Corporate Governance and Agency

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April 2007 PED401. Applications and Cases in International Development

Teaching Notes1

Corporate governance and agency problems – consequences for efficiency and equity
This case concerns questions of the organization of the corporate sector. In the past, we have often focused on how credit and insurance market failures can be particularly costly for smaller-scale and poorer groups, and how this can lead to adverse efficiency, equity and poverty effects. For example, microfinance uses a set of contractual and organizational innovations to deal with market failures. But this focus on the bottom of the firm (or firm-household) distribution does not imply that all is well at the top of the distribution. In fact, there are a whole set of issues around how the corporate sector is organized and how this interacts with both capital and insurance market failures. As in other areas we have looked at, theory helps analyze the nature of the potential problems, including insights from contract theory. A central focus of the session will be on the potential costs of family-controlled and pyramidal corporate structures. A stark example of an agency problem is “tunneling”, the transfer of resources between firms in the pyramid that favors controlling groups at the expense of minority shareholders. This is a form of moral hazard (see below.) But note that theory is often ambiguous. For example, the net effects on efficiency of a pyramidal structure depend on the balance between incentives to expropriate minority shareholders, and the potential of such pyramidal structures to compensate for credit and insurance market failures. This topic will also illustrate two other themes of the course: how there can be interactions between inefficiency and inequity; and how unequal power can shape institutional design. In particular, the potential for “economic entrenchment” of corporate elites is a potentially pernicious source of inefficient and inequitable development paths.

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These notes were prepared by Michael Walton and are solely for teaching purposes.

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Finally the case discusses how design of legal and regulatory systems can countervail concentrated corporate power, and shape corporate structures. This will focus on a contrast between the Czech Republic and Poland in the 1990s that it is suggested has features of a natural experiment. These were not cases of entrenched economic elites, but are of interest precisely because of the fluidity of institution in their transitions.

Analytical context
Agency theory is relevant to many aspects of corporations, from the fundamental question of why firms exist at all to questions of corporate structure.

The boundaries of the firm
If markets are such efficient mechanisms for allocating resources, why do firms exist at all? The huge amount of market activity in mergers and acquisitions and in spinning off parts of complex firms suggest that this is an issue of genuine economic importance, with continual experimentation in finding out what boundaries are most profitable. This is not the primary concern of this case, but we highlight a few of the points in Holmströn and Roberts (1998) to provide some broader context. Coase’s classic answer to why so much economic activity occurs within organizations is in terms of transactions costs in a world of imperfect information. Where the costs of transactions are high, it can be optimal to undertake those within an organization rather than at arms-length. This was later developed in the work of Williamson, who structured the issue of the frequency, uncertainty and asset specificity of transactions: with higher levels of uncertainty and asset specificity, contracting is more complex, and hierarchical management within a company can be more efficient. A related argument in the property rights school is based on the classic hold-up problem. Where a transaction involves relationship-specific investments, one party can hold up the other after the investment has been made, this will be anticipated and the level of investment will be suboptimal. This would predict that transactions for which hold-up is potentially large would occur inside firms; others would occur at arms-length, exploiting the efficiency gains from the market. As in many areas we have looked at, this is only part of the story. A theme of Holmströn and Roberts’ survey is that we need a richer account of the reasons to understand why boundaries form in particular ways. For example:
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In some cases inter-firm transactions with high levels of relationship-specific investment appear to successfully avoid hold-up problems. An example is the traditional relationship between Japanese automobile manufacturers and their parts suppliers. Firms such as Toyota developed relationships with small numbers of suppliers that form one element of their very high levels of efficiency. Hold-up

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problems are attenuated by the repeated nature of the interaction, substantial information-sharing and (for Toyota) the possibility of benchmark competition by having more than one supplier. ! There are also other reasons for boundaries forming along particular lines, that can also be illuminated by agency theory. An example is the optimal level for incentives for cost control. Garages commonly involve franchises, for which operators pay a rent, and so are residual claimants of profits. Supermarkets are more commonly run by the owners. An explanation for this is that the primary margin for better cost control and service for garages lies within the garage itself, whereas for supermarkets it is primarily in inventory management and warehousing. Firm boundaries are associated with the role of organizational knowledge and learning. The overall message from Holmströn and Roberts is that we need a more complex account of boundaries, that would include, but go beyond the relationship between holdup and investment.

