Capital Market Development and Corporate Governance … · Capital Market Development and Corporate...

Final Version

October 1, 2002

Capital Market Development and CorporateGovernance In Poland:

The Way Forward

Stijn Claessens, Daniela Klingebiel, and Mike Lubrano*

*University of Amsterdam, World Bank and International Finance Corporation,respectively. The opinions expressed herein are solely those of the authors and shouldnot be attributed to the World Bank Group. The authors would like to thank DarrinHartzler and Laurence Carter for valuable inputs; Tatiana Didier, Ying Lin and EricWinograd for excellent research assistance; Jola Cichocka for patient operational support;Maciej Dzierzanowski and Piotr Tamowicz of the Gdansk Institute for MarketEconomies for the provision of data on ownership and financial statements of Polishcorporations; Roman Rewald and Andrzej Mikosz of Weil, Gotshal & Manges (WarsawOffice) for their assistance with respect to the legal/regulatory framework in Poland; andparticipants in the “Corporate Governance Forum Conference” held in Serock, Poland onJune 13, 2002 for their comments. This work was made possible in part by a grant fromthe Netherlands Ministry of Economic Affairs through their Netherlands/IFC Trust Fundfor Emerging Markets and Countries in Transition.

Table of Contents

Table of Contents.............................................................................................................2

Executive Summary.........................................................................................................3

1. Financial Markets and Corporate Governance Issues in Poland ............................7

2. Ownership and Control Patterns ............................................................................11

3. Corporate Governance Experiences.......................................................................14

4. The Way Forward ..................................................................................................22

Annex: Firm valuations..................................................................................................33

References......................................................................................................................37

EXECUTIVE SUMMARY

The Market for Corporate Governance

Poland's capital markets remain underdeveloped in comparison to countries of similar percapita income. Large listed companies rely importantly on external sources of finance,mostly from banks and increasingly less from the capital markets. International marketsprovide a source of capital for top Polish blue chip firms, but are largely unavailable tosmaller listed and unlisted companies. Evidence indicates that both listed and unlistedcompanies are finance-constrained, and equity and long-term credit markets continue tofail to provide Polish firms with the resources they need to finance their investmentopportunities.

While corporate governance practices have improved considerably from where they wereten years ago, the oversight of firms and managers remains limited, with still incompletelegal and regulatory tools to discipline managers, and relatively inactive institutionalinvestors. As a consequence, firm performance and firms’ valuations in Poland arebelow those of similar firms in more developed markets. Remaining weaknesses in thecorporate governance framework have in some cases allowed controlling owners tomisuse funds and treat minority shareholders poorly. This has raised the funding costs ofall corporations and led to economic costs as attractive investment opportunities havegone without funding.

Ownership and Control Patterns

The Polish experience with privatization and economic transition has resulted in adistinctive history of ownership and control patterns. However, a long-term trend towardconcentration of ownership and control is now apparent. The nature of this concentratedownership is different from that in many emerging economies in that control in Poland isless often exercised by family groups and more often by founder/managers, unlistedcorporations owned by individuals, and foreign strategic investors. Nevertheless, thetendency is towards ownership structures that in many other emerging markets havegiven rise to important corporate governance problems and risky financial structures. Inaddition, direct state-ownership is still large in many enterprises, and more generally, thestate maintains a large role in the corporate sector.

Pension funds and institutional investors have thus far played a relatively small role in thePolish capital markets (and, likewise, in the corporate governance of listed and unlistedcompanies). But this will end as the mandatory pension scheme grows. Over the next fewyears, the mandatory pension fund scheme’s investment in the equity market is expectedto amount to one-third or more of the free float. Thus, the pension funds have thepotential, indeed the likelihood, of soon becoming the leading minority investors inPolish companies. As such, the potential disadvantages of increased ownership

concentration in Poland could be counter-balanced by the rise of a class of activeinstitutional investors.

Corporate Governance Experiences

As in most emerging markets with high ownership and control concentration, Poland'scorporate governance debate has revolved around issues of minority shareholder rightsand expropriation by controlling shareholders, albeit with some special twists arisingfrom the importance of foreign strategic investors in the control groups of somecompanies and other peculiarities of the Polish environment. Controlling shareholders ofsome corporations have been accused of self-dealing, theft of business opportunities,tunneling, lack of transparency, insider trading and inequitable treatment of minorityshareholders during changes of control. Although less than in many other emergingmarkets, concerns about unfair treatment of minority shareholders have discourageddomestic and foreign investors from coming to the public securities markets and havelimited capital market development. However, the company law and securities lawframeworks with respect to treatment of minority shareholders are about or aboveaverage compared to many middle-income developing countries and have steadilyimproved as loopholes have been filled and enforcement upgraded. Some gaps remain inthe legal and regulatory frameworks and, as in most emerging markets, judicialenforcement will remain inadequate for the foreseeable future due to lack of experiencesamong judges and cumbersome procedures.

Corporate governance practices among Polish companies remain substandard from boththe minority shareholder protection and firm performance perspective. Many Polishsupervisory boards have proven less than sufficiently effective at overseeing the activitiesof management and do not appear to provide outside shareholders with sufficient comfortthat their interests are adequately looked after. While the management of some largePolish companies appears to have become more sensitive to the concerns of shareholdersand have established investor relations programs, most of these are companies withoffshore listings. The efforts of various groups in Poland to develop a code of bestpractice for publicly-listed companies will continue to keep the shortcomings of currentPolish practices on the policy agenda. With more active investors, calls for improvementin real transparency, management accountability and board oversight in smaller listedcompanies can be expected to increase and, hopefully, useful and practical standards willemerge with applicability to both listed and unlisted firms.

The Way Forward

The detailed analysis in this report, benchmarking Poland with respect to other countries,makes clear there is room to improve the legal and regulatory framework for corporategovernance of listed companies to prevent the continuance of the kind of problemsPoland has experienced in recent years. It is of equal or even greater importance,however, to think through the likely shape of Polish capital markets in the future, theaccompanying ownership and control structures and deduce first what this will imply in

terms of corporate governance issues. The specific priorities for corporate governancereform will then more easily follow.

Over the medium-term, the market for securities in Poland will change dramatically onboth the supply and demand sides. On the supply side, there will be continued exit of bluechips to international markets and take-over of smaller firms by multinationals. Smallerlisted and currently unlisted companies (start-ups and privatizations) will face importantfuture financing needs and can present a potentially key source of supply of privatesecurities, provided the cost of financing is low enough. On the demand side, the pensionscheme cannot fail to represent a larger and larger share of investible savings. In addition,private investors will seek to secure their investment in smaller firms. As the capitalmarket shifts from the old paradigm to the new, some of the implications for capitalmarkets development and corporate governance policy (both public and private) are:

1. The structure of intermediation will change as the nature of issuers and investorschange. In many cases, the most efficient means of channeling new investment andorganizing trading of financial interests may lie outside the traditional public markets (atleast for an important part of the issuer's life cycle). Accordingly, the legal/regulatoryand private institutional frameworks for issuing and trading securities (along with theframework regulating institutional investors like pension funds) will need to adapt to thenew reality. This adaptation may involve loosening the limitations on investments bypension funds in securities not listed in the public market and private equity funds,developing less expensive systems for marketing to and trading exclusively amonginstitutional investors, and streamlining the requirements for collective investmentschemes marketed exclusively to pension funds and institutional investors. Forcorporations still in need of public securities markets, a policy of relying more on theinfrastructure for trading established in other markets will avoid costly duplication andallow Poland to reap quickly the benefits of stronger corporate governance regimes.

2. Company governance practices are unlikely to improve unless investors demandit. Pension funds will need to be champions of corporate governance, as they become byfar the most important institutional investors in the Polish market. This is crucial for theperformance of companies, the treatment of other investors, development of the capitalmarkets, and success of the pension regime itself. In OECD markets, and increasingly indeveloping countries (e.g., Latin America), pension funds are emerging as a force fortransparency, standard-setting and voluntary compliance by listed and unlistedcompanies. In order for this to happen in Poland, Polish pension funds will need to haveboth the right incentives and the right tools. Their own governance structures and theincentive arrangements for fund managers need to ensure that funds will take an activeinterest in the long-term performance of investments. Pension funds must also be in aposition to effectively exercise their rights as shareholders and to take collective action toensure high standards of transparency and fair treatment of shareholders. The currentregulatory environment for pension funds will need to be re-thought with corporategovernance policy in mind and appropriate changes undertaken.

3. Mechanisms will need to be found to improve the governance of currently privatecompanies that satisfy the demands of future portfolio investors, be they in the public orprivate institutional markets. Some of the clues to what is needed can be gleaned from therecent experience of private equity and venture capital investors in Poland. Somecombination of private voluntary actions, such as adoption of better board practices,nomination of trained and independent board members, improved accounting andauditing practices, compliance with national codes of best practice, independentassessment of company governance and agreement to private arbitration, may ultimatelybecome the norm for Polish companies seeking access to external capital. Steps need tobe taken now to ensure that the public and private infrastructure for supporting improvedvoluntary corporate governance practices will be in place when it is needed.

1. FINANCIAL MARKETS AND CORPORATE GOVERNANCE ISSUES IN POLAND

The Polish financial markets. While having increased in the last few years, compared toother countries with similar per capita income, including some transition economies, theoverall Polish financial system is still relatively underdeveloped (Figure 1). Thisunderdevelopment applies equally to banks and bond and stock markets. The lowfinancial intermediation reflects earlier periods of macro-economic instability and an onlyslowly increasing confidence in financial assets among households.

