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Incentive contracts, corporate governance, and privatization funds in Romania.

I. Introduction

The design of appropriate financial intermediaries has emerged as a key problem in the privatization process in Eastern Europe. Particularly in mass privatization programs employing vouchers as artificial capital, intermediaries are supposed to play critical roles in administering the ownership stakes of citizen shareholders, in providing opportunities to hold diversified portfolios, in using their large stakes to monitor and restructure companies, and, by engaging in exchange and portfolio management, in functioning as the first genuine financial institutions in economies that have essentially had none for at least 40 years. Much attention has already been paid to the structure of the relationships among the intermediaries, the state, the citizen shareholders, and the companies, which are critical for these roles to be fulfilled.(1)

One aspect that has received rather little treatment, however, is the specific design of incentive contracts for the managers of the intermediaries. Insofar as the intermediaries operate like Western financial institutions, one may simply consult the Western literature on optimal contracts or look to the compensation schemes developed for executives in, for instance, Western investment banks for a guide. But, in the case of East European privatization intermediaries, a number of significant, additional factors intrude.

First, alternative instruments for the governance of the privatization intermediaries may be unavailable or undesirable. In the West, competition, reputation, and relatively well-developed regulations and institutions all contribute to the governance of financial intermediaries; thus executive compensation schemes represent only one aspect and one method of corporate governance. But the standard tools of corporate governance are absent or quite weak in the case of privatization intermediaries in Eastern Europe. Moreover, the communist state in transition is in a particularly poor position to exercise appropriately fine-tuned intervention in the operation of financial intermediaries. Well-designed incentive pay schemes, therefore, may take on much greater importance in controlling their behavior.

Second, a lack of information greatly hampers the implementation of effective incentive contracts. In the West, comparatively well-functioning markets ensure that the initial value of a company or portfolio is at least approximately known, so that the improvements produced by a particular manager or group of managers can be assessed. Markets for company shares and assets, however, are wholly missing in Eastern Europe, implying that the true value of a newly taken-over company is unknown and the contribution provided by an individual manager difficult or impossible to measure.

Finally, the privatization intermediaries may be expected to accomplish additional tasks, greatly complicating the incentive contract design. In Romania, for instance, the Private Ownership Funds (POFs) are envisioned to execute not only the intermediation and control functions, but their regulatory statutes also charge them with part of the job of privatizing the remaining state-owned shares and with exchanging their shares for vouchers. Any effective (not to say optimal) incentive contract must obviously create incentives for all the different tasks that are supposed to be performed. Devising such a multi-dimensional contract, however, is an enormously complex problem.(2)

In the next section, we analyze the governance problems in the design of privatization intermediaries, thus demonstrating the importance of providing explicit incentive contracts for managers of these institutions. Section 3 then turns to the example of the POFs in Romania, which have particularly acute incentive problems related to their design, environment, and multiple tasks. Section 4 discusses the governance problems of the POFs, and Section 5 explores the possibility of devising a compensation structure for their executives using a multi-task principal-agent model. The final section of the paper draws some conclusions concerning the appropriate incentives for the effectiveness of the Romanian privatization program.

II. Mass Privatization and the Governance of Financial Intermediaries

The standard methods of privatization in the West--management and employee buy-outs, public offerings, and direct sales to domestic and foreign investors--suffer from severe informational and institutional deficiencies in the context of Eastern Europe. The problems of valuation, matching, inequity, governance, and insufficient demand have been already treated extensively, and may be readily observed in all the countries of the region.(3) In several countries, therefore, various types of mass privatization programs have either been implemented or are under discussion. These programs aim to accelerate the privatization process by giving away shares in a large number of enterprises to the general population, thus alleviating the problems of the standard methods.

As is widely recognized, the primary challenge involved in the design of a mass share distribution is to create a new system of corporate governance, avoiding such a dispersed control structure that no improvements in economic behavior are realized. Because secondary financial markets are essentially non-existent in Eastern Europe, the initial ownership allocation resulting from the program is likely to persist for quite some time. If this dilemma is to be addressed, therefore, it is incumbent that the program itself contain the solution.

For this reason, nearly all the mass privatization programs proposed or adopted contain a pivotal role for new intermediaries, which hold shares in the privatized companies and are in turn owned by citizens, usually by means of vouchers. The Voucher Investment Funds of Russia, the National Investment Funds of Poland, the Investment Privatization Funds of the Czech and Slovak Republics, and the Private Ownership Funds of Romania are examples in practice.(4) Privatization intermediaries may differ along a number of important dimensions, relating for instance to how they are created, how citizens become their owners, how they acquire shares in companies, the degree to which they compete among themselves, and how they are regulated.

Here, we focus on the means by which the intermediaries may be governed, that is, the ways in which they may be induced or compelled to perform their prescribed functions. In particular, we are concerned with the determinants of the behavior of their managers: why should they perform their appointed tasks or behave in the interests of their putative owners? We consider, in turn, state control and regulation, competition, reputation, institutions for "voice," and incentive contracts as potential governance mechanisms.

One possibility for governance utilizes the regulatory power of the state. Well-developed financial markets are generally regulated to ensure that information is disclosed, small investors are protected, and contracts are enforced. In the West, these restrictions represent part of the general conditions under which intermediaries operate; they do not themselves dictate specific actions or objectives. Such a regulatory framework and understanding of the role of the state, however, is quite undeveloped in East European countries. Not only are governments in the region too inexperienced and probably too inept to regulate behavior, but any significant reliance on the state is likely to develop into excessive intervention in the intermediaries' actions, with the result that the intermediaries become or remain organs of the state, rather than fulfilling their potential as new institutions leading the way to a market economy. This tendency is enhanced if the state has itself created the intermediaries and assigned them shareholders and company shares through some administrative procedure, rather than relying on open, competitive mechanisms. Thus, to the degree that the intermediaries are supposed to be privately-oriented, profit-maximizing organizations, an active role for the state in their governance is probably precluded in Eastern Europe.

