Opal''''s Site Organization and Development of Russian Business_10 pptx

Russian law defines a parent company and its subsidiary, which together constitute a holding company group, as a pair of agents, one of which, namely, the parent com-pany, has sufficient

In general, a number of characteristics regarding the peculiarities of porate management were relevant and significant Irrespective of the JSC involvement in integration, we observed an adverse effect of restructuring

cor-on the chances of selecticor-on in favor of hired managers Globalizaticor-on ence of competition with foreign manufacturers that aggravates operating conditions for companies) encouraged the engagement of hired managers

(exist-No steady effect of the size of enterprise on the setup of corporate control was revealed.10

Severe competition with Russian manufacturers remains a mystery The adverse effect on selection in favor of hired management is typical of all companies and JSCs classified as independent businesses The existence of such competition may reflect restructuring in progress at enterprises, but it also demonstrates operation in relatively competitive markets requiring no special competences

Privatization promoted a combination of functions, but its influence is not stable As for the management labor market, its limited role may be defined by the quality of a selected proxy variable

The question of how Russian companies will advance is worthy of sideration Whether owners will remain as managers or rely on the labor market for hiring top managers will be of interest It is safe to predict that restructuring of the legacy of the state-planning economy will be up for completion and competition in globalizing markets will improve against the smoothing of the effect of privatization and the inevitable resignation

con-of the “red directors” generation, thereby enhancing the intention to hire professional management and search for better candidates It remains to

be seen whether costs from “self-administration” will outweigh company benefits from minimizing the risks of managers’ opportunistic behavior From all appearances, the existence of an alternative mechanism of control through integration has already made these values comparable The risks

of the violation of shareholders’ rights and poor corporate governance are

as important for independent businesses as they were before It is far more difficult to forecast the situation with property rights protection However,

a certain improvement in corporate governance in the 2000s was evident (Korporativnoe Upravleniye 2007, Natsional’nyi Doklad 2008), and this tendency is expected to remain in perspective Incentives for improving intra-corporate practice are derived from the growing demand for invest-ments under increasing competition, and the transition to the engagement

of hired managers pushes companies to arrange for standard intra-corporate procedures promoting corporate governance development

Acknowledgments

This research was conducted with financial support of SU-HSE (individual academic grant of the Scientific Foundation No.06-01-0050 and funds from

the Program for Fundamental Studies granted by the Ministry of Economic Development and Trade of the Russian Federation in 2007–2008) I would like to thank Heiko Pleines, Andrei Shastitko, and Yurii Simachyev for their useful comments and suggestions Special thanks are given to Olga Uvarova for her assistance in data processing.

Notes

1 The explanations of abbreviations reflecting configurations of ownership and management used in tables and graphs of this chapter were made in Chapter 2

2 Records of in-depth interviews show that board activities are often a tribute paid

to formal legal regulations and that their titular nature tends to correlate with both the fusion of the board with executive management and the stability of its membership (Dolgopyatova 2004)

3 Although such ownership indicates, to some degree, an enterprise’s participation

in the holding company group, it may have an individual value as a signal of nontransparency

4 The existence of a foreign or quasi-foreign investor will have no effect on the formulation of a quantitative hypothesis

5 Management turnover is certainly encouraged by inefficient management, but a single survey is insufficient to offer adequate indicators of its measurement

6 Restructuring was required for the overwhelming majority of Russian nies, both privatized ones whose assets were collected under the state-planned economy and new ones, because they emerged in the real sector from what was left from old Soviet enterprises by accumulating their assets Corporate integration became one of the main forms of business restructuring (Radygin 2004)

7 It should be emphasized that, although the point is the company’s external tor of competition in the market of its products, we in fact have only a subjective respondent assessment of the level of competition that can be developed though

fac-a set of conditions

8 A series of signals is available in the survey, namely, the educational background

of the CEO as well as his/her “history” (external manager or incumbent, i.e., staff member of a given enterprise) and management experience at foreign busi-nesses or government bodies However, such characteristics are unlikely to be independent factors of choice; thus, they may be useful at the stage of looking for a suitable candidate (or be its effect) rather than for a shareholder’s critical decision with regard to withdrawal from management

