enteprise, thus effectively prohibiing a fund from becoming a holding company. If any one fund spent substantial resources trying to improve the profitability of a particular enterpnse, the other owners would receive a large share of the benefit.
R. Anderson 14

# Govemance Boards

4.4 In all countries, the s lders of a company exercise their ownership nrghts through the annual meeting of shareholders at which they elect one or more boards thit meet regularly throughout the year. These boards have vaeious names depending on the country but are hereafter referred to collectively as "govrance boards.' The key to improved corporate governan.e is the role, functions, and composition of these boards. The struchtre of govema boards in de Czech and Slovak Republics seems to be different from most other countries.

4.5 A source of confusion in frying to understand the structure and memberip of these various govemance boards is the different uses of the term 'director of a company.' In the United States, companies have a single board which is called the Board of Directrs, and a member of the board is called a director of C:ie company. In Germany, the term director instead refers to a senior manager of the company, and the term Board of Directors means a board of senior managers. Thus, a Board of Directors in Gennany is similar to a senior management committee in the United States. To avoid this confusion, the term director hereafter is only used to refer to the members of the Board of Directors in the United States. Senior managers in all countries are simply called managers, and a board of managers is called a Management Board rather than a Board of Directors.

- 4.6 Also it is important to distinguish between four types of individuals who may sit on the governance boards in the Czech and Slovak Republics and other counres. These are: fi) dira. Thes are prominent figures in business or academia who are asked to resent dispersed shareholders. They are not managers or workers in the company

- and do not represent any particular owner or group of owners.

- ({i) mxor owners If particular owners such as funds own substantial blocks of shmaes, they can select individuals to sit on the govenance boards.

- (iii) managagr. Senior managers of the company can be members of certain governance boards depending on the law in each country.

- (iv) worker. Workers may sit on govemance boards as representatives of the employees of the company as a group or class depending on the law in each country.<sup>11</sup>

4.7 Because powerful interest groups such as major owners, managers, and workers may elect individuals to sit on the governance boards, it is sometimes assumed that they are the "'In those companies with substantial worker ownership of shares (for example, wESOP" companies in the United States), workers may also sit on the boards representing those workers who are shareholders rather than workers as a group or dass. In this latter case, such board members would be included in the second category listed above, namely, representatives of major owners.
Voucher Funds in the Transition Economies 1 5 reprsnatvsof those intret groups and their primary responsibility is to protect or promote the interest of those groups. This is analogous to a member of Parliamient who represen **t** s he interests of his or her constituency. Legally, however, a member of a governanice board is usually required to represent the collective interet of all shareholde **r** ather than any specifics shareholder or interet group. In some countries, shareholders can bring legal action against board memibers who violate this 'fiduciary' responsibility to promote the interest of all sharholdrs.Whether thius happens in practice is another matter. Thouigh this pape **r** efers to "reresnttivs"of major interest groups sitting on the governance boards, this is perhaps a misleading c-haracterization of their legal position on the boards.

4.8 To understand the- structure and functioning of governance boards in the Czech and Slovak Republics, it is useful to compare them with similar boards in Germany and the United States (see Table 2). The German and Czech/Slovak models are simiflar in that they have two governace boards while the United States has only one. The functions and composition of the two boards in the Czech/Slovak model, however, are subscantialy different from the German model,, and some argue that the Czech/Slovak model. more closely resembles the U.S. model because most power is concentrated in a single board.

Table 2

|Co<br>United States|mposition of Governanc<br>JGermany|e Boards<br>Czech and Slovak<br>Republics|
|---|---|---|
|Board of Directors<br>*<br>Outsiders<br>*<br>Managers|Supervisory<br>Board<br>*<br>Outsiders<br>*<br>Major Owners<br>0<br>Workers|Supervisory<br>Board<br>*<br>Outsiders<br>*<br>Workers|
||Management<br>Board<br>a<br>Managers|Management<br>Board<br>a<br>Major Owners<br>**S**<br>Managers|

4.9 In the U.S. model, the single governance board is the Board of Directors and is elected by the shareholders at the annual meeting. Large companies typically have a dispersed ownership structure with no single investor owning more tha a few percent of the total shares. Company maaeetplays a major role in selecting who will sit on this Board fthrgh its control over the voting process at the annual shareholders meeting. Not surprisingly, company managers prefer that they be elected to the Boad. Management also nomiates and recommends to the shareholders for their approval "outside" diremtrs who are not themselves managers of the company. It is argued that this results in a Board largely dominated and controlled by the incumbent managers of the company that often puts the self interest of the
16 R. Anderson manages ahead of the shareholders. Workers have no automatic right to have represenaves on the Board unless workers happen to be significant shareholders.

4.10 In the German model, representatives of shareholders and the managers sit on two separa boards. Shareholders are represented on the Supervisofy Board. Because lare German companies often have major holdes that own a large block of shares (most notably, bank), these shareholders elect their own representatives to sit on the Supervisoy Board along with outside members who represent tie many small shareholders. Under the German policy of 'co-determination," workers are allowed to elect ont-half of the Supervisory Board. The Supervisory Board 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. A case can be made that the German model is superior to the U.S. since esentaives of large solders dominate the Supevisory Board. This avoids the conflict of interest and confused objectives that seems to characterize the Boards of Direct in U.S. companes that are larely dominated by the managers of the company.

4.11 Like the German model, the Czech and Slovak model has two boards, but the representaives of the major shareholders in most but not all cDmpaies have chosen to sit on the Management Board rher _han_ The Supervory Board. The current _corpae_ law in these two countries appears tD pemt the shareholders at their annual meeting to elect members of both boards. Thus the shareholders of a Czech or Slovak company could choose to follow the German model and elect only managers to sit on the Management Board. listead, the shareholders (typically the voucher funds) in most companies have chosen to elect their own repreentatives to sit on the Management Board along with managers. Some managers and government officials have complained ffiat this was not the intent of the law.

4;2 ln this unique Czech and Slovak model, the Management Board is composed of representatives of the funds and senior managers though the proportion varies fwnm company to company. Because of the diference in composition between the boards in Czech/Slovak companis and German companies, the finctions and role of the two boards are also different. Both brad corporate policy and day-to-day implementation are the responsibility of the Management Board in most Czech and Slovak companies. This board typically meets monthly. In this regard, the Czech and Slovak companies are similar to U.S. companies were power is concentrated in a single board.

4.13 The Supervisory Board typically consists of two-thirds outsiders and one-third worker resenaives though sometimes the fimds have also elected their representaives to this board as well as the Mangement Board. This board typically represents the interest of smaller shaeholders and the workes and only meets every two to four months. One of its major functions is to appoint the accnting/audit firm for the company and to certify that the financial accounts of the company are true and accurate.
* Voucher Funds in fe Transition Economies<sup>-17</sup>

4.14 The fact that the funds chose to be represented on the Management Board ither than te Supe isDry Board suggests that they do wish to play an active and strong role in corporate governance and want to be involved in the management of the company. In this respect at least, the Czech and Slovak model is like the holding company model. When asked whether g representatves of major shareholders and managers on the Management Board niight cause the same conflict of interest and confused objectives as is argued to occur in U.S. companies, te response from funds was a clear 'no." The funds as major shareholders always maintain the upper hand over managers because they elect both boards at the annual meetng and thus can, if necesary, replace managers who are on the Management Board.

# Ownership Structure

4.15 The final structr of ownership of Czech and Slovak companies including the importance of funds cannot be known with certainty until privatization is complete in these counties. In the Czech Republic, this could be within a few months when the second wave of voucher privatization is completed. In the Slovak Republic, a second wave is not scheduled to begin unil the second half of this year. The Slovak Republic also intends to use more "standardw methods of prnvatizaton in which enterpises are sold for cash rather than for vouchers. In these, cas, the funds would not become the major owners of the enterpss.

4.16 Mjority ownership of an enterprise fgt. 2 by three or four funds is liklfy to be quite common in the Czech Republic and perhaps to a lesser extnt in the Slovak Republic (for an example, see Fig. 2). This patten is the result of two factors: <!-- Start of picture text --> TYPICAL COMPANY OWNERSHIP<br>2n Fund<br>20$<br>3rd FuLnd<br>1l%<br>Other Funds<br>16% Individuals<br>30%<br><!-- End of picture text -->

- about 70 percent or more of vouchers are likely to be entrusted to voucher funds; and

- current regulations in both countries do not permit a single fund to own more than 20 percent of the shares of an entrprise.

Because many fumds prefer to own the maxmum proportion of shares permtted, three or four funds are liklMy to each own near the maximum of 20 percent of shares with the balance split between other funds and individual shareholders, resulting in the pn of ownership illustrated in Fig. 2.

4.17 Similarly, the number and size of fiuds cannot be known with certainty until after privatzation is complete. After the first wave, the total number of funds was 264 in the Czech
18 H~~~~~~~~~~~~~~. Anderson R-epublic and 165 in the Slovak Republic. Though the riumber of funds was large, ten to twenity large funds dominate the industry. The first wave resulted in the ten larest funds in each country owning about 24 percent of the shares of all companies. Many of the largest funds were founded by the largest domestic banks in the two countries while **itie** others were founded by insurance companies, private individuals, and foreign banks.

