Transition to a  Market Economy

The Three Knots

on Voucher Privatization

by Michal Mejstrik, Oldrich Kyn, Zdenek Blaha, Jan Mladek

Respekt, February 1992

  • Thousands of competing projects have caused a dramatic change in the conception.

  • When does the first wave actually end?

  • The primary task is the protection of the small investor.         

These days the critics of voucher privatization are often occupied with marginal details and the most important problems escape their attention. We want, therefore, to concentrate our attention to three crucial points, which will be decisive for the whole experiment but in our opinion, have not been satisfactorily addressed yet. These are the procedures for evaluation and approval of enterprises’ privatization projects (the so called 'supply side'); the exact sequence of steps for equilibrating supply and demand; and finally the legal regulations of Investment Privatization Funds (IPFs).

We all perhaps feel now that the most difficult problem in all three areas mentioned is the unsatisfactory elaboration of strategy and the inadequate determination of rules of conduct. In addition, the government has a tendency to react to unforeseen problems by changing the rules during the course of the game. The firm and clear rules are the elementary precondition for the smooth process of voucher privatization. The degrees of uncertainty and risk are in our situation gigantic, and we must take all possible steps to minimalize them. More than a half of the adult population has already registered for participation in voucher privatization. It would be a shame to disappoint them because of inconsistencies and gaps in the overall project.

Thousands of Competing Projects


On the supply side, a change in the character of the large scale privatization has occurred almost without a notice. It was assumed originally that a very quick mass distribution of state property through the voucher method would take place. Also it was expected that most of the task of restructuring of enterprises and the elaboration of strategies for their effective development would take place only after the change in ownership. Therefore, it was expected that most of the privatization projects would be simple (preferably 97% of property to vouchers) and that it would be easy to evaluate them quickly. It was not expected that direct sales to domestic entrepreneurs would play any important role in these projects. This was a completely different conception than that,  for example, of the German Treuhandanstalt, which on the contrary devotes great effort to time to restructuring of enterprises before their sale to mostly domestic private hands.

During the process of evaluation, however, the Privatization Ministries began to rise their requirements for the quality of privatization projects and also started to insist on sufficient room for competing projects. After the initial delay of the beginning of the first round of voucher privatization, a dramatic change took place. Thousands of competing projects, whose thorough evaluation requires an immeasurable amount of work, were submitted.  That gave rise to time pressure and subsequently to such a high degree of centralization of decision making, that Czechoslovakia has not experienced for some time. The supply side process thus moved closer to the method of Treuhandanstalt than to our original conception of voucher privatization. The whole process was significantly slowed down. All we can do now is to complete the evaluation of submitted projects. It would be advisable, however, to look for ways of speeding the evaluation process up and making it more rational.  In any case, it should give us the following lesson for the second wave of privatization: hold to an originally agreed upon strategy and do not change the rules during the game.

The End of the First Wave: 
Necessity of Splitting the Shares


A second important set of problems is caused by unclear rules for the attainment of equilibrium between supply and demand during the first wave of voucher privatization. A full knowledge of this algorithm is very important for investors' choice of a successful strategy.

In the first place, it should be known how the prices would be changed at the end of a round in the case that excess demand was not fully eliminated. In the Government Regulation No. 353/91 the rules for adjustments of voucher prices of shares are described only very broadly. These rules are described in more detail only in several unofficial publications written by workers of the Federal Ministry of Finance. It is not clear whether these publications are binding or not, and in addition to that they are certainly not known to all participants in voucher privatization.

Furthermore, the criteria for the termination of the first wave have not been decided and publicized as yet. For citizens and IPFs  to  select a rational investment strategy, they must know after how many rounds the iteration will end, or on the basis of what criterion it will be terminated. One such a criterion could be for example: " when more than 90% of citizens and IPFs have used their voucher points the first wave will be terminated". The remaining 10% would be unlucky and lose all or a part of the sum they paid for their vouchers. Another criterion could be to establish a percentage of sold shares, e.g.. "after the sale of 90% of shares allocated to voucher privatization, the first wave ends". The trouble. is that with these criteria, there is no assurance that even six rounds will be enough. Even worse, however, is that uncertainty about the number of rounds would almost surely lead to a large degree of risk for investors in the later rounds of the process. Therefore, we recommend that the process be ended after a firmly set number of rounds (the best would probably be four or five), In the last round then it would be possible to set final prices so that the demand for the shares of each enterprise and their supply would be exactly balanced. This would, of course, require splitting of shares, which was not taken into account earlier. According to the new Civil Code, however, this is already permitted, and would require only a modification of Government Regulation number 353/91.

A further problem is the exclusion of enterprises for which there is either minimal or excessive demand. According to the current rules the enterprise is excluded when the price of its share exceeds 1,000 investment points. This is because holders of investment vouchers do not have more than 1000 points and would be unable to acquire such shares. It appears that mostly the worst enterprises are going to voucher privatization, and only few good, very attractive ones will be involved. It is possible to easily avoid the exclusion of enterprises due to excessive or insufficient demand. The solution is again in the splitting of shares mentioned above. Splitting would allow to have a rate of 1 for 2,000 or 1 for 3,000 and that would give individual owners a chance to own a part of the attractive shares. And there is nothing troublesome about the shares of some less attractive enterprises ending up in hands bolder investors.

