Journal of Comparative Economics 44 (2016) 1132–1144

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Journal of Comparative Economics

journal homepage: www.elsevier.com/locate/jce

Corporate governance following mass privatization

Josef C. Brada
Arizona State University, Tempe, USA

a r t i c l e i n f o a b s t r a c t

Article history: Brada, Josef C.—Corporate governance following mass privatization

Available online 22 October 2016
Using vouchers to privatize state-owned firms was an innovative but controversial aspect
JEL classification numbers: of transition. In the Czech Republic, voucher privatization created a large group of minority
G34 shareholders who coexisted with large shareholder–managers who controlled firms. Critics
G38 allege that the structure of shareholdings and regulatory failures allowed pervasive theft of
K22 corporate assets, much of it financed by irresponsible bank lending, and led to a financial
K42 crisis and an economic downturn. I argue that neither anecdotal evidence of managerial
L21 malfeasance nor the theories of tunneling and looting provide strong evidence for this
P37
view of corporate governance in the Czech Republic. A lack of small shareholder protection
Keywords: seems to have imposed small costs on the economy, and it may have facilitated rather than
Corporate restructuring hampered the restructuring of firms. Journal of Comparative Economics 44(4) (2016) 1132–
Privatization 1144. Arizona State University, Tempe, USA.
Corporate governance © 2016 Association for Comparative Economic Studies. Published by Elsevier Inc. All rights
Tunneling reserved.
Looting
Czech republic

1. Introduction

A number of formerly-Communist countries implemented privatization strategies that distributed shares in state-owned
enterprises to the general public. In many countries, such mass-privatization programs were combined with other means of
privatization, including sales of firms to workers or mangers, to foreigners, etc. (Brada, 1996). Whether the voucher programs
were the main vehicle for privatization or merely one of many means used, they were seen as being, in many ways, the
most radical way of privatizing state-owned firms. The process was pioneered by the privatization process in Czechoslovakia
and the Czechoslovak experience is often seen as providing the most telling evidence about the effect of mass privatization
on corporate governance. However, the Czech Republic’s process of transition through a mass privatization process in which
citizens could purchase, for a symbolic price, vouchers that allowed them to bid for shares of firms that were privatized
in two so-called waves between 1991 and 1995 has been steeped in controversy because of the widespread perception
that the ownership structure that emerged led to ineffective corporate governance and, as a result, to poor financial sector
development and lagging overall economic performance (see, for example, Estrin et al. 2009, especially section 2.3).1
During the privatization process, it became evident that many Czech citizens were either eager for greater diversification
than the bidding process offered or uninterested in bidding for the shares of individual firms, and 72% of the participants

E-mail address: josef.brada@asu.edu

1
For descriptions of the voucher privatization process, see Mejstřík (1997). The first wave of privatization occurred when the Czech Republic was part
of Czechoslovakia, but because the analyses of the subsequent outcomes deal entirely with developments that took place in the Czech Republic, from now
on I refer to the process as the Czech privatization to avoid needless terminological complications.

http://dx.doi.org/10.1016/j.jce.2016.10.003
0147-5967/© 2016 Association for Comparative Economic Studies. Published by Elsevier Inc. All rights reserved.
 J.C. Brada / Journal of Comparative Economics 44 (2016) 1132–1144 1133

in the first wave and 63.5% in the second wave chose to take part in the privatization process by giving their vouchers
to mutual funds who then assembled their portfolios by bidding for the shares of individual firms being privatized. Critics
of this process have argued that the resulting ownership structure left many firms with dominant owners and a group of
minority shareholders who were open to exploitation by the majority shareholder and that it created close ties between
a commercial bank’s investment fund and the fortunes of the firms whose shares it owned, leading to a perverse sort of
“relationship banking” that facilitated managerial looting of firms.2
Svejnar (2007, p. 6) sums up the mainstream view of corporate governance in the Czech Republic thus: voucher pri-
vatization in the Czech Republic “resulted in dispersed ownership of shares and, together with a weak legal framework,
it resulted in poor corporate governance. The poor corporate governance often permitted managers or majority sharehold-
ers to appropriate profits or even assets of the firms at the expense of minority shareholders.”3 Many observers further
argue that corporate governance after the Czech voucher privatization was so poor that it had significant negative macroe-
conomic consequences, including the so-called kuruna crisis of the late 1990s and the accompanying recession.4 Moreover,
it is alleged that Czech banks, not as yet privatized in the early and mid-1990s, continued to lend to firms that were being
stripped of their assets by majority shareholders, allowing the asset stripping process to continue for longer than it would
normally have and creating a financial crisis (Cull et al. 2002; Desai, 1996). In addition, lax regulation of financial markets
failed to protect minority shareholders and, according to some observers, finally led to a collapse of share prices in the
Czech Republic in the late 1990s (Coffee, 1999; Glaeser et al. 2001).
The central argument of this paper is that the above-mentioned analyses of Czech corporate governance reflects what
Depkat and Steger (2015) identify as a pervasive characteristic of the Western literature on Central and East European cor-
porate and managerial behavior. In their review of this literature, they conclude that its analytical approach entails the
construction of two “selves”. One is the “West”, whose business practices and institutions are seen as a modern and pro-
gressive system where economic and managerial processes and practices are rational, well governed by laws and institutions
and characterized by managerial accountability and professionalism. The managerial and economic practices and institutions
of the transition economies represent the “other”, the antithesis of the “West”. Thus, in East Europe, according to the West-
ern literature, managerial attitudes and behaviors are characterized as opportunistic, tainted by the Communist past, and
distorted by remnants of the irrationality of practices that existed under central planning. Institutions and laws are seen as
inadequate, poorly implemented or embryonic. Moreover, the more East European practice differs from that of the idealized
construction of managerial practice in the “West”, the more it is seen in a negative light. Since the voucher privatization
was arguably the most unique or “East European” of the transition strategies, in the light of Depkat and Steger’s findings it
is not surprising that it has attracted so much criticism.
The global financial crisis of 2008 offers an opportunity to reconsider criticisms of the Czech privatization because it,
again, raises the question of the limits on the effectiveness of corporate governance that any economic system can offer. The
global crisis, too, was driven by failures in corporate governance as owners of banks and financial institutions were unable
to restrain managers from undertaking risky financial bets that gave rise to huge bonuses for mangers but, ultimately, to
massive losses for minority shareholders.
In this paper I reexamine the theories of tunneling and of looting as well as the arguments that corporate governance
was so bad as to materially impair restructuring and economic growth in the Czech Republic. I argue that the evidence
reported in the literature is open to alternative interpretations that are more favorable to this method of privatization
than conventional wisdom suggests and that the corporate governance that evolved in the course of mass privatization
may have, in fact, facilitated the restructuring of firms. Specifically, in Section 2 I argue that anecdotal evidence of poor
corporate governance is both ambiguous in nature and common to all corporate governance regimes. Thus, identifying
cases of alleged managerial malfeasance in the Czech Republic tells us little about whether corporate governance was
adequate to meeting the goals of the voucher privatization. In Section 3, I examine the theories of tunneling and looting,
the two methods by which majority owners were believed to have exploited the minority owners created by the voucher
privatization. I note that the two theories reach opposite conclusions regarding the structure of corporate governance, with
the former implying as small a share of stockholding by the majority owner as is compatible with corporate control while
the latter calls for the majority shareholder to seek as large a share of stockholding as possible. The two theories do have
a common conclusion and that is that both looting and tunneling require extensive bank lending to firms and that the
eventual outcome of either process has to be a large number of bankruptcies. I examine the evidence on bank lending and
bankruptcies in the Czech Republic in Section 4 and show that lending to firms decreased but there was no major wave
of bankruptcies among large Czech firms. The costs of tunneling and looting are examined in Section 5, and I argue that
efforts to link the Czech Republic’s poor macroeconomic performance to its corporate governance are open to question and
that the statistical evidence suggests that the costs of tunneling and looting were small and, in any case, less than the costs
of delaying privatization. In Section 6 I argue that there is a tradeoff between the protection of minority shareholder rights

