Who tolls the bells for firms? Tales from transition economies

Columbia Journal of Transnational Law

Volumn 46, Issue 3, 2008, Pages 612-647

  Pistor, Katharina ^a  

^a The Earth Institute at Columbia University

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EID: 52149088106     PISSN: 00101931     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Review

References (126)

1. See Armen A. Alchian & Harold Demsetz, Production, Information Costs, and Economic Organization, 62 AM. ECON. REV. 777-95 (1972);
2. R. H. Coase, The Nature of the Firm, 4 ECONOMICA 386-405 (1937);
3. Sanford J. Grossman & Oliver D. Hart, The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration, 94 J. POL. ECON. 691-719(1986).
4. See MAXIM BOYCKO, ANDREI SHLEIFER & ROBERT VISHNY, PRIVATIZING RUSSIA 11-13 (1995) (arguing that the de-politicization of assets was the single most critical purpose of the mass privatization program the authors designed for Russia).
5. See, e.g., Cheryl W. Gray & Kathryn Hendley, Developing Commercial Law in Transition Economies: Examples from Hungary and Russia, in THE RULE OF LAW AND ECONOMIC REFORM IN RUSSIA 139-64 (Jeffrey D. Sachs & Katharina Pistor eds., 1997) (arguing that a major function of legal technical assistance in the former socialist countries was to install good laws and subsequently to improve the enforcement of such laws).
6. WORLD BANK, WORLD DEVELOPMENT REPORT 2002: BUILDING INSTITUTIONS FOR MARKETS 101-15, 151 (2002). This report focusing on institutions for a market economy follows only six years after the World Development Report that documented the transition from plan to markets. See WORLD BANK, WORLD DEVELOPMENT REPORT 1996: FROM PLAN TO MARKET 87-97 (1996) (on the legal infrastructure of transition).
7. Interviews with state agents in charge of managing these state assets suggest that they were too under-staffed to attend board meetings regularly and had no clear policy guidance as to how to use state assets. See Katharina Pistor & Joel Turkewitz, Coping with Hydra-State Ownership after Privatization, in CORPORATE GOVERNANCE IN CENTRAL EUROPE AND RUSSIA 192, 194-209 (Roman Frydman, Cheryl W. Gray & Andrzej Rapaczynski eds., 1996) (documenting the extent of remaining state ownership in countries that sought to privatize rapidly and providing evidence on the management of state ownership from interviews).
8. See id. at 209.
9. Steven Fries, Damien Neven & Paul Seabright, Bank Performance in Transition Economies (William Davidson Inst., Working Paper No. 505,2002) (documenting the extent of foreign ownership of domestic banks in many transition economies).
10. Leora F. Klapper, Virginia Sarria-Allende & Victor Sulla, Small- and Medium-Size Enterprise Financing in Eastern Europe 24 (World Bank, Policy Research Working Paper No. 2933, 2002); Mark E. Schaffer, Do Firms in Transition Have Soft Budget Constraints? A Reconsideration of Concepts and Evidence, 26 J. COMP. ECON. 80, 84 (1998).
11. János Kornai, a Hungarian economist who taught for many years at Harvard University, first coined the term "soft budget constraint" as referring to government bailouts of firms, which he attributed to the desire of paternalistic governments to avoid social and political costs of firm closure. See, e.g., JÁNOS KORNAI, THE SOCIALIST SYSTEM: THE POLITICAL ECONOMY OF COMMUNISM 489 (1992). Today the term is more widely applied to refer to dynamic commitment problems in the face of irreversible investments. See Mathias Dewatripont & Gérard Roland, Soft Budget Constraints, Transition, and Financial Systems, 156 J. I NSTITUTIONAL & THEORETICAL ECON. 245 (2000); Schaffer, supra note 8.
