The Relevance of Corporate Governance to Eurasian1 Transition Economies

Stilpon Nestor, Takahiro Yasui and Marie-Laurence Guy2

I. Introduction

Corporate governance has recently come to the forefront of policy debates around the world.
Essentially, it relates to the mechanisms and framework for corporate decision-making, but it may
also include a wide range of other issues, mostly concerned with the incentives that drive firm
behaviour. From the perspective of the 1999 OECD Principles on Corporate Governance,
corporate governance has a two-fold meaning. On the one hand it encompasses the relationships
and ensuing patterns of behaviour between different agents in a limited liability corporation. In
other words, corporate governance refers to the way managers and shareholders, but also
employees, creditors, key customers and communities, interact with each other to form the
strategy of the corporation.

On the other hand, corporate governance also needs the support of public policy, as corporate
strategy formation is made within a framework provided by a set of rules. These rules may
include private self-regulation, but consist mainly of public laws and regulations such as company
law, securities regulation, listing requirements and insolvency legislation. Good corporate
governance practices cannot develop without appropriate public policy, without an adequate legal
and regulatory framework. This is mainly why governments all around the world pay due
attention to corporate governance.

During the last few decades, private sector corporations have vastly increased their role as critical
engines of economic development and job creation all over the world. As economic growth
depends more and more on the development of a competitive corporate sector, the establishment
or improvement of corporate governance is a matter of growing concern for all countries. This is
particularly true for transition countries that need to put together their private corporate sector
from scratch in the context of a difficult economic transformation.

This brief paper is divided in two sections. In the first one, the focus is on why good corporate
governance is important in the economic transition process. Three points will be raised in this
section. First, good corporate governance is indispensable for transition economies to build well-
functioning institutions for economic growth. Second, good corporate governance leads to
efficient allocation of capital and contributes to the development of financial markets. Third, the
existence of proper corporate governance is an important prerequisite for transition countries to
attract foreign investment. The second section of the paper focuses on the Eurasian region. It
will first attempt to describe the key elements of an incentive structure that has produced only

1
In this paper we use the term Eurasia to refer to all the countries that are involved in the Eurasian
Roundtable Process. These are the mainly the countries that have been created as a result of the break-up
of the former Soviet Union, with the exception of Russia, the three Baltic states, Belarus, Turkmenistan and
Tajikistan. We also include Mongolia in this group, even though Mongolia was not part of the former
Soviet Union.
2
Directorate for Financial, Fiscal and Enterprise Affairs, OECD. The opinions expressed in this paper are
those of the authors and do not necessarily reflect those of the OECD.

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limited corporate restructuring in the region. It will then review the main corporate governance
problems through the scope of the OECD Principles.

II. The importance of corporate governance in the context of transition

A. Institution-building for a market economy

In a market economy, private corporations raise funds from investors and, combining these funds
with other inputs—notably labour and land, conduct business. Their objective is simple: to seek
profits. The recognition of the vital role and superior performance of private sector corporations
in economic growth was a powerful motivator for widespread privatisation in many developed
and developing economies in the last couple of decades. In transition countries, a transfer of
corporate ownership on an unprecedented scale was undertaken in the context of economic
transformation over the last ten years. In order for these countries to develop an efficient and
competitive corporate sector, privatisation is rightly considered an indispensable step. It has been
undertaken in more or less all of them, but its implementation has been uneven.

Without good corporate governance the corporate institution cannot pursue its fundamental
profit-seeking goal with maximum efficiency, both in terms of private and social welfare. It is
this important tenet that was often forgotten when transitional privatisation was on the design
board. Corporate governance was assumed to appear automatically, as a direct result of
ownership transformation. In fact, experience in transition economies shows that the transfer of
corporate ownership to private hands is far from sufficient to ensure the development of a robust
corporate sector. A key reason why transition countries have not been very successful in
corporate restructuring is the lack of proper corporate governance. Companies will not function
efficiently without appropriate, enforceable governance rules and institutions to enforce them;
and without building private capacity to support and develop a corporate governance culture
among managers, shareholder and stakeholders. In transition economies, the development of
good corporate governance practices is not only about enhancing the efficiency of equity markets
or “fine-tuning” corporate decision making processes; it is more about creating the key institution
that will drive successful economic transformation to a market based economy, the private
corporation.