2
A study by Koleva and Vincensini (2002) provides a more positive view of the governance role of funds in both the Czech Republic and Bulgaria.
3
Other expressions of this view include Coffee (1996, 1999), Estrin et al. (1999), Megginson (2005), Nellis, (1999), Spicer et al. (20 0 0).
4
See Cull et al. (2002), Desai (1996), Glaeser et al. (2001) and Spicer et al. (20 0 0) for such claims. Nevertheless, Gouret’s (2007) cross-country study
reaches a somewhat contrary conclusion, injecting a note of caution about these early findings, and Bennett et al. (2007) also conclude that mass privati-
zation was associated with better macroeconomic performance.
1134 J.C. Brada / Journal of Comparative Economics 44 (2016) 1132–1144

and the amount of restructuring of firms that will take place. I offer some examples of this conflict that can be found in
US law and in corporate restructurings that have occurred in the United States. Section 7 concludes.

2. What can anecdotal evidence regarding corporate governance tell us?

The corporate governance problem arises because the owners of capital entrust it to managers in the hopes of obtaining
a return on their capital as well as the ultimate repayment of their principal. In the process of financing the firm in this way,
the shareholders yield residual decision-making rights to the managers, enabling the managers to exploit the owners of the
firm in two ways, through expropriation and through the misallocation of resources (Schleifer and Vishny, 1997). Through
expropriation, the managers are able to obtain for themselves some of the assets or income of the firm that rightfully belong
to the owners. Misallocation means that, through the exercise of their residual decision-making rights, managers are able to
make business decisions that improve their welfare but reduce the income from, or the value of, the assets of the owners.
The existence of a large or majority shareholder improves the monitoring of managers and thus reduces their propensity to
expropriate and misallocate, but it immediately raises a second governance problem in that the majority owner has both
the incentives and, in the absence of adequate shareholder protection, the power to exploit the minority shareholders.
Consequently, in seeking to evaluate the effectiveness of corporate governance in a transition economy such as the Czech
Republic, pointing to examples of expropriation and misallocation by managers or majority shareholders, as some of the
literature on voucher privatization does, is insufficient to make the case that corporate governance has failed because the
absence of such behavior is an impossible standard to meet even for an economy where corporate governance is assumed to
be “good”. Box 1 provides three examples, drawn from experience in the United States, of common ways in which managers
could be seen as expropriating shareholders.5 One such way, shown in the first example in Box 1, is through high salaries
and perquisites provided by the firm to managers.6 Doubtless, in this example General Electric could, and did, defend these
payments as reflecting a need to meet the going price for superb managers and to reward outstanding service. The second
example involves transactions between the firm and entities owned by the managers. Such transactions can take place at
transfer prices that effectively shift resources from the shareholders to the manager, for example by buying inputs from a
manager-owned firm at above-market prices. At the same time, there is an economic efficiency argument for transactions
such as this to take place between two firms related by common management. If one of the firms that is a party to an
inter-firm transaction has to acquire relation-specific physical or human capital in order to effectively serve its client, it
will be more willing to do so if there is a common ownership or decision-making link between the two firms. Such a
common link protects the investing firm against so-called hold-up costs, which the firm purchasing the products of the
supplier could impose once the transaction-specific investment has been made by offering to continue buying the products
only at a lower price than originally envisaged by the supplier (Goldberg, 1976 and Lyons, 1994). Finally, the last example
in Box 1 describes numerous, though by no means exhaustive, commonplace ways in which managers or majority owners
can expropriate minority shareholders. It is noteworthy that, of the three examples above, only Lord Black’s behavior was
subject to (unsuccessful) prosecution or intra-company sanctions.

Box 1. Are these tunneling and looting or managerial actions in shareholders’ interest?

Example 1- High pay and excessive perks: The US Securities and Exchange Commission (SEC) said that General Electric
(GE) had failed to "accurately and fully" disclose to shareholders the details of the retirement benefits of Jack Welsh,
its former CEO. These included use of an $11 million apartment, of company cars, jets, and bodyguards, a consulting
contract and a $9 million pension. GE entered into a settlement, neither admitting nor denying the SEC’s findings. GE
said Mr. Welsh had "delivered extraordinary value to GE investors" during his 40 years with the company. Financial
Times, "GE rebuked over Welch benefits," Sept. 24, 2004.
Example 2 - Related party transactions: U-Haul International did business with a real-estate firm owned by U-Haul’s
president, and that firm owes U-Haul $394 million. Swift Transportation paid $17.3 million and sold trucks to a company
owned by Swift’s president. Mesa Air Group Inc. paid $1.3 million for financial services from a company jointly owned
by Mesa’s CEO and CFO. Officials from U-Haul, Swift and Mesa claim the transactions are beneficial to their firms. A
spokesman for one firm said, "Once (shareholders) have a better understanding of (the) benefits, typically they have
no further questions regarding the relationship and they are supportive." Arizona Republic, "Executives’ related ties
questioned," October 10, 2004.
Example 3 – Excess perks and bonuses: A special investigation commissioned by the Board of Hollinger International Inc.
concluded that Conrad Black, the firm’s CEO and controlling shareholder, and his associates had appropriated more than
$400 million of the firm’s profits over 7 years. This amount constituted 95.2% of the firm’s net income for that period. The
means employed covered the entire gamut of ways of expropriating owners, including excessive fees, asset transfers
to related companies, unrepaid or below- market-interest loans, and the charging of personal expenses to the company.

