Project description - Corporate Governance in Russia

Project leader: Professor Eva Liljeblom, Hanken, P.O.BOX 479, 00101 Helsinki, tel. +358-9-431 33 291, eva.liljeblom(at)hanken.fi, http://www.shh.fi/~liljeblo

1. Introduction

Shleifer and Vishny (1997) define corporate governance as the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment. Corporate governance mechanisms include the investor protection provided by the legal system, ownership control issues including the role of the board of the company, the functioning of the market for corporate control, as well as the incentive contracts used to reduce agency problems between the management and the owners.

In Russia, the level of protection provided by the legal system has typically been low, although the situation is improving (the Russian government has recently adopted a number of laws relating to corporate governance, and the Federal Commission on Securities Markets has issued its corporate governance code). Typical findings for the Russian economy are also a highly concentrated ownership and a restricted use of external funding such as bank credits or issued equity (Guriev, Lazareva, Rachinsky and Tsukhlo 2003). In such a situation, alternative control mechanisms such as the ownership control by the controlling owners as well as the role of the board of the company become even more important. Also the information asymmetries between the management and the controlling owners, versus outside investors can become large and may constitute the main reason for the low availability of external funding.  The improvement of financial reporting standards and practice is one step in the process of overcoming such asymmetric information problems.

The existing research on corporate governance in Russia is mostly of an explorative nature, characterising the level of legal protection and ownership distribution, or self enforced mechanisms such as managerial turnover or the use of dual class shares. The purpose of this project is to study two issues which appear critical in the Russian case: (1) the role of the board in the governance process, and (2) the level of financial (mandatory and non-mandatory) communication between the company and the investors. We will also expand the corporate governance research on Russia to a question of utmost importance to investors, (3.) the relationship between the level of corporate governance and value creation. We will focus on publicly listed companies for which stock price and financial data is available, and employ quantitative methods used in financial research, such as panel data regressions.

The structure of this proposal is the following. In section 2, we describe the subprojects. In section 3, we specify the researchers and the expected output. The financing plan is presented in section 4. 

2.1. Corporate governance: The role of the board

Rapid privatisation of the state property in early 1990s created a rather dispersed ownership structure in Russian companies with substantial employee and managerial ownership. Debt for equity deals in the mid 1990s transferred some of most valuable “crown jewels” in oil and basic industries into the hands of a few owners. The 1998 financial crisis gave a new powerful impulse for ownership concentration. Now the ownership structures in Russian firms are highly concentrated, or dispersed among employees, managers, outside industrial / financial investors, and local and federal authorities.

In this study the main approach to corporate governance is a shareholder perspective: corporate governance is defined as the mechanisms to assure that investors receive the return on their investment. However, this doesn’t exclude other stakeholders. We understand that a complicated web of relationships of a firm, which typically is closely held in Russia, requires to take into account stakeholder behaviour that can substantially influence investors ability to receive the return on their investment. There are more interacting, and also conflicting parties such as owner managers and external minority shareholders; controlling shareholders and external minority shareholders; controlling shareholders and insiders (owner managers and employees), and incumbent rent seeking interest groups.

When other enforcement mechanisms of corporate governance are weak, such as financial market, market for corporate control, product market competition, legal protection of minority shareholders, self-regulatory institutions and practices, and board of directors, market seems to react to governance problems by ownership concentration. According to some studies this, indeed, is happening in Russia. During the past five years the share of dispersed shareholdings by insiders (managers and employees) has decreased from 60% percent to 30% percent in Russian enterprises, and the share of more concentrated shareholdings by outsiders has increased from one third to 55% (Radygin, 2001).

An important question, as well from theoretical as practical point of view, is how the board of directors in Russian enterprises is evolving. Can board compensate the weakness of other governance institutions? Board is an endogenously determined governance mechanism, i.e. board is affected by multiple factors of its environment. Most of the empirical studies on boards have been aimed at answering one of the following questions. a) How are board characteristics such as composition or size related to profitability? b) How do board characteristics affect the observable actions of the board? c) What factors affect the makeup of boards and how they evolve over time? (Hermalin & Weisbach, 2001). The main findings in these studies, which mainly investigate Anglo-Saxon boards, are that board composition is not related to corporate performance, while board size is negatively related to corporate performance; board composition and size are correlated with the board’s decisions regarding CEO replacement, acquisitions, poison pills, and executive compensation; boards evolve over time as a function of the bargaining power of the CEO relative to the existing directors; firm performance, CEO turnover, and changes in ownership structure affect changes in boards. 

In analysing boards, at least three things should be taken into consideration. Firstly, one of the basic assumptions is that directors’ effectiveness is a function of the board’s independence from management. To observe independence with its endogenous character is a challenging task for measurement and interpretations. Secondly, a board is not a monolithic equity, but consists of individuals with their own background and views.  Thirdly, the form of finance matters, and affects board’s conduct and relationships. In the control-oriented financial system the main conflict is likely to be between controlling shareholders, whether outsiders or owner managers, and minority shareholders, whereas in the arms-length financial system the main conflict is likely to be between management and dispersed shareholders.