4.18 I[n addition to the first restriction noted above that a fund (or group of related funds) cannot own more tha 20 percent of the shares of a particular enterprise, a second restriction is that afund cannot invest more than0 Opecet of its total assets in the shares of asingle company. These two quantitative restrictions on the portfolio of a fund are sometimes confused but have very different objectives. The first restriction limits the ability of a fuind (or group of related funds) to exercise control over a particular enterprise. Thins second restriction forces funds to own shares in at least ten different enterprises and thus havie a diversifie portfolio. For large funds, this ten percent limit was generally not binding, while the 20 pericent limit on ownership of the sLare of a single company was binding. A large fuind could own 20 percent of the shares of the largest companies, and yet these shares would not amount to more tha ten percent of the fund's total assets. For smaller funds, the ten percent rule could be binding and force such funds toinvest only in smaller companies if they wantecl to own the maximum of 2O percet of the share or else own a smaller percentage of the shaev.- in latrger compamies.

# Comparison with Otiher Countri'es

4.19 Perhaps more by chance than by design, the Czech and Slovak Republics have adopted a system of corporate governance that resembles the system in Germany more tha any other country. The ownership of enterprises in the Czech and Slovak Republics is dominated by a _few_ large financial institutions, namely, the voucher funds. Most of the lairgest funds were founded by the lairge banks. Thus, like bank in Germany, the banks and their affiliated funds in the Czech and Slovak Republics will play a major role in corporate governance.

4.20 Though no system of corporate governance is perfect, the Germian model based on strong institutional ownership may be the best for these two countries and perhaps for other transition economies as well. The U.S. model based on dispersed ownership has been subject to increasing criticismn because shareholders have few ways to minluence poorly performing managers. In such cases, the only option may be a 'hostile takeover" in which a large investor or consortium of investors attempts to buy a controlling block of shares and replace the current managers. Critics of the U.S. system argue tha laws should be changed to permit financial institutions, such as banlks and mutual funds, to play a larger role in corporate governance.

4.21 One important difference between the system of corporate governance in Germany and in the Czech and Slovak Republics is the role and composition of the MaaeetBoard. Representatives of the large institutional investors in the Czech and Slovak Republics (voucher funds) have chosen to sit on the MaaeetBoard while representatives of such investors mn Germany (typically large banks) sit on the Supervsory Board.
Voucher Funds in the Transition Economies 19 4.22 The Czech and Slovak model may be, an improvement over the German model. In Germany, the Supervisoy Board may not be able to adequately supervise and control the Mlanagement Board in ali cases for at least two reasns. First, because workers are represented on the Supervisory Board, managers and rpentivsof the large investors may be reluctant to discuss critical issues or to disclose key information to this board. Second, the Supervisory Board only meets a few times each year and thus may not give adequate attention to the detailed problems of the company. The weaknesses o)f the Supervisory Board in Gennany are illustrate by the recent finacial difficulties of Germany's 14th largest firm, MetaIlgeseflshaft. In this case, the Supervisory Board admitted that it was not aware of the financial problem of this company until it was almost bankrupL'<sup>2</sup> 4.23 Voucher funds in the Czech and Slovak have indicated a desire to play an active role in the maaeetof the company by choosing to be represented on the Management Board along with the managers of the company. In particular, given the need for major restructuring of enterprises in these countries, this active role by the voucher funmds should be encouraged. Thoughi mixing representatives of owners and managers on the Management Board may create some unforeseen difficulties, this type of board has long excisted in the United Sbtats where the Board of Diretor consists both of managers and representatives of shareholders.

# Experience to Date

4.24 How successful have the voucher funds been in governing the enterprises in the Czech and Slovak Republics? In other words, have the new owners brought about needed improvements in efficiecy and profitability of enterprise? Unfortunately, the answer **to** this important question is that it is probably too early to tell with any degree of certainty. The voucher flmds became the owners of the enterprises legally only after Apnil 1993 when the shares of the enteprpnses were distributed to the voucher holders who successfully bid for the shares. The firs annual meetings of shareholders of the companies typically occuured shortly afte the distribution of shares. It was at this first annual meeting tha the voucher funds could elect their .representatives to the governace boards of the enterprises and officially exercise their rights of ownership.'13

## **12M** "Crort Governance Survey" (1994), p. 14.

13Some funds did begin to) exercise their ownership rights in the fail of 1992 under the sponsorship of the National Property Fund (NPF). Until the shares were distributed to the funds and other new shareholders, the National Property Fund exercised the ownership rightL of the State. During this time, the NPF appointed board members for those enterprises included in the voucher privatization. The NPW chose to take a passive role and ap.pointed rpentivsof the voucher funds who had purchased shares in the enterprises in the voucher auctions to sit on the boards of enterprises as early as the fallofl1992, even though the voucher funds were not yet technically the owners.
R. Anderson 20 4.25 Funds have varous policies about who will represent them on the boards of enteprises. The management company for a large fund may have something like 50 employees and have r1ep atives on 90 or more boards. Funds may also appoint non-employees to sit on the boards to supplement their own employees. Attending board meetings is an important and time consuming acdvity for the fund's employees. Most companies pay a fee to board members for each meeting attended. The typical fee is between 2,000 and 5,000 crowns in either the Czeh or Slovak Republics (roughly $64 to $160 at the current exchange zates). This fee is kept by the board memnbe **r** ather than the fund and, in effect, helps to pay the salaries of fund employees. Some companies complained that some board members wanted to increase the number of metings to increase their fees. Others said that at least one fund had tried to ase the fees paid to board members.

4.26 The quality and experience of board members no doubt vary considerably. On the one hand, a fimd sponsored by a foreign bank claimed that its board members were expeienced busiessmen and could make substantial contributions to the management of the enterpnses. On the otier hand, some managers complained about the board representatives from the fimds founded by large domestic banks. These bank funds often appointed local bank branch managers to sit on the boards. One complaint was that they contributed litde to the management of the company and were only interested in receiving the fee paid to board members. Another complaint was that some board members sit on too many boards. It is argued that they do this only to collect the fees and are unable to give adequate time and effort to each board.

4.27 One concern of some fund managers is the govenment requirement that a fund may not own more than 20 percent of the shares of a single company. They argue that this creates difficulties in supervisng and controlling managers and selling a controlling block of shares to an outside investor. The fumds that own large blocks of shares in the company must agree on major changes in the management of the company. In effect, a single fund can often veto and block these changes. Similarly an outside investor who wishes to buy a controlling block of shares, say more than 51 percent, must negofiate and reach agreemne with several funds. Bach may be a holdout with unrealistic demands for a high price for its shares in the company.

4.28 Discussions with fund managers suggest that their activities to improve governance and etrucstu enterprises can be divided into three categones. These are:

- eliminating fraud and self dealing by managers. A common complaint in aU transition economies is that the managers of some enterprses have schemed to transfer the assets of the enterprises to themselves or to benefit unfairly at the expense of the future private owners of the enterprises. This is sometimes called 'spontaneous privatization." For example, one scheme allegedly used by managers of a Stae-owned company is to create a pivate company owned by the managers perhaps with a foreign partner and then enter into contracts with fte Sate-owned company that unfirly enriches the pnvate company. The fumds say th they have been able to stop most such schemes by the managers and in effect preserve the assets of the entrise for the new owners.
*Voucher Funds In the Transition Economies-

21 lo0otef ftbliyio mns .aV The funds say that they initialy have emphasized low-cost imprvments in the operations of the companies. Contray to the belief held by some, the funds argue that much restructuring can be carried out without larg new investmnents. These include reducing the work force,, closing unprofitable facilities, improved marketing efforts, and increased attention to quality. Though the funds say that they are promoting such low-cot efficiency improvements, there is mixed evidence that former State-Owed enterprises now under the control of funds are in fact reducing the size of their work forces. The unemployment rate in the Czech Republic is remakably low, about thre percet, in spite of the common belief that Czech enterprise previously had substantial surplus workers that were not needed. This suggests that enterprises have not been reducing the size of their work forces. Other argue that the booming private sector has hired most of the workers that have been fired by the former State-owned enterprises thus keeping unemployment low. There does not seem any clar answer to this question.

- highsa-Lcstremctring, Until the managers have shown that they can introduce the low-cost efficiency improvements, some funds are unwilling to consider large new investmnents for modernization and expansion. Also the low-cost efficiency improvements will generate additional cash flow that can help to finace the high cost improvements. The funds themselves, however, typically do not have any special access to capital for large new investments. They can only encourage the enterprises to increase internal cash flow and to seek funds from traditional sources such as bank loans.

4.29 Sometimes, fth funds have forced companies to remove corrupt or incompetent manaers.There are at least two reasons, however, why funds have refrimned in most cases from replaidng managers:

- The firs reason is that there is a general shortage of managers with the necessary training and experience. This is not surprising since the managers of enterprises in these countries though usually highly intellient and hard working may have little experiece with the operations of a miarket economy. Thus the flmds say that it is often better to help the existing managers improve their skils rather tha try to find replacements which may not have the necessary skills either. It must also be Doted that fund managers are also likely to be inexperienced and lackng in skills. Just like enterprise managers, fund nmaagers must improve their skils and knowledge of the operations of a market economy.