12. For an analysis of soft budget-constraint in relation to financial market development during the transition period, see Erik Berglöf & Gérard Roland, Soft Budget Constraints and Credit Crunches in Financial Transition, 41 EUR. ECON. REV. 807 (1997). For an overview of how this concept has been applied in the broader economies literature, see Eric S. Maskin, The Soft Budget Constraint: Recent Theoretical Work on the Soft Budget Constraint, 89 AM. ECON. REV. 421 (1999).
13. See Schaffer, supra note 8.
14. Ariane Lambert-Mogiliansky, Konstantin Sonin & Ekaterina Zhuravskaya, Capture of Bankruptcy 5-7 (June 18, 2003) (unpublished manuscript), available at http://ideas.repec.org/p/cfr/cefiiw/w0038.html.
15. Shareholders also exercise liquidation rights, but they need to act collectively since corporate law provisions typically require a majority or even supermajority for liquidating a firm by shareholder vote. By contrast, a creditor can enforce liquidation rights unilaterally, provided that a debtor is "insolvent."
16. This insight was acknowledged by some of the protagonists of the first law and development movement that used legal transplants in an ultimately unsuccessful attempt to improve socioeconomic development in developing countries. For a self-critical assessment of this movement, see David M. Trubek & Marc Galanter, Scholars in Self-Estrangement: Some Reflections on the Crisis in Law and Development Studies in the United States, 1974 WIS. L. REV 1062 (1974). But see Brian Z. Tamanaha, The Lessons of Law-and-Development Studies, 89 AM. J. INT'L L. 470 (1995) (arguing that these conclusions were drawn before the results of such policy interventions could be fully assessed). See also Daniel Berkowitz, Katharina Pistor & Jean-Francois Richard, The Transplant Effect, 51 AM. J. COMP. L. 163 (2003) (explaining the failure of legal transplants as caused by the lack of demand in the recipient countries).
17. Stijn Claessens & Leora F. Klapper, Bankruptcy around the World: Explanations of Its Relative Use, 7 AM. L. ECON. REV. 253 (2005).
18. See Ross Levine, The Legal Environment, Banks, and Long-Run Economic Growth, 30 J. MONEY, CREDIT & BANKING 596 (1998). The basic analytical framework for this research was developed in Rafael La Porta, Florencio Lopez-de-Silanes & Andrei Shleifer, Law and Finance, 106 J. POL. ECON. 1113 (1998) (arguing that legal institutions greatly influence the development of credit and stock markets). For a more detailed account of law as a determinant of credit markets, see also Pistor et al., using a similar framework to investigate the role of law as a determinant of credit market development in transition economies in the 1990s. Katharina Pistor, Martin Raiser & Stanislaw Gelfer, Law and Finance in Transition Economies, 8 ECON. TRANSITION 325 (2000). Their results suggest that specific legal intervention is less relevant for market development than a country's overall performance on rule-of-law indicators.
19. See Douglas G. Baird, The Initiation Problem in Bankruptcy, 11 INT'L REV. L. & ECON. 223 (1991);
20. Elazar Berkovitch & Ronen Israel, Optimal Bankruptcy Laws Across Different Economic Systems, 12 REV. FIN. STUD. 347 (1999);
21. Paul Povel, Optimal "Soft" Or "Tough " Bankruptcy Procedures, 15 J. L. ECON. & ORG. 659 (1999).
22. See Mihir A. Desai, Alexander Dyck & Luigi Zingales, Theft and Taxes, 84 J. FIN. ECON. 591 (2007).
23. Id. at 592.
24. Id.
25. See Baird, supra note 17, at 226.
26. Id. at 229.
27. See Povel, supra note 17, at 673.
28. Douglas G. Baird & Edward R. Monison, Serial Entrepreneurs and Small Business Bankruptcies, 105 COLUM. L. REV. 2310, 2340 (2005).