Figure 1. Polish Financial System In Comparison(as of end 2000)

100.00

125.00

150.00

175.00

200.00

Germany Japan UK US Czech Hungary Poland S. Korea Malaysia Philippines Thailand

% of GDP

Bank's private secor claims as % of GDP Stock market capitalization as % of GDP Outstanding bond market issues as % of

Source: IMF, International Financial Statistics. Bank for International Settlements.

Banks have also dominated financial intermediation to the private sector in Poland, withcapital markets being less than two-thirds the size of the banking system until 1995. Bythe end of 2001, bank and stock markets converged in size, with stock marketcapitalization at 14.9 percent of GDP and banking system domestic credit at 39.1 percentof GDP (Table 1). The government bond market almost doubled in the last decade withoutstanding bonds amounting to 25.3 percent of GDP at the end of 2001. The privatecorporate bond market remains almost non-existent.

Table 1. Assets by Type(percent of GDP)

1998 1999 2000 2001Public bond market capitalization 18.3 17.6 20.4 25.3Private bond market capitalization N. A N. A. N. A. 1.0Stock market capitalization 12.9 19.1 19.8 14.9Banking systems assets 57.4 56.5 65.6 68.6Banking system domestic credit 35.0 36.0 37.2 39.1

Source: National Bank of Poland, Bank for International Settlement, Quarterly Review, variousissues in 2002, IMF, International Financial Statistics, March 2002.

Stock market activity. Besides being small, the Warsaw Stock Exchange (WSE) is notvery active, with overall turnover amounting to only 28.6 percent of market capitalizationin 2001 (Table 2). At the end of 2001, while 230 companies were listed, turnover in thelargest 15 firms accounted for some 62.9 percent of total turnover. Thirty-one out of the230 WSE-companies, including many of the largest and most liquid companies, are alsolisted on an international exchange. At the end of 2001, the total market capitalization ofPolish companies also listed abroadeither in the form of a depositary receipt or througha cross-listingwas almost 3 times that of companies listed only at the WSE. Putdifferently, firms with a capitalization representing some 74 percent of total domesticstock market capitalization were also listed abroad. A significant part of the trading,often that of the more actively traded stocks, has also migrated abroad over the past fewyears, with total trading abroad in 2000 equaling some 85% of domestic trading. Offshoretrading in some stocks even exceeds trading on the WSE.

Rates of return. Part of the limited development of the public markets has been due tothe low rates of return. Macro-instability and high real interest rates have meant thatequity investment has not offered very attractive real rates of return to investorscompared to returns available on government bonds, bank deposits and foreign assets,even abstracting from risk. The annual all-in, real rates of return on equities over the lastfour years has been –12.6 percent, compared to 4.9 percent on bank deposits and evenhigher rates on government bonds (see Table 2). Returns have thus mostly favoredgovernment bonds in the securities markets and otherwise bank deposits. Low to negativerates of return have discouraged both domestic and foreign institutional and householdsinvestors from investing in equities.

Table 2. Stock market activity and returns1997 1998 1999 2000 2001 Average

Stock marketValue Traded / market capitalization (%) 65.5 43.6 37.7 46.8 28.6 44.4Share of top 15 corporations in total market capitalization (%) 76.8 75.2 76.2 76.1Share of top 15 companies in total value traded (%) 55.1 61.7 62.9Number of domestic companies listed on WSE 143 198 221 225 230 203Number of companies listed abroad 13 20 28 30 31 24Total market cap (US$ Millions) 12,134 20,461 29,576 31,279 26,017 23,893Market cap of international companies (US$ Millions) 4,105 13,707 22,989 21,600 19,191 16,318Market cap of companies listed abroad over market cap ofdomestic only companies (percent)

51 203 349 223 291 223

Market cap of companies listed abroad over total marketcapitalization (percent)

33.8 67.0 77.7 69.1 74.4 64.4

Value traded domestically/GDP 5.3 5.6 7.2 9.2 4.2 6.3Value traded internationally/GDP NA 7.8 8.8 7.8 NA NAValue traded internationally/value traded domesticallya NA 138.6 122.6 84.6 NA NA

Rates of return, percent per annum, adjusted for inflation (CPI)Bank deposits (%) 4.3 6.5 3.9 4.0 6.0 4.9Equity market (WSE, %) -13.0 -24.4 24.1 -12.7 -37 -12.6Government bonds NA 0.8 8.49 7.34 5.05 5.42

Source: Warsaw Stock Exchange. IMF, International Financial Statistics. National Bank of Poland.

Firm financing patterns during the late 1990s. Despite the low level of financialintermediation in Poland, large Polish listed firms relied heavily on external financing fortheir investment in the 1990s. For a sample of the largest 30 listed firms, externalfinancing mostly came from banks (37.7 percent) and trade and other forms of non-bankcredit (23.4 percent). Equity financing was more important in the mid-1990s but hassince declined. But even large firms have suffered from a shortage of financing. Manylarge firms do not have long-term debt at all, suggesting that long-term debt is not animportant source of finance for smaller Polish firms either. Other evidence suggests thatlarge Polish firms have been financially constrained in the sense that they have not beenable to attract financing according to their investment opportunities.1

Smaller firms have relied much more on internal financing for investment. Data for alarger sample of firms, including smaller firms, suggest that internal financing was themost important source of financing, with less than half of financing coming from externalsources until 1998, and most of that in the form of debt-financing (Table 3).

1 Indeed, relating regress investment ratios to marginal profitability measures, cash-flow ratios, andfinancial leverage, one finds that Polish firms face large financing constraints, in the sense that firm’sinvestment is sensitive only to measures of cash flow, and not to measures of marginal profitability.

Table 3: Sources of Funds for Sample of Large and Small Polish Firms1996 1997 1998 1999

Number of firms 128 261 536 1306Source of financing Internal 60.55% 67.29% 39.47% 42.86% External 39.45% 32.71% 60.53% 57.14%

Debt 7.14% 20.65% 36.02% 36.52%Loans 15.39% 8.92% 22.80% 11.59%Equity 16.93% 3.14% 1.72% 9.03%

Notes: Data source is the Amadeus database. Only industrial firms are included. Data for 2000 cover amuch more limited number of firms and were therefore not included in the table.2

Issuing activity. Capital markets have provided some financing, but mostly in the form ofdebt financing. Most new issuances over the 1995-2000 period have been in the form ofdomestic debt (Figure 2), some 2.9% of GDP on average, but this was mostly public debt.Next were domestic equity issues, which averaged some 0.9%, peaking in 1997 with1.7%. International debt issues averaged some 0.6% of GDP, peaking also in 1997 at1.1%. Least were international equity issues, yielding some 0.3% of GDP, peaking in1998 at 0.6%, and exceeding domestic equity issues in 1999. In terms of new issuanceactivity, local equity issuance has relatively declined the most: only nine companies werenewly listed on the exchange in 2001 and four in 2000, compared to ten new listingsabroad during the same period.

Figure 2.

New Issuance (% of GDP, 1995 - 2000)

1995 1996 1997 1998 1999 2000

% of GDP

Domestic equity / GDP Domestic debt / GDP International equity / GDP International debt / GDP

Source: Polish SEC Annual Reports

2 The sample of firms for which data are available for all years between 1998 and 2000 is quite small, only31 large firms. The share of internal financing for these 31 firms was 56%, 35% and 62% in 1998, 1999,and 2000 respectively. This confirms that the large share of external financing is a common feature ofPolish corporations over longer periods.

2. OWNERSHIP AND CONTROL PATTERNS

Corporate governance issues arise from the separation of ownership from management,and thus the need for shareholders to monitor management, and from the possibilities ofconflicts of interest among shareholders, particularly between controlling shareholdersand minority investors. An analysis of corporate governance issues thus needs to startwith an analysis of existing ownership and control patterns.

Ownership structure.3 Using publicly available information from the Polish Securitiesand Exchange Commission (PSEC), ownership and control data for almost all listed andsome other firms for 1991-2001 can be obtained.4 The data shows that ownershipconcentration in Poland is comparable to that in continental Europe. As of end 2000, 35%percent of listed companies have an investor who owns more than half of voting rightsand for 50 percent of companies an investor controls more than 39.5% of voting rights.Including direct as well as indirect ownership stakes, the median control stake of thelargest blockholders increases to 45.8%.5 The median sizes of the second, third andfourth blocks are 10.4%, 5% and 0% of voting rights respectively. This suggests that formost corporations, the first blockholder can exercise effective control, as there are noother large blockholders.

There has also been a trend toward increased ownership concentration for Polish firms. In1991, the median size of the largest block (shareholder) amounted to some 18%. Between1991 and 1996 ownership concentration varied, but after 1996 concentration steadilyincreased. In 1996, for almost 76% of public companies the largest shareholder had lessthan 33% of voting rights, compared to only 56% in 1998 and only 44% in 2000. Largeshareholders thus have been increasing their control stakes.

Founder/Managers dominate as owners. In many medium-sized corporations and evenlarger ones there is a congruence of the roles of founder, largest block-holder, andmanager. In about 35 publicly listed firms, managers hold blocks of shares ranging from5% up to 93% with an average block size of 28.5%. In 20 of these 35 corporations, theblocks owned by managers were the largest ones, and in 10 the second largest. In amajority of these cases, senior managers also were founders. These founder-managercorporations comprised mostly private start-ups, and only four companies originatingfrom privatization have large individual blockholders that were also senior managers.