* The second reasn is that there may be some political or public pressure not to remove managers. In general, there is political opposition to large powerful funds, and the funds may be reluctant to take steps that are unpopular though necessary for the long term improvement of the economy, for example, replacng managers or reducing the work force of an enterprise. One fund manager suggested thiat after the second wave of voucher privatization is completed, the funds may be more wilg to replace managers
R. Anderson 22 and make other major changes in the operations of the companies, including reducing the work force.

4.30 Though only a few enterprise managers were intrviewed, they in general seemed to favor the role of funds as the new owners of enterprises. Some managers felt tht the enterprises were unable to take action to improve their situation during the privatization process and while under Sta-ownership. Only now with prvate owners do the managers feel free to make major changes in their companies. They are reieved to be able to propose new plans to their new owners and obtain approval and autorizion from them to carry out those plans.

4.31 This is not to say, however, that there are no complaints about the role of the funds in corporate governance. Criticism of the role of funds is more pronounced among government officials and others in Slovalda. This may result from the belief of some Slovamans that voucher privatization and the voucher funds were created by Czechs in the former combined Republic and imposed upon Slovakia. Some argue that the managers of the new voucher funds are not good owners of enterprises. They are described as 'cowboy" capitlists who made unrealistic promises to vouciSer holders, will sell shares in the newly privafized companies at low prices to foreigners to raise cash to fulfill these promises, are only intrested in short-term profit at the expense of the long-term development of the economy, and have no capital or expertise to contribute to restructuring of enterpris. In addition, most large funds were created by banks and further increase what some view as the already excessve economic power of banks over enterprises. Other funds were created by managers of enterprises to buy shares in their own enterprs and thus limit outside control. Some managers of enterprises are complaining about the interference of the funds in their management of the companies, believe that managers are best qualified to be the new private owners, and thus favor privatzation programs that give managers and workers majority ownership.

4.32 As noted above in par. 2.9, an important function of the voucher funds is to sell their shares to another investor, for example a foreign company, if that mvestor is likely to have a better plan for the management of a company. In practice, there seems to have bem few examples thus far of the funds in the Czech and Slovak Republics selling a controlling block of shares to a new investor who wanted **to** take over the management of an enterprise. Several reasons have been given for this including:

- few investors have been interested in purchasing an existing Czech or Slovak company. Instead they have preferred either to start a new company or to form a joint ventre with an existing company;

- the funds have unrealistic expectations as to the value of the enterise shares and believe tat they can do as good ajob as the outside investor in improving the efficiency and profitability of the company;
Voucher Funds in the Transition Economies 23

- the price for shares, in particular, in the Czech Republic, have rise to high levels on the stock market, and investors are unwiling to match these prices; and

- investors find it difficult to arrange a purchase of a company because the ownership is spread among thre or four voucher funds plus many small owners. In particular, the funds cannot agree among themselves whether to sell..

4.33 One issue is the guarantees or promises tha some funds made to voucher holders to convince tern to become shareholders in the funds. The most notable examnple was the Harvard Fund that promised that a share in the fund would be worth ten times the registration fee, charged by the government for a voucher. This fund was the first large fund to be established, and some say that its success in attracting members was a major factor in the popularity of funds and encouraging citizens to participate in the voucher program. Some other funds made pronmie of various type as well. Initially there was some concern about the impact of these promises, for example, would the fuinds have to sell share in their portfolio to raise cash to honor thei promises. The feeling among government of ficias and fund managers now is that these promises or guarantees are not a serious problem. At least in part, this is due to the high price of enterprise shares on fth secondary market, in particular, in the Czech Republic, and thus the high value of fund shares compared with the value guaranteed or promised by the funds.

# 5. Three Enterprise Case Studies

_5.1_ The following gives thre examples of how enterprises in the Czech Republic largely owned by the voucher funds are governed and the success to date of the new owners in imprvingefficiency and profitability. The examples include a successful company, an average company, and a faiing company. These enterprises are now predominately owned by funds but are still partialy owned by the State (shares are typically held by the National Property Fund).

# Successful Company

_5.2_ Beginning in 1959, the former Czechoslovakida owned an ocean shipping company called Czechoslovak Ocepan Shipping. It curretly has about 18 ships transprting cargo all over the world and a labor force of about 1,000. In the first wave of voucher prvtzain four funds ended up owning more tha _50_ percent of the company. About 30 percent of the company is still owned by a special Stat holding company called HNOP though this is likly to be sold to private nvesto. _5.3_ This company can be called successful but not because of the efforts of the currnt owneurs. In contrast to most other entmprises in the Czech and Slovak Repubics, ts company has always operated on cmercial principles and had to compexte with many other private ocean shipping companes. It was sucessful because Czech crews were low cost but had a
**24**

R. **Anderson** reputatin for high quality. It had access to loans from foreign sources because the ships could be used as collateraL This company does not suffer to the same eaxtat as other Czech companies from the current recession in the Czech economy since its customers are from many countijes. It does not have significant surplus labor, and no major restuturing is required.

5.4 The only complaint by the managers is that the funds do not understand the ocean shipping business though there are no major conflicts between the owners and the managers. ITe Management board plays the major role in corporate govemance and meets once a month. it is composed of the Managig Diector of the company, representatives of the four fimds, and a representative of FINOP. According to mnaers, the fimd representatives tend to emphasize short-term gains i efficiency and profitability while the managers tend to emphasize long-tem growth and qpansion. The Supervisory Board consists of two employees and a represtie of FINOP. Is primary functions are to approve the financial statments of the company and the dvidend payout

# **Average Company**

5.5 An example of- an average company is Stavomont PiAa, a constuction company specalizing in fitting out office buildings. It was split from a large construction conglomerate in 1990. Managers and employees had hopes that they could purchase the entrprise, but in the end it was scld primarily to the voucher funds. Thre large funds own about 52 percent of the sha with the balance splt among other funds, the workers, individual ivetors, and te Natonal Property Fund. The employees ended up owning 13 percent. The National Property Fund only owns 10 percent, and this is likely to be sold in the second wave of voucher _5.6_ The Maagement Board is dominnt and is composed of rpresentatives of the three fuds, the General Drectr, and the Prduction Director. It meets once a month. The Supeviory Board is composed of an employee representative, representatives of two of the large funds, and a well-known professor of economics. It meets eight times a year (about every six weeks).

5.7 The company faces increased competiftion from other former State-owned enterprises and new private companies. In partcular, competiton is intense from companies that use low-wage foreg wors from such counties as the Ukraine and Rumania. It has sold some of its prouction facties and reduced its work force from 1,200 to **_550._** 'he fund rsentives on ffie Mnagement Board have approved and encouraged th restucturing, and there are no major conflicts between the managers and the owners. With good management, this company is likely to survive even in the fice of increased competiton.
25 Voucher Funds in the Transition Economies

# Faling Company

_5.8_ Tesla Karlin is an example of a company that must dstdcally downsize and may evenually cease to opeate because of fundametal changes in the Czech econmy and its trading relationships wiLth other countries. This company was once part of the lirge telecommunications conglomeate in Czechoslovakia, and it specializes in the manufacure of telephone switching equipment.

5.9 Before the break up of the former Eastrn European tading block, this company was one of just a few companies that supplied telehone switching equipment for the entire Eastern block and was considered one of the most technologically advanced companies in ffie region. It was unable, however, to keep up with the latest advances in switching technology because it did not have access to the more modem Western microprocessors that are at the heart of modem digital telephone switches. As a result when the telephone switching market in the Eastern block countries was opened to foign competition, Tesla could not compete with Siemens, Alcatel, and other Western companies.

5.10 The company may survive for a few years due to a joint venture partrship with Siemens. When Siemens was given a contract to supply digital switches for the Czech telephone network, it was required to carry out some -nufcring localy and thus formed the joint venture with Tesla After the end of the current contract, however, the joint ventue will end, and Tesla vill not be able to compete in the market for digil switches. Tesla pmbably can confinue to produce certain anclary equipment for switches or replacement equipment for older switches, but this wili require a much smaller work force.

5.11 Not srprisingly, Tesla was not consider an attactive company in voucher pratizadon. Funds only purchased 31 percent of its shares but still ended up controlling the company. The National Property Fund still owns 20 percent with the balance held by small investors. The dominant Management Board consists of presentatives from the three largest finds, the Geneal Director of the company, the Finance Directr, a rpresentative of the joint venture company, and a repxesentative of the National Pperty Fund. It meets monthly. The Supevisory Board consists of two workes, two representatives of the smaller funds, and two outsiders esenting the individual shareholders. It only meets twice a year.

5.12 The Management Board asked for and received a buiess and financial plan to deal with the necessary findamental restucuing of the company. With Board approval, the company plans to reduce staff from 1,400 to 1,000 by the end of 1993 and fiuther reductions are likly. The managers seemed happy wnth the quality of the rpresettives on the Board. The representative of a fund founded by a large Czech bank is the former branch manager for that bank that primarily dealt with the company. In contrast to complaints from some managers of other companes about local bank managers, the managers of Tesla believe that this board rresentative is familiar with the company and is an effective member of the board. The
R. Anderson 26 representative of a fund founded by a foreiga bank is a Czech citizen with cnsiderable Westem business experience who has provided advice on the restructuing of the company.

