Rent Extraction by Large Shareholders Evidence Using Dividend Policy in the Czech Republic Jan Bena, Jan Hanousek CERGE-EI, new version soon

Corporate Governance DISPERSED ownership  How to align incentives of management with those of atomistic shareholders? Control by a LARGE SHAREHOLDER  Predominant in Europe and East Asia (the Czech Republic)  Shift from management-shareholder conflict to the one amongst shareholders themselves  Faccio et al. (2001): East Asian financial crisis in the late 1990s was to a large extent due to the presence of malfunctioning corporate governance structures based on a concentration of ownership with features of “crony capitalism”

Survey of Dividend Theories Lintner (1956): partial adjustment process towards a target payout ratio Free Cash Flow Theory  Divert free funds managers have power over within corporations away from them  Theory: Easterbrook (1984); Jensen (1986); Zwiebel (1996)  Empirics: Gugler (2003); DeAngelo, DeAngelo, and Stulz (2004); Desai, Foley, and Hines (2002); Dewenter and Warther (1998); Laporta, Lopez-de-Silanes, Shleifer, and Vishny (2000) Signaling Theory  Communicate the level and growth of earnings or future prospects of the company to investors  Theory: Bhattacharya (1979); Miller and Rock (1985)  Empirics YES: Bernheim and Wantz (1995); Amihud and Murgia (1997)  Empirics NO: Benartzi, Michaely, and Thaler (1997) (Tax) Clientele Theory  Some investors benefit from special treatment in the tax law  Summary: Allen, Bernardo and Welch (2000)

Literature: Gugler and Yurtoglu (2003) Analyze dividend announcements and pay-out ratios in Germany Look at the conflict between large controlling shareholder and minority shareholders arising from private benefits of control Dividends are device for small shareholders to limit rent extraction by controlling owners "Majority-controlled and unchecked" firms have the smallest target pay-out ratio "Majority-controlled and checked" firms have the largest target pay-out ratio

Literature: Gugler (2003) Estimates the effect of ownership on dividend policy using data from Austria Ownership and control structure of a firm is a significant determinant of its dividend policy State-controlled firms  Engage in dividend smoothing, have the highest target payout ratios, are the most reluctant to cut dividends Family-controlled firms  Do not smooth dividends, are the least reluctant to cut dividends Czech economic environment and institutional setting is very different from the one in Austria We benefit from a large sample We use different estimation technique

Literature Gugler and Yurtoglu (2003): expropriation problem present in Germany Zingales (1994): expropriation by large shareholders significant in Italy Bergström and Rydqvist (1990): NO in Sweden Barclay and Holderness (1989, 1992): NO in the U.S. Faccio et al. (2001):  Systematic expropriation of outside shareholders in Western Europe and East Asia  Extensive ownership pyramids  Europe:Other large shareholders contain the controlling shareholder’s expropriation of minority shareholders  Asia:They collude in that expropriation Is the Czech Republic like East Asia or like Western Europe?

Research Questions Functioning of the Czech corporate governance Shleifer and Vishny (1997): Large shareholders have a dual impact  Strong incentive to monitor management  Extract rents, enjoy the private benefits of control Do majority shareholders divert profits (extract rents) from minority shareholders? How substantial the rent extraction is? Are minority shareholders able to preclude significant rent extraction?

Evidence from Dividend Policy Dividend payout depends on concentration and domicile of ownership  Firms with a dominant majority owner pay dividends less often and their target payout ratio is small  Firms with a majority owner and at least one strong minority owner pay dividends more often and the target payout ratio is large  Controlling for Investment opportunities Capital structure decision Endogeneity of ownership with respect to performance Several levels of ownership concentration and types of the single largest owner. Holds both for domestic and foreign owners.

Dividend and Capital Gains Income Taxation Companies distribute dividends from after-tax- profits Same income dividend tax treatment applied to individuals and corporations Flat tax rate 25 %; in 1999 lowered to 15 % Foreign owners: tax treaty between Czech Republic and the country of the receiver Double taxation of dividends prevented Marginal tax rate on cash dividends is the same for all types of shareholders Tax considerations or tax clientele effects cannot drive cross-sectional differences in dividend policies

Specific Features of the Czech Republic Privatization  Ownership structure of Czech companies was set bureaucratically by government Legal uncertainty  Corporate governance structures nonexistent  Evolution of institutional and legal framework slow  Weak law enforcement Dividend taxation  Marginal tax rate the same for all types of owners  Tax considerations cannot drive cross-sectional differences in dividend policies  Foreign owners: special tax treaties