In the Russian context, probably one of the key questions of board’s independence is its independence, not only from owner managers, and controlling shareholders, but as well from influence seeking stakeholders. Protection of rights of minority shareholders is an important question in this context. Heterogeneous ownership structure and still unpredictable stakeholder environment in Russia are factors affecting board’s enforcement capabilities.

The following research topics will be analysed within this sub-project:

• Board of Directors as an enforcement mechanism of corporate governance in Russia:
  Quantitative analysis of factors affecting boards including ownership structure, firm performance, managerial ownership, influence seeking stakeholders; Board characteristics and firm performance; Board characteristics and observable actions of the board. Panel data regressions as well as semi-structured interviews will be employed.
• Qualitative analysis of Board Processes and Effectiveness in Russian Companies. The issue of boards’ impact on strategic decision making in the Russian newly privatized and fast-growing firms will be evaluated and analysed, employing several case studies. Boards will be reviewed from a dynamic perspective, as it will be argued that with the development and growth of a company, boards’ roles are changing and becoming more essential for company’s prosperous operations. Russia presents an interesting example for research on boards, owing to large scale restructurisations and developments over the last decade. A comparison to boards of fast growing Finnish enterprises will be made, concentrating on the time period after the bank crisis in 1990, when many found a need to restructure and re-develop their businesses. Societal and market particularities of Russia as compared to Finnish and/or Western countries will be made in connection to the funtionality of the boards, their capabilities on the market, their popularity and usefulness for influencing the strategical development of the companies they govern.

Research Objectives
Boards of directors are a key element of all systems of corporate governance, but in transitional economies they are potentially more important because of both the relative weakness of effective external market and regulatory monitoring and because of the complexity of corporate decision making in emergent markets. This study will seek to explore emergent best practice in the composition and conduct of boards of directors in Russia.

Research Focus
The study will focus on three key aspects of effective board performance:

1. We will explore the changing external pressures that are felt to be shaping board conduct. This will include consideration of the impact of competitive forces, stock market and investor interests, banks and legal and regulatory changes.
2. We will explore the impact of organisational practices on the functioning of the board. This will include consideration of the impact of corporate strategy and structure, management accounting and information systems, internal control and audit, remuneration and succession.
3. We will explore the functioning of the board as a group in relation to (1) and (2). Here we will seek to identify the division of responsibilities between chief executive and chairman and between executive and non-executive members of the boards, including the nature and composition of any board subcommittees. We will explore the selection, recruitment, training, development and evaluation of individual directors. We will explore the challenges and dilemmas faced by individual directors in the conduct of their duties, and the factors that either enable or disable board effectiveness.

Research Methodology
Whilst quantitative studies of boards can identify significant correlations between compositional/structural variables and corporate performance, making sense of these requires a different more qualitative research methodology in order to identify some of the individual, relational and group processes that in practice shape board performance and effectiveness. The research will, besides quantitative panel-data estimations, use semi-structured interviews with executive and non-executive directors, including chairmen and chief executives, as the means of data collection. These interviews will use critical incident technique to draw out key aspects of individual experience around decisive moments of company and board functioning. This part of the research will be conducted in two stages. In a pilot stage we will interview one executive and one non-executive of five company boards. These interviews will then be transcribed and translated and the results used to identify some of the core emergent themes and to refine the interview schedule and process. In the main stage of the research a further thirty interviews will be conducted in another fifteen companies. The resulting interview data will then be coded and analysed.

For this kind of research obtaining access is key and we will make use of our partners in Russia in order to facilitate this. The interviews will be conducted primarily by a post doctoral research associate under the guidance of the principal researcher. The output from the research will include academic and practitioner papers as well as practitioner events to be held during the research.

Researchers: Martin Lindell, John Roberts, Tuomo Summanen, and Dmitri Melkoumov.

2.2. Corporate governance and financial communication

The separation of control and management in corporations leads to information asymmetry between the management and outside investors. The main goal of a corporate governance mechanism is to ensure sufficient protection for providers of capital and, consequently, induce sufficient external financing for firm operations, investments, and other ventures.

The corporate governance mechanism has two important functions in ensuring flow of relevant and reliable information from management to capital markets. First, an efficient corporate governance mechanism requires sufficient and useful information for monitoring management actions. Second, corporate governance plays an important role in ensuring that capital markets have sufficient and useful information for investment decisions.