3 This section draw heavily on work at the Gdansk Institute of Market Economics Research (Tamowicz andDzierzanowski, 2001).4 This database covers at year-end 2000 190 non-financial corporations (public companies) listed on theWSE and 20 firms from OTC market. While the data are very comprehensive, it should be remembered thatthe number of public corporations evolved significantly over time in Poland. In 1995, for example, therewere only 21 corporations listed and in 1991 just 9.5 As in most other countries, only large blocks (more than 5%) need to be disclosed

Control versus cash-flow rights. Whereas ownership structures are similar, contrary tomany other emerging markets, there are no large differences between control and cashflow rights for most Polish firms for all classes of owners (Table 4). A situation of morevotes than cash flow rights exist only for some 25% of the largest blocks and 63% ofcorporations have voting rights equal to cash flow rights. To the extent there aredifferences, preferred shares with multiple voting rights are the most common devices toleverage control rights, with some 79 corporations out of 210 corporations issuedpreferred shares, with greater prevalence among smaller companies. To the extent therewas separation, it measured in number of votes per share an average of 1.5.6

Table 4. Ownership of largest blockholder, cash flow vs. voting rights(2001, By category of investors)

Ownership Cash-flow rights Voting rightsAverage share 48.8% 52.8%Category

Strategic (non-financial) 66.1% 68.6%Foreign financial 41.9% 41.9%

Banks & subsidiaries 31.0% 29.5%National Investment

Funds & others39.4% 35.5%

Other companies 49.5% 53.0%Individuals & families 44.0% 51.7%

State & others 51.1% 53.9%Source: Gdansk Institute.

Type of owners. The identity of controlling owners in Poland varies also from that foundin other emerging markets, where families typically dominate. Public companies aremost frequently controlled by other corporations (including other public companies), andonly then followed by individuals (39.4% and 30.8% of largest ownership blockrespectively). Of all disclosed blocks, individuals owned about 33% and corporations27.6%. Financial institutions – comprising mostly national investment funds and equityfunds managed by corporate investors – owned 14% of all large blocks. State Treasuryand other state entities owned an average of 9.1% and banks only 6.3%.

Individuals do hold large stakes in those firms in which they invest, with an averageblock size of 40.6%. This figure still underrepresents individual ownership, as it does notconsolidate all blocks owned by founders. The average block size owned by domestic(Polish) non-listed corporations is 43.5%, while ownership by publicly listed corporationsis 54.2%. Foreign non-financial investors tend to hold very large stakes in those firms inwhich they do invest, some 67%. This is also for the second largest block, 24% forforeign investors compared to 15.1% and 15.8% for individuals and private corporations

6 Other tools used to separate voting rights from cash-flow rights are voting caps, golden share - statutoryprovisions providing specified preferences (for example, the right to appoint a predetermined number ofmembers of the supervisory board, etc.) to particular shareholder, non-voting preferred shares (introducedsince 2001), and pyramidal and cross-holding structures. Most of these are in limited use. Golden shares areused only in 6 cases and only in about 20 cases was control leveraged through own-share purchaseexecuted by subsidiaries.

respectively. Domestic and foreign financial institutions hold much lower first stakeswhen they invest, 31.2% for domestic investors and 35.5% for foreign.

The size of block holdings is a function of company size, however. Foreigners investmore in large firms and are large in terms of market capitalizationsome 15% in case ofstrategic investors and 5.3% in case of financial investors. Similarly, the stateStateTreasury and other state entities (state owned enterprises, state owned banks,municipalities, foundations) share of market capitalization is 12.5%. Individuals andcorporations represent only 10.2% and 6.3% respectively of market capitalization.Finally, banks are very small in value terms (1.2%), as are other domestic financialinstitutions (0.6%), although this will change as the pension funds sector grows.

These data refer to only the publicly listed corporations and as such understate theimportance of strategic investors and managers as owners. There are many privately heldcorporations where strategic investors have large stakes as well as smaller corporationsthat are more tightly owned by managers/investors. The median stake of the first largestblock for a sample of 560 privately held corporations (which are still relatively large withan annual turnover over 70 mln PLN) is 70%. The median for blocks owned by foreigninvestors in these firms was 97%, while domestic corporations and individuals owned67% and 50% respectively. Banks and national investment funds owned blocks of 33%and 46% respectively. This suggests that many smaller firms in Poland are relativelytightly held, thereby leading to a specific set of corporate governance issues..Institutional Investors. The ownership data indicate that Polish institutional investorsrepresent currently a small fraction of overall shareholdings. This reflects thatinstitutional investors are still small in Poland, accounting for only 7.1 percent of GDP.This is less than in the Czech Republic or Hungary and also significantly smaller than indeveloped countries such as Germany and the US (Table 5). At the end of 2000, withassets amounting to some 4.5 percent of GDP, insurance companies were the mostimportant institutional investors, with foreign portfolio investors second. The mutual fundindustry in Poland is still small as well, although it has seen some growth over the lastthree years.

Table 5: Assets held by Institutional Investors in Poland and Eastern Europe(As a percentage of GDP (2000))

Pension Funds Insurance Mutual Funds TotalCzech Republic 7.1 8.8 12.0 27.9Hungary 3.1 5.5 4.6 13.2Germany 6.8 77.9 79.2 163.9Poland 1.5 4.5 1.2 7.1USA 70.7 41.2 65.0 176.8Source: OECD, Institutional Investors Statistical Yearbook 2001; IMF, International FinancialStatistics, March 2002.

Pension funds. Although, at the end of 2000 total pension fund assets were only 1.5percent of GDP, pension funds are quickly growing and will become the most importanttype of institutional investor in Poland. Pension funds’ investments in the stock market

are expected to amount to one-third or more of the free float in 2004 (The Economist,August 30, 2001). The growth of the pension fund industry started when Polandimplemented a three-pillar system on January 1, 1999 replacing the pay-as-go system.Two mandatory pillars and one voluntary pillar exist. The first pillar consists of a smallerthan previous pay-as-you go public pension scheme. The second, mandatory, pillarconsists of a fully funded component which is an individual pension account withmember choice of pension fund (so-called Open Pension Funds) to which 7.3 percent ofearnings are contributed. Contributions and investment returns accrue in individualaccounts. Additional and voluntary savings are contained in the third pillar, which hasnot taken off, reportedly in part because companies are reluctant to establish third-pillarfunds (which are regulated and required to have a supervisory board appointed partly byworkers), and instead opt to offer their employees mutual fund or insurance products.

Pension fund managers and investments. While about 20 pension fund managers havebeen licensed, the market is relatively concentrated with the largest pension fundcontrolling 30 percent of assets, the next largest fund 21 percent and the five largestpension funds altogether 79 percent. In terms of number of participants, the five largestfunds combined have 7.1 million participants or 69 percent of the total. The largest fivefunds are also all subsidiaries of major life insurance companies. The remaining pensionfunds are small, with the five smallest funds accounting only for 0.6 percent of assets.Due to regulatory requirements and the newness of the funds, investments have been veryconservative, with the bulk invested in fixed income instruments, largely governmentbonds and bills (68% at end 2001). The exposure to equities is only 28.4%, although itvaries among funds, from 31 to 0 percent.

3. CORPORATE GOVERNANCE EXPERIENCES

Corporate governance in most emerging markets concerns mainly minority rightsprotection. Corporate governance can be defined in many ways. Most often it refers tothe structure, rules and institutions that determine the extent to which managers act in thebest interest of shareholders. But in many countries, as in Poland, ownership is veryconcentrated and controlling shareholders can monitor managers’ actions quite well.Furthermore, and especially in emerging markets (but also in many OECD economies),the separation of management from ownership control is far from the norm. Rather,management and ownership control frequently coincides even in the largest publiclytraded corporations. In East Asia, for example, management of two-third of listed firmsis family-related to the controlling owner. Essentially, management is the controller’salter ego in most emerging markets corporations.

The main principal-agent problem in many emerging markets is therefore not conflicts ofinterest between owners and managers, but rather conflicts between majority andminority shareholders, with associated risk of expropriation. The strength of minorityrights and their enforcement is an essential part of limiting the scope for expropriation.Across countries, capital market development is a declining function of the degree of

shareholder protection (Figure 3). And across firms, equity market values are higher inenvironments where shareholder protection is stronger.

Figure 3. Capital market development and quality of shareholder protection

M a r k e t c a p i t a l i z a t i o n / G D Pp e r c e n t

L o w e s t q u a r t i l e( l o w e s t r a n k i n g i n s h a r e h o l d e r a n d r u l e o f l a w )

H i g h e s t q u a r t i l e( h i g h e s t r a n k i n g i n s h a r e h o l d e r a n d r u l e o f l a w )

Source: La Porta et al., 1997.Notes: Quartiles of 40 countries ranked by shareholder protection and rule of law.

Private corporate governance actions can help, but not fully. It is the case that firms canvoluntarily choose to adopt for themselves more stringent corporate governance rules andget rewarded for this through lower costs of capital and more ample financing. Part ofthese voluntary actions can involve firms listing abroad in stronger environments tosignal their willingness to adhere to tighter standards. These voluntary corporategovernance mechanisms are even more important in countries with weak legalenvironments. Yet, research also shows that firm-level, voluntary governance is still animperfect mechanism in weak environments as corporations cannot credibly and fullycommit to their corporate governance actions. Correspondingly, the cost of capital forfirms is higher in weak corporate governance settings, which has social costs as profitableinvestment opportunities are bypassed.