Ownership Structures: Variables Definition Concentration: Czech corporate law assigns control rights to different ownership levels:  Majority> 50.0%  Blocking minority> 33.3% and ≤ 50.0%  Legal minority> 10.0% and ≤ 33.3%  Dispersed≤ 10.0% We define concentration of ownership variables:  MAJORITY  MONITORED MAJORITY  MINORITY  DISPERSED Domicile  Czech, Foreign

Model Lintner's specification with ownership structures Control Variables  Firm size, Leverage, Cash holdings  Bank power (Bank loans / Total liabilities)  Growth Opportunities (Industry level sales growth rate) Data  1,660 companies privatized in traded on the Prague Stock Exchange (ASPEKT)

Data Problems & Estimation Technique Less than 10% of firms pay dividends Missing financial data for firms that do not pay dividends  Sample selection bias if Lintner’s model estimated directly  2-stage estimation (Heckit regression)  STAGE 1: Decision to pay dividends (LPM)  STAGE 2: Size of dividend payout (2SLS/IV) Ownership endogenous with respect to performance  Hanousek, Kočenda, and Švejnar (2004)  Instrumental variables from privatization  Bureaucratic process and predetermined through time

STAGE 1 Results: Decision to Pay DomicileConcentration CZECH *** FOREIGN *** Czech MAJORITY *** Czech MONITORED majority *** Czech MINORITY *** Foreign MAJORITY *** Foreign MONITORED majority *** Foreign MINORITY *** Observations5,437 Sargan test (p-value)1.16 (.16)1.05 (.37) Adjusted R

STAGE 2 Results: Size of Dividends Alfa Target payout ratio Czech MAJORITY *** *** Czech MONITORED majority *** *** Czech MINORITY *** *** Foreign MAJORITY *** *** Foreign MONITORED majority *** *** Observations468 Hausman test (p-value)0.26 Adjusted R

Results Summary Quantitative evidence on expropriation that takes place within Czech companies Firms with a dominant majority owner  Pay dividends less often  Target payout ratio is small Firms with a majority owner and at least one strong minority owner  Pay dividends more often  Target payout ratio is large Holds both for the Czech and foreign largest owners Czech owners seem to extract more than foreign owners

Policy Implications Not simply a matter of redistribution amongst shareholders only Corporate insiders choose to invest in projects with low or negative returns just because they create opportunities for expropriation Investment decisions are distorted and corporate growth is slower than it could be Regulators should  Support the development of sound and transparent financial markets as they seem to be able to police dominant owners most effectively  Strengthen the rights of minority shareholders

Privatization in Central-East Europe and the CIS Survey by Estrin, Hanousek, Kocenda, Svejnar

Main Questions ongoing debate among economists and policy makers about the efficiency and distributional effects of different methods and sequencing of privatizations around the world focus on the experiences during the last years in the transition economies

Characteristics 1 Unlike most developing countries, the transition economies for instance did not merely privatize a number of key state- owned firms or strive to improve the functioning of their legal and institutional framework. They carried out major reforms that made the share of private sector in GDP increase from extremely low levels

Characteristics 2 transition economies differ from most other developing countries because of their relatively high level of human capital, initial lack of wealth in private domestic hands, and the heritage of anti-entrepreneurialism they share with many other developing countries “weak” institutions, such as poorly conceived and/or ineffectively enforced property rights and insufficiently developed capital markets

Ownership Structures in CEE (1) Ownership structures in CEE share three main characteristics:  The significant ownership by insiders (managers and employees)  The importance of remaining state ownership and control (especially regarding big utilities)  The emergence of institutional investors, mainly former privatization funds These three common characteristics engender specific problems and difficulties regarding corporate governance practice

Ownership Structures in CEE (2) Changes are in process with strong common trends  Increased concentration in individual companies. This derives from: Initial excessive ownership dispersion Inability or great difficulty for minority investors to have their rights respected  De-listing of public companies  Formation of holding companies on the basis of former privatization funds

Recent Surveys 1 Djankov and Murrell (JEL 2002, about 30 studies):  privatization to outside owners (not current managers or workers) was the most important determinant of improved company performance, assisted by harder budgets constraints, i.e. that firms’ access to formal or informal state help was curtailed.  other positive factors: presence of domestic competition for the newly privatized firms, as well as competition from imports.  the impact of privatization on company performance was typically smaller and less significant in Central and Eastern Europe than in the Commonwealth of Independent States (CIS) that came into place to replace much of the former Soviet Union explained by two factors: the more widespread occurrence of insider ownership post-privatization, and a weaker institutional environment leading to less effective governance by outside owners in the CIS countries.