29. See Beikovitch & Israel, supra note 17, at 353.
30. Id.
31. Id. at 364.
32. Id.
33. Derek Bailey, Accounting in Transition in the Transitional Economy, 4 EUR. ACCT. REV. 595, 609 (1995) (suggesting that sound accounting practices were largely absent in the early days of transition). See also Katharina Pistor & Chenggang Xu, Governing Stock Markets in Transition Economies: Lessons from China, 7 AM. L. & ECON. REV. 184, 195 (2005) (arguing that in environments where such agents are lacking, the information asymmetries tend to be even more severe).
34. Roman Frydman, Katharina Pistor & Andrzej Rapaczynski, Investing in Insider-Dominated Firms: A Study of Russian Voucher Privatization Funds, in CORPORATE GOVERNANCE IN CENTRAL EUROPE AND RUSSIA 187, 188-89 (Roman Frydman, Cheryl W. Gray & Andrzej Rapaczynski eds., 1996) (analyzing the role of financial intermediaries in the context of mass privatization in Russia and pointing out the severe information asymmetries they face).
35. See Katharina Pistor, Patterns of Legal Change: Shareholder and Creditor Rights in Transition Economies, 1 EUR. BUS. ORG. L. REV. 59 (2000) (coding creditor rights protection in bankruptcy codes and civil codes (for collaterals) in 24 transition economies and finding a strong bias in favor of creditor rights consistent with the legacy of these countries as mostly German civil law countries).
36. See supra note 9, for the literature on soft budget constraints.
37. See supra note 17.
38. For a comparative overview of creditor versus debtor friendly bankruptcy regimes, see Stijn Claessens & Leora Klapper, Bankruptcy Around the World: Explanations of its Relative Use 4-6 (World Bank Policy Research, Working Paper No. 2865, July 2002), available at http://econ.worldbank. org/external/default/main?pagePK=64165259&theSitePK=469382&piPK= 64165421&menuPK=64166093&entityID=000094946_02080204172482. See also Simeon Djankov & Andrei Shleifer, Private Credit in 129 Countries, 84 J. FIN. ECON. 299, 307-12 (2007).
39. See Baird, supra note 17, at 227-28 (discussing the ability of a manager to file for Chapter 11 reorganization). For a broader comparative perspective, see Ciaessens & Klapper, supra note 34, at 7-8.
40. In fact, neither Hungarian nor Russian officially published sources break down the data in the way I present them here. However, I was able to obtain these data directly from the Russian Supreme Arbitrazh Court and Hungarian Ministry of Justice.
41. CREDITREFORM ECON. RESEARCH UNIT, INSOLVENCY IN EUROPE (2004/05) 4, Table 2.
42. Id. at 19, Table 15 (surveying bankruptcy in selected Western European countries).
43. For 2003 data, see the Russian Tax Service, http://www.nalog.ru/document. pbp?id =8586&topic=reg_ur_lic. The data list companies that are in the state of liquidation as well as those slated for reorganization.
44. Id.
45. Act XLIX of 1991 on Bankruptcy Proceedings § 9 (Hung.) (ISI Emerging Markets, Hatályos Magyar Jogszabályok database), available at www.securities.com [hereinafter Hungarian Bankruptcy Code].
46. Id. § 10(3)(e).
47. Id. § 14.
48. Federal Law on Insolvency, Oct. 26, 2002, No.127-FZ, art. 59 (Russ.) (ISI Emerging Markets, Garant database), available at www.securities.com [hereinafter 2002 Federal Law on Insolvency].
49. See U.S. COURTS: 2006 JUDICIAL FACTS & FIGURES, Table 7.2, available at http://www.uscourts.gov/ judicialfactsfigures/2006/Table702.pdf (last visited, April 9, 2008) (stating that of 1,618,987 bankruptcies filed in 2004, including business and non-business bankruptcies, only 602 were involuntary filings). See also Edward Morrison, Bankruptcy Decisionmaking: An Empirical Study (Columbia Law Sch. Ctr. for Law & Econ. Studies, Working Paper No. 239, 2003), available at http://ssrn.com/abstract=880101 (noting that the majority of these involuntary filings quickly end up in Chapter 7, i.e. in liquidation).