Corporate governance issues in Poland. In some ways, the corporate governance issuesfacing Polish corporations are similar to those in other emerging markets. Concentratedownership is a characteristic of Polish private firms as well as of firms in which the state(Treasury) still holds a majority share. Some evidence exists from transfers of blocks thatholders of blocks have been able to extract control benefits at the expense of minority,atomistic shareholders.7 The same study, however, also found that the observed blockpremia are much lower than those in most other countries are, largely due to liquidityreasons. More generally, while violation of minority rights among publicly-listedcorporations has happened, it, misuses by strategic investors of the deficiencies in thePolish formal corporate governance framework have been only in a few, albeit prominentcases (examples include disputes with foreign investorsMichelin, Heineken,Eurekoand domestic investors). On the whole, the expropriation of minority rights for

7 Grzegorz Trojanowski, Equity Block Transfers in Transition Economies: Evidence from Poland. CEPRDiscussion Paper 3280, March 2002.

listed firms has not been the key corporate governance issue in Poland. This is reflectedin the control premium, which is relatively low in Poland at 8% (Figure 4). The premiumin Poland compares to the control premium of listed firms in Germany, Denmark, andNew Zealand. In contrast, the highest control premium is in Brazil, 49%, where therehave been many clear cases of expropriation and violation of minority rights.

Figure 4. Block Premium as Percent of Firm Equity

Source: Dyck and Zingales, Private Benefits of Control: An International Comparison, CEPRDiscussion Paper, 3177, January 2002.

One reason why expropriation and violation of minority rights has been less in Poland isdue to the ownership structures of Polish firms. Many publicly listed firms are not newly-started firms, but rather privatized state-enterprises, where managers hold small or nostakes. As such, the management-owned, listed firm with much scope for abuse is moreof an exception in Poland. In terms of privately held firms, the private corporate sector isalso relatively young in Poland. Many firms thus have had to come to the market in thelast decade for their first or second rounds of new financing. For these firms, outsideinvestors have typically taken a large stake, thereby assuring their ability and incentive toclosely monitor their investments. It has also given investors an opportunity to shape thecorporate governance of the firm through private contracts.

The particular set of ownership structures and corporate governance issues is reflected inthe relative valuation of Polish listed corporations. Conducting an econometric analysisof the market valuation of a sample of listed corporations over the period 1997-2000 forwhich we have complete ownership and financial data (about 125 firms) reveals thefollowing patterns :8

• The value of the firm increases as the largest shareholder has greater cash-flow rightsin the firm. This confirms that ownership concentration leads to better monitoringand management of the firm as the largest shareholder has more incentives andcapacity to do so.

• The value of the firm decreases, however, as the largest shareholder has a greaterseparation between its control and cash flow rights in the firm. This suggests that thelarger the separation, the greater the incentives of the controlling shareholder tomisuse the funds for her own private benefits, and thus engage in expropriation.

• The value of the firm was larger for those firms that were private from the beginningand/or owned mainly by individuals and families. This confirms the general findingfor transition economies and other countries that private ownership is associated withthe better firm performance. It also suggests that strategic individual ownership helpsovercome principal agent problems.

• Ownership by foreign financial institutions was associated with higher statisticallysignificant firm values, while foreign strategic ownership does not seem to enhancefirm values in a statistically significant way. The former may reflect the tendency offoreign financial institutions to invest in higher valued firms, whereas domesticinvestors may not have the choice to do so portfolio restrictions limit their investmentchoices. The latter may reflect some of the corporate governance abuses by foreignstrategic investors.

• Firm values are also higher for larger firms and firms with more rapid sales growth.This is generally found for most countries and reflects the better access to financingfor large firms and the better growth opportunities of fast growing firms.

The regression results thus confirm that some of the corporate governance issues oftenmentioned for listed Polish firms are reflected in lower firm valuation andcorrespondingly higher costs of capital.

Weaknesses in the corporate governance framework. Although Poland has perhapsexperienced relatively fewer corporate governance abuses than many other emergingmarkets, it does have its own set of legal and regulatory weaknesses. It is difficult tocome up with a definite list of all weaknesses, also as corporate governance entails manydimensions, but a benchmarking exercise of the corporate governance framework inPoland shows some remaining shortcomings.

8 Annex 1 provides the detailed results.

Table 6: Shareholder Rights and Corporate Governance Practices in Selected Transition and Comparator Markets

OneShareOneVote

% of SharesReq’d ToCall GM

Proxy byMail

Shares NotBlockedBeforeGeneralMeeting

% of SharesReq’d To

AddAdditional

Item ToAgenda

OppressedMinorityRemedy

MandatoryTender OfferRequirement

CumulativeVoting orEquivalent

ShareholderProtection

Rating(Written

LegalFramework)

Effectiveness of

ShareholderProtection

(USA = 100)

POLAND No 10% No No 10% Yes Yes Yes 3 69

HUNGARY Yes 10% No No 10% Yes Yes [ ] 3 71CZECHREPUBLIC Yes 3-5% No No 3-5% No Yes No 3 51SLOVAKIAREPUBLIC No 10% No Yes

NotPermitted No No [ ] 2 57

SLOVENIA No 5% No No 5% No No Yes 3 40

RUSSIA Yes 10% Yes Yes 2% Yes Yes Yes 5 49

BRAZIL No5% Voting10% Total No Yes [5%] Yes

Yes(Voting

Shares Only) Yes 3 [ ]

CHILE No 5% No Yes [10%] Yes Yes No [ ] [ ]

KOREA Yes [5%] No No [5%] Yes [No] Yes 4 [ ]

MEXICO No 10% No Yes [10%] Yes Yes Yes 1 [ ]

GERMANY No 5% No No 5% No [ ] Yes 2 [ ]

Sources: La Porta et al; 1998, Pistor, 2000, Slavova, 2000.

In most countries, the legal/regulatory frameworks for corporate governance of publiccompanies (and in particular, shareholder protection) depend as much on the securitieslaw regime as it does on the companies and commercial law regimes. Poland is noexception in this respect. Both the company law (Commercial Code of 1934, nowsuperceded by Commercial Companies Code of 2001) and securities law frameworks(Act on Public Trading in Securities of 1997) with respect to treatment of minorityshareholders are average for middle-income developing countries, including those in theregion, and have steadily improved as loopholes have been filled and enforcementupgraded (Table 6). The disclosure regime is generally regarded as working relativelywell, with numerous civil and criminal actions successfully prosecuted against violators.

The new Commercial Code was intended to fill many gaps and conform more closely tocompany legislation in force in EU countries, but its provisions remain untested inpractice and in the courts. The new Commercial Code expands the rights of minorityshareholders to challenge the resolutions of the General Meetings of Shareholders andbetter defines the cumulative voting procedure (election of supervisory board membersby qualified minority group) through which minority shareholders may appointsupervisory board members.

Nonetheless, some gaps remain in the legal/regulatory framework. The most importantfor corporate governance include:

• Ambiguities remain with respect to the role and responsibility of thesupervisory board. There are disagreements in the legal community aboutwhat the supervisory board members’ duty to act in the interest of thecompany means in practice. How does it differ from a duty toshareholders? What are the implications for company practices such asshare buy-backs?

• Rules for handling conflicts of interest by managers, controllingshareholders and supervisory board members need further development.

• The tender offer regime has been importantly strengthened and nowincludes a more effective definition of acting in concert and creepingaccretions of control. However, the Polish Treasury remains in aprivileged position and may transfer control without the requirement of thepurchaser making a tender offer to minority shareholders.

• The new Commercial Code reduces the minimum size of the supervisoryboard from five to three, which could create practical limitations forminority shareholder nomination of members of the supervisory board.The WSE has published a “joint statement on the management andsupervisory board” on this issue, but a requirement that the supervisoryboard of a listed company have at least five, and preferably more,members should probably be included in the WSE’s Listing Rules.

• The “special purpose auditor” provisions of the new Commercial Codestill do not work well in practice. The PSEC and the courts disagree overwhether the auditor must be selected by the minority shareholdersrequesting the audit. The percentage of shares required to request aspecial audit (5%) is less than the percentage required to call ashareholders' meeting (10%). Finally, the standard for auditor liability tothe company is unclear, and the potential for subsequent litigation with anuncertain outcome may be discouraging independent audit firms fromserving as special auditors.

• Polish law continues to permit public companies to set a limit on theexercise of voting rights by a single holder of a particular class of shares.This can be used as an anti-takeover mechanism by founder/managers whoretain multiple voting right shares that are not subject to the single-shareholder limitation of other classes of shares.

• The supervisory board’s responsibility for oversight of the audit functionis weak in practice. Its oversight of internal controls and the independentexternal auditor remains generally inadequate. Independent and minorityshareholder-nominated members of the supervisory board typically have,in practice, no say in the selection of the external auditors.

