Privatization and Principal Principal Conflicts in Transition Economies

Chapter 11
Privatization and Principal-Principal

Conflicts in Transition Economies
Canan Mutlu, Mike Peng, and Marc van Essen
The corporate governance literature identifies two major governance models.

The first is based on equity finance, controlled by capital markets, and mostly
seen in common law system countries such as the United Kingdom and the
United States. The second is based on debt finance, controlled by finan-
cial institutions, and mostly seen in continental European countries (such as
Germany) and Japan. Because both equity and debt markets were underdevel-
oped, transition economies (also some South American and Asian countries)
have introduced a third model characterized by concentrated ownership (Estrin,
Hanousek, Kočenda, & Svejnar, 2009; Pistor, 2006). Transition economies are
formerly socialist countries and are distinguished by a number of institutional
and organizational features that introduce peculiar problems and may dictate
differences in corporate governance mechanisms. In fact, “no other place in the
world offers such ample and creative corporate governance pathologies” (Fox &
Heller, 2006: 391). In particular, principal-principal (PP) conflicts, which refer
to the potential expropriation of minority shareholders by controlling owners,
are among the most well known corporate governance problems in transition
economies (Young et al., 2008).
PP conflicts often stem from two conditions: (1) a controlling shareholder and
(2) weak shareholder rights to protect minority shareholders (Sauerwald & Peng,
2013; Young et al., 2008). The main corporate governance problem in developed
economies is the principal-agent (PA) problem referred to as the conflict of inter-
est between principals and agents (Jensen & Meckling, 1976). However, many
scholars argue that agency theory does not adequately explain how corporate gov-
ernance is shaped by institutional embeddedness (Aguilera & Jackson, 2003; La
Porta, Lopez-de-Silanes, Shleifer, & Vishny, 1998; van Essen, van Oosterhout, &
Carney, 2012). On the one hand, the United Kingdom and the United States are
known for relatively efficient external control mechanisms that limit PP conflicts,
whereas Germany is known for relatively strong internal control mechanisms that
help with traditional PA problems (Dharwadkar, George, & Brandes, 2000). On
the other hand, transition economies are still characterized as institutional voids
and lack strong internal and external control mechanisms (Carney et al., 2011).
M. Goranova et al. (eds.), Shareholder Empowerment

© Maria Goranova and Lori Verstegen Ryan 2015
240 C A N A N M U T L U, M I K E P EN G , A N D M A R C VA N E S S EN
Although transition economies share many common characteristics with other

emerging economies (e.g., weak institutions, and limited financial and techno-
logical resources), they are at the same time distinct because of the magnitude of
privatization and related institutional transitions (Estrin et al., 2009; Megginson
& Netter, 2001). This distinctness—due to establishing market institutions from
scratch—provides unique insights in testing management theories originated
from developed economies (Peng, 2003).
Privatization operates as a natural experiment to study how corporate gov-
ernance mechanisms evolve, interact, and affect firm performance (Boubakri,
Cosset, & Guedhami, 2005; Denis & McConnell, 2003). Extant management
and finance literature is devoted to understanding several aspects of privatiza-
tion: its outcomes (Goodman & Loveman 1991), its antecedents and trends
(Doh, 2000), country-level differences (de Castro & Uhlenbruck, 1997; Henisz,
Zelner, & Guillen, 2005), and the role of government ownership (Vaaler &
Schrage, 2009). Overall, privatization characteristics vary across countries, such
that developed, developing, and transition economies have major differences
that should translate into differences in the means and the ends of privatization
(de Castro & Uhlenbruck, 1997; Lenway & Murtha, 1994). Accordingly, this
chapter endeavors to address a previously underexplored question: How does
privatization impact PP conflicts in transition economies?
We argue that privatization plays two key roles on the evolution of PP
conflicts, as depicted in figure 11.1. First, privatization has a direct effect on
the level of institutional development and specifically on the formulation and
enforcement of legal reforms concerning shareholder protection rights (Pistor,
2006). Although shareholder protection rights, along with other formal insti-
tutions, are essential for effective privatization processes, they are also weak in
transition economies, offering a new window to understanding the new agency
Antecedents of PP conflicts
Formal Institutions
Weak institutional support for
formal governance mechanisms
Informal Institutions
Family control, business groups
Privatization PP Conflicts
Method, speed Goal incongruence between
controlling and minority
shareholders
Concentrated
Ownership
Figure 11.1 The role of privatization on principal-principal conflicts

Source : Adapted from Young et al. (2008).
P R I VAT I Z AT I O N A N D P R I N C I PA L- P R I N C I PA L C O N F L I C T S 241
problems centered on PP conflicts (Dharwadkar et al., 2000; Estrin et al., 2009).

Second, the privatization method also affects the identity of the new owners
(Douma, George, & Kabir, 2006; Heugens, van Essen, & van Oosterhout,
2009). Specifically, the heterogeneity in terms of the methods and speed of
privatization helps us to understand the underlying conditions that contributed
to the evolution of concentrated ownership over dispersed structures (Boubakri
et al., 2005). Therefore, we address PP conflicts in transition economies and
specifically explore the role of privatization on institutional development and
firm ownership structure.
Principal-Principal Conflicts
The literature on corporate governance introduces a puzzle. On the one hand,
many studies have argued from the viewpoint of dispersed ownership that requires
efficient markets, strong shareholder protection, and other market disciplinary
mechanisms. An efficient securities market is then viewed as a precondition of
economic growth (Rajan & Zingales, 1998). On the other hand, empirical evi-
dence has also highlighted the prevalence of concentrated ownership, which is
the dominant capital structure in most regions in the world, including Latin
America (Céspedes, Gonzá lez, & Molina, 2010), continental Europe (Faccio &
Lang, 2002), and Asia (Claessens, Djankov, & Lang, 2000; Jiang & Peng,
2011b). Concentrated ownership is generally characterized by controlling share-
holders, weak securities markets, low disclosure and transparency standards, and
high private benefits of control (Coffee, 2001).
Private Benefits of Control