Corporate structure: dispersed ownership and pyramidal structures
The traditional analysis of firm behavior is concerned with potential principal-agent problems between managers and owners, with the latter typified by individual and family shareholders. “In this view, a corporation is widely held, in that its ownership is dispersed across a large number of small public shareholders, and freestanding, in that listed companies generally do not control other listed companies.” (Morck, Wolfenzon and Yeung, henceforth MWY, p.660). In fact, this ownership pattern, characteristics of the UK and the US, is relatively rare in the world. Of particular interest is who controls a firm, and control is often conferred by levels of ownership of 10 or 20 percent of voting stakes. A number of studies have sought to categorize whether the major corporations in countries are widely held or family controlled: Table 1, taken from MWY provides a summary. Note that in the developing countries family-held firms are typically much more important than widely held companies, including in Argentina, Indonesia, Korea, Mexico, the Philippines, Taiwan, and Thailand. And this also applies to many developed countries, such as France, Germany (on some definitions) and Sweden.

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Table 1 Patterns of control of corporations in various countries.

Source: Morck, Wolfenzon and Yeung, 2005

Family ownership is one feature of the corporate sectors of much of the world. But of perhaps greater importance is that this is typically associated with pyramidal structures of ownership. In its simplest form this means that an apex firm owns shares with second tier firms, that in turn own shares in third tier firms, and so on. This is illustrated in Figure 1. In practice this will be more complex, with cross-holdings of shares within the pyramidal structure. What is interesting about this is that control over lower-tier firms by the apex family group can be conferred with substantially lower levels of underlying cashflow rights. Thus even if we assume that control requires more than 50% of shares, the family controls the fourth tier firms in Figure 1 with only 12.5% ownership. Where control is conferred by 20% or even 10% of ownership—or via crossholdings—the

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divergence between ownership and control can be much greater. In many countries a relatively small number of wealth families control a substantial part of the large-scale corporate sector.
Figure 1 A schematic account of a pyramidal ownership structure.

Source: Morck, Wolfenzon and Yeung, 2005

While the most common form of extensive control is via the family-based pyramidal structure, there are also other forms of business group. In Germany, banks—themselves widely held—own shares in a wide range of corporations with extensive control rights. German banks play an important role in monitoring corporate performance. In Japan, there are extensive cross-holdings within business groups known as keiretsu, that confers substantial control the managers of the group.

Potential consequences
The general principal-agent problem Why should we care about the family-held pyramidal structure? Because agency problems are likely to be significantly different from a freestanding family firm. For freestanding family-owned firms, the classical agency problem emphasized in the literature (of divergence of interests between utility-maximizing managers and dispersed owners) is likely to be reduced or eliminated—the interests of owners and managers will be aligned. But this is unlikely to be the case with pyramidal structures. There is likely to be a divergence of interest between the minority shareholders (here the principals) and

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controlling interests (as their agents), in any area where there are private benefits of control. A particular concern is that of entrenchment, where controlling interests can maintain in power their favored managers, often from the family: this can include “honest but inept insiders as well as clever self-serving insiders” “an egregiously incompetent, but power-hungry son” or even “the most efficient thief”, who is willing to pay most for a control block (MWY pps. 677-678) Tunneling. “Tunneling” is an important example of the agency problems created in a control pyramid. This term—coined in the context of interpretations of the experience in the Czech Republic that we will discuss in class—means the transfer of resources between related firms that benefit individuals or groups with control rights. It can be illegal or legal (Johnson et al. 2000, document a number of individual cases that occurred legally in developed countries.) Note that tunneling is (often) a form of moral hazard. Given the divergence between control and cash flow rights, it is optimal for controlling owners to (partially) expropriate the minority public shareholders—in a pyramid typically from a lower tier to higher tier firm. This can take many forms: “value can be transferred between controlled firms via transfer pricing, the provision of capital at artificial prices; or via inflated payments for intangibles, brand names, and insurance” (MWY p. 678). We think of moral hazard as involving unobservable action, and this is indeed often the case and is highly relevant to the policy discussion below. Note, however, that this is not necessarily so: in some cases, including those documented in Johnson et al (2000), the transfers were carefully documented, but still judged to be legal. Interactions with capital markets and dynamic processes—potential positive and negative effects of pyramids While we are emphasizing the agency problems and associated adverse efficiency (and equity) effects of pyramids, note that in theory pyramids can have either positive or negative effects. Where credit and insurance markets are imperfect, a pyramid can help solve financing problems through inter-firm transfers, both for investment purposes and to help otherwise efficient firms manage shocks. MWY cite work by Tarun Khanna that argues that India’s Tata group has been an important source of relatively efficient internal investment finance, compensating for highly imperfect credit markets. But there can also be negative effects on capital allocation: even if there is more efficient capital allocation within a business group, there is a wedge between the internal costs of capital and that of outsider firms. This wedge is likely to be increased when relationshipbased lending with banks is salient—and especially when banks form part of the business groups. There are also likely to be effects on innovation. Pyamidal structures may resist the Schumpeterian process of creation and destruction that is central to innovation, when this new activities hurt the profits of other firms within the group. On the other hand they