5
These examples were collected during years when governance problems in the Czech Republic were allegedly ongoing. European readers may be more
familiar with events at firms such as Banco Ambrosiano, Banesto, Metallgesellschaft, Parmalat and Voestalpine, among others.
6
For a survey of the issues surrounding excessive executive compensation, see Bebchuk and Fried (2003).
 J.C. Brada / Journal of Comparative Economics 44 (2016) 1132–1144 1135

When these acts were brought to light, the shares of the firm jumped from $3 to $20 per share. Given Mr. Black’s share
holdings in the firm, his gain from the revelations of his tunneling, and the expectation that it would end, may be even
greater than the amount of money he expropriated from the firm. Financial Times, “Hollinger condemns Black’s greed
and alleges ‘corporate kleptocracy’” and “Abuse, handbags and Bora Bora” September 1, 2004 and Nanette Byrnes,
“Not So Fast, Lord Black.” Business Week, September 27, 2004, pp. 104–105.

These examples show that we cannot always determine whether expropriation has taken place. In many cases there may
be an efficiency explanation for arrangements that appear at first glance to give the appearance of expropriation but do,
in fact, benefit all shareholders. More important, these examples demonstrate that the United States has continued to be
characterized by “good” corporate governance, meaning that investors have continued to provide financing to the corporate
sector on more or less the same terms over time, despite a continuous stream of such “examples” of poor corporate gov-
ernance. That similar behavior on the part of Czech managers is cited as evidence of governance failures may represent a
form of the previously mentioned cultural relativism identified by Depkat and Steger (2015), where a behavior that is ig-
nored or accepted as a minor deviation from the norm in one’s own society is judged as evidence of widespread corruption
or a major disregard of norms when it takes place in another society. The widely heralded stereotype of Asian managers as
practicing “crony capitalism” in the period leading up to and during the Asian financial crisis is perhaps another example of
this tendency.

3. Expropriation - the theories of tunneling and looting

3.1. Tunneling

Tunneling, as it is applied to the Czech situation, means the extraction of value from a firm by its managers or con-
trolling shareholders, who are often, though not always, the same individuals, for their benefit and to the detriment of all
or minority shareholders. The means of extraction can range from the illegal, such as outright theft or misappropriation of
company assets, to the questionable but possibly legal, such as excessively high salaries or generous perks, dealings with
companies owned by the controlling shareholder that favor the latter, or the dilution of minority owners’ holdings, to those
transactions that are perfectly legal even in countries with well-developed legal systems.7
A simple model of tunneling was proposed by Johnson et al. (20 0 0b). The controlling shareholder is assumed to hold
a fraction, α , of the shares, while the minority shareholders have the rest, 1−α . The firm is assumed to earn a profit, I, of
which the controlling shareholder expropriates S, and the rest is reinvested in the firm, earning a return, R. Expropriation
imposes costs on the perpetrator of paying off employees or regulators to avoid the risk of disclosure, of otherwise disguising
the activity or of possible legal sanctions if the illegal expropriation is discovered. These costs are assumed to be given by
S2 /2k, where higher levels of the parameter k indicate weaker social, legal or corporate sanctions against such expropriation.
The controlling shareholder thus chooses S to maximize her utility:

Max U (S ) = (α R(I − S ) + S − S2 /2k ) (1)

Solving Eq. (1) for the optimal level of expropriation, S∗ , yields

S∗ = k (1 − α R ) (2)

The responsiveness of S∗ to the model’s parameters is straightforward. The higher the level of k, meaning the fewer or
less costly the sanctions the controlling shareholder faces, the larger S∗ , the amount that the manger will expropriate. Higher
levels of R, the return on investment, reduce S∗ because the controlling shareholder gains more by sharing in the returns
generated by reinvesting profits. Indeed, if the firm is sufficiently profitable and the manger’s ownership share is sufficiently
high so that α R ≥ 1, then S∗ ≤ 0, meaning that the manager would either not expropriate any of the firm’s earnings or
would wish to invest even more in the firm. Finally, the higher the value of α , the controlling investor’s share, the lower is
the value of S∗ as long as R > 1. This is because expropriation in the face of positive profit opportunities imposes a cost on
all owners, including the majority owner, by reducing the value of the firm.
While the interior solution to Eq. (1) suggests that it is optimal for managers to expropriate the firms’ income on an
ongoing basis, Johnson et al. (20 0 0b) caution against such an interpretation. They explain that expropriation by managers
need not be the norm in emerging-market economies where majority ownership shares are high and earnings expectations
are favorable because expropriation reduces the value of the firm, and, with sufficiently high returns to investment and high
levels of α , it is likely that solving Eq. (1) for the optimal level of tunneling results in a corner solution where α R ≥ 1 and
S∗ ≤ 0. They conclude that:

7
See Johnson et al. (20 0 0a) for examples of such transactions. Bena and Hanousek (2008), Atanasov et al. (2010) and Miller and Lazarov (2011) describe
some transition economy experience.
1136 J.C. Brada / Journal of Comparative Economics 44 (2016) 1132–1144

In our model, there need not be any actual expropriation by managers while times are good, for example when aR ≥ 1.
Typically, in most emerging markets [α ] is above 0.3 (i.e., much higher than is usual in the U.S.), so a reasonably opti-
mistic expectation for R might be enough to remove the incentive for managerial theft.... The median cash flow rights (in
companies where insiders control more than 20% of the votes) are 41% in Argentina, 26% in Korea, 28% in Hong Kong,
34% in Mexico, 20% in Israel, and 31% in Singapore. This suggests that the institutions that protect investors’ rights are not
important as long as growth lasts, because managers do not want to steal. (p. 150)
The intuition behind this argument is straightforward. A firm’s shares prices sell at a multiple of earnings, the price-to-
earnings ratio (P/E), which depends, inter alia, on investors’ expectations of future earnings levels and growth (Malkiel, 1963).
Values of the P/E ratio vary over time, but values between 10 and 20 are not uncommon. If tunneling reduces earnings by
$1, then the value of the shares falls by $1 times the P/E ratio. Assuming a P/E ratio of 20, expropriating $1 of earnings
reduces the share price by $20. If the manager owns 40% of the firm, this results in a loss of $8 for the manager against
the gain of the $1 dollar expropriated from profits, which could make expropriation unattractive. Tunneling thus is most
likely to occur when managers’ shares of the firm are small and when the P/E ratio is low, for example when the firm is in
financial distress or not profitable.
As with the countries mentioned above by Johnson et al. (20 0 0b), ownership shares of managers and banks and their
funds in the Czech Republic were also quite high in the firms privatized through the voucher method. Thus, based on the
parameterization of the tunneling model, expropriation in the Czech Republic may have been a desirable strategy for many
majority owners in the very early 1990s due to low values of R stemming from the “transition recession”, but subsequent
growth combined with high ownership shares for majority investors should have brought such behavior to an end with the
exception of the period of the kuruna crisis, which we discuss below. It is noteworthy that, in the examples of tunneling
during the Asian financial crisis presented by Johnson et al. (20 0 0b), many of the firms were going bankrupt, suggesting that
the rate of return on investment was very low, thus encouraging majority owners to expropriate what assets they could.8