PP conflicts typically stem from private benefits of control: specifically, large
shareholders’ gains from exerting influence on a firm at the expense of minor-
ity shareholders (Barclay & Holderness, 1989). The concept is usually defined
as the additional private benefits stemming from a controlling position in the
firm, which add up to the cash-flow benefits of fractional ownership (Dyck &
Zingales, 2004). The possibility of enjoying private benefits tends to arise when
national jurisdictions allow decision rights to be decoupled from cash-flow
rights, by allowing for either dual-class shares or pyramidal holding structures.
In reality, the vast majority of jurisdictions allow for at least one of these control
vehicles (Claessens et al., 2000; La Porta, Lopez-de-Silanes, & Shleifer, 1999).
Private benefits of control tend to take several forms. At least four are rou-
tinely described in the literature: (1) perquisites enjoyed by executives (corpo-
rate jets, exclusive golf club memberships, and the like), (2) excessively high,
performance-insensitive pay enjoyed by executives, (3) “tunneling,” or causing
below-transfer-price sales of corporate assets to other firms that are wholly or
majority-owned by controlling insiders, and (4) inside informational advantages,
which form the private (and usually legal) equivalent of insider trading (Johnson,
La Porta, L ópez de Silanes, & Shleifer, 2000; Young et al., 2008). Prior research
has shown that the average private benefits of control amount to about 14 percent
across countries, typically measured as the block premium that investors are
willing to pay over and above the stock market price of the equity composing
the controlling block (Dyck & Zingales, 2004). This 14 percent amounts to
investors’ expectations concerning the level of private benefits that controlling
shareholders enjoy, that is, those that the noncontrolling shareholders are not
able to share. Private benefits are low, or less than 10 percent, in Scandinavia,
the United Kingdom, the United States, and Japan; intermediate, or greater
than 10 percent but lesser than 30 percent, in most other developed states in
continental Europe and Asia; and excessive, or greater than 30 percent, in the
(partially) failing economies of Europe (the Czech Republic, Italy), Asia, and
Latin America.
The general concern about the private benefits of control is that the control-
ling shareholders may have incentives to extract private benefits at the expense
of minority shareholders (Globerman, Peng, & Shapiro, 2011; Young et al.,
2008). Therefore, two opposing arguments have developed concerning the con-
sequences of concentrated ownership and PP conflicts in transition-economy
contexts. On the one hand, some scholars argue that concentrated ownership
is beneficial for firm performance in cases where legal institutions to protect
shareholders are less developed. In this view, concentrated ownership replicates
the effectiveness of governance that results from low levels of minority share-
holdings in developed economies (Dharwadkar et al., 2000) such that “own-
ers who are not protected from controllers will seek to protect themselves by
becoming controllers” (Lins, 2003: 159). On the other hand, some scholars
underscore controlling shareholders’ expropriation through engaging the firm
in non-value-creating activities that advance personal agendas (Su, Xu, & Phan,
2008; Young et al., 2008).
Expropriation refers to “the disproportional sharing of gains (or losses)
among different shareholders” (Faccio & Stolin, 2006). Well known means of
expropriation by controlling shareholders include appointing underqualified
people to managerial positions (Faccio, Lang, & Young, 2001), paying above-
market rates for supplies (Khanna & Rivkin, 2001), acting in line with national
pride or industrial policy considerations rather than profit motivation (Chen &
Young, 2010), and pursuing personal agendas at the expense of firm interests
(Young et al., 2008). Another well known means of expropriation, noted above,
is below-market value asset transfers to the private holdings of large shareholders
(Su et al., 2008). Accordingly, controlling shareholders choose successful firms
in which to invest, and then transfer profits to affiliate firms in the business
group (Chang, 2003). This way they control several firms through pyramids and
cross-shareholding (Carney et al., 2011). Indeed, even in the United States, the
media has reported extensively on the recent trend toward “unequal shares” in
Silicon Valley IPOs (Surowiecki, 2012), which adds a twist to the “one share-
one vote” system in the United States. Overall, the organizational outcomes of
goal incongruence between controlling and minority shareholders are increased
monitoring and bonding costs, non-value-maximizing strategies, and increased
costs of capital (Young et al., 2008).
The level of private benefits of control and expropriation by controlling
shareholders depends, in part, on the formal and informal context in which
firms operate (Aguilera & Jackson, 2003; Djankov, La Porta, Lopez-de-Silanes,
& Shleifer, 2008). In terms of formal institutions, when the rule of law is weak,
expropriation becomes a more severe problem (Heugens et al., 2009; Jiang &
Peng, 2011a). Specifically, differences in legal investor protection across coun-

tries shape insiders’ ability to expropriate outsiders (Djankov et al., 2008). For
example, Faccio and her colleagues (2001) examine dividends as a proxy for
non-expropriation and report that group-affiliated corporations in Europe pay
significantly higher dividends than similar firms in Asia. These findings indi-
cate that expropriation is indeed “exacerbated” due to a lack of shareholder
rights in Asia. Li and Qian (2013) also show that in institutionally weak regions
in China, target firms’ resistance to acquisition weakens, which is evidence of
the conflict between controlling and minority shareholders related to corporate
takeovers in institutionally weak contexts. Heugens and his colleagues (2009)
further argue that when shareholder interests are firmly protected, controlling
shareholders’ private benefits of control decline and concentrated ownership
becomes redundant.
Informally, such extralegal factors as the media, network relationships, and
moral norms may influence PP conflicts (Jiang & Peng, 2011b). For example,
media exposure can play a positive role in corporate governance by forcing politi-
cians into introducing certain regulations or affecting managerial reputation in
cases of self-dealing. For example, Dyck, Volchkova, and Zingales (2008) show
that coverage in the Anglo-American press increases the probability that a corpo-
rate governance violation is reversed for Russian firms. Similarly, Qi, Yang, and
Tian (2014) show that Chinese firms with more media exposure are more sensi-
tive about their financial reporting quality than their peers with less media expo-
sure are. In contrast, political connections may act as informal mechanisms that
limit shareholder protection. For example, Faccio (2006) reports that controlling
shareholders connected with national parliaments or governments are associated
with barriers to investment and higher levels of corruption.
In sum, researchers acknowledge that the traditional Jensen and Meckling
(1976) conceptualization of PA conflicts does not account for the realities of PP
conflicts that typically dominate transition economies that have gone through
massive privatization and established market institutions from scratch (Estrin
et al., 2009; Young et al., 2008). Next, we explore how privatization impacts PP
conflicts.
The Role of Privatization on PP Conflicts

The primary goal of privatization is “to create true representatives of capital—
individuals or groups of individuals who clearly reap the gains from improved
performance” (Nellis, 1999: 180). Privatization has been a central reform for
transition economies due to its economic, social, and political impact through
restructuring the failing state companies and eliminating the constraints on
managerial actions imposed by central planning (Filatotchev et al., 2003).
Privatization provides an interesting setting to study PP conflicts, because it
is a discrete event that often leads to a drastic change in the ownership structure
(Boubakri et al., 2005) and also has a direct effect on the evolution of institutions
(Pistor, 2006). Privatization in developed economies occurs in the context of
effective internal governance, effective external governance, or both. In marked
contrast, privatization in transition economies occurs in “a context in which both
internal and external mechanisms were weak” (Dharwadkar et al., 2000: 653).
Developed economies tend to have established markets and stable political envi-
ronments, and to emphasize decision making based on economic concerns,
whereas transition economies have weaker property rights and higher political
uncertainty, and rely on authority-based transactions rather than arm’s-length
market transactions (Lenway & Murtha, 1994; Peng, 2003). As a result, the two
antecedents of PP conflicts (i.e., concentrated ownership and lack of efficient
formal institutions) have been in place for many transition economies. However,
transition economies are not homogenous (Meyer & Peng, 2005; Uhlenbruck,
Meyer, & Hitt, 2003). Specifically, the privatization method and speed vary
across countries that have led to: (1) different levels of institutional development,
and also (2) different ownership structures and identities, which in turn affect the
magnitude of PP conflicts.
Gradual versus Rapid Privatization