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may be able to use the rents they enjoy to finance innovation—especially if markets for venture capital are weak in a country. Political economy A broader, and potentially more important, concern, concerns the role of concentrated corporate wealth in the shaping of policies and institutions. MWY argue that under “oligarchic capitalism”, typified by widespread corporate control by relative few wealthy families, the “oligarchs” will have an interest in lobbying for limited public investors’ rights, restrictions on entry, less international competition and a narrower capital market. This, for example, was a feature of the analysis of Mexico discussed in an earlier case, where the resolution of the credibility problem was via the selective provision of property rights to a narrow group of insiders. This helped solve the investment problem, but at the cost of efficiency, dynamism and innovation. It is still seen today in the widespread regulatory capture and legacy of a narrow, concentrated banking system in Mexico (as in many countries.) The role of judicial and regulatory approaches: “Coase versus the Coasians” Can regulation make a difference? Glaeser, Johnson and Shleifer (2001, henceforth GJS) argue that it can. They distinguish between a “Coasian” view of the world (though not one held by Coase himself), that has high levels of confidence that securities transactions can be efficiently managed using the wide range of contracting possibilities open to the sophisticated buyers and sellers, which can then be adjudicated in the courts. By contrast advocates of greater regulation emphasize the market failures (noted above), that could allow issuers of securities to expropriate investors, and so increase the cost of external funds. This implies the need for specialized laws and regulators are needed. GJS develop a model that that explores the contrast between an active regulatory approach to securities markets, and a “Coasian” view that relies on the normal working of the judicial system. Underlying this are two sets of considerations: The zeal of the enforcer, that is judged to be greater for a (non-captured) specialized regulator than for a judge—one who has higher powered incentives for finding and punishing offenders. ! The extent of specialized information and investor protection requirements— especially for minority shareholders—that is embodied in company and securities laws.
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There is a tradeoff here: a zealous regulator will more vigorously protect minority shareholder rights, but at a cost for the corporate system, in terms of punishing the innocent and the cost of information provision. Greater information requirements will lower the search costs for the investigator, and so make more observable the actions of agents, reducing moral hazard. Where a country wants to locate itself on this tradeoff depends on the depth of the agency problems. GJS argue that active regulation backed by

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specialized laws protecting minority shareholders is desirable—and use the comparison between the Czech Republic and Poland to support this. Of course, if the political economy view of the world sees all policies and institutions as endogenous to the underlying structure of power, then this is not very interesting. In practice, power structures and potential coalitions typically provide some room for manoeuvre. Assessing what is politically feasible in policy and institutional design, is central to the art of development practice!