Mixed Enforcement. Although the court system is cumbersome and time consuming, ithas played an important role in the protection of minority shareholder rights. Under theold Commercial Code, several actions could be taken by shareholders to protect theirinterest against those of managers and controllers, and these were maintained an in somecases strengthened under the new legislations. These action include: (1) setting asideresolutions of the shareholders meeting; (2) convening shareholders meetings anddeciding on the agenda of such meeting; (3) election of supervisory boards by cumulativevoting; (4) derivative actions against management, supervisory board members,controllers and auditors for actions that were to the detriment of shareholder interests.Complaining shareholders have on occasion successfully convinced courts to grant theirrequest to temporarily enjoin certain corporate actions (such as share transfers) until thetime of final adjudication of shareholder disputes. This has proven an effective tool todiminish the length of court proceedings and prevent abuses by controllers. Nevertheless,most court cases alleging violations of the company or securities laws are expensive, timeconsuming and of dubious outcome, and this has discouraged investors from aggressivelypursuing many cases. Judicial enforcement will remain inadequate for the foreseeablefuture due to lack of experiences among judges and cumbersome procedures.

By the standards of emerging markets (and some more established markets) the PolishSEC runs well and is an effective regulator. In the area of traditional securities marketsregulation and supervision – approval of listings, review of adequacy of disclosure,licensing intermediaries, policing the behavior of market participants, etc. it hasdemonstrated competence and vigor. However, some of the limitations on itsinvestigative and enforcement powers has left it less effective as a watchdog of corporate

governance of listed companies. The Polish SEC is not empowered to examine orsubpoena listed companies or their managers or controllers, not is it permitted to order thefreezing of financial assets. It has not been permitted to develop its own prosecutorialdepartment (however, the Warsaw prosecutor has established its own special unit forsecurities law violations that cooperates with the SEC). As a consequence, the SEC oftenlacks the tools and the leverage to effectively deal with those who abuse the securitieslaw to the detriment of shareholders. For example, the Polish SEC cannot sign consentdecrees with accused wrongdoers (through which the wrongdoer agrees to refrain fromrepeating the alleged offense or disgorge benefits gained in return for the SEC’sagreement not to seek criminal prosecution). In those countries in which the securitiesregulators have greater control over the prosecution of securities-related crimes, theyhave usually contributed more to developing an environment more conducive toshareholder protection. The solid reputation and acknowledged competence of the PolishSEC indicates that it could make effective use of greater investigator and prosecutorialpowers.

The WSE has taken some important first steps to be a force for voluntary adoption ofgood corporate governance practices. It has discouraged listed companies from adoptingcharter provisions that it believes go against the fundamental rights of shareholders andissued resolutions regarding what it considers to be actions against the rules of a listedcompany, such as issuing stock to controllers at prices that dilute other shareholders.And, of course, it is one of the key sponsors of the GC Forum and its code projects. Butthe WSE can play an even more decisive role in implementing and enforcing goodpractices in corporate governance. It has real instruments of power (Listing Rules,decisions on introducing shares into the market) and the appropriate institutional position.As in the case of most exchanges, the WSE will face resistance from established issuersand will be reluctant to turn down listing requests from companies that do not meet thehighest standard of corporate governance. But poor governance of issuers is a threat tothe survival of any market. If the WSE continues to keep in mind that improving thequality of the securities on the exchange is critical to its long-term survival (in whateverform), then a greater involvement by the WSE in fostering voluntary standards and theirenforcement will become inevitable.

Evolving voluntary compliance. Poland has undeniably come a long way since the early1990s in developing the business culture and private sector infrastructure to support goodcorporate governance practices. Nevertheless, Poland’s private sector establishment –company managers, intermediaries, investors, academics and professionals - still has avery long way to go to bring standards and practices up to developed countries’ levels.Although the Warsaw Stock Exchange is one of the few in Central and Eastern Europeanmarkets that has been actively used to raise new capital for private enterprises, manymanagers of both listed and unlisted companies still do not understand the role offinancial investors in the firm. There remains a generally low level of education on thepart of companies about the expectations of “buy and hold” investors like pension fundsand other institutions. Only the largest public companies have active investor relations

programs and websites with extensive information for shareholders and potentialinvestors.9

We are aware of no systematic examination of the composition and structure of thesupervisory boards of Polish companies. However, company chiefs, investors andprofessionals all report that it remains hard to find independent and capable/trainedcandidates for supervisory boards.

Professional skills of managers are also weak in some sectors. Compensation has been anissue and the development of management compensation schemes that better align theincentives of managers and shareholders have been slow to emerge. Computerland wasthe first to offer stock option plans for managers to better align incentives, but many othercompanies have yet to develop these measures.

4. THE WAY FORWARD

The review of ownership structures, corporate governance issues and the benchmarkingof the corporate governance framework in Poland with respect to other countries makesclear there is room to improve the legal and regulatory framework to prevent thecontinuance of the kind of problems Poland has experienced in recent years and helpbetter resource allocation and growth. However, it is of equal or even greater importanceto think through the likely shape of Polish capital markets in the future, theaccompanying ownership and control structures and deduce first what this will imply interms of corporate governance issues. The specific priorities in the area of corporategovernance reform will then more easily follow.

Over the medium-term, the market for securities in Poland will change dramatically onboth the supply and demand sides. On the supply side, there will be continued exit of bluechips to international markets and take-over of smaller firms by multinationals. Smallerlisted and currently unlisted companies (start-ups and privatizations) will face importantfuture financing needs and can present a potentially key source of supply of privatesecurities, provided the cost of external financing is low enough. On the demand side, thepension scheme cannot fail to represent a larger and larger share of investible savings. Inaddition, private investors will seek to secure their investment in smaller firms. Thefuture model of matching supply and demand will thus involve much more private formsof securities, and much less involve publicly available securities listed and traded intraditional organized markets.

As the capital market shifts from the old paradigm to the new, there are implications forcapital market development and corporate governance policy (both public and private).These implications lie in three areas: tailoring the framework to the expected structure ofintermediation; enhancing the role of institutional investors in the corporate governanceof firms; and adopting the framework to the needs of future investors.

9 Geoffrey Mazullo, East-West Management Institute Study, 2002.

1. Adopting the structure of intermediation.

The nature of issuers and investors will change in Poland as the transition phase iscompleted and institutional investors grow in size. In many cases, the most efficientmeans of channeling resources to new investment and trading financial claims may lieoutside the current public markets (at least for an important part of the issuer's life cycle).Accordingly, the legal/regulatory and private institutional frameworks for issuing andtrading securities (and the framework for regulating institutional investors like pensionfunds) will need to adapt to the new reality. This adaptation will need to involveloosening the current limitations on investments by pension funds in unlisted securitiesand private equity funds, developing less expensive systems for marketing securities toand trading securities among institutional investors, and streamlining the requirements forcollective investment schemes marketed exclusively to pension funds and institutionalinvestors. It also implies reviewing the institutional setting for trading and listingsecurities in the public market.

Enhancing the private markets. Strategic investors in all sized firms have usedshareholder agreements and other private contractual arrangements to assure disclosureand adequate returns on their investment stakes. The process is not efficient, however,and it has been costly to firms and investors. Investors have, for example, used offshorelegal vehicles to structure their investments, but this has involved substantial direct andindirect costs. Ex-post, resolution of disputes has often been costly. The judicial systemin Poland, while more efficient than in many other emerging countries, is not yet fullyequipped to deal with shareholder-manager and intra-shareholder disputes.

When this process has involved strategic investments with controlling stakes, the overallcosts have perhaps been manageable. Indeed, while the overall record has been mixed,the experiences of some of the National Investment Funds (NIFs) show that controllinginvestors can identify and use adequate tools to discipline management. In some cases,NIFs have had a positive impact on corporate governance of companies in which theyhave invested. This is reflected in the large turnover in the managements of the investeecompanies, although many of who were holdovers from the period of state ownership andcontrol.

In the case of minority investments, NIFs and other private investors have suffered fromthe weaknesses in the corporate governance framework for public and private markets.To date, Polish venture capital and private equity funds have provided only a fraction ofthe financing needs of medium sized private Polish firms. Notwithstanding theirrelatively small share of overall finance provided, they have made private equityinvestments in hundreds of companies over the past ten years, in a variety of sectors.Such funds typically take relatively large minority shareholder positions, often 33% orabove, but sometimes as little as 15-20%. Investment exits are reported to be primarilythrough trade sales (approximately 80%) with the remainder through IPOs and sales toother shareholders. In the next few years, the private equity markets can be expected tofurther grow. The pension funds will also have to enter the private markets, as the supplyof issues in the public market will be too little relative to their size.

Some of the more positive experiences of the NIFs, Polish venture capital and privateequity fund investors as active participants in the corporate governance of mid-sizecompanies provide useful insights. As minority investors, some Polish venture capital/private equity funds report that they employ a variety of contractual mechanisms toprotect themselves from expropriation and inequitable treatment by managers andcontrollers. Shareholder agreements or corporate charter provisions upon which venturecapital / private equity investments have been conditioned include:

• Requirements of minority shareholder or supervisory board representativeapproval of certain types of contracts / operations, particularly those with relatedparties and asset sales.

• Minority shareholder or supervisory board representative power to requiredisclosure of information by the management board.

• Minority shareholder appointment of the company’s finance director and auditors.• Requirement of minority shareholder or supervisory board representative approval

of annual budgets.• Approval of executive compensation by minority shareholders.• Minority shareholder right to force sale of company under certain circumstances.• Tag along rights in the event of any sale of shares by the controllers.