The argument that competition among firms leads to appropriate behavior is a favorite of economists, and may be substantially valid for publicly-traded firms operating in competitive environments with good, even if not perfect information. The possibility that the firm will go bankrupt or be taken over, and the likelihood that such eventualities would be reflected in share price movements, create incentives for small shareholders to exit and enter. A poorly managed firm, therefore, would be revealed through low share prices, with at least two important consequences for managerial behavior. First, a well-functioning managerial labor market would penalize the firm's manager by rendering her/him unattractive to potential future employers. This reputation mechanism may be quite potent for mobile executives. Second, an outside takeover is likely to result in the manager's dismissal. Subject to some transaction costs, a takeover must in principle always be a concern for any manager providing sub-par performance.

Although the effectiveness of these mechanisms in the West is much debated,(5) it should be readily apparent that they are likely to be nearly completely ineffectual in Eastern Europe for some time to come. The biggest problems are informational and institutional: potential investors have neither knowledge about the true value of a particular portfolio and what a given manager has achieved nor a market in which to express their judgments. This is surely not to say that competition is meaningless; on the contrary, a large number of intermediaries entering freely and competing on equal terms is probably a necessary condition for them to pursue even approximate profit maximization and to eschew rent seeking from the state. Our point is merely that competition is likely to be still much less effective in inducing appropriate managerial behavior in East European privatization intermediaries than it is in Wall Street brokerages.

In the absence of markets facilitating the "exit" of disgruntled shareholders, their rights to exercise "voice" in the operation of the intermediary take on added importance. In the West, shareholder voice is achieved through some decision-making at general meetings and through the election of supervisory and executive boards, supposed to represent shareholder interests. The development of such institutions in Eastern Europe is a time-consuming process hindered by a lack of experience and a shortage of qualified directors. Moreover, privatization intermediaries typically have still much more dispersed ownership structures than found in the West: their millions of small shareholders have virtually no incentives to monitor managers and decisions, and the exercise of voice is wholly impractical. The tradeability of intermediary shares and, therefore, the possibilities for acquiring a controlling or at least an influential stake surely affect the responsiveness of managers to shareholders in the long run. But the poor development of secondary markets in Eastern Europe implies that such developments may be a long time coming.(6)

The problem of "monitoring the monitors" is thus particularly acute in Eastern Europe where the organizations representing the chief hopes for a new system of corporate control, the privatization intermediaries, are themselves particularly difficult to govern. The remaining instrument of corporate governance, compensation schemes devised to improve the alignment of managerial with shareholder interests, thus take on critical importance. Of course, incentive pay schemes may suffer from many of the same problems as the other mechanisms: information about performance may be unobtainable or of poor quality and the lack of markets implies that the basis for tying pay to standard performance indicators may be missing. This introduces additional randomness into the compensation arrangement, in some cases even rendering it infeasible. But, as we shall see, there may also be alternative possibilities.

Before we demonstrate the problems and prospects for incentive contracts to alleviate the corporate governance predicament, we turn to the specific institutional arrangements in Romania. The Romanian intermediaries illustrate many of the obstacles to governance discussed above. But the problems are still more complex, because of the important role the intermediaries are supposed to play in the privatization process itself.

III. Privatization Intermediaries in Romania

The large privatization program in Romania involves two main components: the "free distribution" of 30 percent of the shares in all the enterprises scheduled to be privatized, and the "subsequent sale of shares" of the remaining 70 percent held by the state. The 30 percent in each company is distributed to one of five Private Ownership Funds (POFs), state-created intermediaries technically owned by all adult Romanian citizens through the "Certificates of Ownership" (vouchers) issued to them by the state. The 70 percent retained by the state is held in the State Ownership Fund, which the Privatization Law (1991) charges with selling completely in seven years. In an earlier paper [Earle and Sapatoru, 1993], we have examined in detail the Romanian privatization program as a whole. Here, we focus on the roles the POFs are supposed to play and the regulation and governance mechanisms that may influence POF behavior.

As noted above, the tasks given to the POFs to accomplish are significantly more complex than those of privatization intermediaries in other countries. This was partly inherent in the original Privatization Law (1991), and it also results partly from more recent changes. According to the Privatization Law, their principal tasks are:

a) to "seek to maximize profits accruing to holders of Certificates of Ownership;"

b) to "revolve their portfolio of shares and make investments in order to maximize the market value of the Certificates of Ownership;"

c) to "assure brokerage services for exchanging the Certificates of Ownership for company shares, according to market conditions;" and,

d) to "accelerate the privatization of the SOF shares in the companies allocated to them."

This last task was fleshed out through a provision in the so-called "Shareholders Agreement," between the POFs and the SOF, which divides privatization responsibilities among the various institutions (including the National Agency for Privatization, although this part of it seems not to have been implemented). According to this provision, each POF is responsible for the privatization of the SOF shares in the medium-sized companies in which they hold a stake, the share sale supposedly to be accomplished within five years. In practice, this is accomplished through a "mandate" given by the SOF to the POF to sell the shares of the former in specific companies.

The first two tasks both concern returns to certificate-holders, the first involving the flow of income (dividends), the second the change in portfolio value. The statutes of the POFs actually require that dividends be capitalized for a period of three years, allowing them only thereafter to be distributed. The rationale is that dividends are expected to be low initially, and the transaction costs of distributing them to 16.5 million citizens would be enormous. But the prohibition on dividend payout also represents an unusual constraint on the behavior of a financial institution, and, in the absence of well-functioning secondary markets, also deprives the citizen owners of the one source of income that they could be deriving from the program. Below, we discuss the use to which the POFs are so far putting their earnings.