3.2. Looting

Looting represents another way in which owner-managers can appropriate wealth at the expense of minority sharehold-
ers and creditors. According to Ackerlof and Roemer (1993), looting occurs when managers or majority shareholders cause
the firm to borrow money, which they divert to themselves, often through the mechanisms described in the preceding sec-
tion, while the firm, failing to make productive use of these loans, is driven into bankruptcy. Limited liability protects all
shareholders from responsibility for the loans taken out by the firm beyond the value of their investment in the firm. Mi-
nority shareholders and the lender thus both lose, while the majority shareholder is compensated by the portion of the loan
that is expropriated by him, which should be greater than his initial investment in the firm if looting is to pay off.
If looting were commonplace, Ackerlof and Roemer note, then private lenders would cease to make loans to firms pro-
tected by limited liability or they would make contractual or other arrangements to protect themselves against looting.
However, if there are government loan guarantees or if there are government programs to lend to firms, then such looting
becomes feasible. Moreover, Ackerlof and Roemer stress that the firm has no incentives to seek out profitable projects, thus
imposing costs on society as well. They apply their model to explain a number of episodes of looting, including the Savings
and Loan scandal in the United States. In this episode, concentrated owners of savings and loan institutions obtained outside
funds, which they partly appropriated for themselves and partly used to finance risky loans, and their failing banks had to
be rescued by the government deposit insurance program. The same analysis also applies to the more recent global financial
crisis, where financial institutions “too large to fail” forced governments into providing extensive bailouts.
The possibility of looting, in the sense that Ackerlof and Roemer interpret it, in the Czech Republic has been raised by
a number of authors. Cull et al. (2002) and Desai (1996) argue that the investment funds that came to own the bulk of
the shares in companies were themselves owned by banks, that the government remained the dominant shareholder in the
four largest banks, and that it encouraged banks to lend to firms privatized through voucher privatization and, in fact, took
over their bad debts through the Consolidation Bank, an entity created to buy up bad loans from commercial banks. The
latter policy is equivalent, in terms of the Ackerlof-Roemer model, to the government guarantees afforded to savings and
loan institutions in the United States by the system of deposit insurance.
As with the arguments for the existence of tunneling in the Czech Republic, the evidence for looting lends itself to
various interpretations. First of all, it is difficult to differentiate between conscious efforts to drive a firm into bankruptcy
and aggressive risk taking by managers of poorly-performing firms to try to achieve large gains by taking greater risks.9
The moral hazard posed for creditors by such borrowers who have “nothing to lose” is well known. It is quite clear that
a number of the firms privatized in the Czech Republic were, in fact, firms with weak finances and few realistic prospects

8
It is worth pointing out that, in the case of firms that are facing bankruptcy, tunneling has nothing to do with the protection of minority shareholders.
In a bankruptcy, all shareholders lose all of their investment, so asset stripping or tunneling by the majority owner cannot harm minority shareholders.
The loss due to tunneling of assets is borne entirely by the bankrupt firm’s creditors, and thus the Johnson et al. (20 0 0b) model may be more relevant to
demonstrating the need for reforms in bankruptcy law than to showing the need for stronger protection of small shareholders.
9
This strategy is similar to that of sports teams that, when losing towards the end of a contest, will undertake risky strategies such as removing defensive
players in favor of players more likely to score or of adopting strategies that stand the chance of either obtaining a score quickly or resulting in an easy
score for the opposing team.
 J.C. Brada / Journal of Comparative Economics 44 (2016) 1132–1144 1137

for survival. Indeed, this is why such firms often attracted no buyers or core investors in the course of their privatization.
That such firms were able to obtain loans amidst rather chaotic conditions and then slid into bankruptcy may simply be
the outcome of their circumstances and the poor judgment of banks rather than of a conscious strategy on the part of their
owners, even if the latter did engage in some tunneling as bankruptcy loomed. Nor is it possible to dismiss the possibility
that the firms that failed were simply poorly managed. Case studies of the responses of firms to the process of transition
stress the importance of effective management and throw up numerous cases of poor managerial decisions that had severe,
if not fatal, consequences for the firms involved (see, for example, Brada et al., 1995). Certainly, in the Czech Republic,
managers were scarce, and good ones were unlikely to gravitate toward troubled companies.
Looting can only continue so long as do the soft loans that support excessive dividends and other unproductive distri-
butions to owners, but the logic of the looting model is that, at some point, bankruptcy is the inevitable, and even sought
after, outcome. At that point, the creditor suffers a loss. Thus, if significant looting had been occurring in the 1990s, then,
after that, barring the continuing acceleration of soft lending to corporate clients, numerous bankruptcies would have been
the inevitable result, and this would have served as clear evidence of looting.
Finally, it is worth noting that critics of Czech corporate governance point to both tunneling and looting as problems, but
the two phenomena require diametrically opposed ownership structures for their existence. Tunneling, as Eq. (2) shows, is
most pervasive when α , the ownership share of the controlling shareholder, is as low as possible while still providing the
owner-manager with sufficient control over the firm to make tunneling possible. Looting, however, requires highly concen-
trated ownership, meaning high values of α , because a high ownership share is required to make looting both possible and
attractive. It is worth quoting Ackerlof and Roemer (1993) in extenso on this point. Writing about the ownership structure
of banks and savings and loan institutions as it relates to looting, they point out:
“As one would expect, abusive strategies are easier to implement when ownership is concentrated and managers are tightly
controlled by owners. In fact, this is why bank regulators had enforced rules prohibiting concentrated ownership until the
1980s. There were other thrifts with widely dispersed ownership and serious divergences between the interests of managers
(who wanted to keep their jobs and reputations) and owners (who would have made much more money if the managers
had looted their institutions). They missed out on the action we try to document.” (p. 7)