First, in order to have good corporate governance, all related agents, in particular managers and
shareholders, need to recognise and perform their roles appropriately. Such a cultural shift takes
time and it is not yet evident in most transition economies. Mass privatisation has created a
number of private shareholders, who have not yet realised the role, rights and responsibilities they
are expected to assume as corporate owners, perhaps because they have got shares almost for
free. Most of them are simply waiting for the payment of dividends that are often trivial.
Corporate managers do not seem to fully understand their role as the agents for shareholders,
either. They run their companies as if they own them, seeking personal benefits at the cost of
shareholders, and often of the company as a whole. Change in this context will take time and will
require an effective mix of "carrots and sticks". In many cases, it will boil down to recognising
that increasing the longer term value of the company is better than diverting its assets to a foreign
bank account.

Second, the legal and regulatory framework for corporate governance is still weak in transition
countries. Upgrading it, both in terms of coherence and enforceability, is probably the most

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urgent task that policy makers are facing in reshaping their micro-economy. Most of these
countries have already enacted a company law that is the core of the corporate framework.
However, in many cases, the law does not provide a sufficiently clear and complete set of rules
and is not well implemented, due to the lack of a proper enforcement mechanism.

A limited liability corporation is in fact a legal creation, established by the provisions of company
law. By limiting liability of shareholders to the amounts they invest in the share, the law allows
such an institution to raise funds from the wider public, in order to conduct and expand a
business. By enabling the corporation to have its own well-defined property, it provides creditors
with an assurance that lending is supported by corporate assets. Without adequate legal backing,
such a complex institutional arrangement cannot function satisfactorily or develop soundly.
Moreover, while company law is a key for the corporate governance framework, it is not enough.
Other laws and regulatory rules also have significant influence in shaping corporate behaviour.
They include insolvency legislation and securities regulation, which have yet to be developed and
implemented in many transition countries.

From another perspective, corporate governance is a procedure to select corporate managers

under a market mechanism. In an adequete corporate environment qualified managers can reward
capital providers sufficiently and thus attract more investment to develop their business; while
unqualified ones should face difficulties in raising funds for their operations and lose their
businesses. This market-based selection of corporate managers is a central feature of a healthy
institutional set-up. By ensuring managerial competence, it fuels the development of a robust
corporate sector and hence, of the economy as a whole. This aspect of corporate governance is
still largely missing in transition economies.

Finally, it should be pointed out that the improvement of corporate governance should have an
important spillover effect on society as a whole. Unaccountable and opaque corporations are
more than likely to undermine the rule of law and the effectiveness of government, creating and
sustaining a vicious circle of corruption, bribery and mismanagement not only in the private
sector but also in the public sector. The development of good corporate governance can be seen
as key public institution-building ingredient for a transparent and accountable society.

B. Efficient allocation of capital

Corporate governance is closely related to corporate finance and investment. Under communism,
corporations depended entirely on the government for their investment needs. In contrast, in a
market economy, they have to raise funds from the public directly or indirectly through financial
institutions; and/or generate enough earnings to fund their own development. The public and the
financial institutions provide their money to corporations not as a gift but in expectation of
sufficient financial returns. In seeking maximum returns, fund providers try to discipline
corporate managers to work for their interests.

Good corporate governance is key for the development of equity markets in developing and
transition countries, as it is for all other economies. First of all, if shares do not generate
sufficient financial returns, nobody wants to invest in them. Secondly, if the value of shares
cannot be evaluated appropriately due to unaccountable and opaque management of a
corporation, it is also difficult to expect active trading of shares of such a corporation. In other
words, if there are enough companies that provide reasonable returns by an accountable
management, the whole market will grow and the corporate sector in its entirety will benefit from
a lower cost of capital. In the opposite scenario, an overall market impression of “bad

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governance” will impose higher costs on the few good corporations and will drive them out of the
market in search of other (usually foreign) listings. This is the so-called “adverse selection”
effect.

Good corporate governance is also important for the sound development of the banking sector.
Banks channel public savings to the corporate sector. If banks cannot assess the viability and risk
of the companies to which they provide credit, as a matter of course, a number of important
systemic risks arise. Banks will see their balance sheets submerge with rising bad loans and will
thus be forced to direct or indirect renationalisation. Another common “disease” of the banking
sector in unstable transition environments is banking capture by corporations. This capture often
occurs with the help of the government, pointing to the importance of another aspect of
governance, the governance of banks. One cannot overestimate the importance of good
governance practices in the banking sector for the health of the financial sector.