We can group privatization strategies into two categories based on the speed
of the reforms (see table 11.1). The first category is gradual privatization that
emphasizes the importance of stability of the formal institutional framework and
seeks to change laws and regulations slowly. One of the goals of the gradual strat-
egy is to avoid conflicts with established informal rules and norms. This strategy
requires a strong government to secure and maintain stability (Raiser, 1997).
The most well known and successful example of gradual privatization is
China (Stiglitz, 2002). China is viewed as a model of evolutionary and experi-
mental institutional change (Raiser, 1997). Starting in the early 1980s, China
has slowly converted many of its state-owned enterprises (SOEs) into public
companies. By establishing the Shanghai and Shenzhen Securities Exchanges in
1990 and 1991, respectively, China gradually increased its experimentation with
privatization to reform its vast state system (Ma, 1995; Wei & Varela, 2003).
The specific benefit of the case-by-case or gradual approach is that it helped
to expedite the development of the business environment and institutional context
Table 11.1 Privatization speed
Gradual privatization Rapid privatization
● Gradual reforms ● Rapid and radical reforms (generally a

● Stability of formal institutions is emphasized result of exogenous shocks)
● Aims to avoid conflicts and frictions with ● The speed of the process may be adjusted
informal institutions based on the ease of implementation
● Low exogenous shocks (i.e., political, ● Runs the risk of political interference by
economic, etc.) insiders or interest groups
● Requires strong government to secure and ● High potential conflict between formal
maintain stability and informal institutions
● Requires strong government to manage
the rapid transition process
Leading examples: China, Vietnam Leading examples: Majority of the CEE &
CIS countries
Source : Raiser (1997).

suitable for capital markets. For example, since the 1980s, China has been the
world’s fastest growing major economy. However, it has not undertaken large-
scale privatization among its most significant SOEs in the same manner as have
the former Soviet Union and Central and Eastern Europe. Most Chinese SOEs
have been transformed, with many traditional SOEs employing more market-
oriented managers, listing part of their shares for sale to the public, and col-
laborating with foreign multinationals (Peng, Bruton, & Stan, 2014). However,
given the gradual speed of privatization and the continuing influence of the
state, Chinese privatization has been labeled as “partial privatization” (Economist,
2012; Gupta, 2005; Ralston et al., 2006).
The second strategy is rapid privatization, which refers to shifting the whole
institutional scheme quite rapidly to conform to the fundamental requirements
of a new economic system. Rapid privatization generally happens as a response
to exogenous shocks (such as dramatic political or economic events) and requires
a strong government to manage the transition process and avoid political inter-
ference and conflicts. Rapid privatization or shock therapy was implemented
mostly in Russia, Poland, the Czech Republic, and the three Baltic states of
Estonia, Latvia, and Lithuania. Relatively more gradual programs were applied
in Hungary, southeast Europe, and most countries of the former Soviet Union
(Filatotchev et al., 2003). The main rationale behind rapid privatization is that
it helps market forces to grow rapidly and leads to a quicker economic recovery.
Moreover, rapid recovery helps to avoid the window of opportunity for certain
interest groups taking political action that could stop or even reverse the reforms
(Balcerowicz, Blaszyk, & Dabrowski, 1997). Jeffrey Sachs, one of the leading
economists behind the rapid privatization strategy, has reflected on these concerns
(Wedel, 2001: 21):
You cannot cross a chasm in two jumps (you have to cross it in one).
Suppose the British were to decide to switch from driving on the left side of the
road to the right side? Would you recommend they do so gradually, starting with
trucks one year and cars a year later?
Privatization improves managerial incentives by shifting residual income and

control to private investors. The proponents of rapid privatization believed
that speeding the redistribution process would promote healthy transitions to
a market economy. However, the evidence has suggested that the majority of
Central and Eastern Europe (CEE) and the Commonwealth of Independent
States (CIS) countries have suffered from economic turmoil, whereas gradual
reformers such as China and Vietnam have witnessed robust economic growth
(Tian, 2000). One of the main reasons behind this failure is the lack of formal
institutions that accompanied the privatization process (Pistor, 2006). A leading
example is Russia. As a pioneer of rapid privatization, Russia initiated mass priva-
tization of large state companies through voucher auctions in the early 1990s.
Through vouchers, shares of large enterprises were distributed to all citizens.
Unfortunately, due to a lack of efficient controls and regulation, massive priva-
tization led to self-dealing by managers and controlling shareholders (Sonin,
2003). Self-dealing was accelerated by governmental sales of the shares of its
largest companies to a small number of powerful individuals (oligarchs), who

further corrupted the government and blocked institutional reforms (Black,
Kraakman, & Tarassova, 2006).
Although Russian formal institutions looked relatively advanced on paper,
enforcement was highly problematic (Buck, 2003). Therefore, Russian mass
privatization offers many cases that reveal the negative externalities of rapid
privatization and expropriation by controlling owners (Puffer & McCarthy,
2003). A well known example is Yukos, a giant Russian oil company, which was
acquired by Bank Menatep, controlled by Mikhail Khodorkovsky. Due to a lack
of regulatory controls and institutional enforcement, Khodorkovsky was able to
engage in massive self-dealing, retaining 30 percent of the bank’s revenues while
cutting wages, reducing investments, and destroying minority shareholder value
(Black et al., 2006).
Rapid privatization was a less severe failure in the Czech Republic (Claessens &
Djankov, 1999; Makhija, 2004). The Czech Republic also used the voucher
method, yet only a limited number of shares were given to insiders and out-
side owners were given priority. Poland was also relatively more successful than
Russia. One reason is that countries such as the Czech Republic and Poland
implemented case-by-case sales of state assets (Boycko, Shleifer, & Vishny, 1996;
Stiglitz, 2002). To do so, Poland privatized small businesses and then privatized
large state firms.
Despite differences, rapid privatization turned into a mass failure in many
transition economies. Western advisors, armed with the traditional theories of
the firm and with little research of their own on SOEs, often advised the state
in these transition economies to construct the “ideal” private firm, which is
often modeled after the typical large US firm with diffused private ownership
(Peng et al., 2014). However, the institutional and political realities in transi-
tion economies often resulted in the SOEs being privatized to insiders (manag-
ers and employees), who enjoy concentrated ownership (Filatotchev, Wright, &
Bleaney, 1999). Unfortunately, evidence now shows that such privatization to
insiders tends to result in poor firm performance (Djankov & Murrell, 2002).
In contrast, incomplete privatization in CEE—a euphemism for the SOEs to
remain “SOEs” with some private participation—“is surprisingly effective”
(2002: 741). Given the failure in the past and the relative success of gradual
privatization, many countries, such as Russia, are now shifting toward a sig-
nificant revival of state control of firms (Puffer & McCarthy, 2007). In Russia,
62 percent of the stock market capitalization is now contributed by SOEs
(Economist, 2012).
In sum, the main difference between developed economies, such as the
United States and Germany, and transition economies has been the insufficient
and relatively slow legal reforms that have accompanied mass privatization. In
particular, legal reforms did not initiate but have been responsive to economic
change. Privatization has generally been followed by legal reforms assisted by
foreign institutions, such as the IMF (Pistor, 2006). Consequently, they were
not sufficient and in some cases have contributed to higher private benefits of
control. As these private benefits grew, those in control did not want to relin-
quish power and further blocked institutional improvements concerning minor-
ity shareholder rights (Bebchuk, 1999; Sonin, 2003).
Institutional Development in Transition Economies