The second task pertains to maximizing the so-called "market value" of the certificates. In the short run, what market value this should represent is far from clear. On the unregulated street market, the certificate price is very low: between 5,000-10,000 lei, or 5-10 USD at August 1993 exchange rates. The Funds, however, seem to treat this market, the only one that as yet really exists,(7) as wholly irrelevant: they have announced that certificates (i.e., the shares in all five of the POFs) have a "nominal value" of 145,000 lei as of early fall, 1993. This was determined by some combination of book valuation (according to statute) and closed-door negotiations, in unclear proportions.(8)

Fulfilling either of these two tasks may be accomplished through passive portfolio management or active monitoring and restructuring of companies. As we suggested in the previous section, above, the purpose of creating intermediaries in most mass privatization programs is the latter: the intermediaries should become the agents of economic restructuring, in particular through identifying firms that have better chances to survive and turning them around. It is not clear whether this way of thinking underlies the original design of the POFs, but granting them only 30 percent stakes would in any case seem to preclude it. In terms of their ability to influence decisions at the level of firms, the POFs are quite weak, since they can always be outvoted by the SOF.(9)

In their first year of operation (which began in fall 1992), the POFs have had rather significant earnings, in the form of dividends from the companies in their portfolios. Although precise figures are lacking, it is reportedly companies in trade and construction which are responsible for most of the dividends. Because some majority-state-owned companies are still receiving direct and indirect subsidies from the state (including subsidies covering losses, those compensating for controlled prices, soft credits, exchange rate and interest rate subsidies, and so on), it is possible that some POF dividends represent recycled subsidies. The whole process of dividend determination is rather murky in an economy still dominantly state-owned.

Given the prohibition on paying dividends to citizen certificate-holders for three years, how have the POFs used their earnings? Aside from a restriction on making loans (they are supposed to become mutual funds, eventually, not banks), the POFs are essentially unconstrained on the investment side. They have allegedly used their cash to buy real estate (including office space for themselves) and to make a variety of other new investments and joint ventures, as well as in some cases to acquire luxury consumer goods (for the new office space). What is most clear is that essentially none of the dividend income is being invested in restructuring the companies already in the POF portfolios. Given their minority stakes, this outcome was probably inevitable; but it bodes ill for the long-term prospects of Romanian enterprises in the large privatization program.

Despite some problems in interpreting the law, these first two tasks may be viewed as rather standard for financial intermediaries anywhere. But the third task of the Romanian intermediaries, to provide "brokerage services" to Certificate of Ownership holders for the exchange of certificates into company shares, at "security market prices" raises new complications. To start, it is not clear what "security market prices" mean: the transactions that have been completed so far were based on the announced, so-called "nominal" value of the certificates, and on prices for shares that do not reflect a market value, given the absence of a market for these shares. But, more importantly, the Funds seem to have no reason to be interested in this exchange. For the shares in companies divested, a particular Fund receives either its own certificates, which become void thereafter, or certificates of other Funds. In the latter case, a "compensation system" was agreed upon among the five POFs, through which cross-holdings of certificates (the total value of certificates of a particular Fund obtained by another Fund in this exchange process, and vice-versa) are offset for equal values, the remaining balance being "compensated for" by cash, at the declared value of the certificates. Therefore, this "brokerage service" leads to a Fund losing part of its shares and obtaining at best a limited amount of cash in return. Although the further reallocation of ownership rights from the privatization intermediaries can certainly be regarded as a desirable process, it is not clear that the legal provisions are sufficient to accomplish it. Indeed, aside from the program of management and employee buyouts (in which 130 small companies had been 100 percent sold as of October 1993), the POFs have not engaged in a single exchange of this kind.

The final, explicitly stated objective of the Romanian intermediaries is privatization. Once again, however, it is not clear what incentives the POFs have to undertake such an activity. The "Shareholders' Agreement" seems not to be binding, as no penalties seem to apply should the POFs not fulfill this responsibility (although informal suasion seems to be somewhat at work), and no other monitoring mechanism is in place. In fact, the POFs may choose whether or not to assume the privatization of medium-size companies from the SOF on a case-by-case basis.

Another question arises with respect to the precise definition of the task. In the government's view, the task is to privatize the companies as quickly as possible, but finding the "best investor," i.e. matching each company with the investor that will put the company's resources to best use, is also supposed to be a concern. According to the NAP, an investor should be assessed on the basis of the following criteria, in order of priority:

a) value of investments pledged by the future owner in the privatized company. The POF, as the seller, is supposed to maximize investments for the development of the company.

b) maintenance of the number of employees for two years from the date of the sale. Maintaining the number of employees, however, is likely to induce additional problems in operating the company, and even a loss in profitability. Therefore, it is expected that it would significantly decrease the sale price; and,

c) observance of European ecological standards. Similarly, consigned pollution reduction or prevention investments are likely to reduce the price the buyer is willing to pay.

Therefore, a trade-off clearly exists between privatizing quickly and the matching process, a difficult and time consuming one. Although price is not explicitly stated as a priority, it seems to be an indicator of at least some political concern. Interviews with POF staff indicate that price is actually a more important criterion for the POFs than for the SOF. The reasoning is that a higher price raises the market value of certificates, when the POF shares may be sold (for cash or certificates at "nominal value") together with the SOF shares. The validity and utility of this line of thinking aside, this raises the interesting possibility that the POF will be a still much more cautious seller than is the SOF: in this case, transferring some privatization responsibilities to the POFs is likely to slow down the process.