The establishment of proper corporate governance is especially important to transition economies

in two ways. First, in these economies, domestic savings are scarce. They should be used most
efficiently for the development of the economy. This means that the financial resources need to
be allocated to the most profitable companies with the highest growth potential. This cannot be
achieved if the fund providers cannot get adequate information and cannot ensure adequate
monitoring through corporate governance mechanisms. Hence, corporate governance directly
impacts on the efficient allocation of scarce savings.

Second, a rules-based corporate governance mechanism is crucial for transition economies,

because direct capital and product market disciplines are not expected to work effectively, due to
important market imperfections and failures. These disciplines will thus not be sufficient to
police corporate managers. In advanced market economies, when shareholders are not satisfied
with the performance of a company, they may shift their investments by selling shares in the
market, which leads to decrease in the share price. The company would subsequently have
difficulties in raising funds either by issuing new shares or corporate bonds due to the eventual
downgrading of its rating. Banks would, in principle, be less willing to provide loans to such a
company. The managers could also encounter the real threat of take-over as the share price goes
down. In developing and transition countries, this mechanism of market discipline hardly works
because of the lack of securities markets and of an efficient banking sector. Take-over may be
possible but is still hard to carry out when no organised markets exist and no reliable corporate
information is available. Therefore, in order to ensure efficient management of corporations in
those countries, direct rules that create a governance mechanism through which shareholders and
sometimes also creditors can discipline corporate managers are required.

Overall, the policy makers’ effort in this area should be to promote the emergence of a virtuous
cycle. Good corporate governance is an important factor in the establishment of a well-
functioning financial market which leads to the efficient allocation of financial resources, and is
key for economic growth. In its turn, an efficient financial market should promote better
practices in corporate governance by increasing market discipline on corporate management

C. Promotion of foreign investment

Because of the relative scarcity of domestic savings, development and transition economies need
to raise funds from foreign countries. The establishment of proper corporate governance has
become increasingly important in this context, as foreign investors tend to put greater importance
in selecting their investments.

4
In the last few decades, international financial markets have dramatically changed. One of the
prominent changes is their globalisation. Vast amounts of capital are now transferred from one
country to another on a daily basis. Numerous investment funds and other money management
vehicles have been established and have considerably helped the expansion of securities markets.
Most importantly, pension reform in some major OECD economies has created enormous pools
of funds that are invested in various markets around the world.

The globalisation of capital markets benefits transition countries. Although the recent financial
crises in emerging economies have highlighted the risks involved in such transactions, it is still
true that foreign investment played a key role in the remarkable economic growth in these
economies before the crisis. Moreover, the evidence suggests that equity investors, either
portfolio or FDI, were not the ones to rush for the exit. It was mostly short-term bank lending that
created the sharp reversal in capital flows.

The growing foreign investment trend is largely irreversible, because excessive savings in
advanced market countries seek investment opportunities in developing countries that lack
sufficient domestic savings. Sizeable assets accumulated in pension and investment pools need to
be diversified. They are partly allocated into high- risk but high- return investments in
developing economies. Large-scale institutional investors also tend to pay attention to corporate
governance, as many of them, especially pension funds and life insurance companies, have a
long-term investment perspective to match the long maturities of their liabilities. Instead of
selling- out quickly whenever returns do not match expectations, these investors have been trying
to make sure good corporate governance, in particular transparency and proper protection of
minority shareholders, is in place to ensure sufficient long-term value growth. In order to attract
these long-term foreign investors, it is of urgent necessity for transition economies to establish
good corporate governance. Empirical analysis suggests that economies with poorer corporate
governance have been more severely damaged in Asia, as a result of foreign investment outflows.

Foreign portfolio investment comes, most would argue, second to foreign direct investment as a
facilitator of rapid transition. Foreign direct investment has been shown to address most
effectively the problems faced by corporate sectors in transition. It does not only consist of a
transfer of funds but also of skills, market access, technology and know- how. Thus, economies
that have attracted more direct investment among transition countries have consistently
outperformed the rest in terms of the speed and sustainability of their transformation over the last
ten years.

Is corporate governance relevant to FDI? After all, a direct investor assumes control so that she
can function without external constraints. In practice, however, direct investors worry very much
about the corporate governance framework. As most of them function under transparency and
accountability standards set globally, they might find themselves severely disadvantaged in an
environment where local companies can externalise these costs through corruption, hidden
subsidies and opacity. Direct investors need a sound company law framework as much as
portfolio investors as they will often have to deal with minority shareholders and creditors in
environments lacking in rule of law. In transition economies, one is not surprised to find direct
investors having the state, local government or voucher recipients in the capital of the companies
they control. If the corporate governance rules are not clear, these situations can create (and have
in the past created) a lot of problems.