Some illustrative empirical patterns
“Control pyramids effectively entrust the corporate governance of the greater part of the corporate sectors of many countries to a handful of elite, established families, who can quite reasonably be described as oligarchs.” (MWY p.693) To the extent this is true, does it matter? As noted in the selected review of theory, effects of pyramidal corporate structures are theoretically ambiguous, so the issue is empirical. While there is not the space to review the literature here (see MWY), we highlight a few results. First, to motivate interest, there are some suggestive associations between billionaire wealth and various measures of development performance. Billionaire wealth is measured by the ratio of Forbes’ estimates of total wealth to GDP. When this is added to simple cross-country growth regressions, measures of “self-made” billionaire wealth have a positive relationship with growth in per capita income, while measures of “inherited” billionaire wealth have a negative relationship (Table 2). This holds for a variety of definitions of whether billionaires are self-made or rich because of inheritance or political connections. It is not possible to infer causation, for all the usual reasons, and there may in particular be problems of omitted variables: something about a society’s economic or political institutions may be good for both major business entrepreneurs and overall growth, and vice versa. But it is at least consistent with the view that entrenched familial wealth may be associated with structures that are bad for growth. (Similar associations hold for other development outcomes, such as health status.)

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Table 2. The association between growth in real per capita GDP and self-made and inherited billionaire wealth

Source: Morck, Wolfenzon and Yeung, 2005

A rather different and also highly suggestive result comes from measures of the premium the market grants to the value of control rights. It is possible to distinguish purchases that confer control over a firm, such as blocks of shares. These often have a higher price than regular purchases, indicated that the market attributes private value to controls.

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Table 3. Some evidence on the value of control rights

Source: Morck, Wolfenzon and Yeung, 2005

A number of studies have found evidence of tunneling, in countries ranging from Korea, Central and Eastern Europe, India and in Europe, and this is a growing area of empirical research. But it is also true that pyramidal/familial structures have existed in countries that have by most standards of economic development been extraordinarily successful: Korea and Sweden are examples, as are many of the East Asian “miracle” countries. How do we interpret this? Is it because the gains from pyramidal structures (from solving credit market failures) offset the costs? Did other parts of the institutional context offset the worse costs of pyramidal structures in these cases? Or would the pattern of growth been more efficient and equitable than actually occurred? These are important questions for future work and policy design.

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The Czech Republic and Poland
Czech Republic’s Vaclav Klaus: “We knew we had to liberalize, deregulate, privatize at a very early stage in the transformation process, even if we might be confronted with weak and ..not fully efficient markets….Conceptually...all you had to do was apply the economic philosophy of the University of Chicago”. 1995 Poland’s Leszek Balcerowitz. “The capacity of the state to deal with various problems varies, mainly because of varying informational requirements…” 1995 (cited in Glaeser, Johnson and Shleifer. 2001) A natural experiment in institutional design? The discussion of theory has emphasized the potential for entrenchment of patterns of control via both economic and political channels. The case we will look involves a very different setting, of the Czech Republic and Poland, both societies in an unusually high degree of flux, owing to the ruptures associated with the political transition from communist control. Apart from the intrinsic interest of their experiences, they illuminate the issues we are concerned with, both because of the institutional fluidity, and because contrasting policy and institutional changes were adopted in a form of natural experiment. As has been discussed in the quantitative courses, to assess the effect of an intervention, we want to compare the effect of the treatment on an individual, household, community or country with what would have happened if everything else was the same except the treatment. This can never be observed, and so we are always looking for information that is close to this structure. Well-designed randomized experiments are about as good as you can get, and quasi-experimental methods seek to approximate the ideal, with varying degrees of success. When the comparison is between just two countries, there is of course no possibility of undertaking any statistical tests, but it is worth thinking of the structure of the problem through a similar prism. The hypothesis is that the Czech Republic and Poland were similar in relevant respects except choices over institutional design that we are interested in, so this allows us to explore the consequences of the design choices. In 1989 both led the transition from communism in Central and Eastern Europe, after 40 years under communist rule. Both were fully industrialized under Soviet-style central planned. The Czech Republic was somewhat richer in 1989, and Poland had a larger agricultural sector. Then both undertook a quite rapid process of liberalization. To quote Glaeser, Johnson and Shleifer (2001): Both countries initiated economic reforms immediately after shedding communism. In Poland critical legislation on liberalization was passed in the fall of 1989, and the key measures came into effect on January 1, 1990. Small-scale