# 6. Undesirable Fund Behavior

6.1 Perhaps the key policy issue for countries with a voucher privaizaton program is the regulatory ftamework for funds. Even if the government does not wish to see funds established, it is very difficult to stop millions of citizens from forming organizations of various kinds to pool their vouchers if they see a benefit from doing so. Such a pooling of vouchers could be done by exsting companies, members of an extended family, groups in the work place, private clubs, and so forth. Thus recognizing that privately-sponsored funds will be created, the best policy is to put in place a regulatoxy framework to mitigate any adverse impacts of their opeatons and **to** accenuate their positive contributions.

6.2 One option for a regulatory framework is to treat funds like all other corporatos. in other words, whate regulatory framework is set up for corporations would also apply **to** voucher funds. In Western countries, the regulatory framework for mutual funds and fr corporations are similar. Thus, the analysis below of the appropriate regulatory framework fa voucher funds also largely applies to all corporations.

6.3 Before discussing a regulaty fiamework, it is desirable to explicidy identify the tpes of fund activities or behavior ftiat are harmful to the operation of the economy and thus which may need to be controled through regulation. Too often discussions of prposed regulations do not identify the behavior that the regulation is meant to controL In many tansitio economies, vague complaints and concems are expressed about the opeation of fimds, but little analysis has been made as to whether these concerns are valid and justify regulation.

6.4 Much of the concern about the new fimds is the result of suspicion of any new powerful oganizaton that may control vast economic remsources. Funds are a new idea to the govemmess and citi of transiton economues, and they are concerned about the potental economic or political power of the funds. After having thomwn off the yoke of Communist central planning, citzens may be worred that their economic future is now in the hands of a few large fimds over which they have no controL This suspicion of concentatons of economic power and weal als has a long traditon in Westn countnes leading to "populist movementsW tha demanded the government control and regulate holding companes, combines, trusts, and other -malefactors of great wealth. " 6.5 The essence of a market economy, however. is that apparent economic power is greatly limited by competition. Huge seemingly powerful organizations such as General Mots or IBM have been humbled by competitive preures. Ownership of large economic ruces does not necessarily transate into econonic power if markets are competidve. Furthermore, the funds need to have the power necessary to exercise control over the managers of enterprises
Voucher Funds in the Transition Economies 27 if the funds are going **to** play a useful role in corporAte governanice and the rsucrigand modenizaionof enteirises in thec transition economies. Eliminatinig the power, of flmds ove the enterprises out of vague concerns about undesirable concenwtratons of economic, power could crpple the of the trnsition economics for years to come.

# Monopolization

_6.6_ Voucher funds may engage in four types of undesirble behavior that might justify goverment regulation. The firs _is_ monpoiztion. A single fund may obtain an influential or controlling ownership interest in two or more enterprises in the same industry or **markt** The fund could then influence the two entrprises **to** cooperate in settg prices instead of competing. This increased market concentration could lead to reduced competition, and higher prices.

# Shirking

6.7 The second type of undesirable behavior is shirking. Managers of funds including thie management companies may shirk their responsibilities toinremas the vaule of the finds ansts on behaf of the sharholders of the fund - in ote words, they simply do not try very hard. The nee company has been hired to cairy out the tee fntctions noted above beginning on pamp 2.1 (providing a diversified portfolio, picing unearvalued companies, and corp governancei). Instead, the maaeetcompany may simply be content **to** receve a management feeo frm the fund but devote few resources to mprng the manam of the fund's portfolio.

v8 As a comparison, shirking by managers of lArge companiei **s** argued **to** be a serious problem in both Weste and transitin economies and is the basic reas some argue that the system of goverace of iarge companies needs to be improved. As major owner it of companies, the funds in transition economies can play an important role in improving nihe governance of companies. The problem, however, is the goverMance of the funds themselves to assure that fund maneolrs are performing to their iarximm potential. Thus, the introduction of voucher f-nds nm trannstion economies may oly have shifted the problem of corporate governance from the companires to the new funds.

6.9 A key issue is what government regultions can be put in pae **mto** improve the incendivs for fund managers to, better manage the fund. As a starting point, what are the likely incentives for fund managers to work hard to impiove the of the fund? There are at least thre incentives: * the management company receives a fee usually stited as a percentage of the value of the fud's ases. I the manageme company can increase the value of the fumd's assets, its fee increases. A management company can do this i at leas **t** wo ways: (d ) buying shar in undervalued companies whose pinces wll inse when other investors
R. Anderson 28realize the true value of these companies; and (ii) working to improve the performance of the companies in which the find owns shares and thus increasing the value of those shams. The second of these two ways is the most important for the improved performance of the economy and thus should be encouraged by government polcies and regulons; O thie fund shareholders at the annual meeting of shareholders can elect a different Supervisory or Management Board if the shareholders are dissatisfied with the performance of the fund. These boards then have complete legal authority to replace a poorly performing management company with another company that they think will perform bet. Though the many shareholders in the large fimds may find it difficult to orgai effective opposition to ffie current fund managers and elect a different Supervisory or Management Board, this is a risk that the management company must face if it is peroring poory; and

* the management company will wish to improve its reputation as a good manager of funds. If it develops a good reputation, the company may be asled to manage other m funds or it may be successful establishing new funds that attract many investors.

# Self Dealing

6.10 The third type of undesale behavior is self dealing. Even **worse** dtan shirking by the fund managers is if they use their contol over the fund's assets to enrich themselves or promote the interests of individuals or organizations other than the shareholders of the fund. This type of behavior can be termed self dealing, conflict of interest, or outright faud. Any acivity of the fund's managers should have only one objective, namely, promoting the interest of the fund's shareholders.

**S.II** As a compason, managers of enterpises in the tanion economies have often been accused of such self dealing, and thus it is argued that the enterprises need strong owners who can control this behavior. The funds can be these stog owners. Ihe problem, however, is what will stop the managers of the funds from egaging in the same type of behavior that the managers of the enterpises have been accused of in the past? Conflicts of intrest or self dealing may occur between the fund managers, the management company, the sponsor of the fund (for example, a bank), and the companies owned by the fund.

6.12 An example of self dealing might be if the fund managers sell shares at an un ably low pnrce or buys shares at a high price. The purpose of such transacons might be to benefit the sponsor of the fund, the management company or its employees, or other affiliated companies. in such transactions, the shareholders of the fund are harmed because the value of their portfolio of hiares is reduced.
Voucher Funds in the Transition Economies 29 6.13 The major problem in identifying and controlling this tYpe of behavior is defining what is meant by an unreasoably **"low"U** price or "high' price. For examnple, when a fund SellS any shares from its portfolio, it is always subject to the criticism that the price would have gone up in the future and thus the fond sold too early. This type of decision, however, is not the type of behavior that is of concer since the fund maaeetmust always make decisions about when is the right time to buy or sell share. What is of concern is if the fuind managers sell the shares to a favored buyer for less tha the fund could receive from another buyer or pay more to a favored seller that they would have to pay to another seller.

6.14 As a second example of self dealing, regulatry authorities in the United States have recently raise concern about fund managers using the fund's immense fiancial resources to manpultethe prices'of shares owned by the managers themselves. If a lairge fund decides to buy shares of a particular enterprise, this could cause the share price to rise, If the fund managers persnally own shares in thius enterpris in addition to shares owned by the fund, they could use iLcf ability to control the fund to raise the price of these shares for their own benefit 6.15 An example of an alleged conffict of interest is that large funds in the Czech and Slovak Republics are controlle by the large banks. Thus banks are major lenders to an enterprise and probably can control the maaeetof the enterprise through their control of the funds. It is argued that the banks may freenterprises to adopt polices that benefit themselves as the lenders rather tha benefit the fund shareholders. For eammple, a fund under the control of a bank might insist that an enterprise only borrow from the bank and on terms favorable to the bank- Of course, this situation also exsts in Germany where banks are both lenders and major sharholersof latrge enterprises. A further complication is tha the funds founded by the banks are also owners of shares in the banks. Bank control of funds could become a way for bank managers to stop any outside investors from controlling the banks.

6.16 A second example of conflict of interest is the concern in Russia that managers of large enterprises or industry associations may establish funds for the sole puirpose of controlling their own enterprise or industry. The managers may be able to force workers in their enterpris to turn over thei vouchers to funds created by the managers or even use enterprise capital to buy vouchers.

# High Risk Investments

6.17 The fourth typ of undesirble behavior by funds is making high nisk investments. MAanagers of funds may have incentives to engage i nrsky investment strategies that are not in the interest of :fund shareholders. It is difficult **to** see, however, why -fund managers would have a greater incentive to engage in high risk investments compared to the fundshrole. it is conceivable that such incentives may arise from the system frLr compensating or rewarding the maaeetcompanies. If a compensation system rewards a Large increase in the value of the fund's portfolio but does not equally penaize a large decrease, then the mngmn
R. Anderson 30 companies may choose a high risk investment strategy causing the value of the fund's assets to fluctuate greatly.

6.18 In the Czech and Slovak Republcs, for example, the compensation for the management company is set equal to a fixed percentage of the value of the assets of the fund, typically, one to two percent. Thus if the value of the fund's assets rise, the management company benefits proportionately. If the value fills, the magemet company suffers prortionately. With this kind of compensaion system, the management company would have no reason to prefer highly risky investments. Though regulatory authrities in many countries try to prohibit funds from engagig in high risk investments, it is not clear that there is a great need for such regulation.