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III. The Eurasian corporate reform context

In Eurasia as in other transition economies, economic reforms were widely expected to lead to
substantial reallocation of resources, rectifying the distortions inherited from central planning.
While causing temporary economic and social upheaval, this allocation would then underpin the
subsequent recovery. However, even though market reforms have been going on for almost a
decade in the region, there is still little restructuring and a persistent lack of investment in the
corporate sector. Corporate reform results after nearly ten years of ongoing reforms show that the
transition process is longer and more complex than initially envisaged.

A. The incentive environment for corporate reform

a. Weak and ineffective privatisation

A decade ago, with the break-up of the Soviet Union and the market-oriented reforms in many
former socialist economies, privatising inefficient state-owned companies became the symbol of
change from central planning to capitalism. Privatisation seemed to promise an end to the
inefficiencies of central planning--the key to freeing the resources and talents and lifting living
standards. An unprecedented transformation has doubtless occurred as most Eurasian countries
have changed from an almost 100% state-owned economy to one that is now primarily privately
owned. However, real change and modernisation at corporate level has been slow to emerge,
mainly due to a pervasive set of negative incentives driving corporate behavior.

To begin with, privatisation has produced much more limited results as a driver of restructuring
as initially expected. While small and medium size enterprises have almost all been privatised, a
high proportion of economic activity still remains in state hands, in most Eurasian countries. The
state owns or effectively controls major utilities, and many of the largest firms. This contrasts
quite sharply with the three Baltic states as well as in Russia. In Kazakhstan, the 330 largest
enterprises producing more than 1/3 of the GDP are still under state control. The situation of
large state-owned corporations in Eurasia does not seem to suggest that prolonged state
ownership might lead to better outcomes for the companies or for society as a whole.

Eurasian countries have adopted a wide variety of privatisation methods. Ukraine has mainly
used voucher privatisation and transfers to insiders; only very recently it has been trying to attract
foreign investors to some of its biggest enterprises. Other countries have already introduced
tender privatisation and have, as a result benefited from more substantial foreign investment, as
has energy-rich Kazakhstan. Corporate ownership is still dispersed in the Ukraine, with over 19
millions shareholders. It is more concentrated in countries where the privatisation method of
trade sale led to significant ownership by strategic investors. Ukraine and most other countries in
the region are also using the management-employee buy-out approach to privatisation, by which
shares of an enterprise are sold or given to managers and employees. Within the new
privatisation programme, the Ukrainian parliament has for example approved, in July of this year,
a law on the preferential sale of 50% plus one share of one of the largest metal producers in
Ukraine, Mariupol Ilicha, to the company’s management and employees, united in a closed joint
stock company. The powerful position of managers, in Ukraine as in Russia, gives this approach
the twin advantages of feasibility and political popularity. Nevertheless, experience shows that a
large scale sell-off to insiders creates important obstacles to corporate restructuring down the line,
as insiders are unwilling to meet the conditions for attracting badly needed external finance,
especially better corporate governance.

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Voucher privatisation has been the main privatisation method in Georgia, Armenia and the
Kyrgyz Republic. Its simplicity and distributional fairness make it politically and
administratively quite attractive. Its main downside is that a dispersed ownership structure will
result in weak corporate governance pressure from shareholders and will thus delay restructuring,
leaving unchecked control to incumbent company managers. These problems have been partly
addressed by pooling vouchers in investment or mutual funds. These investment funds were
established during the mass privatisation process in order to collect privatisation certificates from
citizens. In Kyrgyzstan for example the mass privatisation programme created around 400,000
shareholders, a quarter of which are shareholders of investment funds. In Kazakhstan, citizens
were required to invest their vouchers through these funds. In practice, voucher funds have not
lived up to their assigned role as corporate governance principals. They were often captured by
managers or other politically well connected parties. In some cases, they co-operated with
insiders to strip assets off companies and then disappear with the proceeds.

The initial hopes that mass privatisation would create the foundation for improved governance
and transform firm-level incentives have not been realised. Voucher programmes have brought
few tangible benefits to enterprises. With hindsight, institutional weakness was severely
underestimated at the beginning of the process. The expectation that corporate governance
institutions and practices would develop overnight to the benefit of the firms and society as a
whole has proved irrealistic. Both the corporate sector and the newborn financial intermediaries
suffered from the same ailments: weak monitoring by their beneficial owners and a complete lack
of a “fiduciary culture”.