4. Empirical evidence

If looting and tunneling had been pervasive in the Czech economy, then there should be two observable consequences.
The first is a steady growth of lending to firms by the banking sector. In the case of looting, it is these loans that provide
the resources that majority owners are able to expropriate. Similarly, proponents of the tunneling view of Czech corporate
governance argue that is was prolonged and exacerbated by lending to unviable companies by banks who sought to keep
their investment funds from suffering losses due to the poor performance of these firms. The second observable consequence
is that, if such “soft” lending to firms comes to an end, then numerous and large bankruptcies must follow. In this Section,
I show that neither occurred.
The argument that the structure of the Czech banking industry and significant government ownership of the banks for
some time after the start of transition served as the equivalent of a government guarantee of loans to firms and that banks,
therefore, would lend to firms engaged in tunneling and looting is supported neither by the data nor by developments in
the banking industry. Fig. 1 shows lending to the private sector by financial institutions in the Czech Republic, Hungary and
Poland. While bank loans relative to GDP were higher in the Czech Republic than in the other two transition economies at
the start of transition, what is more important is that the ratio of bank loans to GDP in the Czech Republic fell by about
40% of GDP between 1994 and 2003. Moreover, the volume of non-performing loans declined over this period as well. This
represents a massive shift in the financing of private non-financial sector activity, as bank lending to firms decreased over
time.10 Pervasive looting and tunneling, however, would have required ever greater lending to firms by banks as the firms
would need to both roll over old debts and associated interest and to take out new loans for current losses resulting from
tunneling and looting; the quality of loans would also have deteriorated.
The development of the banking system is also inconsistent with the hypothesis that banks engaged in lending to sustain
looting for any length of time. First, while the “big four” state-owned commercial banks dominated the market early in the
transition, the number of banks in the Czech Republic expanded rapidly, and the market share of the big four fell from
over 80% to 50% percent in less than a decade while foreign banks with few or no ties to local firms assumed a growing
share of the market. Moreover, the “big four” were eventually taken over by foreign owners, who would not have been
interested in continuing to fund failing firms. Had the decline in credit to the corporate sector been due to more stringent
bank regulation by the monetary authorities, then there would have been an excess demand for bank loans and massive
bankruptcies among Czech firms suddenly cut off from credit. If the desire to loot had remained the same in the course
of the 1990s while the supply of credit was drying up, a major credit crunch should have emerged in the Czech Republic.

10
In the early years of the transition, the government provided subsidies and guarantees to firms, and this would have served to reduce their indebt-
edness. However, this support amounted at most to about 15% of GDP, so it could not account for all of the 40% of GDP decline in corporate borrowing.
Moreover, much of the funds thus disbursed went to shore up banks, not the non-financial corporate sector.
1138 J.C. Brada / Journal of Comparative Economics 44 (2016) 1132–1144

Fig. 1. Private credit by deposit money banks and other financial institutions to GDP (%).

However, Pruteanu (2004) shows that, for much of the period under review, the Czech credit market was in equilibrium,
interspersed with periods of both minor excess demand and excess supply.
A key piece of evidence against the tunneling and looting hypothesis is the number of bankruptcies among Czech firms,
which should have been disproportionately high relative to other transition economies where corporate governance was
better due to the more limited use of voucher privatization and where bank lending to firms did not decline as steeply as
it did in the Czech Republic. Thus, if significant tunneling and looting had been occurring in the 1990s, then, barring the
continuing acceleration of soft lending to corporate clients, numerous bankruptcies would have been the inevitable result,
and this would have served as clear evidence of looting. After 1996, as the banking system was progressively privatized and
put in the hands of foreign owners, one should have expected to see a decline in soft lending. So, with such lending coming
to an end, a wave of bankruptcies should have emerged with the privatization of the banking system, and this would have
been the clear evidence needed of tunneling and looting and of its magnitude.
Judging whether bankruptcies were higher in the Czech Republic than in countries that did not make use of voucher pri-
vatization is difficult. One difficulty stems from the fact that different countries adopted different reform strategies. Poland,
for example, adopted a strategy of cleaning up firms financially before privatizing them. This involved putting a large num-
ber of financially-troubled non-privatized firms into liquidation early in the transition process. As a result, between 1990
and 1995, over 1300 large state-owned enterprises (SOEs) were liquidated in Poland. In the Czech Republic, by way of con-
trast, there was little if any effort to restructure firms and to put them on a sound financial footing before the voucher
privatization; restructuring was to be the job of the new owners (Kim, 1997). As a result, and in sharp contrast to the Pol-
ish case, between 1991 and 1995, only 62 Czech SOEs and 57 joint stock companies (former SOEs that had been privatized)
were declared bankrupt (Mitchell, 1998). In part, this was due to the fact that, even though the Czech bankruptcy legislation
was enacted in 1991 (Gerlach, 1998), it was not put into practice until 1993 because the authorities feared that, given the
amount of inter-enterprise debt, even a small number of bankruptcies could trigger a cascade of firm failures that would
disrupt the entire economy.11
A second difficulty with cross-country comparisons is that national bankruptcy legislation varied considerably in scope
and intent (Gerlach, 1998; Kim, 1997). For example, Hungary passed a very strict bankruptcy law that was in effect from

11
Even when the legislation was put into effect, the number of bankruptcies was small due to the inexperience of the courts and of creditors with the
law, high creditor costs and other problems described by Mitchell (1998) and Venyš (1997). Kim (1997) provides a compelling rationale for the need to
limit the use of bankruptcy as a tool for firm restructuring in the case of rapid privatization.
 J.C. Brada / Journal of Comparative Economics 44 (2016) 1132–1144 1139

Fig. 2. Number of Declared Bankruptcies in the Czech Republic.

January of 1992 to September of 1993. Under the law, all firms with liabilities that were overdue for more than 90 days were
required to file for bankruptcy. The consequence, as Mitchell (1998) reports, was that in 1992 alone there were about 14,0 0 0
filings for reorganization or liquidation, the two forms that bankruptcy proceedings could take, by Hungarian firms. Even
absent this rather extreme example of the difficulty of cross-country comparisons, there were other important differences
in national bankruptcy legislation that make it difficult to relate the number of bankruptcies to whether or not firms were
obtaining credit or being subsidized so that their owners or managers could continue to pursue tunneling and looting
strategies.
Consequently, I turn to time series evidence. Fig. 2 reports the number of declared bankruptcies in the Czech Republic
over time.12 Under Czech bankruptcy law, there is a distinction between bankruptcy filings and declared bankruptcies, with
the former greater than the latter. This is because courts may decline to accept filings for legal or procedural reasons,
or filings may become moot if the debtor satisfies his obligations to the creditors. The number of declared bankruptcies
increased rapidly after the bankruptcy legislation went into effect and continued to grow during the first decade of the
transition. The number of bankruptcies subsequently declined until the onset of the global financial crisis. In view of the
fact that data bases on Czech firms contain observations on about 10,0 0 0 firms, (Filer and Hanousek, 2002), at first glance
it would appear that the peak number of bankruptcies reported in Fig. 2, about 2500, does reflect exactly the situation of
numerous bankruptcies as credit to firms was tightened that would be required to demonstrate the existence of extensive
looting and tunneling. However, such a conclusion is incorrect. This is because the majority of bankruptcies involve self-
employed entrepreneurs and small firms whose legal form is that of so-called limited liability companies, most of them
startups. Large firms, usually organized as joint stock companies and generally created through the voucher privatization,
form a very small part of the firms tabulated in Fig. 2. Mitchell (1998) reports that, in 1996, of the firms declared bankrupt
in the Czech Republic, 4.5% were SOEs, 4% were agricultural cooperatives, 1% were other cooperatives, 2% were partnerships,
58% were limited liability companies, only 10% were joint stock companies and 20% were individual proprietors. Professor
Moravec in a private communication gives the share of self-employed entrepreneurs in total bankruptcies at 20–25%; firms
with 1–10 employees at 66–73%; firms with 10–49 employees at 5–7%; firms from 50 to 249 employees at 1 to 2%; and
firms with more than 250 employees at 0.5%.
Thus, the examination of the bankruptcy data for the Czech Republic shows that the bulk of bankruptcies occurred in
firms that either had no shareholders or were very small and thus unlikely to have originated from the conversion of SOEs
into joint stock companies through the voucher privatization. Large firms with majority owners, exactly those firms alleged
to have poor corporate governance, to be characterized by extensive looting and tunneling and to be found in the portfolios
of bank-owned investment funds, make up a very small share of total bankruptcies. Thus the evidence shows that, while
credit to the corporate sector was reduced in the first ten years of the transition, this decline in credit did not lead to a
wave of bankruptcies among those firms where problems of corporate governance and expropriation by majority owners
and managers were thought to be pervasive.