Privatization, either rapid or gradual, has largely redefined the institutional
background in transition economies. Although the final goal was similar,
different countries have favored different privatization programs that spurred
different levels of institutional development. For example, CEE countries have
increasingly adopted EU standards, whereas CIS countries acted more slowly in
adopting market institutions (Estrin et al., 2009). Country-level differences in
reforms and change processes created institutional environments with different
degrees of market development. Reflecting this heterogeneity, shareholder pro-
tection also differs widely across transition economies. Developed by Djankov
and his colleagues (2008), the strength of investor protection index ranges from
0 to 10, with higher values indicating more investor protection and measuring
the strength of minority shareholder protections against misuse of corporate
assets by directors for their personal gain (Doing Business, 2014). As seen in
table 11.2, the strength of the investor protection index ranges between 3.3
(Vietnam and Croatia) and 7.3 (Albania and Slovenia) for transition economies,
whereas the score for a developed economy such as the United States is 8.3. The
good news is that many transition economies are closing the gap with developed
economies over time, as their mean shareholder protection index has increased
to 5.6 in 2014 from 4.5 in 2006.
Shareholder protection alone does not tell the whole story behind institutional
development and potential expropriation by controlling shareholders. Legal pro-
tection offered to business owners, minority shareholders, and employees con-
sists of both general and specific degrees of protection (Gilson, 2007; Heugens
et al., 2009; van Essen, Engelen, & Carney, 2013). The general quality of the
legal environment refers to background institutions that underpin more specific
legal protections. For example, minority shareholders may be frustrated in exer-
cising their legally mandated voting rights through professional managers, who
can disregard minority shareholder value while exercising their decision-making
authority. Therefore, it is beneficial to minority investors if judicial interven-
tion to enforce their rights is efficient and easily available through a “relatively
sophisticated legal system” (Shleifer & Vishny, 1997: 755).
In this respect rule of law represents the general degree of legal protection
offered to all shareholders (Kaufmann, Kraay, & Mastruzzi, 2009). The rule of
law captures “the extent to which agents have confidence in and abide by the
rules of society, and in particular the quality of contract enforcement, property
rights, the police and judiciary” (2009: 6). For example, a jurisdiction may have
sophisticated investor protection legislation but the costs of enforcing legitimate
claims may be prohibitive due to inefficiencies in the legal process. In essence,
the rule of law index measures the quality and efficiency of the legal system
within a particular country and also incorporates other contextual factors such
as levels of corruption and the efficiency of the public bureaucracy (Shleifer &
Vishny, 1997). In these respects, strong rule of law represents the likelihood that
specific “rules on the book” that are designed to protect particular shareholder
interests will in fact be enforced (Levitsky & Murillo, 2009).
As seen in table 11.3, the rule of law across transition economies tends to be
around negative values except in several countries such as Croatia, the Czech
Table 11.2 The strength of investor protection in transition economies
Country 2006 2014

Strength of investor Strength of investor
protection index (0–10) protection index (0–10)
Albania 2.7 7.3

Armenia 5 6.7
Azerbaijan 4.3 6.7
Belarus 4 5
Bosnia and Herzegovina 4.7 4.7
Bulgaria 6 6
Cambodia 5.3 5.3
China 4.3 5
Croatia 3.3 3.3
Czech Republic 5 5
Estonia 5.7 5.7
Georgia 4 7
Hungary 4.3 4.3
Kazakhstan 4.3 6.7
Kosovo – 5
Kyrgyz Republic 6 6.7
Latvia 5.7 5.7
Lithuania 5 5.7
Macedonia, FYR 4.3 7
Moldova 4.7 5.3
Montenegro – 6.3
Poland 5.7 6
Romania 5.7 6
Russian Federation 4.7 4.7
Serbia 5.3 5.3
Slovak Republic 4.7 4.7
Slovenia 6.3 7.3
Tajikistan 1.7 6.7
Turkmenistan – –
Ukraine 3.3 4.3
Uzbekistan 4 4
Vietnam 1.7 3.3
Transition Economy Mean 4.5 5.6
East Asia & Pacific 5.2 5.3
Europe & Central Asia 4.5 5.7
Germany 5 5
Japan 7 7
United Kingdom 8 8
United States 8.3 8.3
Source : Doing Business (doingbusiness.org).

Table 11.3 Rule of law across transition economies
Country Rule of Law Index (ranges from approximately −2.5 [weak]

to 2.5 [strong] governance performance)
1996 2006 2012
Albania − 0.93 − 0.73 − 0.57

Armenia − 0.49 − 0.49 − 0.40
Azerbaijan −1.16 − 0.81 − 0.81
Belarus − 0.73 −1.29 − 0.92
Bosnia and Herzegovina − 0.26 − 0.50 − 0.23
Bulgaria − 0.46 − 0.14 − 0.12
Cambodia −1.14 −1.19 − 0.97
China − 0.43 − 0.55 − 0.49
Croatia − 0.61 − 0.05 0.21
Czech Republic 0.84 0.84 1.01
Estonia 0.47 1.09 1.13
Georgia −1.45 − 0.47 − 0.03
Hungary 0.83 0.96 0.60
Kazakhstan −1.19 − 0.97 − 0.66
Kosovo − − 0.91 − 0.56
Kyrgyz Republic − 0.76 −1.31 −1.15
Latvia 0.03 0.64 0.76
Lithuania 0.36 0.66 0.81
Macedonia, FYR − 0.41 − 0.56 − 0.24
Moldova − 0.19 − 0.54 − 0.36
Montenegro – − 0.34 − 0.01
Poland 0.67 0.35 0.74
Romania − 0.02 − 0.14 0.02
Russian Federation − 0.87 − 0.93 − 0.82
Serbia −1.28 − 0.56 − 0.39
Slovak Republic 0.15 0.52 0.46
Slovenia 1.05 0.87 0.98
Tajikistan −1.69 −1.12 −1.18
Turkmenistan −1.36 −1.58 −1.38
Ukraine − 0.93 − 0.81 − 0.79
Uzbekistan −1.09 −1.40 −1.27
Vietnam − 0.40 − 0.43 − 0.50
Transition Economy Mean −0.45 −0.37 −0.22
Germany 1.57 1.76 1.64
Japan 1.32 1.35 1.32
United K ingdom 1.59 1.75 1.69
United States 1.45 1.57 1.60
Source : World Bank World Governance Indicators.