Having said all this, a process of asset recombination is indeed occurring in most of the region,
mostly in grey markets. The shifting of assets to new, more closely held firms is quite
widespread, as managers with small minority ownership stakes in newly privatised firms (or with
the power to shift assets in still state- owned firms) try to gain greater control over company
assets. In this regard, the nascent markets of the region are not used to raise funds but much more
to swap shares and redefine corporate ownership in opaque and often illegal ways. This
exacerbates adverse selection and creates enormous problems in their development.

Slow and ineffective privatisation has been the main cause for a lack of restructuring. “Red”
directors of state owned or newly privatised companies, especially in one-company towns, refuse
to go ahead with inevitable downsizing and change of economic activity of their companies. State
enterprises have traditionally provided many social services to employees, which diverted them
from their core activities, raised their costs and kept them from being competitive. Dealing with
social assets is a major problem in post- privatisation restructuring as companies are often the
only providers of key social services and the state institutions that could succeed them are not up
and running. Divestiture of social assets is sometimes postponed or blocked by the same
managerial elites that have benefited form the first wave of reforms. Power to determine social
welfare is often a key currency for capturing policy by these powerful vested interests.

Slow and ineffective privatisation can also be largely blamed for a lack of investment. Domestic
investments have fallen and foreign investments have remained limited in many countries in the
region. In contrast, countries that have taken a more proactive attitude towards foreign sales have
seen more restructuring and rising investment levels. Kazakhstan has allowed important
investment both in its energy and utilities sectors and has seen some growth in these sectors. A
small country like Moldova managed to attract over $48 million of direct investment in the first
quarter of 2000 as compared with $6.99 million in the same period of the previous year as the
cash privatisation programme moved ahead.

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b. The rule of law and judicial enforcement

The absence of rule of law constitutes a major shortcoming for the development of corporations
in all countries of the region. Proper protection of property rights requires first, an adequate legal
framework, and second, its effective enforcement. In Eurasian countries, however, both
requirements are often not satisfied. In contrast to Central and Eastern Europe, the Baltics or even
Russia, the long period of central planning and a very recent statehood for the majority of these
countries signify a lack of a legislative or regulatory tradition. While some countries rushed to
adopt laws suggested by foreign consultants, they have often found that they bear little relevance
to realities in the country. In Moldova and Georgia major legal instruments underpinning the
corporate ownership environment have been adopted. Ukraine and Armenia have yet to
consolidate their legal framework. In Ukraine, key laws have long been pending in parliament
(i.e. new civil code, tax code, land ownership code, etc.).

Throughout the region, courts are often described as corrupt and slow; but judges will often argue
that their work is particularly difficult since there are still many loopholes and contradictions in
existing laws. Changes are often ill considered and are themselves subject to further change with
little regard for the overall coherence of the legal system. The reform of the judiciary and its
upgrading is a priority throughout the region.

Without strong institutions that can uphold the rule of law, companies whether domestic or
foreign have trouble with enforcing contracts, collecting debts, and resolving disputes. In state-
owned or newly privatised enterprises, incumbent managers find expropriation easy, as rules that
would stop them from doing so are either non-existent or not being enforced. They also find it
rational, as the weak protection for investment makes diversion of assets to foreign bank accounts
more appealing: the government or a competitor may confiscate holdings or change the rules on
the firms at any time. In an environment where expropriation is rampant, there is no way to
ensure that money flows to its intended purpose. In a system that lives on bribery, businesses are
forced to pay more money to more and more people, as the people in positions of power change.
Georgian companies reportedly pay an average bribe tax of 8 percent of their annual revenue,
while over 50 percent of companies in Azerbaijan admit to frequently bribing officials The
economy and society as a whole are the ultimate victims of these practices.

c. Macroeconomic and structural weaknesses

Weak corporate restructuring is also a result of the failure of policy to provide for a longer-term
perspective of growth based on macroeconomic stability. Although most transition countries of
the region (except Moldova) will be recording positive growth in output this year, a decade of
macroeconomic instability, high inflation, and inconsistent fiscal and monetary policies have
undermined confidence in the economy. The difficulties of operating in an uncertain
environment shorten business horizons and negatively affect the private sector. Exchange rate
depreciation and volatility also add uncertainty. Recent backtracking in trade liberalisation in
Central Asia has changed again the economic prospects for many enterprises in Kazakhstan,
Uzbekistan and Kyrghyzstan. Because of unpredictable economic developments, local managers,
although they often control and own large blocks of company shares, often perceive their
positions as uncertain and temporary. With short time horizons, their expected gain from
increasing company value are less than what they can obtain by stripping assets. Faced with the
choice of maximising company value or diverting cash flows for immediate personal gain,
controlling managers have frequently taken the second option, and not only because of the lack of

8
a “rule-of-law stick”. In an environment of prolonged instability, the absence of any “carrot”
makes the situation even more difficult.