# 7. Options for Regulation

7.1 There are many posible reguatory options for controlling or limiting the four ps of undesirble behavior desczibed above. Table 3 provides a list of 27 options including those that are sometmes used in Western countnes (shown i _italcs_ in the table) and others that have been prposed for transition economies. The table also shows the paagraph number of this report in which that option is discussed in more detail. The fact that many regulations have been prposed does not necessarly mean that detailed and compLcated regulation of funds is desirable. As discussed in more detail below, it is probably best that the regulation of fuids be _kept_ simple until experience shows which regulations may be needed. Many of these options may aldy be included in the corporate law governing the strucure and operations of all coports. The followmg discusses these options and how they might be applicable to tniton eonomies with funds.

- 7.2 These regulatory options can be divided into five broad types:

- regulaio a promote competition;

- regulatons that require greater ifomation dislosure so that fund shareholders can better monitor and control the performance of fumd managers;

- regulations ta give fund shareholders greater rights and powers in the goverance of the funds;

- reguations that limit or control certain undesirable operations and activities of the funds; and

- regulations that limit the investments that a fund can make.
31 Voucher Funds in the Transition Economies

***-t :- -**

Table 3

||RegultoryOptions|
|---|---|
|Undesirable<br>Behavior|Possible Regulation<br>_(Ialics_indicates reVlation sometim used in Westen countries.)|
|Monopolizatio<br>_______|n 1._appymergerlaow tofinlds (seepara.7.4)_<br>_2. lmIxt fund ownrship to 5% of company_(pam_7.6)_<br>_3. linits on total sue of afld_<br>_ra 7.7)_|
|_Shirking_|_4. disclosure of auted financial results (an_<br>_7.11)_<br>_5. shareholde_**_r_**_ighs, eg. proceduresforprxy solitions_<br>_(para 7.23)_<br>6. incentive contracts with management companies (para. 7.31)<br>7. selection of management company and contact must be approved at anmnal<br>meeting of shareholders (para. 7.26)<br>S. management fees paid in fimd shares with no resale for fixed period (para.<br>7.31)<br>9. require funds to be "open ended" (para. 7.18)<br>10. require funds to be corporations rather dan unit trusts (para 7.20)<br>11.minimumcapital requirements (para. 7.29)|
|Self Dealing,<br>Conflict of<br>Interst, or<br>Fraud|_12. limits on managementfes (para_731)<br>_13. separate cgstody offind assets (para. 7.29)_<br>_14. audits offinncia_<br>__tas_<br>_(para. 7.11)_<br>_15. disdosure of ownership connecions betuwe sponsor, management_<br>_company, f;id, and enterprises (para. 7.12)_<br>_16. disclosure of all commercd_**_a_**_l greements between sponsor, mangeme_<br>_conpany, fimd. and nteprises (para 7.12)_<br>17. disdosure of prices paid and received for sales of shares in fimd portfolio<br>_par._7.13)<br>18. prohibition against sale of shares at below current "market price" or<br>purchase at above current "market price" (part. 7.32)<br>_19._restrictions on who can sit on governance boards (para. 7.24)<br>20. prohibition of certain ownership connections, e.g. banks may not be<br>owners of management companies or funds may not own sharesin<br>management companies/sponsors (pan. 7.33)<br>21. prohibition of commercial agreements, e.g. between management company<br>and enterprses owned by fund (para 7.36)<br>22. limit on percent ownership of an entprise by a fund, e.g. 20% (par.<br>7.38)|
|High Risk<br>Investments|_23. discdosure of iesmen_<br>_stagy_<br>_tara. 7.14)_<br>_24. shareholder approval of changes in invsmnen strategy (para 7-26)_<br>_25. limits onfwzd borrowing or leverage &ara. 7.37)_<br>_26. ni,r&_<br>_onpercent of fud assets investd in single entrprise, e.g. 5% Oara._<br>_737)_<br>_27. lImits on investment in risky assets (para. 7.37)_|
R. Anderson 32 The following discusses each of these types of regulations and how they reduce one or more of the four kdnds of undesirable behavior.

# Promote Competition

7.3 Funds should not become vehicles for creating monopolies or engage in anti-competitive behavior that results in high monopoly prices paid by consumers. In partcular, this may occur if a fund owns a significant shareolding in two or more companies selling similar products in the same markeL As an influental owner, the fund can direct the two companies to charge higher prices and avoid price competiion. In effect, the common ownership by the fund can amount to a merger between the two companes and ajoint business and pricing strategy. If the two enterpris together only **_accwt_** for a smal share of the market (including imports if the product or service can be imported), such a merger would not significantly reduce competiton and is thus of little concern.

7.4 Such a merger via a fumd is no different, however, from other types of mergers (for example, one company buying aU or part of another company, or two companies joining to form a combined third company). Government laws and regulations dealing with mergers or other anti-competitive behavior should also apply to activities of funds. If the competition laws of the country are soundly constructed, there should be no need for special laws or regulations applicable only to funds.

7.5 For example, many countries require two or more companis that are planning to merge to notify the anti-monopoly agency and obtain advance approval from that agency if the merger would significantly reduce competition. Two companies are considered to have merged if a hird company such as a fimd has purchased shares in the first two companies sufficient to give it influence over their business activities. Naturally, the merger or competiton law in a particular country has to define how large a shareholding must be before the fund is consdered to have influence over the business activities of the companies in its portfolio, but this definition should apply equally to a flmd or any other company buying shares in another company. For example, if a fund purchases more than five percent or more of the shares in two companies operating in the same mark then this could be considered a merger and subject to reviw by the anti-monopoly agency.

7.6 This concern about funds reducing competition could also be dealt with by prohibiting a fund from owning more han asmall fiacon of the shares in any company, say up to five percent. As a result, a fund has no influence over any enterprise and thus cannot engage in anti-competitive activities. Though such a restiction might be effective from a competition policy point of view, it would elimate any positive role that funds could play in corporate governanoe and improving the efficiency and profitability of enterprises. Such a draconian provision is not necessary if the government has an effective merger policy that applies to funds as well as other enterprises.
Voucher Funds in the Transition Economies 33 7.7 Beyond encouraging competition among enterprises, regulations may also encourage competiion among funds. An option to promote competition among funds is to limit the total size of a fund. In the Czech and Slovak Republics, a fund or group of related funds may not own more than ten percent of all the shares held by funds. Such a restriction may promote competition in the- market for fund services or in the fund industry. Voucher funds make up an industry just like any other industry providing services to consumers. Such a restriction would ensure that no single fund obtains a monopoly in this industry and that at least ten funds must exist One problem with such a regulation, however, is its enforcement For example, how does one fund know the total value of shares held by all other funds. What happens if a fund is very popular among voucher holders and thus the fund violates this regulation -because it is given too many vouchers? Should the fimd stop accepting vouchers and tun away new members?

# Require Greater Disdosure

7.8 Perhaps the most widdy used regulatory option is to require funds (as well as other corporations) to disclose information about their operations. The objective is to give fund shareholders adequate information so that they can judge the performance of the fund managemeat If current shareholders are dissatisfied with the performance, they can elect a different Board of Supervisors or Management Board at the next annual meeting of solders that in tun can select a new management company. This presumes, however, that the current management is not able to control or manipulate the voting at the annual meeting and that the widdly dispersed shareholdes take enough interest in the operation of the fund to vote at the annual meeting. If adequate information is disclosed, potential new shaholders that are hnkidng of investing in a pardcular fund can also evaluate and compare past performance and mivestmens rtge **t** of one fund against another.

7.9 This type of liberal or "light handed" regulation is probably the least contrversi because it does not limit or control the management and investment strategy of the fund as long as the shareholders approve of that strategy. The philosophy s that fands can adopt any strategy as long as they fully and honestly disclose this to their shareholders. The cost of compliance with this type of regulation is not large being merely the cost of gatherig and pblishing the required information about the fund's operations. Govemment regulators do not impose their own judgement about how funds should be managed and let fund shareholders and market forces deenine successful strategies. 14 7.10 Disclosure regulahons can go at least part way to controlling three out of the four types of undesirable behavior on the part of funds (see Table 3). Disclosure by itself is not adequate "4Even this type of regulation has been criticized, however, as imposing unnecesary costs on companies **and fimds** and beneffitng **special** interest groups (brokers **and** dealers) at the expense of the shareholders. _Se_ Phillips and Zecher (1981).
R. Anderson 34.

to contol monopolizn by funds. In this case, shareholdes of a fund have no incentive to stop fund managers from engaging in tds ype of behavior since it increases profits for the fund and the shareholders rather than reducing them. The government must intvene to control his type of behavior as discussed above in para 7.3.

7.11 Regulations can require the disclosure of a variety of information about a fund's activities. Disclosure of past financial results in tie form of balance sheets, profit and loss statements, change in portfolio of shares held, and so forth can give eholders infonation about the funds operations, discourage shirking by fund managers, and create inctives for better peformance. Requirements to provide financial statements audited by approved accounting companies can also help to discover fraud or self dealing.