5. Measuring the costs of tunneling and looting

How much effort one would want to expend on fighting tunneling and looting should depend on the prevalence of
these phenomena and of the social costs that they impose. Some observers believe that these costs were large indeed. For

12
I am indebted to Professor Tomáš Moravec for a private communication providing this data, which is compiled from official sources. This supplements
bankruptcy data found in his interesting article, Moravec (2013).
1140 J.C. Brada / Journal of Comparative Economics 44 (2016) 1132–1144

example, Coffee (1999) claims that “small dispersed stockowners witnessed widespread looting of Czech investment funds
and the systematic exploitation of minority shareholders in Czech firms….” Glaeser et al. (2001, pp. 855–6) write that, in
the Czech Republic, “…expropriation of investors has been rampant…” while in Poland it has been “…relatively modest.”
Yet these studies provide no estimates of the cost of this poor governance, even as they link it to various macroeconomic
consequences. The critics of voucher privatization do point to the poor performance of the Czech stock market, whether
in terms of companies listed, the regulation of listed firms or offerings of IPOs (Glaeser et al., 2001 and Coffee, 1999). The
former note that Poland adopted laws and regulations “…highly protective of investors, mandated extensive information
disclosure by securities issuers and intermediaries and created an independent and highly motivated regulator” (p. 855) of
financial markets, while the Czech Republic adopted weaker laws and, more important, took a laissez faire approach toward
regulation. The consequences of this failure to regulate the securities market were allegedly twofold. One consequence, noted
by both papers, is that the Czech stock market failed to develop as robustly as did the Polish one. The second effect is the
loss of investor confidence in Czech securities by investors. Specifically, both papers point to the sharp decline in Czech share
values from 1996 through 1998 and the resultant decline in market capitalization as evidence of ” systematic exploitation
of …minority shareholders” (Coffee, 1999). As a result, Coffee argues that after 1995, “…foreign portfolio investors began to
flee the Czech market. Foreign direct and portfolio investment dropped from $103 million in 1995 to $57 million in 1996
and then turned negative in 1997.” Glaeser et al. also point to the slide in Czech share prices during this period (see their
Fig. V).
Both papers are persuasive in documenting the shortcomings in Czech securities regulation, but connecting these to
slower growth of Czech GDP and the kuruna crisis of 1997 is problematic. To begin with, it is difficult to connect falling
share prices on the Prague stock exchange and the outflow of short term capital from the Czech Republic post-1995 to
investor response to poor corporate governance. A much more plausible and generally accepted explanation is that, prior
to 1995, the Czech Republic experienced massive capital inflows into bank deposits, fixed income securities and the stock
market because foreign investors saw a “double play” or “double pay” on such investments. Market interest rates in the
Czech Republic were much higher than those in neighboring Western European countries, and the Czech koruna was seen
as being significantly undervalued. Thus, foreign investors had a virtually riskless opportunity to exploit the higher interest
rates in the Czech Republic as well as to earn additional returns through the appreciation of the koruna. The Czech National
Bank, which sterilized most of these capital inflows, the Czech Government and outside observers were all well aware of the
gathering possibility that this investment bubble would burst, and it did when the Klaus regime failed to enact an effective
stabilization package in 1997.
Knowledgeable observers (Begg, 1998; Drabek, 1999) agree that the 1997 crisis began in the foreign exchange market
in response to obvious macroeconomic stresses and that foreign investors reacted to the risk of devaluation, not to any
sudden awareness of problems in corporate governance. Evidence about investor sentiment comes from the fact that foreign
investors sold both shares in Czech firms and Czech government securities at about the same time and at the same pace,
suggesting macroeconomic and not corporate governance concerns. Fears of devaluation, the Czech koruna crisis of 1997,
and the resulting sharp recession are all that is needed to explain the decline in Czech share prices.
More precise evidence aimed at showing the effects of looting and tunneling comes from a study of firm performance in
the Czech Republic by Cull et al. (2002). They construct a sample of limited liability companies (LLCs), which are assumed to
have a single owner or highly concentrated ownership; joint stock companies (JSCs), larger firms often having their origin
in the voucher privatization and having a larger number of shareholders; and state-owned firms (SOEs). LLCs are further
categorized as having domestic or foreign owners. JSCs are also categorized by ownership type: dominant foreign owner,
dominant fund owner, and no dominant owner identified. Cull et al. propose several hypotheses for their data that they
believe would reveal the presence of tunneling and looting. One is that, because LLCs should have an α higher than do JSCs,
the former should exhibit less tunneling than do JSCs with a dominant owner. Less tunneling, in turn, should be reflected
in better economic performance. The second hypothesis is that foreign-owned firms are subject to more stringent controls
against tunneling in their home countries, thus they will tunnel less in the Czech Republic and perform better than Czech
firms.
The authors use two indicators of performance, return on assets (ROA) and output growth, and employ panel regressions
for 1993–96 that specify each firm’s return on assets or sales growth as a function of firm size (assets) and of dummies for
industry, year and type of ownership. They find that the results support the hypothesis that LLCs did better than did JSCs
based on the difference between the ownership dummies for LLCs and JSCs because the difference in the dummies for the
two types of firms is statistically significant. Thus, tunneling is assumed to be more prevalent among the latter group of
firms, a group that includes a large number of firms privatized through vouchers. However, the authors do not provide a
mean value for the dependent variable, ROA, so while one can judge the statistical significance of the difference between the
two coefficients, there is no way to judge the economic significance, that is, by how much does the greater tunneling among
JSCs reduce their performance vis a vis the LLCs. It is possible to guess at the economic significance of ownership from the
authors’ use of a trimmed sample that eliminates firms whose ROA was less than −50%. Assuming a rough symmetry for
the dependent variable, ROA, we can guess that the range of the dependent variable for the trimmed sample is −50% to +
50%, and for the untrimmed sample it would be greater than that. So while the dependent variable has a range of at least
−0.5 to + 0.5, the difference between the JSC and LLC dummies is on average about −0.05 in both the authors’ Tables 3
and 4. Thus the ownership dummy explains a very small fraction of the −0.5 to + 0.5 range in ROA across the sample of
firms used by the authors. This means that, on average, the typical JSC has a 5% (not 5 percentage points) lower return on
 J.C. Brada / Journal of Comparative Economics 44 (2016) 1132–1144 1141