9 Labor market supply can also differ depending on the size and the status of populated areas (capital city, town, and village) However, the situation is not exactly straightforward On the one hand, a more important status and popula-tion will offer a wider choice of labor, while, on the other hand, small villages are unattractive to business owners as a place of principal residence When a busi-ness includes divisions located elsewhere, especially in small towns and villages, shareholders will be more inclined to look for local candidates for managerial positions, while they themselves could manage companies located in Moscow or other large cities

10 The number of employees is closely correlated with the company’s form of poration, and the last indicator includes the effect of size

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Corporate Governance and

Decision-Making in Business Groups

Svetlana B Avdasheva

Introduction

This chapter and the following one are devoted to independent legal entities that constitute united companies and are known as business groups (BGs) or holding company groups In modern economic literature, BGs are defined

as “a set of firms which, though legally independent, are bound together by

a constellation of formal and informal ties and are accustomed to taking coordinated action” (Khanna & Rivkin 2001: 47–48) Russian law defines

a parent company and its subsidiary, which together constitute a holding company group, as a pair of agents, one of which, namely, the parent com-pany, has sufficient authority to determine the decisions of another based

on ownership rights or any other type of control rights.1 In this respect, both terms, BGs and holding company groups, are synonymous

In Russia, the term “business group” usually applies to legally independent entities under the same control that were historically independent businesses and have experience acting independently BGs are sometimes considered

to be newly established integrations that occurred after privatization

In this book, a business group is defined as a set of legally

independ-ent independ-entities joined by ownership rights The set of independ-entities (independ-enterprises) is under control of the ultimate owner (or small groups of interrelated ultimate owners) or parent company No distinction is generally made between BGs founded during the Soviet times and those established in mergers during the economic upturn that started in 1999 after the completion of a mass movement of privatization

Competing hypotheses of corporate governance in

Russian business groups

In contemporary studies, considerable attention is given to Russian BGs as

a form of concentration of capital and assets and, at the same time, as a way to restructure privatized enterprises Mergers are also among the most

important events changing the organization of markets in Russia During the economic upturn, the ratio of merger value to GDP increased from 4%

in 2001 to about 8% in 2005–2007.2 The largest groups control almost half of the relevant industrial markets in Russia (Guriev & Rachinsky 2005) and the great majority of companies listed on stock exchanges (Boone & Rodionov 2002) After the acquisition of undervalued assets or their takeo-ver via the use of various informal instruments during the 1990s, BGs have been making substantial efforts to restructure their constituent companies

one-“Oligarchs” are not only the largest shareholders but also more efficient owners in comparison to the owners of nonaffiliated enterprises (Guriev & Rachinsky 2005)

However, the rapid development of BGs contradicts common knowledge about the prominent features of the Russian national model of corporate governance (see Chapters 1 and 7 for details) BGs are supposed to be based

on the separation of ownership and management However, in recent veys, it has been demonstrated that, in most Russian companies, ownership and management converge Given a weak institutional environment, the most successful way to resolve agency problems in a typical Russian com-pany is the “do-it-yourself” option That is the reason that many executive managers of privatized firms became the controlling owners, and new own-ers of companies (both privatized and newly established) became execu-tive managers (in reality, if not formally) or hired managers that were so closely affiliated that the agency problem could be considered to be nonex-istent Therefore, an important problem in the study of transition in Russia

sur-is explaining the model of corporate governance in Russian BGs Thus, it sur-is necessary to understand which specific tools are used to prevent losses from the agency problem in Russian BGs

It is worthwhile to discuss five hypotheses regarding the instruments of corporate governance in BGs:

Hypothesis H1: There is no agency problem in Russian BGs, since they are

not companies The formation of BGs is a completely artificial process vated by political considerations From this point of view, the support provided

moti-by the Russian government to large company alliances thoroughly explains the incentives for typical privatized enterprises to join BGs.