Despite their position as minority investors in closely controlled companies, such venturecapital / private equity fund managers report that the Polish legal/regulatory environmentis adequate to structure and enforce the types of shareholder agreements and charterprovisions described above. Judicial enforcement is costly and slow, but apparentlycourts are more expeditious in deciding the types of contractual issues involved than theyhave been in settling suits brought under company or securities law provisions. Thegreater certainty of ultimate outcome seems to encourage greater voluntary compliance.Nevertheless in spite of this relative success, there is ample scope, as in most emergingmarkets, to improve the efficiency of the judicial process. Furthermore, many of themechanisms used in the private markets could be institutionalized in the public marketand future private markets among institutions to increase confidence in the governance ofissuers and lower transaction costs.

Adjusting the infrastructure for trading and listing. Clearly, the Warsaw Stock Exchangeis one of the leading bourses of Central Europe (Box 1). However, the exchange is facingpressures due to the consolidation of controlling share blocks leading to de-listing ofsome of the top firmsdespite efforts on the part of the WSE and Securities Commissionto prevent de-listing en masse. There will also be few new privatizations in the next fewyears and thus few new listings. This tendency towards de-listing as consolidationcontinues apace combined with decline in privatizations leaves the future of the WSE inquestion. Furthermore, as for many other emerging markets, blue chips are increasinglytraded abroad via depository receipts (now 17 large issuers and 15 NIFs). Already morethan half of trading has migrated offshore in Poland.10 This has had benefits as issuers’

10 Claessens, Klingebiel and Schmukler, 2002

costs, terms, and liquidity have improved with migration to markets with greaterliquidity, higher reputations for rules and greater transparency. Given the increasedremote access to trading systems, domestic investors did not lose out on their ability totrade stocks. As such migration does not mean that Polish firms and foreign anddomestic investors will lose.

Box 1: The Warsaw Stock Exchange (WSE)

The WSE was founded in 1991 to deal in shares of privatizing companies. Over the years, theexchange has added trading in state and corporate bonds, derivatives, shares of NationalInvestment Funds (NIFs), warrants and index funds (i.e., WIG20). However, trading in equitiescontinues to dominate the WSE with about 85% of the turnover. In late 2000, the WSE begantrading with the advanced WARSET electronic trading platform. There is talk of privatization ofWSE, organized as a joint stock company with 53 shareholders with the majority of sharesremaining in the hands of the State, and the proper allocation of accumulated funds.

The de-listings, limited new supply and migration do have consequences, however, forthe organization of local capital markets and reform priorities. They make it moredifficult for the WSE to sustain itself as a fully-fledged local stock exchange. As tradingvolumes decrease, financing the fixed overhead of market oversight, clearing andsettlement systems, among others, and generating enough order flow for local brokersand enough business for local investment banks, analysts, accounting firms, and othersupporting services becomes harder. The tendency for liquidity pools to concentrate in afew markets and the inherent difficulties to establish credible frameworks furthercomplicate the development of a liquid stock exchange, especially in an emergingmarket. The difficulty for small exchanges to survive is highlighted in the drive formergers among many larger exchanges, particularly in Europe, but also between the USand Europe.

The future of the WSE is consequently not obvious. In the short-run Poland should linkits local trading systems more tightly with global markets. This will also mean furtherharmonization of corporate governance, accounting, listing and other rules with those ininternational financial centers, particularly the EU, and the strengthening of securitiesmarkets’ enforcement. In the longer run, for those corporations still in need of publicsecurities markets, a policy of relying fully on the trading infrastructure of other marketswill avoid costly duplication and allow Polish firms to reap more quickly the benefits ofstronger corporate governance regimes. Consolidation or a merger with other marketswill have to be considered, as an independent, full-fledged local stock exchange willbecome very hard to maintain. The signing of a cross membership agreement withEuronext earlier this year is a step in the right direction. All along, Poland will have tocreate the conditions, such as improving shareholder rights and the quality of local legalsystem, that allow corporations to issue and trade shares efficiently anywhere. Finally, toavoid domestic institutional investors being held captive to an increasingly illiquid anduntransparent local market, portfolio restrictions that require investment in localinstruments only should be avoided.

While an independent, full-fledged stock exchange may not be Poland’s comparativeadvantage, many medium-sized firms with local informational needs may not be able togo directly overseas. There is evidence that information is still to some degree discoveredand processed in markets with close proximity to the issuer. Having venture capital firms,commercial banks, non-bank financial institutions, and institutional investors with linksto international financial centers participate in the financing of new and expanding Polishfirms will help bridge the information gap to international markets. This may still be aneed for some mechanism in Poland to bring firms for the first time to privateinstitutional or local markets. This may not require a tradition stock exchange, however,but rather take the form of an organized private placement market. Further areas fordevelopment are streamlining the IPO process and the accompanying cost structures toallow smaller companies to come to the market for the first time. The role of securitiesmarkets can be maintained by reducing the costs of listing and delisting. And the WSEcould take the lead in the education of growing companies regarding accessing capital viathe public markets.

Further rationalizing the tax system. Corporate tax rates were lowered to 28% in 2001and will fall further to 22% in 2004. Though payroll taxes remain high, the Governmenthas put a great deal of effort into refining the tax code so as to encourage thedevelopment of SMEs and to bring those outside the tax system into the fold. Proposedchanges to the code are also aimed at encouraging investment in fixed assets. Thetaxation of financial transactions has also been rationalized, including the tax treatment ofsimilar financial instruments, but differential taxation of debt and equity income streamsat the personal level still influences debt structures, and thereby corporate governance tosome extent. Furthermore, there is no indexation of the book value of equity with respectto inflation, thus creating a tax liability on the book, but no real capital gains value, notonly in case of sales to another strategic investor, but also in case of new sales of treasuryequity. Also, to minimize the scope for intra-company transfers, only interest paymenton intra-company debt up to a one-to-one debt equity ratio can be the deducted fromcorporate taxation. Any excess is treated as a dividend payment and thus not tax-deductible. To minimize withholding and royalty taxes, legal structures outside ofPoland (e.g., in the Netherlands or Luxembourg) are often used, which creates extra costsand leads to less transparency. Finally, Poland uses a cash-based system for taxation,which makes some debt restructuring such as debt-equity swaps involving interest arrearsvery unattractive as they are considered prepayments, creating a tax consequence. Thesedistortions, while not a major factor in corporate governance, can nevertheless be usefullyreduced over time.

2. Developing better institutional investors.

In any market, company governance practices are unlikely to improve at an adequatepace unless investors demand it. In the context of Poland, the largest pool of investibleassets will come from the mandatory second pillar pension scheme. While still relativelysmall, its asset base is growing rapidly. Pension funds will need to become champions ofcorporate governance in Poland. This is crucial for the performance of companies, thetreatment of other investors, development of the capital markets, and success of the

pension regime itself. In OECD markets, and increasingly in developing countries (e.g.,Latin America), pension funds are emerging as a force for transparency, standard-settingand voluntary compliance by listed and unlisted companies.

Polish pension funds and other institutional investors need to have both the rightincentives and tools to become more active in corporate governance. While the regulatorysystem for the second pillar (Open Pension Funds) is largely in line with internationalstandards, the main weaknesses as to the role of the pension funds in Poland in corporategovernance arise from three areas: Weaknesses in their own corporate governance due toan absence of a private oversight (governance) function for pension funds independentfrom that of the fund manager; Lack of tools due to legal and regulatory limitations onthe power of individual funds to vote shares in investee companies; And regulationsleading to a tendency for pension funds to adopt similar investment portfolios and bepassive investors.

Enhancing the corporate governance of pension funds. Funds’ own governance structuresand incentive arrangements for fund managers need to ensure that funds will take anactive interest in the long-term performance of investments. The objective of agovernance regime for pension funds should be to set incentives and provide appropriatechecks and balances that together maximize the likelihood that managers will conduct theoperations of the funds in the best interests of beneficiaries (future pensioners).Generally, this means long-term maximization of returns. Institutions concerned for thelong-term maximization of returns on investment in securities are expected to take aparticularly active interest in the corporate governance of issuers.

This active role has not thus far been the case in Poland. Open Pension Funds may havebeen less active because their managers have conflicts of interest. Those conflicts ofinterest can at least be partially ameliorated by improvements in the governance system.Polish Pension funds managers have supervisory and management boards like othercommercial companies in Poland, but there is no separate governance structure for thefund (which in itself is not a separate legal entity). Instead, the Polish system relies onregulation and the fund manager’s legal duty to act reasonably in the best interests of thefund and its beneficiaries. This is in no sense an unusual arrangement in the world ofcollective investment vehicles. Mutual funds organized in contractual form (as in muchof continental Europe) and as trusts (as in the UK), often provide no separate governanceor oversight mechanism for the fund distinct from that of the fund manager. (U.S. mutualfunds have long been required to organize as corporations with separate boards ofdirectors.)

However, there has been increasing criticism of this practice in recent years. In Europe,funds organized as corporations with separate boards of directors (OICs) have grown innumber, and even in Britain most new funds are organized in similar fashion. In theaftermath of the Investment Trusts collapses of the late 1990s, Korea instituted alegal/regulatory regime that provides for corporate-type funds. And in the U.S.,increasing concern for the independent oversight of funds led to tighter rules forcomposition of fund boards to assure a greater proportion of directors that are not

affiliated with the fund manager. Pension funds in Poland could appoint, either on avoluntary basis or as a legal requirement, some sort of board of qualified independentpersons charged with a duty to look after the interests of the beneficiaries. This wouldlead to additional incentives for pension fund managers to take a greater interest in thelong-term performance, and hence the corporate governance, of investee companies.