assets than does the typical LLC. Given the claims that massive looting and tunneling in Czech JSCs existed to the extent
where the functioning of the stock exchange was impaired, foreign investors fled the country, and a currency crisis ensued,
it seems surprising that such massive theft of assets could have reduced returns at looted firms by only 5% relative to their
better-managed counterparts.
Moreover, in thinking about the welfare consequences of public policy, it is useful to consider opportunity costs. Even
if mass privatization led to profits that were marginally lower at firms thus privatized, the alternative would have been to
privatize slowly and leave many firms as SOEs for years. Cull et al.’s results do speak to this point as well. The performance
of SOEs in their sample is markedly worse than that of JSCs. Thus, if we accept the authors’ notion that poor economic
performance is proof of tunneling, then tunneling and economic performance must have been even worse at SOEs than
they were at JSCs, which implies that any form of privatization, even mass privatization, was beneficial for the economy
because the performance, even of firms that are being systematically looted by their new “private” owners, was better than
that of unprivatized SOEs.
In sum, the efforts to link poor corporate governance to bad macroeconomic outcomes ignores other and potentially
more plausible explanations. The study by Cull et al. leads to the conclusion that the effects of tunneling and looting on firm
performance were relatively minor and that creating firms that were subject to tunneling and looting improved economic
welfare compared to a slow privatization that kept SOEs in existence for a longer period of time.

6. Minority shareholder protection: too much of a good thing?

The criticism of the Czech voucher privatization’s lack of regulatory oversight to protect minority shareholders implicitly
assumes that the main and immediate objective of the voucher privatization should have been to create a functioning stock
market that was liquid, that had a large trading volume and that was major source of new funds for existing firms as well as
for startups. The protection of minority shareholders against expropriation would be important if this objective were to be
achieved, since it is they who would provide new funds for firms by participating in IPOs and supplemental share offerings
(Anastasov et al. 2010).
That such stock market development would be of great economic value early in the transition process is doubtful. In the
early transition, small investors lacked faith in, or information about, newly-privatized firms and nascent entrepreneurs and
start-up firms, and so they did not have much interest in investing their money in IPOs or supplemental share offerings of
existing firms, and it is only in these two ways that new funds could be injected into the corporate sector through the stock
market. The available evidence (Kim and Park, forthcoming) suggests that the stock market was neither an important nor
an effective source of funding for restructuring in the early transition. Consequently, a much more pressing goal than the
creation of a robust stock market for the early transition was to facilitate firm restructuring, meaning turning former state-
owned firms into business units that would be profitable in a market economy that was open to international competition
and liquidating those firms or business activities that could not be made profitable. Unfortunately, the literature on restruc-
turing in transition economies tends to rest on a very narrow conception of the process of restructuring firms by focusing on
these firms’ obvious shortcomings in the quality and modernity of their products, their lack of world-class technology, and
their bloated workforces. Thus, restructuring of firms in transition economies is often equated with updating their products
and improving their quality, acquiring modern, often foreign, technology, and eliminating redundant workers. In fact, these
are rather narrow measures for improving firm performance and, rather than calling them restructuring, it may be more
appropriate to recognize that these are activities that occur on an almost daily basis in a modern corporation.
The foregoing view of restructuring misses much of the restructuring that is done by controlling shareholders in market
economies and of the restructuring that was also desperately needed in transition economies. In market economies, corpo-
rate takeovers and restructurings are rarely only, or at all, about improving a firm’s products and technologies or cutting
labor costs. Rather, the objective of restructurings is to change the boundaries of the firm, meaning to alter the range of
activities that the firm undertakes, or to restructure the firm’s mix of assets and liabilities. Changing what the firm does
may involve eliminating certain product lines or whole divisions of the firm that are either unprofitable or that have poor
growth prospects, outsourcing the production of some inputs that the firm had previously produced for itself and acquiring
the ability to self-produce other inputs that are not readily available from outside suppliers. Financial restructuring involves,
among other things, changes in the firm’s mix of physical and financial assets, of equity and debt, of the maturity of its
debt and in the ability to manage cash flows so as to meet obligations to lenders and to suppliers while financing needed
investment projects.
Newly privatized transition-economy firms, whose initial size, high levels of vertical integration, broad range of business
activities and product mix and debt obligations reflected the inherited objectives and dictates of the former economic system
rather than the needs of firms meant to operate in small open market economies, were in particular need of restructuring
that eliminated unviable assets and activities and that enabled management to align their firm’s financial obligations with a
new reality. Above all, managers and majority or “strategic” investors, as they were called in the Czech Republic, were under
pressure ensure the survival of, and, ultimately, to maximize the value of, the firms under their control.
What is often overlooked in such restructurings is that it is majority shareholders or managers with important equity
stakes in the firm who take the lead in such major changes in the firm’s business and financial profile because they have
greater incentives and ability to monitor managers or to apply their better business knowledge to leading the restructuring
process (Maug, 2006). If their efforts are successful, then minority shareholders free-ride on the majority owner’s better
1142 J.C. Brada / Journal of Comparative Economics 44 (2016) 1132–1144