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privatization began in May 1990, although large-scale privatization started with a whisper in 1991, ran into political obstacles, and spread over most of the 1990s. In Czechoslovakia reforms were also initiated in early 1990, with the devaluation of the currency, budget cuts, and banking reform. The formal reform package, including price increases, started on January 1, 1991. The law on large-scale privatization was adopted on February 1, 1991. Privatization through vouchers took place in two waves: in 1992 (completed in mid-1993) and 1993 (completed in 1994). Most rules of privatization, including those on Investment Privatization Funds, were developed in 1991…… Moreover, both countries were virtually finished with these basic reforms by 1994. They received virtually identical scores on every World Bank indicator of the pace of transition..” (pp. 865-866)
Table 4 Comparative indicators for the Czech Republic and Poland

Czech Republic Years under communism Transition Per capita income, 1989 (1995 US$) Private sector share of GDP, 1997 Privatization indices Large-scale Small-scale Price liberalization index Banking reform/liberalization Legal environment 40 1989 5730 75%

Poland 40 1989 3045 65%

4 4+ 3 3 4

3+ 4+ 3 3 4

Source: Glaeser, Johnson and Shleifer. 2001

Some of the similarities are given in Table 4. However, there were also differences in both the approach to privatization and the choice of regulatory regime for the newly created corporate sector. The Czech Republic was more “Coasian” in the sense that it chose to rapidly transfer state-owned property to private citizens, and then chose a lighter regulatory regime, trusting more in the newly created property rights, private contracting and the judicial system. Poland selected a more gradual approach to privatization of large-scale enterprises, using a variety of methods, including direct sales and share transfers to mutual funds. It backed this with a more active regulatory regime, with stronger protections to minority shareholders. Now the classic evaluation question is whether this policy difference was driven by some “unobservable” characteristics that

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would also explain subsequent differences in outcomes. Here the hypothesis is that the primary driver was differences in the ideology and preferences of the leadership, captured in the quotes at the beginning of this section. Both had strong economic leaders committed to the transition to capitalism, but while the Czech Republic’s Vaclav Klaus was a fierce proponent of the power of free markets, Poland’s Leszek Balcerowitz was more concerned with the need to nurture the state’s capacity to manage capitalist structures in the context of market failures. The differences in design choices The first difference concerned the design of privatization. The Czech Republic’s privatization gave all Czech citizens rights to purchase booklets of voucher points at a modest prices; these could then be used exclusively for purchase of shares in state owned companies put up for sale. There was, however, awareness that atomistic owners would be in a weak position to monitor the performance of their firms (in what was referred to above as the “classic” agency problem under dispersed ownership). So free entry was allowed to Investment Privatization Funds (IPFs) as both a means of providing information to citizens and aggregating bids, and as a mechanism of corporate governance of the newly formed private firms (Coffee, 1996). As already noted, Poland chose a more gradual and managed route. Note that voucher privatization had apparently attractive efficiency, equity and political economy characteristics: it could swiftly transfer ownership to “true” owners; gave rights to participate to all citizens; and could lock in the transition swiftly vis-à-vis either old state managers or new insiders. The second difference concerned the regulatory stance. Here the Czech Republic’s legislation on company and securities was much laxer than Poland’s with respect to a whole series of requirements on protections for minority shareholders and information disclosure (see examples in Tables 5 and 6, all from GJS). Moreover, regulatory action in the Czech Republic resided in a division within the Ministry of Finance, while Poland created a powerful, independent regulator.

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Table 5. Indicators of differences in policy stance

Czech Republic Company law: degree of protection against expropriation of minority shareholders Securities law Moderate to low: overall rating of 2 out of 6 on Supervision in an office within the Ministry of Finance Weak licensing, and disclosure requirements
Source: Glaeser, Johnson and Shleifer. 2001

Poland Moderate protection: overall rating of 3 out of 6 Independent Securities Commission Strong licensing and disclosure requirements

Table 5. Indicators of differences in securities laws

Czech Republic Required to engage in “honest trading” Brokerage enterprises: Regulator has right of inspection of brokers Must report who has more than 5% of voting rights Investment advisers Licensed by regulator Stock markets Trading must take place on a stock exchange No

Poland Yes

No No

Yes Yes

No No

Yes Yes

Source: Glaeser, Johnson and Shleifer. 2001

Outcomes What were the outcomes? The Czech Republic’s privatization was much more rapid. Indeed, by end-1994 over 80% of Czech citizens had become shareholders in privatized companies and 65-90% of all assets had become privately owned (Coffee, 1996). But a highly concentrated ownership structure was created, with IPFs playing a central role in holding multiple companies.