The Private Ownership Funds are thus supposed to fulfill a set of complex tasks, which are potentially conflicting, and which all demand a tremendous amount of effort, particularly on behalf of the managers that coordinate them. As acutely as ever, the classic corporate governance problem arises: how may the managers of the POFs be induced to fulfill these tasks?

IV. Governance of POFs

According to the Privatization Law and Statutes, the POFs are supposed to be and to behave like private institutions, but in fact they are strongly associated with the state. Not only were they established by the state, their directors are appointed by the government, and essentially all their personnel come from the state sector. Moreover, official statements concerning the purposes of the POFs often use the language of administrative commands. For instance, the "Overview of the Privatization Law," published together with the law in a single booklet, states, "The POFs are obliged to manage the shares allocated to them so as to maximize the value of the Certificates of Ownership" (emphasis added). Of course, if the POFs are truly private, one should speak of incentives rather than of obligations.

But apart from this sort of usage and the associated murkiness of the line dividing the public and private spheres, the POFs have tremendous freedom to operate and seemingly little accountability. We already noted their freedom to invest their earnings in "other commercial activities within [their] scope of activities" (according to the Privatization Law). Although they are supposed to be subject to routine annual audits, the first will come only at the end of 1993 and will probably bring little information. POFs are required to disclose information--even to their putative owners, the certificate-holders--only in an annual report published in the official gazette.

Moreover, the state established no monitoring or enforcement mechanism for any of the tasks it set for the POFs. They are not in fact compelled to do anything in particular. This might be fine were the POFs not monopolists and were there other methods of governance in place, but we shall see that governance is quite weak. Because state regulation of POF activities is ill-defined, it is also quite unclear in what direction these institutions may evolve in the future. According to the Privatization Law, they are supposed to become "Western-type mutual funds" in five years time, but what that means in terms of behavior, governance, and permissible activities remains to be determined. The lack of clarity in POF regulation leaves plenty of room for political influence and bureaucratic discretion, hardly encouraging for the development of market-oriented behavior.

The design of the Romanian program includes almost no role for competition among privatization intermediaries. Not only were a very small number of intermediaries created by the state with no possibility for free entry, but competition among them has been largely foreclosed by the administrative assignment of individual shareholders (each Certificate of Ownership actually includes equal shares in each of the five funds) and by the mechanical allocation of company shares. Each fund "specializes" in a geographic area (for "small companies" roughly defined as under 200 employees) and in a "color sector" (branches of light industry) while sharing in the "strategic sectors" (heavy industry, agriculture, banking, trade, and transportation) with the others. The five funds are supposed to be roughly equal in size (measured by capital, profits, and/or employment). The program thus steers the POFs away from competition by limiting the number and defining a separate sphere of activity for each.

Concerning institutions of corporate governance, each POF is supervised by a "Council of Administration," which retains most important decision-making responsibilities. The seven members are nominated by the government and approved, separately, by the National Assembly and the Senate. Although the members are supposed to be "chosen from persons with commercial, financial, industrial, or legal experience," the design seems aimed more at balancing political coalitions than at achieving skilled governance, and from the beginning there was an obvious danger that political considerations would dominate selection of the POF Council members. In fact, current discussion includes proposals that the Councils be explicitly representative of the party composition in Parliament, rendering the political connection that much more definite. The Council members seem therefore likely subjects of political pressure, with few incentives to carry out the tasks hoped for from them. Furthermore, the Council is responsible for selecting the POF managers, and for establishing their compensation structure, and will hence probably convey to the management the same politically-driven behavior.

The POF "owners," the citizen certificate-holders, have very limited ability to influence the Councils and thus the performance of the fund. According to the Statutes, no shareholders' meetings will be held during the first five years of operation (under the rationale that meetings with 16.5 million participants are infeasible). During this period, there is only one possibility for control. Because certificates are tradable, they may be accumulated, and the Statute grants a sufficiently large group of certificate holders (defined as 100 individuals) possessing a sufficient number of certificates (defined as 10,000) some limited control rights: they may intervene in the fund management with suggestions for improvements in POF operation, or requests for a financial audit or to replace a member of the Council of Administration.(10) The Council of Administration is supposed to make an initial determination on these actions, and the National Agency for Privatization is supposed to be the ultimate adjudicator. Although difficult to predict, such possibilities for "voice" seem rather ineffective, and there is certainly no sign of that happening yet.

It is also extremely unlikely that exit will constitute an effective mechanism of governance: the withdrawal of one or several small owners will not be of any significance in the context of the multitudes of shareholders in any given Fund, and transaction costs for an individual investor to withdraw its certificate and collect information about alternative uses are very high. As already noted, there seems to be no force compelling POFs to fulfill their "brokerage" function, to exchange shares for certificates, which would have provided one avenue of exit.

The remaining possible governance mechanism is the establishment of an appropriate management compensation system, which would supply the managers of the Romanian privatization intermediaries with the necessary incentives to perform their appointed tasks.

V. Incentive Contracts for POF Executives

In this section, we undertake a multi-task principal-agent analysis to determine the theoretically optimal contract for POF managers.(11) Under some simplifying assumptions, the solution provides the relationship between pay and performance along a number of dimensions. As we shall see, however, applying this solution in practice poses some grave difficulties.

A solution to the agency problem of the Private Ownership Funds consists in improving the alignment of the interests of the POF manager (the agent) with those of the 16.5 million certificate-holders and those of the government (the principals), taking into account changes in the allocation of risk. The problem could be approached as one with multiple principals, but for the sake of simplicity we will consider that the interests of the two

1 Frydman and Rapaczynski [1991] were the first to analyze these problems extensively. They have been further addressed in Earle, Frydman, and Rapaczynski [1993a; 1993b].