Important incentive distortions have their origins in the tax system. In this respect some Eurasian
countries such as Kazakhstan, Kyrgyzstan and Armenia have outpaced Russia in introducing a
new comprehensive tax code, although enforcement is still sometimes arbitrary. In contrast,
Ukraine still has a tax code that results in punitive effective tax rates for enterprises. In its turn,
this makes managers adopt double book keeping and encourages the diversion of assets from
companies.

Weak competitive pressures have caused companies to remain inflexible to developments in

output markets. The pervasive presence of the state in the economy continues in many countries
through extensive direct and indirect subsidies. Extensive licensing requirements hamper the
development of competition; in Kyrghyzstan some companies are reportedly required to obtain up
to 100 licenses to carry out their activities. In Uzbekistan state enterprises are being changed into
shareholding companies and private enterprise account for 45 percent of all registered firms but
business decisions to set prices, output, and investment are often not market-based, nor within the
purview of business. In the absence of any discipline, managers are left free to pursue their own
(or their political patrons’) objectives with little regard for the firm’s overall profitability.

Although exposure to bank lending is almost completely absent in Eurasian corporations, most
enterprises are known to run up wage arrears and inter-enterprise indebtedness remains
substantial in all Eurasian countries. This is partly a heritage from the Communist period, when
payments to other enterprises or tax authorities were made only on a book basis and were not
accompanied by a real cash transfer. Continuing arrears make the imposition of discipline in
external payments more complicated, with illiquidity contaminating the whole corporate sector.
At the same time it renders the latter more opaque: the real situation of individual enterprises
becomes more difficult to fathom in a general environment of arrears and barter payments

Insolvency systems have not been effective in Eurasia, neither as a disciplinary mechanism, nor
as a mechanism to re-allocate resources. In the case of Ukraine, for example, the current
bankruptcy law, which does not apply to state companies, provides for liquidation of a bankrupt
company but does not clearly specify the procedure for financial restructuring during bankruptcy
and is vague in many other respects. Thus, in 1998, 9075 cases reached the court, 3500
proceedings were initiated, but as of today less than 40 cases have had concrete results for the
debtor company. Other countries such as Georgia or Kyrghyzstan have been dotted with
relatively advanced insolvency legislation, which has, however, remained largely non-enforced.

d. The legacy of the Soviet management culture

Critical to the understanding of issues surrounding the emergence of corporate governance in the
Eurasian economies is the fact that many of the shortcomings of the former system were due to
massive and pervasive failures in the governance structure that existed under central planning and
social ownership of capital.

Radical shifts in corporate ownership and control structures in the region have ushered in
significant changes in the way companies and their management view their shareholders and set
their objectives and prospects for the future. However, a lot of the old patterns have stubbornly
persisted. State authorities and firms continue to be tied together in a web of incestuous
interaction, where the boundaries between regulator and regulee are often lost. Corporate
behaviour is still pray to the persistence of soft budget constraints. The state provides a wide

9
range of direct and indirect subsidies to firms, while firms provide public officials with a certain
amount of control over company decision-making and cash flows. Hence, the management’s
behaviour continues to be motivated largely by the search for new direct or indirect subsidies, not
by meeting existing or potential investor concerns. For some of the older managers, a lifelong
education in opportunism when it comes to using company assets for one’s own welfare—in the
absence of formal material rewards for success—has found new uses in the unpredictable
transition context. As some commentators have pointed out, while the Soviet manager’s
experience in making input and output decisions for firms was largely non-existent, improving
one’s own welfare by diverting state resources was a high art.

B. The main corporate governance problems

Since their adoption in 1999 by the 29 OECD member countries worldwide, the OECD Principles
of Corporate Governance have become the main point of reference for corporate governance
reform from a policy perspective. In March 2000, they were included in the Compendium of 12
global standards for financial stability, compiled by the Financial Stability Forum. As such, they
are expected to be used increasingly for country assessments by international financial
institutions, namely the World Bank. It seems therefore appropriate to look into some key
problems areas in Eurasian corporate governance using the taxonomy of these Principles, i.e.
following their five chapters.

a. The rights of shareholders

What is perceived as the region’s unfavourable investment climate is, to a considerable extent,
due to the lack of credible investor protection. Corporate laws do not establish sufficient legal
rights for shareholders, and even when they do, enforcement mechanisms and remedies against
violations of shareholder rights are inadequate or non-existent. The protection of the rights of
shareholders is a pillar of any effective corporate governance system. The first important right in
this respect is an effective system for the registration of ownership. In Eurasia, share registration
has often been the victim of fraudulent practices in the past.