Republic, Latvia, Lithuania, Poland, Romania, Slovakia, and Slovenia. In gen-

eral, this failing indicates a general lack of legal efficiency and weak enforcement
of rules and laws following privatization. In fact, this deficiency constitutes one
of the two legs of PP conflicts: weak formal institutions. However, the optimis-
tic side of the story tells us that, despite having weak institutional backgrounds,
the dynamic trend in many transition economies is upward, as evidenced by the
mean rule of law having increased to − 0.22 in 2012 from − 0.37 in 2006 and
− 0.45 in 1996.
Not only formal but also informal institutions play a role on PP conflicts
(Sauerwald & Peng, 2013). Informal rules and norms fill the void when formal
institutions are ill-defined and weakly enforced (North, 1990; Peng, 2003). As a
result, informal institutions assume the role of formal institutions in many tran-
sition economies (Peng & Heath, 1996). All countries host formal and informal
institutions, but their development does not always go hand in hand. Some soci-
eties have strongly developed formal institutions, but face deteriorating informal
ones (Paxton, 1999; Putnam, 1995). Other nations have a thriving system of
informal institutions, but are confronted with ailing or dysfunctional formal
ones (Fukuyama, 2001; Woolcock, 1998).
Informal institutions can work either positively or negatively to boost or con-
strain formal institutions (Estrin & Prevezer, 2011). Therefore, informal insti-
tutions assume two different roles in corporate governance when formal ones
are weak (Helmke & Levitsky, 2003). The first view holds that informal insti-
tutions are substitutive. Substitutive informal institutions occur where formal
institutions are ineffective but goals between formal and informal are compat-
ible (Estrin & Prevezer, 2011). Specifically, one set of institutions is said to
substitute for another “when its presence raises the returns available from the
other” (Hall & Gingerich, 2009: 450). A good example of substitutive informal
institutions is China. During institutional transitions, local governments often
implemented informal reforms and compensated for the weak formal institu-
tions because local states and company owners had substitutive economic inter-
ests (Pistor & Xu, 2005; Xu, 2011). In other words, in substitutive systems,
informal institutions fill the institutional voids of formal institutions.
The second view is that formal and informal institutions are competing, in the
sense that “informal institutions challenge formal institutional structures and
those acting through informal institutions have differing goals from the actors
within the formal institutions” (Estrin & Prevezer, 2011: 9). Furthermore, the
maintenance of two institutional systems in parallel may be associated with irre-
coverable costs and inefficiencies (Peng et al., 2009; Stiglitz, 2000). The exam-
ples of competing informal institutions are corruption or clan-like networks,
underground mafias, and clientelism. Known examples are the Russian oligarchs
and the clan networks and politics in the Kyrgyz Republic and Uzbekistan, which
blocked the development of formal institutions such that “informal mechanisms
of network-controlled exchange and norms . . . became the rules of the game”
(Estrin & Prevezer, 2011: 44).
The Russian oligarchs of the 1990s indeed set an example of controlling
shareholders, who aim to retain control rights and limit the development of
shareholder protection rights. It is in fact one of the underlying reasons why
concentrated ownership remains as the common choice of ownership struc-

ture in transition economies. Daily and Dalton (1992) explain this through
threshold firms that are near the point of transition from founder to profes-
sional management. Even though the optimal strategy may be to yield con-
trol to professionals, some controlling shareholders prefer to retain private
benefits of control (Gedajlovic, Lubatkin, & Schulze, 2004). The powerful
controlling shareholders want to remain in control and therefore may act as
“natural opponents of improvement in protection rights” (Sonin, 2003: 716).
Therefore, given the weak formal institutions and high private benefits of con-
trol in transition economies, it is important to understand whether powerful
blockholders exercise their power over key government agencies and block the
development of market institutions regarding the protection of minority share-
holder rights.
Weak formal institutions provide a window of opportunity for oligarchs, and
the transition from communism has most of the time witnessed political insiders
grabbing wealth and resources at the expense of economic growth, firm value,
and institutional development. This behavior is indeed a manifestation of crony
capitalism, where political connections replace the role of market transactions.
Although political connections are typical in many developed and developing
countries, their size and effect are significant in transition economies (Peng &
Luo, 2000). In general, a significant majority of controlling shareholders have
political connections, particularly in countries with higher levels of corruption.
In Russia, for example, connected firms represent 86.75 percent of the econo-
my’s market capitalization (Faccio, 2006).
Despite all of these difficulties, new reforms are being introduced in many
transition economies to improve the institutional setting for shareholder rights.
As summarized in table 11.4, common actions are requirements for increased
transparency and disclosure of related-party transactions, greater corporate dis-
closure to the board of directors and to the public, more comprehensive report-
ing schemes, and allowing minority investors to initiate suits against directors in
cases of director negligence (Doing Business, 2014).
In sum, major economic reforms such as privatization tend to be followed
by legal reforms, which then may not be sufficient and contribute to private
benefits of control (Pistor, 2006). Those in control may not want to relinquish
power and may further block institutional development (Daily & Dalton, 1992).
However, although at different rates and speeds, many transition economies are
taking measures to limit expropriation by controlling owners.
Privatization and Ownership Structure