Recent Surveys 2 Megginson’s recent book (2005, about 35 studies):  surveys the evidence on the impact of privatization in transition economies  He concludes that “mass” (or voucher) privatization, whereby ownership rights were distributed widely and at nominal prices to the population, often led to disappointing outcomes, perhaps because frequently associated with insider ownership  Companies where insiders gained control did poorly but firms with “real owners” (financial institutions, foreign corporations, or local entrepreneurs) were able to improve their performance.

EHKS survey About 65 studies from early 1990’s up to early 2007 Some overlap with Djankov and Murrell (JEL 2002) and Megginson (2005) More attention to quality of:  estimation techniques  Data  Sample size (N x T)

Effects of Privatization on Enterprise Performance relative to state owned firms, private firms are expected to have superior corporate governance via the role of external owners in monitoring managerial performance Managerial incentives to act in ways that improve corporate value are also sharper because of  (a) managerial markets that reward efficiency and punish poor performance  (b) managerial payment schemes such as stock option plans that align managerial and owners’ incentives  (c) effective monitoring, often driven through competition in stock exchanges and highly transparent through stock market prices,  (d) effective bankruptcy laws that affect private but not necessarily state-owned firms, and  (e) the threat of hostile takeovers whereby poorly functioning managers can be replaced through competitive bids by alternative management teams.

Role of Institutions The previous arguments suggest that institutions that will be crucial for privatization to be successful will include property rights enforcement, capital market development and a well functioning managerial market.

Privatization and capital markets connection between privatization method and stock market development in transition countries has not been well established or sufficiently covered Generally speaking, developments of the capital markets in transition countries has so far been largely shaped by the nature of privatization programs, although privatization methods in transition countries were rarely driven by the objective of developing a modern capital market

Obstacles in Assessment 1 The process of transition and development expands the number of factors influencing the impact of privatization, and therefore needing to be controlled in empirical work. First, it may matter how the firms were privatized  In developed market economies, privatization has almost always been to the highest bidder, but transition was associated with experimentation in privatization methods.  Different privatization methods can in turn lead to different owners, managers, governance structures, and therefore post-privatization company performance.

Obstacles in Assessment 2 Second, it may matter to whom firms were privatized -- insiders as opposed to outsiders, concentrated or dispersed owners, domestic or foreign owners Third, the selection of firms was not a random process, and indeed the proportion of retained state shares, as well different types of private ownership may be determined by enterprise characteristics. It matters how estimation is done because of endogeneity, data quality&quantity, standards

Empirical Evidence: Categories Since the studies are heterogeneous with respect to their methodologies and the nature of the data used, we classify studies as belonging to category 1, 2 or 3 category 1 (C1) containing studies that use IVs or at least fixed effects to handle the selection/endogeneity problem in ownership and have a sample size of at least 200 firms, or at least 75 firms in small countries such as Slovenia category 2 (C2) including studies that use IVs or fixed effects but work with smaller sample sizes than C1 category 3 (C3) having studies that use OLS In our evaluation, we place emphasis on studies in C1 and C2.

Total Factor Productivity (TFP)1 Twenty four studies that analyze the impact of ownership on TFP or rate of change of TFP Nine studies belong to C1, seven to C2 and eight to C3 The studies that break private ownership into several categories find that the overall private v. state ownership dichotomy includes different private ownership effects They suggest that privatization to foreign owners increases or does not decrease efficiency… while the effect of domestic private ownership is less uniformly positive, sometimes is negative, and the quantitative effect is usually smaller.

Total Factor Productivity (TFP)2 Concentration of ownership plays an important part, with a majority private ownership having mostly positive effects on TFP. The positive effect is again driven primarily by foreign ownership of firms The effect of majority domestic private ownership ranges from positive to negative.

Labor Productivity 1 Estimates related to the effect of ownership on labor productivity (not controlling for the use of others inputs) are based on twenty two studies with fourteen belonging to C1 and C2. The results of these studies have a less clear-cut interpretation since differences across types of firms could be due to different efficiency or simply to different non-labor factor intensity. The findings of C1 and C2 studies are again mixed, with private ownership registering primarily positive or insignificant effects. As in the case of TFP, the diversity persists across both the CEE and CIS regions.