If the JSCs in the group are integrated in the company, that is, if they are organized into a hierarchical system, then four hypotheses are possible:

Hypothesis H2: The principal-agent problem is solved by the convergence of

ownership and management, as is traditional in Russia BGs have the same system of corporate control as do independent or autonomous enterprises This means that management is not separated from ownership and ultimate owners manage the enterprises in the BGs.

If the BGs are organized as hierarchies but management is separated from ownership, then,

Hypothesis H3: The principal-agent problem is solved by the development

of internal corporate governance tools, which include boards, independent directors, and internal audit units This should be extremely important in the Russian context of weak external instruments to uphold the discipline of execu- tive management.

Hypothesis H4: The principal-agent problem is solved by the owner having

additional bargaining power One example is the state as a dominant owner.

Hypothesis H5: The executive management in BGs is disciplined by the

ben-efits of joining the group For instance, BGs can be supported by relational-type contracts (Goldberg 1980) between an owner who is an outsider not participat- ing in management and an executive manager In this case, the outside owner does not need to spend resources to control executive management Discipline within the group of enterprises is upheld by mutual interests.

Not all of the hypotheses are mutually exclusive This is especially true for H3–H5 Improvement of subsidiary performance can complement the impact of corporate governance bodies as a disciplinary device The poten-tial opportunism of executive management can be prevented by direct supervision of a parent company and by increasing the performance of the enterprise within a BG The objective in this chapter is to examine the hypotheses, from H1 to H4, using the results of the Japan–Russia joint sur-vey conducted in 2005 The next chapter is devoted to the impact of BG membership on the performance of subsidiaries, and the analysis will pro-vide evidence in favor of H5

Organization of Russian business groups

The ratio of enterprises that are members of BGs and their share in the overall employment in the relevant industry are presented in Figure 8.1 Communications, fuel and energy, and metallurgy lead in the percentage

of industry employment in the BGs, while light industry and construction materials are comparative outsiders The larger companies are involved in group membership Of 323 enterprises that identified themselves as affili-ated to a BG, 44 respondents declared themselves to be parent companies; the others are subsidiaries Almost one-third of the subsidiary companies in the sample are in regulated industries that include the generation and trans-mission of electric power and regional telecommunication companies The share of JSCs affiliated with BGs is very close to the alternative estimates of the share of BGs in economic activity in Russia (see, for instance, Guriev & Rachinsky 2005)

Although BGs are primarily of interest as a form of ownership tion following privatization, not all the enterprises in the sample joined the groups after privatization and liberalization In the fuel and power indus-tries, the largest groups emerged before 1992 In all other industries, most of the groups were founded after privatization Mergers intensified during the economic recovery after 1999; most of the deals for the sample took place in

realloca-2002 During this year, 50 enterprises, or slightly less than one-sixth of the whole subsample of affiliated companies, joined their groups About half

of the BGs are horizontal; they include enterprises in the same industry Slightly more than a quarter are vertical; they contain producers along the same technological chain The rest are conglomerate Most groups include numerous auxiliary units as separate legal entities in addition to the basic production facilities; half of the groups include trade enterprises, and about one-fifth include banks and/or financial/insurance companies

Therefore, the firms in the groups represented in the survey are very erogeneous by the origin, industry, and experience of being autonomous as

het-a business unit However, by considering such diverse comphet-anies, we chet-an collect evidence to support several of the hypotheses presented in this study

on the nature of corporate governance in the subsidiaries

Before discussing the various alternative hypotheses, it is necessary

to analyze the allocation of responsibilities and the decision-making

0 10 20 30 40

(%)

50 60 70 80 90Total

CommunicationsConstruction materialsFood industryLight industryWood, paper, and wood products

Chemicals and petrochemicals

Machine building and metal working

MetallurgyFuel and energy

Percent of enterprises affiliated to BGs by industryPercent of workers employed in BGs by industry

Figure 8.1 Share of business groups (BGs) in number of companies and in employment (%) Source: Author’s illustration based on survey data.

process within the BGs The goal here is to make sure that coordination and decision-making within the groups comply with a hierarchical system, which gives rise to the agency problem If, according to the classification of the new institutional economics (Williamson 1985), coordination within BGs is more of a hybrid-type coordination between legally and economi-cally independent units, then the stability of these companies should be analyzed solely in the framework of relational contracting and not in the framework of corporate governance and corporate control.