2 The intermediaries in the enacted but still (as of fall 1993) not implemented Polish Mass Privatization Program are supposed to bring in foreign investment, which may also be regarded as a goal not necessarily identical with maximizing returns to shareholders.

3 See Frydman and Rapaczynski [1991] and Earle, Frydman, and Rapaczynski [1993b].

4 Blanchard and Layard [1990], Lipton and Sachs [1990], and Frydman and Rapaczynski [1991] are early examples of conceptual proposals.

5 See, for instance, Milgrom and Roberts [1992].

6 The possibility that banks will play active roles, as in Germany and Japan, is usually raised in discussions of corporate governance (for instance, Frydman et al., 1993), but banks capable of such behavior do not yet, for the most part, exist in Eastern Europe.

7 An effort by the Foreign Trade Bank to establish a formal secondary market seems to have essentially collapsed.

8 A further confusion about the value to be maximized arises from the provision in the POF Statutes which allows them to "intervene in case the value of their certificates drops significantly" (below a floor established by each POF itself). The extent of this intervention is decided by its Administration Council, and is supposed to be limited by the size of its "risk fund" (a fund established at the level of each intermediary, meant to cover certain unexpected expenses, though neither the source of the fund nor the scope of these expenses are clear). This regulation seems curiously similar to the semi-decentralized arrangements typical of central planning in the days of yore.

9 Romanian commercial companies in the large privatization program are currently governed by supervisory boards, usually with three members: one representing the relevant POF and two from the SOF.

10 One interpretation of this is that each participant may participate only with up to 100 certificates, making it still more difficult to constitute such a coalition.

11 The setup for the model in this section is based on Holmstrom-Milgrom [1990], although the derivation and application are our own.

principals merge. On the one hand, assuming the government is committed to privatizing, it will also be preoccupied by the citizens' support for reform, and it is thus interested in maximizing their returns. On the other hand, the citizens are concerned with creating a private sector, finding new opportunities for using their certificates, and are therefore interested in privatization. If the agent is risk-averse and the principal risk-neutral, then improvements in the incentive alignment must be traded off against the cost to the agent of bearing more risk.

We further simplify by considering the case where the principal is interested in the performance of only two tasks. We denominate them as "maximization of shareholder returns" and "privatization." As argued above, both dividends and the value of certificates are subsumed in total returns to shareholders; thus, we may join them together. By "privatization," we refer both to the sale of SOF shares in medium-sized companies and to the provision of "brokerage services," insofar as both actions put company shares in the hands of individual citizens.

Leaving aside problems of measurability for the moment, we assume that the degree of fulfillment of the two tasks may be partially observed by the principal, using indicators designated as [[Omega].sub.1] for returns to shareholders and [[Omega].sub.2] for privatization. Further assuming a linear utility function, P, for the principal, we may write the expression for her maximand as

E(P) = E([p.sub.1] [[Omega].sub.1] + [p.sub.2][[Omega].sub.2] - Y) (1)

where E(x) = expected value of x, [p.sub.i] = transformation coefficients reflecting the relationship between the observables and the arguments in the principal's utility function and the relative weights placed by the principal on each of the tasks, Y = payment to the agent, and i = 1, 2.

The performance indicators are linear stochastic functions of the agent's effort, designated as [e.sub.1] for effort directed towards the maximization of returns and [e.sub.2] for effort directed towards privatization:

[[Omega].sub.1] = [e.sub.1] = [[Epsilon].sub.1] (2)

[[Omega].sub.2] = [e.sub.2] + [[Epsilon].sub.2]. (3)

We assume the error terms, [[Epsilon].sub.i], are normally distributed with zero mean, [Mathematical Expression Omitted] variance [Mathematical Expression Omitted], and stochastic independence ([[Sigma].sub.ij] = 0). [[Epsilon].sub.i] and [e.sub.i] are private information to the agent, and only their sum ([[Omega].sub.i]) is observable to the principal. Stochastic independence is intuitively appealing for tasks as diverse as working with a given portfolio (for the objective of increasing shareholder returns) and selling shares from another portfolio (privatizing the SOF shares).

The principal pays the POF executive an amount Y, comprised of a fixed part (f) and a variable part, the latter depending upon the observable indicators

Y = f + [w.sub.1][[Omega].sub.1] + [w.sub.2][[Omega].sub.2] = f + [w.sub.1] ([e.sub.1] + [[Epsilon].sub.1]) + [w.sub.2] ([e.sub.2] + [[Epsilon].sub.2]) (4)

where [w.sub.i] are the incentive intensities given to the manager for each of the tasks.(12) This means that if the agent increases his effort for a task [e.sub.i] by one unit, the expected compensation increases by [w.sub.i] units.

Combining with Equation 1, the expected returns to the principal may thus be written as:

E (P) = E[[p.sub.1] ([e.sub.1] + [[Epsilon].sub.1]) + [p.sub.2] ([e.sub.2] + [[Epsilon].sub.2])] - E [f + [w.sub.1] ([e.sub.1] + [[Epsilon].sub.1]) + [w.sub.2] ([e.sub.2] + [[Epsilon].sub.2])] (5)

or

E (P) = ([p.sub.1] - [w.sub.1]) [e.sub.1] + ([p.sub.2] - [w.sub.2]) [e.sub.2] - f. (6)

In addition to his expected income, the utility of the agent, ex ante, also depends on C([e.sub.1], [e.sub.2]), the cost of providing effort (including anything that the agent foregoes to serve the interests of the principal). We assume C to be convex and symmetric, with the following partial derivatives: [C.sub.i] [is greater than] 0, [C.sub.ii] [is greater than] 0, [C.sub.ij] [is less than] or [is greater than] 0, [C.sub.ij] = [C.sub.ji], and [C.sub.11][C.sub.22] [is greater than] [C.sub.12](2). Thus, the marginal cost of supplying effort is increasing. The mixed partial derivatives measure the degree of substitutability or complementarity among the tasks. If [C.sub.12] [is greater than] 0, then the tasks are substitutes, for accomplishing more privatization increases the marginal cost of providing more returns to shareholders, so that the agent tends to choose one task or the other rather than pursuing both together. They are complements if [C.sub.12] [is less than] 0, in which case [e.sub.1] and [e.sub.2] tend to be supplied together.