Enhancing the corporate governance tools of pension funds. Pension funds must also bein a position to effectively exercise their rights as shareholders and to take collectiveaction to ensure high standards of transparency and fair treatment of shareholders. Underthe current regulatory regime, Open Pension Funds may ordinarily vote no more than10% of the shares of an investee company at a general meeting. (In effect, the same ruleapplies to mutual funds, since none is permitted to hold more than 10% of the votingshares by virtue of the diversification requirement.) There is currently even a legislativeproposal to lower the ceiling on Open Pension Fund voting to 5% which would furtherrestrict the participation by pension funds in corporate governance. The stated rationalecomes from a conception of the Polish market as one where shares are broadly held, andwhere too much power in the hands of the pension funds might act as a barrier toshareholder democracy and involve pension funds too much in the actual management ofPolish enterprises. As noted above, this conception is wrong.

Poland’s equity market is on a long-term trend toward greater concentration of ownershipand control, with the principal corporate governance concern not management vs.shareholders, but rather majority vs. minority shareholders. In such a context, the focusshould be on unshackling the largest non-controlling shareholders so that they can serveas champions for all minority shareholders. The best candidate to champion minorityshareholder interests in Poland are the Open Pension Funds, and indeed there has been amore active involvement in corporate governance issues by selected pension funds in thelast year or so. Examples from other countries show that pension funds can be effectivein championing corporate governance (Box 2).

Box 2: Examples of Pension Fund Activism

Latin American pension funds (which share some of the most salient regulatory and marketstructure characteristics of Poland’s pension regime) did not historically take on the role ofchampions of good corporate governance in their markets. However, in recent years they havefaced declining rates of return, public and political pressure to take a more active role in investeecompany governance, legal/regulatory changes, and threats of additional legal/regulatory action.Partially in response to these forces, pension funds in Argentina, Brazil, Chile, Colombia, Mexicoand Peru have taken important steps toward greater activism, including:

• Collaborating in the election of board directors on investee companies. (Argentina, Brazil.)• Supporting the development of codes of best practice and the establishment of Institutes of

Directors and Corporate Governance. (Brazil, Colombia, Mexico.)• Supporting independent benchmarking (rating) of corporate governance of investee

companies. (Colombia.)• Collaborating in the establishment of “corporate governance funds” that collectively manage

shares in investee companies that the funds want to improve their governance. (Brazil.)

Box 2: Examples of Pension Fund Activism (continued)

• Lobbying for legal/regulatory reforms in support of minority shareholder protection.(Argentina, Brazil, Chile, Mexico, Peru.)

• Meeting with representatives of the U.S. Council of Institutional Investors and similar OECDcountry organizations to learn about the development of institution shareholder activism inmore advanced markets. (Argentina, Brazil.)

Enhancing the incentives of pension funds to be active investors. A full critique of thelegal/regulatory regime for Open Pension Funds is beyond the scope of this paper, butthere are a few other explanations for the lack of corporate governance activism on thepart of the pension funds. They center on the current market structure and a number ofregulations that induce pension funds to be passive rather than active investors.

• Minimum return guarantee and fee regime. Pension funds in Poland have agovernment provided minimum guarantee on their returns. This guaranteed returncombined with concentration in the industry (two dominant players) encourages fundmanagers to mirror each other’s portfolios rather than to seek maximum returns.Benchmarking systems like those in place in Poland have long been cited as creatingasymmetric incentives for managers, leading in most cases to low divergence amongportfolio compositions and insufficient incentives for managers to maximize returns.Funds follow uniform investment policies, as they cannot afford to deviate too muchfrom the general investment profiles. This herding leads to passive investmentmanagement and eliminates incentives to invest efforts in selecting and monitoringspecific corporations. A redesign of the minimum return guarantee would go a longway toward incentivating pension funds to become more active in corporategovernance. Furthermore, the fee regime (based on a percentage of contributions)leads to very active marketing and acquisition of market share ahead of fundperformance, again diverting funds from active management.

• Asset allocation restrictions. Poland’s current investment regime is relatively liberalwith respect to equity investment (up to 40%), but it does exclude entirely certainfinancial assets (private equity and real estate) and sets rather stringent limits on otherclasses of assets. Also pension funds can only invest up to five percent abroad,significantly below that typical in OECD countries, making pension funds dominatelocal financial markets and risk becoming captive domestic investors. As thegovernance of pension funds improves, investment restrictions should be liberalized.EU accession will also call for more liberalization, including higher limits on assetsabroad.11 Relaxing these restrictions will increase incentives to actively improveminority shareholder rights and their enforcement. By the same token, pension fundsshould be allowed to offer different funds to beneficiaries, increasing the rewards formore active investment management. More generally, a more competitiveenvironment, including allowing other financial intermediaries to offer products tobeneficiaries and allowing funds to outsource asset management, can lead funds to

11 The European Directive on the activities of institutions for occupational retirement provisions seeks tofacilitate the free movement of capital by abolishing uniform quantitative investment requirements.

become more active in corporate governance of corporations to maximize rates ofreturn.

• Conflicts of interest and disclosure requirements. There is scope for conflicts ofinterest on the part of some of the largest fund managers whose parent companieshave other relations with fund portfolio companies. While there is no specificevidence of actual abuse, the possibility of conflicts of interest may adversely affectthe corporate governance role of the pension funds. Furthermore, the disclosureframework of pension funds can be strengthened by providing affiliates with more (atleast once a year) basic information about the fund, including its financial situation,rates of returns, charges and costs of the fund, all compared with the system’saverage. This information should also be available to each pension fund’s supervisoryboard so it can adequately perform its duties. More information will help createincentives for better and more active management, and thus create incentives forbetter oversight of corporations.

3. Enhancing the process of going public and other voluntary measures.

Mechanisms will need to be found to improve the governance of currently privatecompanies that satisfy the demands of future portfolio investors, be they in the public orprivate institutional markets. Some of the clues to what is needed can be gleaned from therecent experience of private equity and venture capital investors in Poland reviewedabove. Some combination of private voluntary actions, such as adoption of better boardpractices, nomination of trained and independent board members, improved accountingand auditing practices, compliance with national codes of best practice, independentassessment of company governance and agreement to private arbitration, may ultimatelybecome the norm for Polish companies seeking access to external capital. Steps need tobe taken now to ensure that the public and private infrastructure for supporting improvedvoluntary corporate governance practices in put in place.

Measures aimed at public markets. The public market (or any future private institutionalmarket) could develop its own private voluntary mechanisms modeled on thosesuccessfully employed by venture capital and private equity investors. This mightinvolve the elaboration and publication of one or more sets of model charter provisionsthat traded companies would adopt and advertise to the market. Brazil’s “NovoMercado” includes three sets of increasingly demanding corporate governancerequirements that companies voluntarily agree to adopt in order to signal investors oftheir better-than-average shareholder protections. The early experience (Novo Mercadowas launched only late 2001) has been positive, and in particular, the IPO market hascome to insist on the most exigent requirements. The details of the Novo Mercado’scorporate governance standards were designed to address specific shortcomings inBrazilian law and practice, and thus many of its characteristics may not be appropriate forthe Polish environment. Nor are we here advocating that a separate listing segment likethe Novo Mercado be established by the WSE. However, home-grown sets of recognizedstandards – developed by some private-sector body with representation from interestedinvestors, companies, market participants and experts – backed up by credible private

enforcement mechanisms, could provide companies with an important tool to signal toinvestors that minority shareholder interests will be effectively protected. More or lessformalized alternative dispute resolution mechanisms to settle contests between investorsand companies could also be an important component.

Other voluntary measures. Over the past two years a few initiatives to improve corporategovernance standards on a voluntary basis have emerged with private sector participationand support. The Good Practices Committee / Corporate Governance Forum (CGForum), supported by the Warsaw Stock Exchange, has conducted a series of seminarswith the participation of important elements of the markets – company executives,investors, intermediaries – as well as acknowledged legal and academic experts. With thecollaboration of these participants, the CG Forum has elaborated a draft code of bestpractices that it expects to finalize towards the end of this year. Other respectedacademic and other institutions, including the Gdansk Institute for Market Economics(GIME), have conducted well-publicized seminars, proposed their own standards andmilitated for better practices on the part of listed and unlisted companies.

These activities have clearly helped to place corporate governance reform squarely on thepublic and private sector agendas. But the momentum built up thus far will be of littlelong-term importance if it is not followed by improvements in actual practices anddevelopment of the infrastructure to support them. Well-drafted standards of goodpractice that are generally accepted by market participants will undoubtedly be a force forcompanies to adopt better governance. This needs to be followed by a strengthening ofthe private sector framework to support good governance, including possibly the creationof an active and national institute of directors, a broader network of director training,corporate governance rating and ranking services, greater involvement and expertise onthe part of the financial press, and other infrastructure to support institutional investorinvolvement in corporate governance.