The ability to participate in basic decisions concerning the company, chiefly by participation in
general shareholder meetings is set forth as an important right. Most typical shareholder
violations in Eurasia include the refusal to provide information on a company’s activity in view
of the shareholder’s meeting, the creation of important obstacles towards participating in the
general meeting and the introduction of changes to company charters without a general meeting’s
decision. In 1999, the Ukrainian Securities Commission received 9,345 complaints from citizens
and professional securities market participants on the violation of their rights and lawful interests;
this is 33.5% more than in 1998. Share dilution by controlling owners has also been reportedly
widespread and the ensuing transfers of control, mainly to incumbent management, have been
quite opaque. These are ongoing failures of the system in Ukraine, Moldova and Georgia. They
most often affect small voucher-holders-turned-shareholders and employees.

b. Equitable treatment of shareholders

The OECD Principles stipulate that the corporate governance framework should ensure the
equitable treatment of all shareholders. To begin with, this includes the right to judicial
protection. As we mentioned above, this right is severely limited under weak rule of law
conditions prevailing in Eurasia. In Georgia, although the minority shareholder rights provided in
the Law on Entrepreneurs are deemed adequate, the basic problem is that minority shareholders

10
are not fully aware of their rights, and management – who may or may not be aware of these
rights themselves – are not motivated to make minority shareholders aware of their rights.
Meanwhile, the few institutional investors that could have spearheaded the effort for better
corporate governance have not been present. In Kazakhstan, it is hoped that the newly formed
pension funds will fulfil some of these roles and increase the potential of local securities market.

As described above, self-dealing by managers and controlling shareholders is the scourge of most
Eurasian countries. Throughout the region, corporate governance is part of a vicious circle of
entrenched insider control and low outside investment. Company managers, who are often also
shareholders, use the company’s assets for personal gain to the detriment of minorities. As a
result, outside investors have little confidence that they will be able to weigh on the company’s
decision making process and stay away.

Self-dealing—or related party transactions as it is known in company law—may take a number of

forms. It can be done through transfer pricing, i.e. selling at very low prices to companies set up
by insiders or buying at very high prices from such companies. It can take the form of outright
asset stripping through asset sales to insider-controlled companies. Self-dealing cannot be
reversed unless very strong legal sanctions are attached to it. These should arguably include penal
sanctions, as is the cases in some OECD countries, such as France. There should also be a strong
and enforceable requirement on managers, to disclose any direct or indirect interest they have in a
transaction with the company. Securities Commissions should be given enough power to
implement such requirements. In most Eurasian economies, there are no rules on disclosure of
related party transactions.

c. The role of stakeholders

The OECD Principles point out that it is in the long-term self-interest of firms to encourage
stakeholder active participation in the governance process. Legal rights of stakeholders (i.e.
employees, creditors, long- term suppliers and customers among others) should be effectively
respected. Factors such as business ethics and corporate awareness of the environmental and
societal interests of the communities in which a company operates can have an impact on that
company’s reputation and long-term success; but these are not yet on the agenda of local Eurasian
managers or investors.

Most importantly, the legislative framework that primarily ensures the protection of stakeholders’
interests from abusive corporate behaviour is not in place. Consumer and environmental
protection laws, environmental protection and an adequate, market–oriented labour law are still in
their infancy in most of the region.

In Eurasia, stakeholders-- especially employees-- receive little information and have little voice in
corporate governance, despite the fact that they are also shareholders of their company.
Employee presence could potentially be a powerful force for monitoring the fiduciary functions
of managers and limiting self-dealing. However, at present, employee stakes are often
manipulated through threats and strategic behaviour to consolidate the power of management and
create a bigger divergence between control and cash flow rights.