The privatization of state-owned companies has not only affected the institu-
tional structure that defines the rules of the game but has also led to a great revi-
sion of ownership structure in terms of ownership concentration and ownership
identity in transition economies. On the one hand, ownership concentration
may constrain agency problems. On the other hand, it may also aggravate PP
problems. At this point, ownership identity plays a pivotal role on the magnitude
of PP problems.
Table 11.4 Business reforms for protecting minority shareholders in transition economies
Albania
2009: Albania has introduced regulations for the approval and disclosure requirements of
related-party transactions and by reinforcing director duties and available remedies
Armenia
2013: Armenia has introduced a requirement for shareholder approval of related-party
transactions, requiring greater disclosure of such transactions in the annual report and
making it easier to sue directors when such transactions are prejudicial
Azerbaijan
2009: Azerbaijan has introduced regulations for the approval of related-party transactions
and expanding remedies available against liable directors
Belarus
2012: Belarus has introduced requirements for greater corporate disclosure to the board of
directors and to the public
2008: Belarus has regulated the approval and increasing disclosure requirements for related-
party transactions
Georgia
2012: Georgia introduced requirements relating to the approval of transactions between
interested parties
2011: Georgia has allowed greater access to corporate information during the trial
2008: Georgia has amended its securities law to better regulate the approval and disclosure
requirements of related-party transactions
Kazakhstan
2012: Kazakhstan has introduced regulations for the approval of transactions between
interested parties and making it easier to sue directors in cases of prejudicial transactions
between interested parties
2011: Kazakhstan has required greater corporate disclosure in company annual reports
Kosovo
2013: Kosovo has introduced a requirement for shareholder approval of related-party
transactions, requiring greater disclosure of such transactions in the annual report and
making it easier to sue directors when such transactions are prejudicial
Kyrgyz Republic
2009: The Kyrgyz Republic has granted minority investors standing to undertake legal actions
to protect their rights as shareholders, by requiring an independent assessment of the transaction
before its approval and by increasing remedies in case of director negligence
Lithuania
2012: Lithuania has introduced greater requirements for corporate disclosure to the public and
in the annual report
Macedonia
2014: Macedonia has allowed shareholders to request the rescission of unfair related-party
transactions and the appointment of an auditor to investigate alleged irregularities in the
company’s activities
2010: Macedonia began regulating the approval of transactions between interested parties,
increasing disclosure requirements in the annual report and making it easier to sue directors
in cases of prejudicial transactions between interested parties
Moldova
2013: Moldova has allowed the rescission of prejudicial related-party transactions
Table 11.4 Continued
Slovenia
2013: Slovenia introduced a new law regulating the approval of related-party transactions
2009: Slovenia has allowed minority investors to initiate suits against directors on behalf of
the company in order to defend their rights as shareholders
2008: Slovenia strengthened investor protections by requiring that boards of directors
obtain a prior approval from the shareholders before entering into transactions representing
25 percent or more of the company’s assets
Tajikistan
2013: Tajikistan has made it easier to sue directors in cases of prejudicial related-party transactions
2011: Tajikistan has required greater corporate disclosure in the annual report and greater
access to corporate information for minority investors
2010: Tajikistan has introduced amendments brought to the Joint Stock Companies law that
increased the transparency obligations related to the conclusion of transactions
2009: Tajikistan strengthened investor protections by regulating the approval and increasing
disclosure requirements of related-party transactions, and by allowing minority investors
to initiate suits against directors on behalf of the company in order to defend their rights as
shareholders
Ukraine
2010: Ukraine has adopted a new law on Joint Stock Companies that regulates approval of
transactions
Vietnam
2014: Vietnam has introduced greater disclosure requirements for publicly held companies
2012: Vietnam has raised standards of accountability for company directors
2008: Vietnam has increased disclosure requirements in regular transactions
Source : Doing Business (doingbusiness.org).
Ownership Concentration
As the weak institutional context makes the enforcement of agency contracts
more costly and problematic (North, 1990) following privatization, private own-
ership has tended to concentrate over time in transition economies (Filatotchev,
Kapelyushnikov, Dyomina, & Aukutsionek, 2001; Young et al., 2008). Some
scholars argue that concentrated ownership may lead to better firm outcomes for
five reasons. First, by concentrating ownership in the hands of a single or a few
owners, blockholding alleviates the transaction costs and collective action prob-
lems that dispersed shareholders face in monitoring managers (Black, 1990).
Because transparency is problematic in transition economies, information asym-
metries between principals and agents tend to be higher, making monitoring
costly for principals. Concentrated ownership reduces coordination costs due
to significant voting power, which can then direct managerial decision making
(Dharwadkar et al., 2000). Second, due to economies of scale, large blockhold-
ers are able to develop monitoring capabilities that are unavailable to smaller,
more dispersed shareholders (Ryan & Schneider, 2002). Third, blockholders may
act as a countervailing power against the claims of powerful non-shareholding
corporate insiders, such as employees or managers, in the ex post distribution of
a firm’s earnings (Roe, 2003; Zingales, 1998). Fourth, blockholding serves as a

substitute for a country’s poor legal protection (Heugens et al., 2009; Jiang &
Peng, 2011a; Shleifer & Vishny, 1997), which may stand in the way of owner-
ship originally separating from control (La Porta et al., 1998). Finally, large
shareholders have more at stake in terms of firm performance. For example,
Djankov and Murrell (2002) show that when investment funds, foreigners, and
other outsiders become influential owners, ten times as much restructuring takes
place in former state-owned companies than when the new owners are diffused
shareholders. Overall, ownership concentration is viewed as a substitute for legal
protection and a key corporate governance mechanism in weak institutional set-
tings (Boubakri et al., 2005; La Porta et al., 1998).
However, given inadequate shareholder protection, the controlling share-
holders may engage in extracting a premium before dividend distributions that
become a root cause of PP conflicts (Young et al., 2008). Therefore, an increasing
number of scholars associate powerful blockholders with economic inefficiency
and institutional weakness. The leading example has been Russia, where owner-
ship redistribution has resulted in managerial self-dealing, pyramid structures,
share dilutions, and related party transactions (Filatotchev et al., 2001). In short,
due to the tension between entrenchment and incentives (Morck, Shleifer, &
Vishny, 1988), the literature points to a trade-off between rent seeking and
incentives for concentrated ownership, which makes the identity of the con-
trolling owners an important factor for the outcomes of this trade-off (Douma
et al., 2006; Heugens et al., 2009; van Essen et al., 2012).
Ownership Identity
As seen in table 11.5, different privatization methods were favored by different
transition economies that led to differences in the redistribution of shares and
eventual ownership identities. We can broadly categorize the three privatization
methods as (1) privatization by sale, (2) management and employee buyouts, and
(3) the voucher method. Privatization by sale occurs when shares are sold to out-
siders at an agreed-on market price, whereas in management-employee buyouts
shares are sold to insiders. In the voucher method, citizens can inexpensively
buy a book of vouchers that represent potential shares in any state company.
The voucher method transfers the assets at a nominal price to either insiders
(e.g., in Russia) or outsiders (e.g., in the Czech Republic) (Bennett, Estrin, &
Urga, 2007).
Privatization in developed economies has been relatively efficient due to
strong capital markets that led to a match between buyers and sellers (Megginson
& Netter, 2001). In transition economies, the dynamics of efficient markets
were lacking; this became an underlying reason why shares were not neces-
sarily bought by the most efficient owners. As potential “good” owners were
largely excluded from the reallocation process, most of the shares ended up in
the hands of black market operators, who could accumulate wealth during the
communist era but lacked managerial capabilities fit for market competition.
More importantly, these new owners may have used their ownership rights to
pursue noneconomic personal objectives, such as employment protection, status,
and political power. In short, concentrating and entrenching ownership in the
Table 11.5 Major privatization methods in transition economies
Country Privatization year Privatization method
Albania 1995 Management-employee buyouts