7.12 Disclosure of any ownership connections, commercial agreements, or business deaings between the management company, the sponsor, the fimd itself, and entepises owned by the fund reveals potential conflicts of interest that can lead to self dealing or even fraud. If such conflicts of interest are a serious problem then the shareholders can change the fund management at the next annual meeting.

7.13 In parficular, a fund could be required to disclose the prices paid for shars or receved from the sale of shares. This would help to eliminate the possibility that a fund was selling its shares for an excessively low price or buying shares at a high - since these prices could then be compared with other prices paid for the same shares at the same tme. In geneal it would not be necessary to disclose the other party to the sale unless that party was affiliatd in some way with the management company or the founder of the fund. Such transadons should be given special scrutiny to guard against self dealing.

7.14 Disclosure of a fund's investnent strategy can limit high risk investments not acceptable to the fund's shareholdes. For example, the fund should dsclose whether it will have a diversified portfolio or invest in only a few industries or enterprises, the extent of borrowing by the fund (eveage), and the type of securites to be purchased (for example, common stock, shares of other fimds resulting in pyramids of owneshiip, debt instruments, shares listed on recognized stock exchanges or unlisted shares, real estate, foreign or domestic securities). There is noting inherently wrong wth a fund engagig in a high-risk investmnt stategy as long as the shareholders are fully informed and approve of te strategy.

# Increase Rights of Fund Owners

7.15 The third type of regulation includes those that regulate the intenal governance of the fund, in other words, how sha exercise their ownership rights over the fund's managers. If the sharolders have weak control over the fund managers, the managers may be prone to shirling, self dealing, and high risk investments. Strong oversight and control by shareholders of the fund will improve performance by fimd managers and in trn improve performane by enterpises owned by the fund.
Voucher Funds In the Transtion Economies 35 7.16 An important issue in thi regard is the legal form of the voucher fimd since is detrmine the rights of the fimd's owners. Though details and terminology vuy from country to country, an inwestment fund can be estabhed in two basic ways - as a corporation or as a unit trust. For eample in the Czech Republic, voucher funds initaWly could only be created as a corporation but later could be crated as unit uts. It is not always easy to decide which of these basic legal fom are being refeed to especially in tunslaon since the tems used to descrtibe these various types of funds are not Odardized. This paper will use th term investment company for funds that are establislard as corporatons and unit trust for finds establshed as f. 5 s Much of the analysis in this paper assumes that a voucher fund is established as an investment oDmpany.

7.17 The basic difference between these two legal forms is that a unit us is not a separate legal penon as is an investment company. A unit trust has a legal stuctur based on a contract typically between a managemet company, a depository or tustee, and the partcipants or investors. The partcpants in a unit tmst receive paicipaion units" instead of shares and typically have a right to receive a pro raa share of all the trust's assets and income. The owners of paicipaton units usually have very limited rights or ability **to** control the activies of the trustee or the managemet oompany. Thus, the unit tust form of ogani seems to result in a poor system of corporate governace of the funds.

7.18 A second issue in establishing the basic structure of a voucher fimd is wher it is open ended" or "closed ended." In principlt, both types of funds (investment company or a unit trust) can be set up as open ended or closed ended. The difference betwe ese two concepts is that an open-end fund must age to redeem ares or participation units for cash if equested by the fund paricipants. In effect, priipants can sell thei shares or units bacc to the fund. The shares or units are redeemed for the "net asset value" of the fund ftat is the total market value of the fund's asst divided by ffie number of shares or units of the fund outstanding. Naturally, if many holds demand redemption, the fund must sell some of its portfolio of enterpise shares to **raise** the necessary cash. In contrast, shareholders in a "closed-end" investment company or holders of par on its in a "closed-f;nd 'unit tust can only sell their shares or participaton units to other inveson. If the fund is pemning badly, the pric for these shares or units may be below their net asset value.

7.19 The advantage of open-end funds from the point of view of promodng good corpoat govemance is that a poorly managed fund may simply wither away as its hahders demand that their shares be redemed for cas. This would put substantial pressum on f-nd mmagers to imprve the performance of the fund. In a closed-end fund, however, the shareholers can only sel their sha to another investor if the fund is performing badly, the fund itself is not L'Te teminology for these various types of funds is made more confusing by the similar teminology used for the companies that are hired to manage the _fiuns._ In the Czech and Slovak Reublics, for example, such management compaies are also referred to as investment companies.
Rt. Anderson 38 reduced in size, and the fuInd managers may continue to manage a large fund paying themselves substantial fees in spite of their poor performance.-~~~ 7.20 Fund participants have the greatest Table 4 rights and can put the mnost pressure on managmentto perform if the voucher fund owners,' flights Under Various Forms of is established as an open-end corporation (se Voucher Fund Organization Table 4). In this case, fund owners have two pen End Closed End ways of exercising their rights as owners and __I thus creating Prsi sure On fund managers: (i) Corporation High Medium vote for a new Board of Supervisors or **Mant** Unit Tru kdium Low agement Board at the next annual meting _ who wll change the management company or (i) reeem shares for cash and force the fund to beome smalher. In a closed-nd corportion, the shareholders have only the first way of exercising their rights, i.e., elect a new Board of Supervisors or Management Board. In an open-nd unt trust, the unit holders have only the second way of exercising their rights, i.e., demand redemption of their participation units. Even worse in a closed-end unit trust, the fund participants have almost no way of putting pressure on th fund managers.

7.21 Though open-end funds improve fund goverance, they have one disadvantage at least in the early period of transition in the economies. Such funds may be forced to sell _large_ amounts of shares on the secondary markets if fund shareholders demand redemption. Since secondary markets in these countries are initially poorly developed and illquid, funds may simply not be able to sell their entrprise shares or such large-scale sellig of shares could cau a collapse of these markets.<sup>16</sup> 7.22 It is a troubling development in the Czech Republic that somate funds in the sond wave of voucher privatization are settig themselves up as closed-end unit tmsts and a large nuiber 21 argument advanced against open-ended hinds by some und managers is that too many fund shareholders will make the wrong deciion aboutwhen to redeem their shares and thus hurt the over performan of open-ended funds. These managers argue that unsophisticated investm wfill sh **to** redem their shares in the funds when stock market prices are at a cyclical low level and, convmdsy, ush **to** buy new shares from the fnids when stock market prices are at a cyclical high level. In other words, small investors systematicaly make the wrong decisions about when **to** ene and leave the stock market. This in tu forces an open-ended fund to buy shares when prices are high and sell shares when prices are low - an investment stat exactly the opposite of what is desirable. tois argument is similar to the "odd lot" theory of stock market wading in the United States. This theory says that when small investors are seling shares (small blocks of shares are called "odd lots"), the smart u sophisticated investor knows that this is a good time to buy because such 'bod lot" traders are usually wrong. Similarly when the odd lot trader is buying shares, this is a sign that the market is overvalued, and the sophisticated buyers then sell their shares.
Voucher Funds in the Transition Economies 37

# Table S

of vouher holders have tranfed their vouchers to this type of fund (see Table _5)._ This organizatonal foo.m gives the paTUcipnts in`the fund the las control over mana agement Thus one reguatory option is to requr tat funds be established as open-end corportions to maimiz the ability of the fimd paricipants to influence and control the managers of the fund. Given t concern e_sed above that open-end funds could cause instabiity in the new secondary marke1t for shares, a copronise might be to require that funds establish themselves as closed-end coraios initially but become open ended after an intial trAnstion period, say hee years.

their .

<!-- Start of picture text --> Legal Form of Czech Voucher Funds<br>in the Second Wave<br>Points*<br>Legal Form Number (million)<br>-<br>Corporation<br>-<br>Closed End 195 1,570<br>Unit Trust<br>-Closed End 121 1,480<br>Unit Trust<br>-<br>Open End 37 670<br>Total 353 3,920<br><!-- End of picture text --> 'Voucher points transferred by Czech ditizens to this type of fund.

7.23 In the analysis that follows, it will be assumed tht the voucher fiud is established as a corpoation raer than a unit tust. General corporate law will probably specify certain sbareholder rights that apply to all cororatons including voucher funds. These include:

- votes per share, in other words, whether some class of shares may be non-voting or have more than one vote;

- 3 number of shareholders that need tobe preset for a quorum to exst at the annual eetng of shareholder (for ecample, 30 percent of all shaReholdes);

- percentage of shareholders resented at the annual meeting that need to apprve election of governance boards (typically a simple majority); to apre genl resolutions (typically a simple majority), and to arove undamnal cnges in the conpany's articles of association (typically 66 to 75 percent);

- whether cumulative voting is possible, ie., can shreholders allocate their votes to a single member of a goavernance board or must they vote for a complete satfe of members; and

- prvisions for soliciting and voting proxies of those shareholders who cannot attend the annual meeting.

7.24 If a voucher find is establish as a corporatio, an issue is who will be allowed to sit on the govemance boards of the fund to represent the many shareholders. Because ownership of a large fund is dispersed among thousands of shareholder is the risk that the manage-
R. Anderson 38 meat company will decide who sits on the govremance boards and that these boards will not adequatey supevise the mnagement company. It seems desrable chat the members of the Supervisory Board should be idependent of the sponsor, the management company, or any related or affiliated company. Thus, one reguatory opfion is not to allow any employee or shareolder o£f the sponsor, the management company, or any affiliated company to sit on the Sup y Board.