Labor Productivity 2 Similarly, as in the case of TFP, foreign ownership and concentrated ownership are found to have a non- negative effect… while the effects of employee and management ownership are estimated to be mostly statistically insignificant. Finally, newly established firms are found to have lower labor productivity than others in some studies but not in others Using Czech data, Hanousek et al. (2007) find that ownership by domestic industrial companies and investment funds generates lower labor productivity than all other types of ownership (including state) and that ownership by foreign industrial companies and government retention of a golden share (veto power over certain key decisions) have a positive productivity effect.

Profitability 1 Profitability is in many respects the ultimate measure of efficiency, although in the transition economies, as in many developing countries, profits may be underreported by firms to evade taxes. The effects of ownership on profitability or rate of change of profitability have been examined in thirteen studies, four of which belong to C1, five to C2 and four to C3. Most studies use data from the Czech Republic and Ukraine, but some use data from Belarus, Bulgaria, FYR Macedonia, and Russia. The results are again mixed.

Profitability 2 Foreign ownership (especially by non-financial companies) appears to have a positive or insignificant effect on profitability… while the effect of foreign ownership on the rate of change of profitability is insignificant. The effect of domestic private ownership is for the most part insignificant or depends on the particular type of owner (bank, investment fund, individual, etc.), with some financial owners generating positive effects. In this finer categorization, however, the effects vary across studies.

Sales and Revenues eighteen studies, with ten of them controlling for endogeneity/selection of ownership (C1 and C2). The results are again mixed, with private ownership (containing all types of private owners) displaying a positive effect on the level of sales in some studies. However, the effect of private ownership is insignificant or negative in the other studies, suggesting that firms reduced their size or rate of growth after privatization. Among the studies that control for endogeneity/selection of ownership, Hanousek et al. (2007) finds ownership by foreign industrial firms to have a positive effect but the effect of ownership by foreign non-industrial (financial) firms is found to be insignificant.  Hence foreign industrial ownerstend to increase the scale of operations of the acquired firms, while foreign financial owners (funds and banks) tend to reduce it.

Employment Eighteen studies have examined the effect of ownership on employment or rate of change of employment, with eleven of them belonging to categories C1 or C2. The results are again quite varied, but there is a discernible tendency for privatized firms, especially those with foreign owners, to increase or not to reduce employment relative to firms with state ownership, ceteris paribus. In the early-to-mid 1990s, when employment was falling in many transition economies, this relationship amounted to a smaller or similar decline in employment in the privately owned, especially foreign owned, firms as in the SOEs. Employee ownership and control appear to have zero effect on employment, providing parallel evidence to the TFP studies that this form of ownership does not result in excess employment.

Wages Studies of the effects of ownership on wages find that state ownership is associated with lower wages in some countries, such as Russia and former Czechoslovakia, but not in others, such as Poland. Private firms also tend to have steeper and more concave experience-earnings profiles – paying higher returns on a year of experience to employees with low experience (recent entrants into the labor market) and lower returns to the more experienced (older) workers. In countries where in the 1990s firms tended to owe wages to their workers, SOEs were more likely to exhibit wage arrears than firms with mixed ownership and de novo firms, but not more than domestic private and foreign-owned firms

Other Indicators of Performance Finally, at least thirty four studies have analyzed the effect of ownership on other dependent variables  Tobin Q, return on assets etc. The results are again diverse, but there is a pattern: private ownership does not have a major effect on return on assets, investment, environmental emissions, and the price cost margin private ownership has a non-positive effect on costs and a positive effect on exports. It also appears that financial firms as owners have a negative effect on the rate of change in labor cost/sales, profit/labor cost and profit/equity.

Preliminary conclusions 1 While the earlier surveys of CEE and CIS differed in their conclusions about the effects of privatization on performance, most of them created a general presumption that the effect of privatization on performance is positive. More recent studies have used larger data sets and controlled more thoroughly for potential endogeneity/selection of ownership. The results presented in this survey suggest that the estimated effects of ownership on performance vary with data sets, econometric techniques and the time period under consideration.

Preliminary conclusions 2 Moreover, while foreign ownership is at times associated with superior economic performance, domestic private ownership has much less definite impact on performance than had been claimed in some of the earlier surveys. Our study hence suggests that privatization of state-owned firms to domestic owners in Central and East Europe and the Commonwealth of Independent States, one of the largest transfers of wealth in history, did not have the expected, strongly positive effect on economic performance per se.