Armenia 1994 Voucher
Azerbaijan 1997 Voucher
Belarus 1994 Management-employee buyouts
Bulgaria 1993 Privatization by sale
Croatia 1992 Management-employee buyouts
Czech Republic 1992 Voucher
Estonia 1993 Privatization by sale
Macedonia 1993 Management-employee buyouts
Georgia 1995 Voucher
Hungary 1990 Privatization by sale
Kazakhstan 1994 Privatization by sale
Kyrgyzstan 1996 Voucher
Latvia 1992 Privatization by sale
Lithuania 1991 Voucher
Moldova 1995 Voucher
Poland 1990 Privatization by sale
Romania 1992 Management-employee buyouts
Russia 1993 Voucher
Slovakia 1995 Privatization by sale
Slovenia 1998 Management-employee buyouts
Ukraine 1995 Voucher
Uzbekistan 1995 Management-employee buyouts
Source : Bennett et al. (2007).
“wrong” hands have contributed to PP conflicts and blocked economic develop-

ment across many transition economies (Bennett et al., 2007).
As a result, the identity of the controlling shareholder matters for the trade-
off between rent-seeking and incentives (Douma et al., 2006; Heugens et al.,
2009; van Essen et al., 2012). We can broadly categorize ownership identi-
ties into four classes as (1) the state, (2) insiders (i.e., managers, employees),
(3) local individual investors, and (4) outsiders (i.e., foreign, institutional inves-
tors) (Dharwadkar et al., 2000). Table 11.6 summarizes the impact of different
ownership identities and their corporate governance outcomes.
First, state ownership remains a controversial issue in transition economies
(Sun, Tong, & Tong, 2003). On the one hand, state ownership is about top-
down determination of strategic goals and therefore minimum managerial
discretion and capability. On the other hand, it enables access to government
support given the importance of political ties and strategic connections in tran-
sition economies (Peng & Luo, 2000). China is a good example of state own-
ership, where the government still holds the majority of shares in many public
firms (He, Zhang, & Zhu, 2008). However, state ownership may be detrimental
to firm performance and destroy minority shareholder value, as it may prioritize
political interests more highly than the profit motivation inherent in a typical
private firm (Chen & Young, 2010; Wei & Varela, 2003).
Table 11.6 Privatization method and corporate governance effects
Voucher or “give away” privatization Privatization buyout or management Divestments to domestic Divestments to foreign investors
and employee buyout institutions
Countries Russia, Georgia, Moldova, etc. Poland, Romania, Slovenia, Slovakia, The Czech Republic and Hungary, Estonia
Croatia, Macedonia, Tajikistan, Russia
Ukraine, and Uzbekistan
Owner Adult population (mostly insiders or Insiders (management and Local institutions Foreigners
identity powerful individuals/groups) employees)
Corporate Ineffective restructuring due to lack of Managerial equity may function Relatively more effective Effective restructuring enabled
restructuring market capabilities as an incentive mechanism that restructuring by higher incentives to achieve
promotes value-enhancing activities superior firm value, more
and restructuring. However, lack of advanced market capabilities,
market capabilities may be a problem and entrepreneurial skills.
Higher managerial turnover
Corporate Ineffective governance due to (1) managerial Ineffective governance due to Institutional investors More effective monitoring due
governance entrenchment, (2) opportunism, (3) lack of (1) managerial entrenchment and might have the incentive to to higher incentives and abiding
effects commitment to firm value due to having (2) limited investment portfolio monitor insiders but this by multiple legal and regulatory
low levels of personal investment or lack may be limited by inefficient norms
of purchase, (4) entrenchment to personal institutions and lack of
networks monitoring capabilities
Effect on Weak institutions, weak capital markets, Managerial equity may align May exert better control More stringent monitoring
minority and concentrated ownership may limit the managers’ action with shareholder over managers and enhance of the management enhances
shareholders incentives of controlling insiders to care expectations, which may help firm value shareholder value
about minority shareholder value and create minority shareholders. Weak
resistance to outside board members. institutions and capital markets
Controlling insiders may increase may limit this effect and promote
information asymmetry and block minority managerial entrenchment
owners’ monitoring effectiveness
Source : Filatotchev et al. (2003).