We argue that the two tasks set for the POF executives--maximizing shareholder returns and privatizing medium-sized companies--are likely to be substitutes. Both require significant time and energy, so if the marginal value of leisure increases with total effort, then the marginal cost of pursuing one task rises, holding constant the amount of effort devoted to that task, as more effort is expended on the other task. For instance, if a POF executive works a ten-hour day, spending five hours on each of the two tasks, then working an extra, sixth hour daily on privatization raises the disutility of the fifth hour spent on increasing the returns to shareholders.

Since the POF managers are likely to be poorly diversified (certainly relative to the state or the small shareholders), it is natural to assume that they are risk averse, with a constant absolute risk aversion utility function. The risk premium RP, representing the amount that the agent is willing to pay in order to obtain a certain income, or that he must be granted to take the job involving this risk, is then as follows:

[Mathematical Expression Omitted]

where r = the coefficient of absolute risk aversion. The agent's "certainty equivalent" is the expected income, E(Y), less the cost of providing effort and the risk premium:

CE = E(Y) - C([e.sub.1], [e.sub.2]) - RP (8)

or

[Mathematical Expression Omitted].

For the agent to accept the POF contract, he must receive a certainty equivalent at least equal to the certainty equivalent that he could obtain from an alternative activity (the participation constraint). The relevant alternative for POF directors is probably employment with a foreign joint-venture or other well-paid private sector employment. We show below that the level of the agent's utility, thus the satisfaction of the participation constraint, is independent of the optimal incentive intensities, in this framework.

Efficient contracting requires maximization of the joint utility of the principal and the agent: the problem is thus reduced to maximizing E(P) + CE, subject to an incentive constraint. This incentive constraint specifies that the marginal returns to the increase in the effort of the agent must equal the marginal personal cost of his effort, which is derived from the choice that the agent makes about allocating effort to maximize his utility function, given the incentive intensities established by the principal.

Formally, the maximization problem may be written as:

[Mathematical Expression Omitted]

s.t. [w.sub.1] = [Delta]C/[Delta][e.sub.1] = [C.sub.1] and (11)

[w.sub.2] = [Delta]C/[Delta][e.sub.2] = [C.sub.2]. (12)

Solving the first order conditions to derive the "normal equations" yields:

[Mathematical Expression Omitted]

[Mathematical Expression Omitted].

We can then derive an expression for [w.sub.1]:

[Mathematical Expression Omitted].

Similarly, [w.sub.2] takes the form of:

[Mathematical Expression Omitted].

Thus, even under our simplifying assumptions, determination of the optimal contract is extremely complex. The sophistication obviously necessary to design such a contract, together with the inexperience and poor incentives of the individual shareholders, reinforces the argument that coordination of the contract design may be necessary. For instance, the state may announce [w.sub.1] and [w.sub.2]. In a situation where there is free entry of intermediaries and they compete among themselves, only [w.sub.1] and [w.sub.2] may be prescribed, while the funds are free to announce f (and thus to compete for customers). But in the case of the POFs, the design of which offers little basis for competition, f should probably be chosen by the state as well.

Several conclusions concerning the optimal incentive payment system may be drawn. From equations (15) and (16), we may see that the magnitude of the variable part, and hence the efficient contract, does not depend on the fixed part of the linear compensation model, f. The size of the fixed part can be derived from the participation constraint, as discussed above.

The incentive intensity is, however, influenced by several factors. First, the optimal [w.sub.1], the reward for increasing returns to shareholders, varies directly with the value placed on this task, [p.sub.1] (recall that the cost function is assumed to be convex). The relation of the incentive intensity for task 1, [w.sub.1], with value placed on task 2, [p.sub.2], depends on the complementarity of the tasks in the agent's cost function. If they are substitutes, which we noted above is the most likely situation for POF executives, an increase in [p.sub.2] would reduce optimal [w.sub.1]. The opposite would be true if the two tasks are complements, in which case an increase in [p.sub.2] would increase optimal [w.sub.2]: the principal should reward shareholder returns more, the more she values privatization!

In the case of complete independence between the two tasks, i.e., when [C.sub.12] = [C.sub.21] = 0, equation (15) becomes:

[Mathematical Expression Omitted]

while, similarly, equation (16) becomes:

[Mathematical Expression Omitted].

Thus, the magnitude of the incentive intensities for each task are determined by the importance placed by the principal on each task, the variance in the performance indicator associated with that particular task, the risk aversion coefficient and the convexity of their cost functions, respectively.

Optimal incentive intensities are also influenced by the agent's degree of risk aversion. Under the independence assumption, the more risk averse the agent, the lower the optimal [w.sub.i]. When the two activities are not independent, in particular when they are highly complementary, this result may not hold.

A factor which is, in general, critical for the determination of the optimal contract is the noise in measuring performance. The less precisely the performance of a task can be measured, that is the higher the variance of the results ([Mathematical Expression Omitted]) and/or the greater importance of the role of random events in the outcome of the manager's activity, the smaller should be the incentive intensity for that task. Higher variance in the measurement of the other activity has an ambiguous effect: depending on the complementarity of the two activities and their relative weights in the principal's objective function, optimal [w.sub.i] may be higher or lower for higher [Mathematical Expression Omitted].