If subsidiaries are part of companies but not independent businesses and the disciplinary devices within the groups are to be considered it is neces-sary to evaluate corporate governance as disciplinary device In order to

do that it is necessary to compare the corporate governance, including the convergence of ownership and management in companies that are either affiliated or nonaffiliated with a BG, as well as the role of internal corpo-rate governance instruments, such as the board of directors and shareholder meetings In Chapter 7, it was demonstrated that corporate governance in subsidiaries in holding company groups differs substantially from corporate governance in JSCs representing autonomous business In this chapter, the different types of subsidiaries are investigated Special attention is given to the comparison of corporate governance in companies in regulated indus-tries, such as energy and telecommunications, and nonregulated industries

In regulated industries, the agency problem can be prevented, since the state can uphold the discipline of executive management with a broad range of supplementary instruments Correspondingly, we can expect more effective internal corporate governance in the holding company groups in regulated industries

The remainder of the chapter is organized as follows The second tion is devoted to decision-making in BGs The scope of centralization and the involvement of stakeholders in strategic planning are under analysis

sec-in order to support or reject H1 The third section is a comparison of the internal instruments of corporate governance in the JSCs in regulated and nonregulated industries in order to discuss H2–H4 The fourth section is

an attempt to quantify the role of different instruments used to discipline executive management in Russian BGs

Decision-making in the holding company groups:

Centralization or networking with stakeholders?

During the last decade, among Russian economists, there were a number

of competing opinions about decision-making within BGs Ten years ago, most experts considered BGs as completely artificial alliances without com-mon group decisions and without a special system of decision-making

In the course of time, most researchers concluded that the ency of the ownership structure and decision-making prevents identifying

nontranspar-the type of coordination that occurs within a group and even nontranspar-the group boundaries It spite of nontransparency, centralized decision-making takes place (Pappe 2000) The ownership structure within the groups, as well as the group boundaries, became more transparent over a 10-year period, and the same was true for the decision-making within the groups However, the results of the comparison of the decision-making and management in the BGs with those in a large company are still debatable In some studies, it was reported that both strategic and daily management decisions in the groups are extremely centralized (Dolgopyatova 2004) Others observed the cen-tralization of only strategic management decisions, as daily management decisions are decentralized (Radygin 2004) However, in almost all studies, there was agreement that BGs are a specific type of firm with hierarchi-cal governance of transactions and not a network of enterprises that are equal partners Moreover, with the course of time, Russian BGs restructured the system of decision-making toward further separation of strategic and daily management decisions and the centralization of strategic decisions (Pappe & Galukhina 2006).

According to the results of sample surveys of enterprises in the project Structural Changes in the Russian Industry (Yasin 2004), there is evidence that authority is divided between parent companies and subsidiaries in a rather irregular way: the parent company makes all financial, marketing, and investment decisions, which include not only strategic but also daily decisions, along the traditional lines of this division, and subsidiaries make production management decisions only

There were 30 respondents, representing both affiliated and nonaffiliated enterprises All the respondents were top managers of their firms: 14 were general directors, and 11 were deputy directors Most of the companies were established in the Soviet period and then privatized (60% were open JSCs, and 30% were closed JSCs); 37% of the respondents were in light indus-try, 30% were in the food industry, and 33% were in the machine-building industry As reported above, interviews were conducted in medium-size companies: 13 of the companies had 100 to 500 employees, 12 had 501 to 1,000 employees, and only 5 had more than 1,000 employees The typical firm in the sample had relatively stable financial performance, while there were some firms in bankruptcy, including those that were under exter-nal management at the moment of the interview Firms interviewed had demonstrated a very large increase of output since 1998 Of the 30 firms included in the interview, 16 were part of various BGs, which are outside owners of the enterprises Only one respondent said that his enterprise was part of a BG that did not participate in authorized capital and, in spite of that, performed the functions of executive management