Second, selling shares to insiders (management and employees) is generally

considered to be ineffective due to the risk of managerial entrenchment and risk
aversion (Morck et al., 1988). This approach has been the primary method in
Poland, Romania, Slovenia, Slovakia, Croatia, Macedonia, Tajikistan, Ukraine,
and Uzbekistan, mostly because it is politically easier to execute (Filatotchev
et al., 2003). Although some studies argue that insider private ownership is
superior to state ownership (Earle & Estrin, 1996), others have shown that in
the context of Central Europe, privatization has no beneficial effect on any per-
formance measure in the case of firms controlled by insider owners (Frydman,
Gray, Hessel, & Rapaczynski, 1999). Although insider ownership at certain
levels may have incentive effects (Morck et al., 1988), in transition economies
this effect may disappear. One leading reason is that managers selected under
a communist regime may lack the necessary skills and capabilities to function
under new competitive conditions. Due to this lack of ability, insider ownership
may also lead to inefficient decision making, such as opting to minimize layoffs.
However, the most important risk is managerial entrenchment. For example,
Filatotchev and his colleagues (1999) show that insiders in Russian privatized
firms tend to be hostile toward outsiders and collude with other insiders to pre-
serve insider control at the expense of shareholder value.
Third is selling shares directly to local individual investors. As discussed
above, many former Soviet Union countries such as Russia, Moldova, and
Georgia followed this method. Accordingly, eligible citizens can utilize vouch-
ers, distributed free or at nominal cost, to bid for shares of SOEs (Brada, 1996).
However, the results have mostly been disappointing. Specifically, although local
individual investors can reduce traditional PA problems by using personal con-
nections in key management positions, these same appointments can also make
managers disregard the interests of minority shareholders, making them suscep-
tible to expropriation (Dharwadkar et al., 2000). Peng, Buck, and Filatotchev
(2003) also find that outside board members and new managers do not improve
performance in privatized Russian firms. In short, the lack of control mecha-
nisms in these systems tends to promote self-dealing by oligarchic shareholders
(Filatotchev et al., 2003).
In general, outside ownership, foreign and institutional ownership in par-
ticular, are viewed as better alternatives (Estrin et al., 2009; Makhija, 2004).
Institutional investors may have better monitoring capabilities, as they have
access to inside information and superior information processing capabilities.
However, for two reasons these benefits may be hampered in transition econo-
mies. First, institutional investors may have multiple portfolio investments that
limit their monitoring effectiveness of any individual company (van Essen et al.,
2012). Second, weak governance and underdeveloped financial and institutional
settings may increase the likelihood of minority shareholder expropriation by
institutional owners, who might be more interested in their own interests and
more readily disregard minority shareholder value (Dharwadkar et al., 2000).
Foreign owners are also acknowledged for having superior monitoring and
managerial skills that may lead to better restructuring and organizational out-
comes in transition economies. In terms of managerial skills, Frydman and his
colleagues (1999) show that privatized firms controlled by foreign investors are
more profitable because foreigners are more ready to accept entrepreneurial risks
and have higher incentives to do so. Foreign owners are also concerned with
the resource needs of the firms in which they invest, and therefore may more
effectively provide the strategic resources necessary for superior performance
(van Essen et al., 2012). In terms of monitoring, foreign ownership seems to be
a relatively more effective option because foreign investors tend to require more
stringent disclosures and better standards of corporate governance from newly
privatized firms (Boubakri et al., 2005). This practice is mostly driven by the
fact that they are embedded in multiple institutions and are likely to be under
greater government scrutiny than are local firms, which are able to leverage
political and social connections (Dharwadkar et al., 2000). This view suggests
that foreign owners may be more cautious and therefore “select” for good gover-
nance through their initial investment decisions (Douma et al., 2006; van Essen
et al., 2012). In practice, this scrutiny tends to discourage foreign investors from
disregarding minority shareholder interests.
Overall, outside ownership (institutional and foreign) has fared better than
insider-dominant ownership. As noted above, the leading examples of this suc-
cessful approach are the Czech Republic, Estonia, and Poland, which applied
more controlled mass privatization and distributed the majority of the shares
to foreign and institutional investors, who tend to have the incentive, motiva-
tion, and capabilities to monitor management (Makhija, 2004). This method
has been effective in part because outside owners tend to be more interested in
firm value and are therefore likely to take more drastic restructuring measures
(Filatotchev et al., 2003).
In sum, privatization’s effects vary depending on the types of owners (Estrin
et al., 2009; Frydman et al., 1999). Although concentrated ownership is an
internal corporate governance mechanism, it also contributes to PP conflicts in
countries such as Russia, where privatization has given control rights to interest
groups or oligarchs, who can ignore the interests of minority shareholders and
promote their own agendas (Puffer & McCarthy, 2003; Young et al., 2008).
Therefore, the identity of the controlling owners matters for the magnitude of
the PP conflicts in transition economies.
Conclusion
This chapter endeavors to contribute to the corporate governance literature by
highlighting the role that privatization has played in the evolution of corpo-
rate governance mechanisms in transition economies. Specifically, variances
in the privatization experiences of transition economies have had a significant
impact on the two major antecedents of PP conflicts: the development of institu-
tions concerning shareholder rights and the types of owners in privatized firms
(Djankov & Murrell, 2002). Because investor protection is generally weak in
these economies, ownership concentration has evolved into a key mechanism of
corporate governance (Boubakri et al., 2005). Although concentrated owner-
ship is viewed as a remedy to PA conflicts in some developed economies such as
Germany and Japan, it is also viewed as a root cause of PP conflicts in transi-
tion economies with weak external governance mechanisms (Faccio et al., 2001;
Jiang & Peng, 2011b; Peng & Sauerwald, 2013; Young et al., 2008).
Why are transition economies important for researchers and policy makers?
Transition economies offer a unique context, thanks to establishing market
institutions from scratch (Dharwadkar et al., 2000; Peng, 2003; Peng & Heath,
1996). But, beyond that, transition economies have gone through different
experiences of privatization that have led to heterogeneity in the restructuring
of SOEs and also to differences in formal and informal institutions. Therefore,
they provide valuable insights into the antecedents and outcomes of PP conflicts,
which can help practitioners, investors, and policy makers to establish better
governance structures (Peng & Sauerwald, 2013).
In general, the conflict of interest between controlling and minority share-
holders can more easily manifest itself in transition economies, which are charac-
terized as corporate governance vacuums (Young et al., 2008). Specifically, the
uncontrolled allocation of shares to insiders or powerful interest groups has pro-
moted “unchecked insider control” that led to asset stripping, corruption, and
hampering of corporate governance reforms (Broadman & Recanatini, 2000:
9). In addition, in countries such as Russia, uncontrolled and rapid privatization
increased the power of infamous oligarchic shareholders not only against minor-
ity shareholders but also against institutional reforms and economic growth
(Estrin & Prevezer, 2011; Pistor, Raiser, & Gelfe, 2000).
Future research may benefit from the unique and rich context provided by tran-
sition economies’ privatization experiences. It is especially important to under-
stand whether the approach that governments take to privatization varies across
developed, developing, and transition economies (de Castro & Uhlenbruck,
1997) and whether the magnitude of PP conflicts vary with the characteristics
of the privatization process. Another important line of research is the effect
of privatization on entrepreneurship (Doh, 2000; Zahra, Ireland, Gutierrez, &
Hitt, 2000). The primary goal of privatization is economic growth and entre-
preneurial development, which depend in part on market institutions, property
rights, and shareholder protection measures. Inadequate shareholder protection,
coupled with expropriation by controlling owners, may not only limit minority
shareholder value but also block entrepreneurial activity. It is also important to
understand the international activities of privatized firms, given the increasing
importance of standard corporate governance measures that help to alleviate the
concerns of international investors. For example, investors tend to be skeptical
of cross-border mergers and acquisitions when the government is the control-
ling owner, due to potential PP conflicts (Chen & Young, 2010). Therefore, to
counterbalance the negative connotations of concentrated ownership and lack
of shareholder protection rights in their home countries, an increasing num-
ber of transition economy firms cross-list in the United States and the United
Kingdom in an effort to signal their protection of minority shareholder rights
(Doidge et al., 2009; Peng & Su, 2014; Reese & Weisbach, 2002).
In conclusion, transition economies offer important contexts to aid in under-
standing the evolution and interaction of corporate governance mechanisms,
thanks to their diverse approaches to fundamental economic reforms and insti-
tutional dynamism. Specifically, privatization characteristics serve as a labora-
tory to explore the antecedents and outcomes of dynamic institutions, evolving
corporate governance mechanisms, and new agency problems.
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Chapter 11

Privatization and Principal-Principal

Canan Mutlu, Mike Peng, and Marc van Essen

The corporate governance literature identifies two major governance models.

M. Goranova et al. (eds.), Shareholder Empowerment

Although transition economies share many common characteristics with other

Figure 11.1 The role of privatization on principal-principal conflicts

problems centered on PP conflicts (Dharwadkar et al., 2000; Estrin et al., 2009).

Private Benefits of Control

Peng, 2011a). Specifically, differences in legal investor protection across coun-

The Role of Privatization on PP Conflicts

Gradual versus Rapid Privatization

Table 11.1 Privatization speed

Gradual privatization Rapid privatization

● Gradual reforms ● Rapid and radical reforms (generally a

Source : Raiser (1997).

Privatization improves managerial incentives by shifting residual income and

largest companies to a small number of powerful individuals (oligarchs), who

Institutional Development in Transition Economies

Country 2006 2014

Albania 2.7 7.3

Source : Doing Business (doingbusiness.org).

Country Rule of Law Index (ranges from approximately −2.5 [weak]

1996 2006 2012

Albania − 0.93 − 0.73 − 0.57

Source : World Bank World Governance Indicators.

Republic, Latvia, Lithuania, Poland, Romania, Slovakia, and Slovenia. In gen-

concentrated ownership remains as the common choice of ownership struc-

Privatization and Ownership Structure

Table 11.4 Continued

Source : Doing Business (doingbusiness.org).

a firm’s earnings (Roe, 2003; Zingales, 1998). Fourth, blockholding serves as a

Table 11.5 Major privatization methods in transition economies

Country Privatization year Privatization method

Albania 1995 Management-employee buyouts

Source : Bennett et al. (2007).

“wrong” hands have contributed to PP conflicts and blocked economic develop-

Source : Filatotchev et al. (2003).

Second, selling shares to insiders (management and employees) is generally

Denis, D. K., & McConnell, J. J. 2003. International corporate governance. Journal of

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