7.25 The membership of the Management Board raises another issue. The Management Board is pected to canry out the anagementof tbe company. In the case of voucher funds, however, te ma t iS tpay carried out by a management company under conct to the fund. In this case, a Management Board may be largely superfluous and unnecessry. In any event, there does not seem to be any reason not to allow employees of the mement comny to sit on this board since they are the individuals actally managing the company. 7.26 Specia shareholders' rights have been proposed for voucher funds that would not be applicable to corporations in general. These include:

- shareholders at their annual meeting must approve ffie ament of the management company and the terms of the _contract_ with the company; and

- shareholdes must also approve any basic changes in the investment stategy of the fund.

7.7 Liel reguLion that require greater disclosure, regulatiorns that increase the rights of fund owners are relatively non-controveial in the sense that such regulations are genrally rcognized as necesary to imrove governance of companies including voucher funds. Experts may disagree, however, on what ipecific regulations will best promote effecfive governance by shareholder. For example, is cumulaive votng better than non-cumulaive voting or what proportin of shareholders should be required for a quorum?

# Control **Fund** Operations

7.28 A fourth tpe of regulation indudes those that control and limit the acal operations and activities of the funds. These are more controversial han the previous types of regulatons because thiy impose the government's judgement about the proper mle of funds and may oveide the preferences of the owners of the funds. In contrast, regulations that require imato disloue and increase shareholde **r** ights ar desgned to allow the shareholders to make better decisons about the functioning of the fumds and to control and direct the managers of the funds so that they promote the interest of the shareholders. Such regulations, however, gill lave the basic decisons about the role of the fimds to their owners.

7.29 The followig are examples of possible govenment regulations intended to control and limit the opations and actvities of the funds. To control the risk of fraud or theft from the fund, _sweval_ oimties require that funds deposit their assets such as shares or cash with
-:Voucher Funds in the Transition Economies

39 licensed depository institutions that can control any saLL3 or transfer of these assets. A regulation in the Czech and Slovak Republics is that the sponsors of a fund must contribute a certain minimum star up capital for the fund to assure that it has the resource to carry out its functions until income is earned from its investmnent portfolio. The required capital, however, - is not large only one mllion crowns or about $30,000.

7.30 To discourage shirking by managers and create incentives for better fund promne reglatonsmight specify the tems of the,mngmn contmct between the fund andmage - ment company for example, the requirement in the Czech and Slovak countries tha annual fees paid to maaeetcompanies may not exceed two percent of the funds asst and the reqirmen i Russia tha such fees may not exceed five percent. These regulations are designed toplac an outer limit on fees -ai to maaeetcompanies and to avoid situations in which the management companies have taken effective control of the funds away from the fund's shareholders and are paying themselves excessive fees at the expense of the fund 7.31 More questionable, however, are government regulations that specify the detailed structur of fees or other terms of the management contract between the fund and the manage-, ment company. One proposal in Slovenia is that part of the fees paid toDaagmn companies should consis of shares in the fund, and the maaeetcompany may not sell the shares for a fixed number of years. Similarly in Poland, the proposal is to compensate mngmn companies by a mix of cash and shares in the fund. These proposals are designed to give the managemient company greater incentives to increase the value of the fund's assets because thie managmentcompany itself holds a lairge number of fund shares. It has also been proposed that a goyverment regulatory agency approve all mngmn contracts. In these ca3se, the government iuiz decided that iLt knows the best terms of the mngetcontract and tha1 **t** he owners of the funds cannot decide on the best temns or cannot impose these terms on fth managmentcompany. Detailed government regulations may be harmful because the governiment may not know the best terms of a management contract, and such regulatons limit the ability of funds to experiment or try other forms of a management contract.

7.32 To reduce self dealing and conflicts of interest when a fund buys or sells shares, the Czech and Slovak Republics require tha the priLce paid for shares must be no higher tha the current "market price" and the price received for share must be no lower tha the current "market price." It is not easy to enforce such a regulation because of th-e difficudty in defining what is the current market price. This is particularly true in the emerging stock markets in the transtion countrie. In such markets, shares may be traded only infrequently or in small volumes on the public stock exchange. The prices for small trades may not be applicable to the large trades that a fund is likely to make, for example, when a fund sells a large block of shares directly to another fund without going through an exchange.

7.33 Also to reduce self dealig and conflicts of interest, it has been proposed that the governmet Dshould stricy reguate both who can own **E** companies and all commer-
R. Anderson 40 cial raeet between the sponsors, the maaeetcompanies, the funds, and the enterprises owned by the fuinds. For example, it has been proposed thiat banks not be allowed to sponsor fuinds or be the owners of management companies because of the conflict of interest that some see between being a lender to an enterprise and representing the owners of the entrprse.In response, banks have proposed 'Chinese walls" that would stop any flow of infrmaionbetween the lending operations of a bank and the management companies owned by the batk This dual role of banks, however, is quite common in Germany and Japan where banks are both leaders and owners of enterprises and does not appear to have caused significant concern about conflicts of interest and self dealing in those countries.

7.34 Also prohibiting banks from sponsoring funds or owning maaeetcompanie may mean that funds and maaeetcompanies may be- operated by less qualfied individuals or orgaizaion. Transition economics do not have large numbers of people with the necessary trAining and experience to manage funds. Banks and their employees may have more of the necessary training and experience than almost anyone else.

_7.35_ In the Czech and Slovak Republics, funds may not own share in its mngmn company or in the owners of the maaeetcompany (for example, a bank tha founded the managmentcompany and the fund). The concern here is that the fund's ownership of share in the bank that sponsored the fund may allow the bank managers to Jargely control the ownership of the bank and prohibiLt any other investor from gainig control over the bankr A related concern might be that the fund will be used to nmanpulate the price of shares in the bank.

7.36 For similar reasons, others have proposed that a mngmn company or its owners (for example, a bank that founded the fund) shtould be prhbtdfrom having any commercial agreeents wit enterprise owned by the fund. Such prohibited commecald getet would icuelending to the enterprises, consulting agreements, and selling any products or services to the enterprises. Such a comprehensive provision seems to effectively exclude any exis;ting entrprseor business from establishing a maaeetcompany because that enterprise or firm would have to give up any other business activity. This seems to have the effect of requiring that a fund be founded by someone with no business or financial experience. In contrast, the assmptonbehin **d** isclosure requirements is that fund owners can control any self dealing or conflicts of interest that may aris if ownership connections and commercil agrements are required to be disclosed.

# Limit Fund Investments

7.37 To control or limit high risk investments by funds, some countries have imposed variou resnctonson the types of investments that a fund can make. For example as discussed above, the Czech and Slovak Republics requir that a fimd not invest more than ten percent of its assets in the share of any one enterpris. The objective is to limit risk: by requiring a diversfied portfolio. Such a restriction, in effect, require a fund to invest in at least ten differen
Voucher Funds in the Transition Economies 41 enterprise. The reality in these countries is tha the Large and most important funds invest in maymore than ten enterprises though this rule may be binding on smaller funds. It has also been proposed in other countries that funds not be allowed to invest in certain types of assets (for example, real estate, non-listed, or illiquid securitie) or to borrow to male investments because such leverae is excessively risky. Again such regulations assume that fth fund owners cannot choose an appropriate investment strategy or cannot control the fund managers.

7.38 Most Western countries and some Table 6 transition countries impose controls on the proportion of shares in a single enterprise that may be owned by a fund (or group of related funds). For examples, see Table 6. Though this type of regulation is widespread,ConrOwesi it is difficult to find an explanation of why itConrOwesi is Deeded.

|Restrictions on Fund Owne<br>in a Single Com<br>nrOwesi<br>nrOwesi|rship of Shares<br>pany<br>1maximum|
|---|---|
|<br>Czech Republic|20%|
|Soain0||
|Russia<br>|10%<br>|
|Lihaa<br>Lihaa50|0|
|United States|5%|
|France|10%|
|Germany<br> <br>|10%<br>|
|OC<br>eomnain<br>OClecmedtin|5<br>-5|

7.39 The fact that this type of regulation is common m Western countries is sometimes used as an argument why a similar regulation is needed in transition economies. This, however, may lead to the result that a poor or harmful regulation in Western countries is simpy trnsferedto tnnsition economies withctiut analysis of why **it** is needed or POssibit adverse consequences. In other words, transition countries should not blindy make the same mistakes as Western countries in their regulation of funds.

7.40 There is often a lack of clear goverment statements as **to** why these limitations on fund ownership were adopted in Western countries, but same reasons might be that:

- funds in some counties are set up as trusts rather tha corporations, have only limited legal rights, and are not considered appropriate legal entitis to own and control companies;

- in the United States, funds can technically own more tha five percent of the shares of a company but are inhibited from doing so by regulatory and tax restrictions;<sup>17</sup>

**175.** Gray and Hanson (1993) p,6.
42 R. Anderson

- in many Westen countries, there is widespread suspicion of what appea to be large concentrations of cconom;c power in funds and a desire to control that power in some way. For example, demanls for stricter reguation of investment funds by the Federal Government of the United States began in the 1930's when concerns about concentrations of econr,mic power were at their height due to the Great Depression;

- in the European Economic Community, there may be concern that a fund established in one country could control enterpnses in anotier country; and

- managers of enterpris may fear control by lage institutional investors and thus support limitations on ownership by funds.