These measurement problems are especially significant in the case of Romanian intermediaries, given the difficulty of estimating the value of Certificates of Ownership and of judging the success of privatization. As noted above, the only existing market for certificates is a street market, which evaluates certificates at close to nothing. At least in the near future, therefore, there is no way to measure the increase in the value of certificates in order to judge the effectiveness of the managers in pursuing this objective. The so-called "nominal" value, as discussed above, is also irrelevant for this purpose.(13)

Probably the best approach would be to compensate the POF managers with shares in the POF itself. New shares in numbers that are some small percent of those outstanding could be issued for this purpose each year.(14) These should probably be shares that cannot be sold for some period of time after they are first issued; the waiting period could be three to five years. By thus making the executives long-term owners in the Fund's portfolio, they receive an incentive to maximize its value.

But it is still less clear how the results of the privatization task can be measured so that appropriate incentives can be arranged. If total book value of companies privatized is set as the criterion, the implicit incentive is to privatize predominantly capital-intensive industries. Similarly, if employment is established as a yardstick, labor-intensive activities will be favored. If the share of production of the privatized units in total GNP is considered, it is likely that companies producing relatively high-cost goods would stand a better chance of being placed on a privatization list, and firms in consumer goods sectors, which probably have better chances of survival in the market and are important for the standard of living, would receive lower priority. If the standard were value-added, then low profit firms would receive a lower priority. It would again be possible to compensate the POF executives in shares of the companies to be privatized, but this also leads to a distortion: only relatively high value companies would be privatized. The criteria suggested by the National Agency for Privatization--future investments, employment preservation, observance of ecological standards--are still harder to measure with a comparable metric.

Indeed, the tremendous uncertainty in measuring the success of privatization suggests it may be better to treat it as an unobservable outcome, rather than to provide some incentives based on some wholly inaccurate indicator. In our framework, this is equivalent to saying that the variance of the indicator measuring privatization is infinite. Thus, when [Mathematical Expression Omitted] goes to [infinity], it follows from equation (16) that [w.sub.2] is zero, while [w.sub.1] from equation (15) becomes:

[Mathematical Expression Omitted].

Again, the results depend on the complementarity or substitutability of the two tasks. If they are complements, so that [C.sub.12] and [C.sub.21] are negative, then a higher degree of complementarity between maximizing the returns to shareholders and privatizing should induce a more intense incentive for the observable task "1." But if the tasks are substitutes, as we have argued, so that [C.sub.12] and [C.sub.21] are positive, then the higher their degree of substitutability, the lower the incentive intensity for maximizing returns to shareholders should be: any incentives to perform task one will only take effort away from task two, to the detriment of privatization. In this case, it is even possible that the optimal incentive intensity is negative! If the principal really cares most about privatization, and the two tasks are strong substitutes, then setting a negative incentive for portfolio management may lead to the agent spending more time on privatization. Of course, under this scheme the agent could equally well spend his time on some third activity, even one that could be harmful to the principal's objectives.

We believe that, under the circumstances, the best incentive contract for POF executives would consist of three components: a small, fixed cash salary; an annual allotment of POF shares that may not be sold for five years from the date they are received; plus a fixed percentage of the companies for which they sell 50 percent or more of the shares (from the SOF holding), which they would be allowed to trade immediately. Finally, because the POFs have only a negative interest in providing the so-called "brokerage services," since doing so would reduce their portfolios, they should simply be compelled by law to exchange shares for certificates, at prices they announce in advance, and subject to some transaction costs. This would give them incentives to set accurate relative prices for company shares (in terms of certificates).

As noted above, the privatization incentive raises the payoff to privatizing more valuable firms relative to the less valuable. But we consider this to be useful in two respects. First, it functions as a selection mechanism, increasing information about companies so that they can be screened into "good" and "bad" groups. Second, there are some reasons to believe that, for the purpose of establishing a well-functioning market economy, this selection is appropriate. The new owners will have better incentives to operate efficiently and compete in the marketplace, rather than demand subsidies and rents from the state, if the assets they receive have a higher economic value. Because of the social difficulties associated with closings and layoffs, privatizing the bad ones may lead to little or no change in their subsidies and in their behavior, with negative repercussions on the developing new private sector as well.

VI. Conclusion

The difficulties in instituting standard mechanisms of governance for the Private Ownership Funds cast doubt on the prospects for them to carry out their assigned tasks in Romanian privatization. Although these problems hold to some extent for privatization intermediaries elsewhere, several factors--the continued role of the state, the lack of competition, and, most important, the addition of privatization responsibilities to their tasks--imply that they are particularly acute for the POFs. Thus, while we would argue that incentive contracts are an indispensable tool of governance for privatization intermediaries everywhere, they represent perhaps the only hope for motivating POF executives to fulfill their complex, tangled, even contradictory responsibilities. As we have shown, the design of efficient contracts for POF managers would be extremely intricate and would depend on several determinants--the degree of managerial risk aversion, the extent of substitutability of the tasks, and, most importantly, the error variance in evaluating performance--which are difficult to estimate. Unfortunately, however, it seems that the POFs have not even attempted to implement such a scheme.