Among the special problems is also the exclusive preliminary round, in which citizens may allocate their vouchers to IPFs. We often hear the concern that too many citizens rely on the IPFs, either because of insufficient information about the firms or because of the lack of confidence in their own abilities to invest. It would be better therefore, to extend the possibilities for allocation of investment points to funds into further rounds of privatization, except of the final round. In this way, citizens would not have to decide on IPFs immediately in the preliminary round. They would be able to postpone that decision after they tried and found their own investment strategies not successful enough.

Do not Play Without Rules


The final set of problems, which we would like to address, is the legal regulation of the activities of IPFs. The absence of the law on investment companies and on securities trading creates at least two serious problems. The first is the protection of the small investor against the abuse of power by the strong investment funds' administrators. If no legal protection is empowered, there will remain ample opportunities for various types of crooks. Most often, the victim of fraud and machinations is the small investor. Protection of the small investor therefore is a primary task, which is respected by most developed nations.

The second important problem is that the fund administrators and advisers will not be able to choose an optimal investment strategy as long as they do not know what rules will be set during the course of the privatization process or after its termination. It would therefore help to lower significantly the uncertainty resulting from the erratic mood of government officials, by quickly approving the law on IPFs. If this does not happen, it is at least needed to issue as quickly as possible relevant Government Regulations.

The rules, which these legal norms should contain, are all quite clear from the experience elsewhere in the world. It is sufficient to read about investment funds' regulation, for example, in the U.S., Canada, and Western Europe.  Perhaps the most important lesson comes from the acknowledged fact that the best protection of the small investor is the increasing competition between funds. This requires, above all, creating in this industry the largest possible freedom of entry and exit. The small investor would thus have a true freedom of choice between various funds and their advisers.

Elementary conditions for emergence of competition have already been created in the CSFR. We have here today more investment funds per capita than in the USA. After the completion of the privatization wave, this situation will be very useful. The prevention of sale of shares would certainly not encourage competition in the sector of IPFs, and would in fact commit investors to the funds, which they joined originally, perhaps as a result of poor and inadequate information. On the contrary, it is necessary to ensure that secondary financial markets begin to operate as soon as possible, and that the current voucher funds begin to operate with real monetary capital as soon as possible after the end of the first wave. In accordance with the prevailing world tendency, most funds should be open and diversified (i.e. mutual funds or funds which by law must on request buy back shares from shareholders and which cannot invest more than a set percentage of capital into one sector, as defined by law). In the USA today more than 90% of property is held in such funds. We must create such rules that allow even the small investor to shift his property from one fund to another easily, quickly, and without great expenditure. That is the best defense against dishonest administrators who would like to steal property from small investors. The requirement of diversification further protects the small investor from random fluctuations on the securities markets.

On the other hand, privatization is also expected to generate a strong pressure from owners on the management of newly privatized firms. This function can be hardly performed by open and diversified funds. Part of the argument against voucher privatization is the danger of fragmentation of ownership resulting in the passive role of small and institutional investors. It seems, that at least some IPFs or their coalitions are well aware of this problem. The requirement that all funds diversify their portfolios would, of course, significantly reduce their ability to play this role. Therefore it would be expedient if some of the current IPFs remained (according to own choice) closed and undiversified.

In accordance with the world experience it is possible to recommend a list of further rules for the protection of the small investor. The first of these is a law preventing conflicts of interest for state and bank officers, consulting institutions, and IPFs. Of equal importance is approval of a law on “disclosure,” that is on publication of all important information about the funds, including the following:

1) Information about the personnel of the funds and their administrators: their employment and activity in the past 15 years; their earnings; what they actually did. Of course, this is not to examine political views and actions, but to provide the information from which the public can infer professional trustworthiness of the person that will be in charge of large sums belonging to ordinary people.

2) Financial balance sheets of  fund administrators, their direct and indirect financial reserves, and especially the amounts of capital invested in the fund.

3) It is also necessary to inform the shareholders about the internal organization of the fund; its goals and fees for financial services. This should give to ordinary shareholders some basis for assessing trustworthiness of the fund in which they invest their vouchers.

A further instrument for the protection of the small investor is the condition that funds may avoid double taxation only when they divide at least 90% of profits among shareholders. Open, diversified funds must -- at least in the USA calculate daily the internal value of their shares as a fraction of the value of the portfolio per one share. In order to ensure that the founders and administrators of the funds cannot govern and operate the fund in a manner inconsistent with the interests of the shareholders, every share of the fund must be endowed with voting rights. Contracts of funds with their managers must be revocable at any time and must be renewed every year by approval of a majority of shareholders.

At this moment it has not yet been officially decided in what form shares will be distributed after voucher privatization ends. Will it be in material form (i.e. on paper) or only as a list on a computer. More importantly it has not been resolved when or how it will be possible to trade the shares. Will it be through a stock market, through banks or through a computer system created for voucher privatization? The citizens should be able to decide in what form they want to receive their shares and to whom they wish to entrust them.

Zdenek Blaha, Oldrich Kyn, Michal Mejstrik, Jan Mladek.


Prague, January 31, 1992.





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