In most cases, the responsibility for decision-making was allocated so that the parent company was the marketing center of the group and all market-ing and financial decisions were centralized; the affiliated enterprise was a

production facility only but enjoyed significant autonomy in production decisions and labor management The following quotations from the inter-view are typical:

“Key decisions are made at the enterprise level; the group was formed only for

mar-keting.” This respondent was the general director of a machine- building

enterprise with 300 employees The strong opinion expressed by the respondent that marketing decisions were of secondary importance to him is crucial here

“The holding company (parent company in this context) controls all the finances, buys all the inputs for production, and provides us with the technologies, including all of the documentation We supply the final products in exchange for that.” This respondent was the general director

of a machine-building firm with 1,800 employees The director of the enterprise considers the management and decision-making within the group as internal markets but not as hierarchical coordination

“The enterprise is freed from unusual and unnecessary decisions The ent company performs the functions of the Soviet Glavk (industrial plan-ning body under socialism) We don’t care about what and how much to produce The holding (parent) company supplies the raw materials, sells our products, and takes care of all the accounting, taxes, and finances The director shouldn’t think about taxes and wages The holding com-pany (parent company) is a buffer that saves us from the market ” This respondent was the general director of a machine-building enterprise with 1,100 employees The notion of enterprise as a production unit of broader company is typical here

par-“(The parent company) deals with the marketing for the most part I do not care any more to whom the product is sold or at what price it is sold.” The respondent was the general director of a food processing enterprise with

430 employees

The results of the interview lead us to the conclusion that, first, making in the BGs has changed significantly from that in the period when enterprises functioned as independent entities; yet, secondly, the main trend of these changes is not to modify the decision-making process at the enterprise level but to strip the enterprises of all marketing decisions; the enterprises then become pure production facilities It is symptomatic that the top managers of the enterprises stress the use of Soviet-type planning inside the BGs as the main advantage of this form of organization The con-clusion is that holding companies are a very Soviet form of capitalism, and this important explanation of the rise of this organizational form in Russian industries has been suggested by others, for example, Clarke (2004)

decision-The level of centralization of decision-making in BGs needs to be assessed

to verify the hypotheses on the corporate governance of BGs given above A

high degree of centralization of decision-making would mean that ship and management are not separated, and, thus, the agency problem is resolved (H2) If the parent company concentrates all important decisions

owner-at the level of headquarters, or, as is typical for Russian JSCs, owner-at the level of

a small group of ultimate owners, there is no specific agency problem in the BGs other than the typical agency problem faced by all big companies However, if the top management of affiliated companies enjoys substantial autonomy, then the agency problem between parent and subsidiary intensi-fies, and specific instruments are needed to resolve it

Our survey results are ambiguous as to whether decision-making is tralized or decentralized The degree of centralization does not seem to be very high if we look at the decisions made exclusively by the parent com-pany without participation of the enterprise Strategic decisions are made

cen-by the parent company alone in 40% of the groups, while daily ment decisions are completely centralized in only 5% However, in slightly more than half of the enterprises, parent companies participate or coordi-nate strategic and daily management decisions, although subsidiaries retain

manage-an influence on them Importmanage-ant evidence is that the degree of tion of daily management decisions significantly increases over time From enterprises that became subsidiaries in the groups before 1995, the last year

centraliza-of mass privatization, 55% consider themselves as fully autonomous in daily management decisions Among the enterprises that became subsidiaries after 1995, the ratio falls substantially to 37% Therefore, recent BGs employ more centralized decision-making

This evidence is in favor of H2: even if ownership and management at the level of subsidiaries are formally separated and the ultimate owner does not own the shares of subsidiaries, the role of the parent company reflects the participation of the owner in management By taking part in daily management decisions in subsidiaries, which is the case for more than half

of the enterprises, parent companies and the ultimate owners ingly prevent the soundest manifestations of agency problems at the level

in enterprises was evaluated by researchers of Russian enterprises either itively or very negatively According to the first point of view, contacts with stakeholders suggest relational rents in the networks of traditional suppliers