The problem with inducing appropriate POF behavior is symptomatic of Romanian privatization more generally. Institutions are created to perform certain functions, with little thought given to whether they will be able to carry them out. The August 1991 Privatization Law assigned the State Ownership Fund (SOF), for instance, the job of privatizing its 70 percent stakes in a period of seven years from its founding. It was established in Fall 1992, but by Fall 1993 had not succeeded in selling any shares at all, except for a trivial amount in the management and employee buyout program for small companies.(15) Nor have the POFs sold a single SOF share; that should come as no surprise, in light of our earlier discussion. This poor experience with the individual sales approach to privatization, of course, is not unique to Romania: no country of the region has been able to privatize rapidly using this method.(16)

Another problem of Romanian privatization which the POFs also exemplify is the

lack of clarity in institutional relationships. It is odd, for instance, that the POFs are supposed to do anything at all with the companies in their portfolios, given that the majority stakes remain in the hands of the State Ownership Fund. Indeed, given that control rights over the companies will have been privatized only when a significant number of the SOF shares have been sold, and the fact that the "ownership" rights of citizen certificate-holders are extremely limited, it may be dubious even to consider the POFs private.

This lack of clarity holds equally in the division of privatization responsibilities. A POF is supposed to receive a "mandate" from the SOF for privatizing a medium-sized company, but who requests it, who is interested in doing this, and who can block it remains unclear. Again, it should come as no surprise that, as far as we could determine, not a single "mandate" had been arranged by October 1993, making it essentially inconceivable that any medium-sized Romanian companies will be privatized in 1993.

In addition to providing incentive contracts for POF executives, of the type we have outlined above, and compelling them to provide "brokerage services," our analysis suggests some other changes that could be salutary. Under current arrangements, the POFs have extraordinarily little outside control and must reveal little information. But if they are to be truly, not just nominally, private, this must change. They should reveal much more about their activities to their citizen certificate-holders, who should also receive much stronger control rights. The POFs should be allowed to compete in issuing dividends. And they need to have incentives to be active owners in the 70 percent state-owned commercial companies, rather than passive shareholders merely draining them of dividends for re-investment in other activities.

But, as we have argued, the POFs are not to be blamed for the fact that they are not behaving as active owners in their commercial companies. This behavior is rather a result of their poor incentives as minority stakeholders. They will never be able to act like fully private institutions as long as they face the SOF across the supervisory board table.

What this makes clear is that the real problem of the POFs is the problem of Romanian privatization--in other words, how to privatize the SOF. It seems clear to us that the current approach of piecemeal sales will never work. But will Romania have the courage to apply stronger medicine?

12 See Holmstrom-Milgrom [1987] for the motivation of assuming a linear compensation schedule.

13 Even should the unregulated street market price be taken as appropriate, the POFs' ability to intervene on the market to raise the price of certificates also raises questions about the wisdom of relating management pay to the increase in the value of certificates: the market price can be manipulated by the Fund and, hence, it does not necessarily reflect the "true" value of the certificates.

14 Once again, if there were free entry and open competition among intermediaries, it might make sense for the government to set up a compensation structure that sets fixed salaries for the executives plus pays them in shares, but allows them to compete initially in the number of shares that would be issued annually for this purpose. Alternatively, this number of shares could be set by the state, say at 2 percent of all shares outstanding, and intermediaries would compete along the fixed payment dimension.

15 As of October 1993, 123 companies had been sold 100 percent to their employees. They were "valued" at 15 billion lei, or about 10 million USD, although only 4 million USD were paid in cash. The remainder were transferred for certificates or for six-year credits with a nominal interest rate of 28 percent--in an economy experiencing over 200 percent price inflation annually! Since the book value of Romanian companies is about 10,527 billion lei [according to the 1992 valuation], of which the SOF portion is 7,369 billion lei, we calculate that the SOF has managed to rid itself of only about .14 percent of its holdings. At this rate, the seven "good" years of Romanian privatization will be followed by 700 "bad" years before the process is completely finished!

16 Earle, Frydman, and Rapaczynski [1993b] contains an extensive discussion of sales.

REFERENCES

Blanchard, O.; Layard, R. "Economic Change in Poland," Center for Research into Communist Economies Research Report, 1990.

Earle, J.; Frydman, R.; Rapaczynski, A. "Notes on Voucher Privatization Programs in Eastern Europe," in The New Europe: Evolving Economic and Financial Systems in East and West, Kluwer, 1993a.

-----. "Transition Policies and the Establishment of a Private Property Regime in Eastern Europe," Manuscript, 1993b.

Earle, J.; Sapatoru, D. "Privatization in a Hypercentralized Economy: The Case of Romania," in Earle, J.; Frydman, R; Rapaczynski, A. (eds.), Privatization in the Transition to a Market Economy, Pinter Publishers and St. Martin's Press, London and New York, 1993.

Frydman, R.; Phelps, E.; Rapaczynski, A.; Shleifer, A. "Needed Mechanisms of Corporate Governance and Finance in Eastern Europe," The Economics of Transition, 1993.

Frydman, R.; Rapaczynski, A. "Markets and Institutions in Large-Scale Privatization. An Approach To Economic and Social Transformation in Eastern Europe," Reforming Central and Eastern European Economies. Initial Results and Challenges, edited by Corbo, V.; Coricelli, F.; Bossak, J. Washington, DC: The World Bank, 1991.

Holmstrom, B.; Milgrom, P. "Aggregation and Linearity in the Provision of Intertemporal Incentives," Econometrica, 55, 2, 1987.

-----. "Multi-Task Principal Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design," Technical Report No. 6, Stanford Institute for Theoretical Economics, 1990.

Lipton, D.; Sachs, J. "Privatization in Eastern Europe: The Case of Poland," Brookings Papers on Economic Activity, 1990.

Milgrom, P.; Roberts, J. Economics, Organization, and Management, Englewood Cliffs, CA: Prentice Hall, 1992.

Rosen, S. "Contracts and the Market for Executives," National Bureau of Economic Research Working Paper 3542, 1990.
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Author:Earle, John S.; Sapatoru, Dana
Publication:Atlantic Economic Journal
Date:Jun 1, 1994
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