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d. Disclosure and transparency

Good corporate governance calls for a strong disclosure regime, acknowledging transparency as a
key element of an effective market economy. They call for timely and accurate information to be
disclosed on matters such as the company’s financial and operating results. Most countries in the
region have taken the initiative to improve transparency and reporting practices by either
adopting International Accounting Standards, as in the Kyrghyzstan, or by using International
Accounting Standards as the basis for national accounting systems, as in Ukraine and Moldova.
Indeed, in some respects Eurasia is much more advanced than Russia in adopting market-based
accounting practices and breaking with the old Soviet tax-based accounting prescribed by the
Ministry of Finance. However, in practice many companies continue to have a double
bookkeeping policy, especially to avoid paying heavy taxes.

In the Ukraine, there are no clearly specified mechanisms or restrictions on the appointment and
withdrawal of external auditors. Even though independent auditors are required, the company
management usually appoints and dismisses them with little outside scrutiny. Most strategic
investors are familiar with lax accounting and audit practices and try to impose international
independent audits before acquiring company stakes. But management is still in a position to
raise important obstacles to a meaningful due diligence. An important task that lies ahead is the
creation of adequate professional bodies in the region that can impose a credible quality and
ethics control on their membership and become the driving force for transparency. During the last
couple of years there have been quite a few positive developments in this respect in the region

It is much more difficult to obtain disclosure of non-financial information such as the company’s
objectives, major share ownership and voting rights, remuneration of key executives, personal
material interests of the board and management in matters affecting the corporation, and material
foreseeable risk factors. In most Eurasian countries there are few requirements for non-financial
disclosure. Under these circumstances, control structures are non-transparent and consequently
self-dealing goes largely undetected. Reportedly in Kazakhstan there are five big corporate
groups in the country but due to complex arrangements between companies, it is practically
impossible to identify the real owners of these companies.

Developing Eurasian infant stock exchanges might depend on the availability of financial and
non-financial information. Stock exchanges should therefore take the lead in introducing
international standards and practices, both in terms of regulation and enforcement.

e. The responsibilities of the board

The board of directors should be the main mechanism for the effective monitoring of
management and for providing strategic guidance to the corporation. It is the duty of the board to
act fairly with respect to all groups of shareholders and with stakeholders, and to assure
compliance with applicable laws. Board members should be able to exercise objective judgement
on corporate affairs, independent of management. Good corporate governance hinges upon the
competence and integrity of directors and the board as a whole.

Boards of directors are legally mandated in most of the region’s countries. In Ukraine, since
January 1998, joint stock companies with more than 50 shareholders have to elect a board of
directors, which represents the interests of shareholders. But, in practice, management is often
unwilling to recognise the body, which supervises its activities. As it stands, many established
joint stock companies don’t have operating boards of directors.

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As the presence of the state as a shareholder is still quite important in the region, it could be used
to improve board structures. The government and its asset management institutions (i.e. State
Property Funds) could adopt property management policies force companies to have independent
boards that take their monitoring roles seriously. Directors could be trained to this effect.
Important positive spillovers could be generated for private companies and the market as a whole,
if the government were to become a corporate governance pioneer. In many OECD countries the
state is taking a similar stance of an activist owner: Sweden and Italy have both used their
ownership stakes to improve board structures and enhance corporate governance.

IV. Concluding Remarks

The Eurasian transition experience shows that reformers have underestimated the importance of
institutions. The lack of properly functioning private institutions, i.e. corporations, impacts
directly on growth by limiting the availability of debt and equity investment. It also impacts on
the distribution of income within a society: with more transparency and accountability major
shareholders or controlling directors will have less of an opportunity to strip assets at the expense
of all the other stakeholders--and the society as a whole. But the proper functioning of companies
also depends on the existence of adequate public institutions, such as courts, bailiffs, securities
commissions etc. that are ready to enforce property rights and governance rules.

While good corporate governance cannot exist without an adequate level of public governance,
public governance will never taker off unless the private sphere of the economy and its main
players, the companies become transparent, law- abiding corporate citizens. Awareness of this
mutual interdependence should be at the centre of any reform effort.

Over the last few years, decision-makers have become more aware of weak corporate governance
practices and their effect on the economy as a whole and are taking steps to strengthen their
corporate governance framework. In July 1997, the Kyrgyz government was the first in the
region to adopt by decree a handbook on corporate governance, which emphasises the importance
of good corporate governance and provides a model company charter.

But government initiatives are not enough. Private sector action is essential if good governance is
to take hold. For private sector action to take place, managers and other key decision-makers
need to be persuaded that good corporate governance is good for business. In this respect, outside
investors and, in the case of Eurasia, international financial institutions such as the EBRD and the
IFC could take a much more activist stance and give corporate governance more weight in their
investment policies.

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