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Then, in 1996 and 1997 there was a sequence of scandals, involving asset-stripping, the collapse of some financial institutions and allegations of embezzlement (ibid.) The term “tunneling” was coined in descriptions of this experience. Moreover, “..during the mid1990s, the heyday of tunneling in the Czech Republic, the regulators did very little to stop it. Part of the problem was the weakness of the laws. But equally important was probably the lack of interest in securities regulators combined with judicial ineffectiveness.” (GJS) By contrast when financial scandals occurred in Poland, they were widely reported, and vigorously pursued by the regulator, making use of the legal rules designed to protect investors. There were markedly different effects on the evolution of stock markets. The Czech stock market initially grew much faster than the Polish market, but then the pattern reversed: Figure 2 illustrates for stocks listed in the IFC investable index, that is limited to stocks liquid enough for foreign investors to take positions. Even more striking is the differing abilities of firms to raise capital. While no Czech company sold equity for cash in an initial public offering between 1991 and 1998, 136 nonprivatizing companies had done so in Poland.
Figure 2. Market capitalization of stocks in IFC Investable Index.

Source: Glaeser, Johnson and Shleifer. 2001

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Table 6. Initial public offerings for cash, 1991-1998

Source: Glaeser, Johnson and Shleifer. 2001

The above evidence is only indicative. An alternative interpretation of the Czech experience is a Darwinian one: it effectively went for an upfront floating of all companies, and then the market weeded out the least fit firms, with the least marketfriendly charters. GJS argue that this was unlikely to be the case, on the grounds that “the survival of theft-proof firms is not an efficient mechanisms of economic selection.” Tunneling could be used to strip assets of good or bad firms alike. They argue that the key difference was in the design of regulation, and that well-designed laws and could indeed have effectively regulated the IPFs and related intermediaries.

Policy questions
It is 1990 in either the Czech Republic or Poland. There is intense interest in the design of the transition to private ownership. You are part of a planning group assessing alternative design options. There are debates over the pace and design of privatization itself, the role and sequencing of regulation, alternative mechanisms for monitoring of corporate performance and the importance of the overall political context. You are familiar with debates over corporate governance in rich countries, and the high risk of agency problems under both dispersed and concentrated forms of ownership. You are particularly interested in what form of regulatory framework would make sense conditional on the choice of privatization approach (fast or slow, voucher or managed etc.) What do you recommend?

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Alternatively, you may wish to consider the question of whether regulatory choices can be useful to tackle problems of entrenched family-based structures of corporate ownership in a country with which you are familiar and have information.

References
Coffee, John. 1996. "Institutional Investors in Transitional Economies. Lessons from the Czech Experience." in Roman Frydman, Cheryl, Gray and Andrzej Rapaczynski Corporate Governance in Central Europe & Russia: Volume I: Banks, Funds and Foreign Investors. New York: Oxford University Press. Cull, Robert, Jana Matesova, and Mary Shirley. 2002. “Ownership and the Temptation to Loot: Evidence from Privatized Firms in the Czech Republic.” Journal of Comparative Economics, 30:1-24. Glaeser, Edward L., Simon Johnson, and Andrei Shleifer. 2001. "Coase versus the Coasians." Quarterly Journal of Economics, 116(3):853–99. Friedman, Eric, Simon Johnson, and Todd Mitton. 2003. “Propping and Tunneling.” Journal of Comparative Economics, 31(4):732-50. Holmström, Bengt and John Roberts. 1998. “The Boundaries of the Firm Revisited.” Journal of Economic Perspectives, 12(4): 73-94 Johnson, Simon, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer. 2000. “Tunneling.” American Economic Review, 90(2):22-7. Morck, Randall, Daniel Wolfenzon, and Bernard Yeung. 2004. “Corporate Governance, Economic Entrenchment and Growth.” Journal of Economic Literature, XLII, 655-720.

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Map of the Czech Republic and Poland

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