An urgent next step is for the WSE and other leading private sector institutions (with thesupport of the Polish SEC) to settle on a common set of national standards of corporategovernance against which each listed company will be required to measure itself (as inthe case of the combined code in Great Britain, the codes adopted in a number ofemerging markets, and the national code under consideration in the United States). Thiswill send a clear signal to companies about what investors regard as the key elements ofshareholder protection, and will also facilitate the development of other elements of theprivate sector infrastructure for governance. Such a code must be conceptually clear,well tailored to the Polish market realities (while still including aspirational elements tokeep the evolution of practices running in the right direction), and acceptable to asufficiently broad-based segment of the market. Through the efforts of the PC Forum andothers, the issues that will need to be addressed have all been placed squarely on the tableand the discussion is advanced. The task now is to take into consideration all points ofview, resolve the remaining key differences to the extent possible and issue the standardsso that companies, investors and others can begin to use them as a common benchmark.

ANNEX: FIRM VALUATIONS

The table depicts the regression results for a sample of most listed Polish corporations over the period 1997-2000. The regressions are performed using a random-effects specification. Numbers in brackets are t-statistics. The dependent variable is the ratio of the market value of assets to the book value of assets at theend of each year. Market value is defined as the sum of the market value of common stock and the bookvalue of debt and preferred stock. The book value of assets comes from firms’ balance sheets. The mainindependent variables are the share of cash-flow rights held by the largest shareholder (ownership) and theshare of voting rights held by the largest shareholder (control). Control minus ownership is a continuousvariable measuring the simple difference between the share of control rights and the share of cash-flowrights in the hands of the largest shareholder. Sales growth, capital spending over sales, firm age, firm size(in logs), and industry dummies are included as control variables. If sales growth is included, the regressionresults refer to the 1998-2000 period.

Ownership effects and results by type of ownerRandom Effects - 1997-2000

(1998 if sales growth is in the regression)Constant 0.414 1.743 1.882

[2.723] *** [5.149] *** [5.665] ***Cash Flow Ownership 0.313 0.339 0.321

[2.007] ** [2.128] ** [2.031] **Control - Cash Flow Ownership -0.383 -0.606 -0.572

[1.034] [1.488] [1.409]Log of Assets 0.025 0.012

[4.145] *** [2.002] **Sales Growth 0.236 0.248

[3.217] *** [3.311] ***Capital Spending over Sales -0.016 -0.019

[0.188] [0.217]Operating Income over Sales -0.079 -0.046

[0.538] [0.307]Type of Owner - None 0 -0.002 -0.031

[.] [0.010] [0.180]Type of Owner (Foreign) – Strategic 0.214 0.141 0.117

[1.587] [1.164] [0.981]Type of Owner (Foreign) –Financial 0.308 0.306 0.3

[2.221] ** [2.012] ** [1.974] **Type of Owner (Domestic) - banks & subsidiaries 0.256 0.248 0.224

[1.620] [1.608] [1.464]Type of Owner (Domestic) - insurance companies -0.021 0 0

[0.162] [.] [.]Type of Owner (Domestic) - investment & pension funds 0.332 -0.039 -0.042

[1.393] [0.253] [0.275]Type of Owner (Domestic) - National Investment Funds 0.005 -0.036 -0.056

[0.041] [0.291] [0.464]Type of Owner (Domestic) - other companies 0.14 0.076 0.051

[1.056] [0.560] [0.376]Type of Owner (Domestic) -individuals & families 0.364 0.302 0.266

[2.568] ** [2.040] ** [1.866] *Type of Owner (Domestic) - State & others 0.108 0.028 0.019

[0.744] [0.205] [0.140]

Industry Dummy - Agro & Food 0.121 -1.088 -1.085[0.981] [3.363] *** [3.354] ***

Industry Dummy - capital goods & chemicals -0.016 -1.279 -1.284

[0.187] [4.222] *** [4.235] ***Industry Dummy - consumer, durables & textiles -0.18 -1.364 -1.366

[2.208] ** [4.501] *** [4.506] ***Industry Dummy - Construction & Materials 0.156 -1.1 -1.104

[1.693] * [3.513] *** [3.525] ***Industry Dummy - Computer & Telemedia 1.189 0 0

[4.212] *** [.] [.]Industry Dummy - Trade & Services 0.107 -1.12 -1.123

[1.229] [3.788] *** [3.798] ***Industry Dummy - Others 0 -1.245 -1.253

[.] [4.490] *** [4.523] ***

Observations 596 506 506R-squared 0.332 0.412 0.408Robust t-statistics in brackets* significant at 10%; ** significant at 5%; *** significant at 1%

Results by type of origin of firm

The table depicts the regression results for a sample of most listed Polish corporations over the period 1997-2000. The regressions are performed using a random-effects specification. Numbers in brackets are t-statistics. The dependent variable is the ratio of the market value of assets to the book value of assets at theend of each year. Market value is defined as the sum of the market value of common stock and the bookvalue of debt and preferred stock. The book value of assets comes from firms’ balance sheets. The mainindependent variables are the share of cash-flow rights held by the largest shareholder (ownership) and theshare of voting rights held by the largest shareholder (control). Control minus ownership is a continuousvariable measuring the simple difference between the share of control rights and the share of cash-flowrights in the hands of the largest shareholder. Sales growth, capital spending over sales, firm age, firm size(in logs), and industry dummies are included as control variables. If sales growth is included, the regressionresults refer to the 1998-2000 period.

Random Effects - 1997-2000 (1998 if sales growth is in the regression)

Constant 0.465 1.804 1.928 0.534 1.784 1.865[3.152] *** [5.671] *** [6.103] *** [2.813] *** [5.445] *** [5.667] ***

Cash Flow Ownership - 1 largest 0.346 0.353 0.333 0.24 0.291 0.276[2.493] ** [2.446] ** [2.330] ** [1.686] * [1.859] * [1.782] *

Control - Cash Flow Ownership -0.061 -0.266 -0.258 -0.514 -0.678 -0.672

[0.189] [0.758] [0.736] [1.523] [1.895] * [1.879] *Log of Assets 0.025 0.011 0.022 0.008

[4.106] *** [1.807] * [3.656] *** [1.417]Sales Growth 0.246 0.257 0.188 0.196

[3.315] *** [3.411] *** [2.765] *** [2.841] ***Capital Spending over Sales 0.013 0.006 -0.049 -0.054

[0.130] [0.063] [0.546] [0.598]Operating Income over Sales -0.03 -0.002 -0.06 -0.039

[0.180] [0.011] [0.401] [0.258]Origin (Single Dummy) 0.031 0.035 0.031

[1.844] * [2.135] ** [1.951] *Origin - Privatization IPO 0.122 0.046 0.057

[0.875] [0.303] [0.372]Origin - From Capital Groups 0.033 -0.1 -0.101

[0.219] [0.634] [0.629]Origin - floated by national investment funds -0.062 -0.143 -0.145

[0.412] [0.910] [0.914]Origin - private but formerly state owned 0.079 -0.003 -0.005

[0.545] [0.016] [0.034]Origin - private from the beginning 0.459 0.354 0.352

[2.651] *** [1.899] * [1.877] *Origin - others (municipal) -0.198 -0.28 -0.288

[0.900] [1.101] [1.124]Origin - others (mixed) 0 0 0

[.] [.] [.]

Industry Dummy - Agro & Food 0.156 -1.114 -1.112 0.163 -0.955 -0.952[1.398] [3.602] *** [3.597] *** [1.338] [3.191] *** [3.189] ***

Industry Dummy - capital goods &chemicals

0.031 -1.304 -1.309 0.036 -1.126 -1.128

[0.354] [4.424] *** [4.443] *** [0.376] [4.021] *** [4.031] ***Industry Dummy - consumer,durables & textiles

-0.119 -1.358 -1.363 -0.117 -1.19 -1.192

[1.396] [4.572] *** [4.590] *** [1.241] [4.207] *** [4.222] ***Industry Dummy - Construction &Materials

0.172 -1.151 -1.156 0.187 -0.959 -0.959

[1.923] * [3.814] *** [3.827] *** [1.828] * [3.326] *** [3.331] ***Industry Dummy - Computer &Telemedia

1.271 0 0 1.091 0 0

[4.424] *** [.] [.] [4.130] *** [.] [.]Industry Dummy - Trade &Services

0.142 -1.159 -1.158 0.049 -1.086 -1.085

[1.526] [3.926] *** [3.929] *** [0.532] [3.928] *** [3.934] ***Industry Dummy - Others 0 -1.321 -1.325 0 -1.159 -1.161

[.] [4.737] *** [4.757] *** [.] [4.316] *** [4.330] ***

Observations 596 506 506 596 506 506R-squared 0.305 0.385 0.381 0.356 0.432 0.431Robust t-statistics in brackets* significant at 10%; ** significant at 5%; *** significant at 1%

REFERENCES

Claessens, Stijn, Simeon Djankov, and Daniela Klingebiel. 2001. Stock Markets inTransition Economies. Financial Sector Discussion Paper 5. Washington: World Bank,September.

Claessens, Stijn, Daniela Klingebiel, and Sergio Schmukler. 2002. “Explaining theMigration of Stocks from Exchanges in Emerging Economies to International Centers.”Working Paper 2816. Washington: World Bank.

La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny,2002, Investor protection and corporate valuation, Journal of Finance, June.

Pistor, Katharina, 2000, "Patterns of Legal Change: Shareholder and Creditor Rights inTransition," Working Paper 49, European Bank for Reconstruction and Development,London.

Slavova, Stefka, 2000, "Law and Finance in Transition," London School of Economics,Department of Economics.

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