market information and successful restructuring efforts because they, too, benefit from the better performance and higher
returns that a successful restructuring brings without expending any effort of their own. The potentially negative welfare
implications of excessively strong shareholder rights for minority shareholders has been demonstrated by Grossman and
Hart (1980) and are well summed up by Maug (2006) who writes that “…there is a trade-off between efficiency and fairness
in minority freezeouts and that the focus on fairness (minority shareholder rights) may be misplaced.”
How much effort a controlling shareholder would expend on leading a restructuring depends positively, ceteris paribus,
on the size of her holdings of the firm’s shares and on her ability to exclude minority shareholders from all or some of their
share of the gains produced by the restructuring. To be clear, the amount of effort majority owners will expend on restruc-
turing depends in part on their ability to deprive minority owners of their rights. This fact represents a critical dilemma for
policy makers. Strong protection for minority shareholders does improve their willingness to supply funds to corporations
through the stock market, but the tradeoff is that such protection weakens majority owners’ incentives to undertake needed
restructurings.
If restructuring is seen as a more important short-term objective than is the development of the stock market then,
as has long been recognized in the legal literature, (see, e.g., Israels, 1952), strong protection of minority shareholders can
become an obstacle to restructuring. Small shareholders can obstruct restructuring, especially when corporate law requires,
as it did in many Czech companies, super-majorities for decisions on liquidation of parts of the firm, the sale of assets,
spin-offs, etc. Strong protection against squeeze outs, in which minority shareholders are forced to sell their shares to the
majority owner at a mandated price, means that small shareholders can make it more expensive for the firm to undertake
restructuring because they have to be paid more for their shares. The effectiveness of such protection in raising the price
that small shareholders receive for their shares is demonstrated by Atanasov et al. (2010), who document the gains to
minority shareholders in Bulgaria after that country tightened rules protecting their interests in squeeze outs.
Given the extensive need for restructuring in transition economies, it is not surprising that they faced greater governance
problems from such majority-minority owner conflicts than they did from the traditional principal-agent problems stressed
by the agency approach to corporate governance (Young et al. 2008). As Maug (2006) notes, many strategies for reducing the
returns to minority shareholders or eliminating them entirely exist in all economies. For example, the majority shareholder
can sell the firm’s more valuable assets to an affiliate, or she can dilute the minority shareholders’ stake in the company
by issuing new shares at low prices to herself but excluding minority shareholders from the offering. Another alternative is
the “squeeze out” where the minority shareholders are forced to sell their shares, possibly at a price below their true value.
Majority shareholders can employ a number of strategies to implement a squeeze out, and most of them are designed to
reduce the minority shareholders’ returns from the shares they own. Tunneling, employing all the techniques previously
discussed such as excessive salaries for manager-owners, asset sales, dealings with manager-owned firms, etc., are all ways
in which minority shareholders can be induced to sell their shares to the majority owner.13
Box 2 describes another strategy for restructuring, one that involves spinning off parts of the firm that are unlikely to
have good profits and growth in the future into independent corporations, which are often also forced to take on a dis-
proportionate part of the parent company liabilities. Shares in the spin-off may be disproportionately allocated to minority
shareholders of the parent firm, and, even if they are shared equally among all shareholders of the parent firm, those
mangers leading the restructuring will be additionally rewarded because the performance of the parent firm, now unbur-
dened by unproductive assets and high debt, will improve, leading to increased pay.

Box 2. Are spinoffs desirable restructurings or abuse by majority shareholders?

In a spinoff, the parent company turns a division into an independent company, providing it with assets and liabilities as
it wishes. Since a spinoff does not require a sale to an outside buyer, it is an attractive tool for getting rid of unwanted
parts of the firm. It also is a way in which management can improve the financial performance of the parent firm and
divest themselves of undesirable liabilities. It can also leave the shareholders of the spinoff with worthless assets.
Example 1: General Motors and Ford spun off their parts-making divisions into independent firms, but required them to
provide parts to the former parent at low prices and also passed on to the new firms debts that had been the obligations
of the parent firm. Both spinoffs went bankrupt, but the performance of the parent firms improved in the long run.
Example 2: Kerr-McGee spun off its titanium-oxide pigment business into an independent firm. The new firm was given
all of Kerr-McGee’s environmental liabilities and had to borrow $200 million in order to pay a one-time dividend to the
parent firm. The new company promptly went bankrupt.
(Steven M. Davidoff. “In Spinoffs, a Chance to Jettison Undesirable Liabilities” New York Times, March 13, 2013, page
B9.)
Example 3: The media company Time Warner spun off the magazine portion of its business. The spinoff, called Time
Inc., received the parent firm’s many magazines, whose growth and profits had dropped in recent years, as well as $1.3
billion in debt, nearly half of which was used to pay a special dividend to Time Warner shareholders. This followed
divestitures of Time Warner’s cable and Internet businesses. These spinoffs have enabled Time Warner to concentrate

13
The critics’ claim that majority owners in the Czech Republic chose tunneling over the restructuring of firms misses the point that restructuring and
tunneling could be complementary elements of a strategy to improve firm performance.
 J.C. Brada / Journal of Comparative Economics 44 (2016) 1132–1144 1143

on the more profitable and faster-growing parts of its business such as entertainment and digital programing. Its stock
price increased from $14 to $83 per share while the spinoffs have languished (David Carr and Ravi Somaiya, “Time Inc.
to Set Lonely Course After a Spinoff”, New York Times, June 9, 2014, Page A1 and Jonathan Mahler and Emily Steel,
“Time Warner Chief’s Turnaround Effort Opened the Door to Fox’s Bid”, New York Times, July 17, 2014, Page B9.

The message of this section is that there is a fundamental conflict been the willingness and ability of strategic investors
to restructure firms and the rights of minority shareholders. Both are necessary for the existence of a viable corporate sector
that is both competitive and efficient and able to attract needed funds from small investors. However, the weight attached
to these two objectives clearly varies with the circumstances in which an economy finds itself. If there is a greater need
for restructuring, it may make sense to have less restrictive protections for small investors. Thus the Czech Republic’s less
stringent protections for minority shareholders than are found in developed market economies can be seen as potentially
appropriate and efficiency improving.

7. Conclusions

In this paper, I have sought to point out some ambiguities and contradictions in the models and the evidence that has
been used to support claims of tunneling and looting in Czech firms and to link them to macroeconomic problems and
to lagging capital market development. A critical examination of the theoretical models of looting and tunneling suggests
that these models do not demonstrate the inevitability of looting and tunneling among firms with dominant shareholders
to the extent that has been averred in the literature. Moreover, although looting and tunneling are often presented as twin
phenomena in the Czech Republic, I show that each requires a rather different ownership structure for its existence.
The empirical evidence for corporate governance failures is also questionable. First, I have stressed the proposition that all
systems exhibit failures in corporate governance, and instances found in the Czech Republic may be no different from those
that can be found in advanced countries with exemplary shareholder protections. Moreover, what appear to be corporate
governance failures are sometimes, or even often, examples of behavior that actually benefits shareholders rather than harms
them. I have also argued that the evidence for looting and tunneling is problematic, and that the logical outcome of these
two phenomena would have to be either continued massive bank lending to support an ever greater number of loss-making
firms or a large wave of bankruptcies if such lending were to stop; neither of these occurred in the Czech Republic.
Czech voucher privatization did not in fact create massive failures in corporate governance, and, as a result, the success
or failure of the voucher privatization should be judged by other criteria, including the resulting distribution of wealth, the
rapid restructuring of firms, and an ownership structure that appears to have made the Czech Republic open to a large
amount of foreign direct investment. Moreover, in the tradeoff between small shareholder protection and incentives for
majority shareholders to undertake the restructuring of firms, erring on the side of majority shareholders, at least in com-
parison with developed market economies, may have been the right choice.

Acknowledgment

I am grateful to the editors of this symposium, Byung-Yeon Kim and Ali Kutan, and to two anonymous referees whose
comments significantly improved the paper. I also benefited from comments by Jasminka Sohinger, Vladimír Tomšík and Paul
Wachtel and participants in seminars at the Prague University of Economics, the University of Saints Cyril and Methodius
and Warsaw University. I also thank Professor Tomáš Moravec for sharing his data on Czech bankruptcies with me.

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