7.41 Such regulations can senously impair the ability of funds to play a role in corporate goverance and thus reduce the benefits from voucher prvation. If a fund cannot own more than 10 percent of the shares of an enterprise, the government is implicitly adopting the first model of corporate govence described above, namely, dispersed ownship with no large owner exercising control over an enteprise. If a fund cannot own more than 50 pect of the shares of a single company, te the third model of corporate govremance based on a holdmg company structure cannot be implemented. If a fund can own somewhere between 10 and 50 perent of the shares in a sing enterprise, then the second model of corporate govemance is still feasible, namely, institutional ownership. As discussed above in the case of the Czech and Slovak Republics where a fund can own up to 20 percent of the shares of an enprise, the limited initial information seems to suggest that this model of corpoate governance is working reasonably well. Thus, limits on fund ownership of about 20 percent do not seem to greatly impair the ability of funds to govern enteprises.

7.42 Thus it would appear that counties such as the Czech Republic, Slovaka, and Russia are adopting the institutional ownership model but in effect prohibiting the holding company model. There may be one valid argument for effectively prohibiting the holding company modd because of the weak legal system in these countres and inability of rglatory authonties and the courts to protect the rights of minoty saeholders. In the institutional ownership model, all owners are minority owners, and a coalition of such owners is necessy to control the enterprise. In the holding company model, however, a _sie_ majority owner can largely cotrol the enterprise in spite of the wishes of minority shareholders. In this case there would seem to be more potenial for confficts of interest and self dealing. The majority shareholder could influence and control the enterprise for its own benefit even though the intersts of the minoxity shareholdes would be harmed.

7.43 One example of self dealing by a majority shareholder was given by a fund manager in the Czech Republic. In this case, however, the majority owner of a Czech company was a foreig company, and the fund was a minority owner. The majority owner was requiring the enterprse managers to sell products to the majority owner for distribution in a foreign country. The fund and other minorty owners, however, believed that the transfer pnce was too low thus
43 Voucher Funds in the Transiton Economies unfirly reducing the profits of the Czech company and the dividends paid to the minonity owners. If this allegation is true, the majority owner was controlling the Czech company for its own benefit rather than the benefit of all shareholders, in other words, a dear case of self dealing.

7.44 Ihus, it may be desimble to Limit funds to being miority but sfill large shareholders of enterpises. The fimds as large minorqty ehlders would still have an incentive to devote resources to monitoring the perfomce of the enterprises, to assign staff to be on the govenance boards, and to intervene in coopraon with other owners if it appe that the enterprise is mismanaged. To effectively control the enterprise, however, a fimd would have to join a coalition with other funds. This would guarantee that the enterprise could not be used to promote the interests of just one shareholder at the expense of other shareholders. Such a coalition of large shareholders would still be able to effectively govern the enterprise and thus not sacdfice the increases in efficiency and profitable that is the objective of privatization. 7.45 Such a limitation on ownership by funds, however, effectively rules out the holding company model of corpate govemance. It must be noted that this concem about conflicts of interest and self dealing would also arise when an owner of an enterprise other than a fund owns more than a majority of are but lss th 100 pect ownership. f funds are prolhibited from becoming majoty shareholders, then this should apply equally to other types of owners as well. There is no clear reason why funds should be singled out for this type of restriction.

# 8. Recommendations

8.1 The transition economies where privatly-sponsored funds have arisen must develop a fexible and evolving regulatory regime for these new institutions. Because these funds play a different role from imilar funds in Westem countries, models of regulion used in those countries are probably not applicable without modification. In contrast to some Western countries, funds in transition economies should be encouraged to play a positive role in corporate governance and thus help to overcome a major weakness in these countries, namely, a lack of good pivate owners for enterprises. Regulation f these new funds should be expermental and change over time when arious prcblems arise in the opeation and management of the new fimds.

8.2 One regulatoxy stregy is for the goverments in these countries to refrain from initially sng any specil regulatory rerments on funds other than those that would apply to all corporations including competition laws. Prsumably corporate law in these counties already requires corporations to disclose infomation about their operations and specifies the nghts of shareholders in controlling the managers. If special problems arise in the opeation of the funds in the future, the goverment could then add additional reguations specfically designed to meet those problems.
R. Anderson 44 8.3 A second strategy would be to try to anticipate all of the possible problems that might arise with the funds and put in place now a lengthy and cozaplex set of reguladons designed to deal with those problems. Such a regulatory framework would go beyond simply requiring funds to disclose information about their operatons and specifying the rights of shareholders and would impose quantitative controls on the operation of funds and on fund investments. These nmght iaclude limits on the proportion of shares that a fund can own in a company, required provisions in management contracts including the fee structure, prohibitions on certain individuals and entrprises founding funds or owning management companies, limits on business relationships between the funds and other parties, limits on high risk investments, and so forth.

8.4 There are several difficulties with the second strategy. It assumes that shareholders will **r** not effectively control the funds because of weak shareholde ights or because fund managers will not provide adequate informadon about their operations. It also assumes that the govemment can predict the impact of these detailed regulations. The risk in imposing detailed quantittive regulations is that they may distort incentives and have unintended and undesirable consequnces. For example, a complex fee structure may induce management companies to adopt an undesrable investment strategy that no one could foresee when the structe was adopted. Another example is that prohibitions against certain individuals or institutions owning management companies may result in such companies being run by poorly qualified individuals. Also such detiled regulabons may not allow the operation and structure of funds to evolve as market conditions change.

_8.5_ On balance, the best strategy at least initially is to subject the funds only to the normal requirements of corporate and competiton law that apply to all corporations but with just a few dditonal regulations to deal with special problems of voucher finds that can now be cleady identified. These additional regulations would primarily require the funds either to disclose additional information or give shareholders greater rights in the management of the funds. Detailed regulations that control fund operations or restrict investment decisions do not appear to be needed at present though such regulations could be introduced in the future if problems arise in the operations of the funds.

- 8.6 The recommended special regulations for funds not applicable to other corporations are

- a fund should be established as a corporation rather than a unit trust;

- members of the Supervisory Board may not be employees or shareholders of the management company, the owners of the management company (for example, a bank that sponsored a fund), or any affiliated company;

- a lmit should be placed on the total annual fees that a fund may pay to a manament company. Such a limit should be designed to stop clearly excessive fee payments. For
45 Voucher Funds in the Transition Economies example in the Czech and Slovak Republics, total annual fees paid to a management company cannot exceed two percent of the fimd's asset value.

- funds should submit their selection of a management company and the management contact for approval at each annual meeting of the shareholders;

- finds should also submit their investnent strategy for approval at the annual meeting;

- funds should disclose any ownership connections or commercial relationships between the management company, its owners, the fund, and all of fte enterprises in the fimd's portfolio;

- funds should disclose the prices they p-d for or received from the sale of shares in their porfolios including the date the transaction was made;

- fond should disclose the other party to any purchase or sale of shares as well as the prce if the oher party is affiliated in any way with the management company, the sponsor of the fund, or major shareholders of the fimd or if the other party is another fund also being managed by the same management company; and

- funds should be required to place their shares and other assets in the custody of an approved depository institution to avoid possible theft and fraud.

8.7 As discussed above, an argument can be made that funds should also be limited to owning nomore than 20 or 30 percent of the shares of an enterprise to avoid conflicts of interest and self dealing that might arise if funds were allowed to be majority shareholders of a company. In effect, this restriction would requie a fund to share control of an enteprise with other funds. Such a restiction would, however, effectively rule out the third model of cporate govemance based on a holding company. Our knowledge of the various models of corporate governance is not sufficient to say that any one model is clearly superior to another. If it appers that serious conflicts of interest or self dealing arises when a fund owns a majority shareholding in a company then limiting a fund's shareholding is an option for the fuue. In any event, if such a restiction is applied to funds, it shouldalso be applied to any other owner of shares in a company.

8.8 Also a strong argument can be made that funds should eventually be required to be open-end funds in which solders can demand that the funds redeem their shares for cash. This would place substantal pressure on fund managers to improve performance or else see the fund and thus their management fees decline in sie. This requrment, however, should only be intoduced after the secondary market for shares has developed and matured and thus large _sing_ of shares by fumds would not unnecessarily disrupt the markeL
**R. Anderson**

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~~8.9 Since the fends in the Czech and Slovak Republics have been owners of enterprises for no more tha one year, it is difficult to draw firm conclusions about the role of these funds. Also, this report is based on a limited number of interviews with government officials, funds, and enterprises. The experience to date, however, does suggest that the funds are beginning to play a useful role in corporat governance which is potentially their greatest contribution to the sucessul eform of the transition economies in Central and Eastern Europe. No concrete evidence of serious problems wiLth fund management has yet arisen. Since the role and functions of these funds are evolving and experience with this type of fund in Western countries is lmimited, it is difficult to specify the best regulatory framework for these funds. In these circmstnce, the best regulatory strategy is to adopt initialy a relatively light handed or hlbera approach to regulation tha allows the funds to evolve and change. Only when serious problems or weaknesses arise in the performance and behavior of funds should the government impose additional regulations designed to deal with those specific problems.