This research project investigates the links between corporate governance and financial information. The research questions include:

• Information: What is the quality of the financial information provided by Russian companies e.g. in forecasting future earnings or bankruptcy? To what extent do the companies voluntarily provide more information than what is mandatory, and is there a relationship between the amount and precision of financial information and the availability of funding, as well as company valuation ?
• Managers' behavior: Why and how do managers use discretion over the dissemination of financial information? Do managers manipulate accounting numbers? Why and how do managers choose the content of information and the dissemination mechanism for the disclosure of financial information?
• Role of corporate governance: How can the corporate governance mechanisms ensure that managers use their discretion over the quality of financial information to enhance it and not to reduce it? How do various corporate governance mechanisms differ in their influence on managers' use of discretion over financial information and in complementing or substituting financial information?

Research Objective
To assess the level and quality of financial information provided by Russian companies, and its relation to the market valuation of Russian companies. To investigate how various corporate governance mechanism affect the level of financial disclosure (the manager’s descretion over financial information).

Research Methodology
Standard quantitative methods used in financial research will be employed, such as association and event studies (studying the relationship between stock prices and financial information releases), as well as panel data estimations when studying the role of the corpporate governance mechanisms. A disclosure index for Russian companies will be built, measuring the level and quality of the mandatory and voluntary financial information provided by the companies.

Researchers: Andriy Andreev, Anders Ekholm, Eva Liljeblom, Paavo Yli-Olli, Julia Przevalskaja, Ahmed Sheraz and Jakub Zasada.

2.3. Corporate governance and shareholder value

The ultimate goal of corporate governance is to align the managers' goals with those of the investors, i.e. to ensure shareholder value creation. Evidence on the value enhancing effects of strong corporate governance has been obtained in recent studies above all on the U.S. market. Gompers, Ishii, and Metrick (2001) found that more strongly governed firms outperform weak ones in terms of future profits, sales growth, and share price appreciation. Weakly governed firms have higher capital expenditures and make more corporate acquisitions. Datta, Iskandar-Datta and Raman (2001) found that more strongly governed firms pay lower acquisition premiums, and have a better post-acquisition stock price behavior. Also e.g. La Porta et al (JoF 2002) found in their cross-country study strong support for the value improving effects of stronger corporate governance.

We intend to expand the study of the corporate governance mechanisms in Russia by looking into the relationships between firm specific corporate governance variables (such as ownership variables, board structure, executive compensation systems) and firm performance in terms of book-to-market ratios, future profits and growth, and investment and acquisition behavior in order to investigate the relationship between various governance structures and shareholder value. This subproject is expected to result in important information on what types of governance structures are the most efficient in a market under development like the Russian one, and should therefore be of great interest for firms and individuals investing to the market.

Research Objective

To investigate the relationships between governance variables such as

• ownership (no. of dominating owners, degree of control, type of owner etc.)
• board structure (size, composition (external/ internal), the board’s ownership of the firm, board turnover etc.)
• executive compensation systems (bonus/ stock plans, executive options)
• merger clauses and other poison pills employed by the company and firm performance as measured by both market based and accounting based variables, as well as merger activity and success,  in order to assess which governance mechanism are most value enhancing.

Research Methodology
Standard quantitative methods used in financial research will be employed, such as panel data regressions.

Researchers: Eva Liljeblom, Anders Löflund, Benjamin Maury, Daniel Pasternack, Ihsan Ullah Badshah and one more Ph.D. student to be recruited.

3. The researchers

The project is lead by professor Eva Liljeblom (Hanken). Co-leaders are professor Paavo Yli-Olli (Univ. of Vaasa) and M.Sc. Tuomo Summanen (Finpro and Univ. of Cambridge). The project researchers (18) can be divided into senior professor level researchers, post-doc researchers and Ph.D. students as follows:

The senior researchers (7) include prof. Martin Lindell (Hanken), prof. Eva Liljeblom (Hanken), prof. Anders Löflund (Hanken), partners in Russia: Dr Alexandr Radygin, Institute for the Economy in Transition (IET), and General Director Oleg Adamovsky, Centre for Economic and Financial Research (CEFIR), Dr John Roberts (Univ. of Cambridge), and prof. Paavo Yli-Olli (Univ. of Vaasa).

The post-doc reserachers (5) include Ph.D. Andriy Andreev (Hanken), Ph.D. Anders Ekholm (Hanken), M.Sc. Benjamin Maury (Hanken), M.Sc. Tuomo Summanen (Finpro and Univ. of Cambridge), and Ph.D. Daniel Pasternack (Hanken).  The two M.Sc. are expected to take their Ph.D. exams before the project starts.

The Ph.D. students  (6) involved in different subprojects are M.Sc. Ishan Ullah Badshah (Hanken), M.Sc. Ahmed Sheraz, (Hanken), M.Sc. Dmitri S. Melkumov (Hanken), M.Sc. Julia Przevalskaja (Univ. of Vaasa), M.Sc. Jakub Zasada (Hanken), and one more to be recruited.