50. Orge Martinez-Vazquez & Robert M. McNab, The Tax Reform Experiment in Transitional Countries, 53 NAT'L TAX J. 273, 278 (2000).
51. John P. Bonin & Mark E. Schaffer, Revisiting Hungary's Bankruptcy Episode, in DESIGNING FINANCIAL SYSTEMS IN TRANSITION ECONOMIES: STRATEGIES FOR REFORM IN CENTRAL AND EASTERN EUROPE 59, 69 (Anna Meyendorff & Anjan Thakor eds., 2002).
52. See infra pp. 16-18, for detailed analysis of Hungarian data.
53. See, e.g., Schaffer, supra note 8, at 88-92.
54. For a sobering account on the financial distress experienced by firms during transition, see OLIVIER BLANCHARD, THE ECONOMICS OF POST-COMMUNIST TRANSITION 1-21 (1997). See also Nadezhda Ivanova & Charles Wyplosz, Arrears: The Tide That is Drowning Russia, 8 RUSS. ECON. TRENDS 24 (1999).
55. Philippe Aghion, Oliver Hart & John Moore, The Economics of Bankruptcy Reform, 8 J.L. ECON. & ORG. 523, 543 (1992).
56. See Ivanova & Wyplosz, supra note 50, at 24.
57. Decree of the President of the Russian Federation on Measures to Enforce Legislative Acts on Insolvency (Bankruptcy) of Enterprises, Dec. 22, 1993, No. 2264 (Russ.) (ISI Emerging Markets, Garant Database), available at www.securities.com.
58. Id. art. 2.
59. See Schaffer, supra note 8, at 98.
60. See Ivanova & Wyplosz, supra note 50, at 26.
61. See Schaffer, supra note 8, at 97.
62. Id.
63. Id. at 98.
64. Id.
65. Levine, supra note 16, at 603.
66. Simeon Djankov, Caralee McLiesh & Andrei Shleifer, Private Credit in 129 Countries, 84 J. FIN. ECON. 299, 303, Table 1 (2007).
67. The flow problem was mitigated over time at least in part by reducing taxes. In particular, Russia drastically reduced its corporate tax in 2001 and introduced a flat tax of only 24 percent. However, this did not eliminate the stock problem, which was considerable. Neither did it prevent the tax authorities from claiming that tax sheltering strategies amounted to tax evasion as evidenced by enforcement actions taken. On the Yukos case in particular, see infra note 64.
68. For a full account of the use of bankruptcy law to re-nationalize Yukos, see CURTIS J. MILHAUPT & KATHARINA PISTOR, LAW AND CAPITALISM: WHAT CORPORATE CRISES REVEAL ABOUT LEGAL SYSTEMS AND ECONOMIC DEVELOPMENT AROUND THE WORLD (2008) 149-72.
69. Article 61 of the Russian Civil Code states the grounds on which liquidation petitions may be brought. They include irremediable violations of the law, continuous violations, and failure to comply with registration requirements, among others. Grazhdanskii Kodeks RF [GK] [Civil Code] art. 61 (Russ.).
70. See Berkowitch & Israel, supra note 17, at 360.
71. Gregory Frank, Police Enforcement of Tax Arrears Collection: Political Opportunism or the Last Resort for Transition States, 33 IDS BULL. 77, 77-83 (2002).
72. See Act XCIII of 1990 on Duties (Hung.) (ISI Emerging Markets, Hatályos Magyar Jogszabályok database), available at www.securities.com.
73. See Frank, supra note 67, at 79.
74. Id.
75. See Act XCII of 2003 on the Rules of Taxation § 98 (Hung.) (ISI Emerging Markets, Hatályos Magyar Jogszabályok database), available at www.securities.com.
76. Frank, supra note 67 at 80-81. See also Nalogovyi Kodeks [NK] [Tax Code] art. 36-37 (Russ.) [hereinafter Russian Tax Code]. The 1993 Law of the Russian Federation on the Federal Tax Police Bodies (Vedomosti Syezda Narodnikh Deputatov Rossiyskoy Federatsii i Verkhovnogo Soveta Rossiyskoy Federatsii) was amended in 1995 and subsequently abolished in 2007 by Law 86-FZ of 30 June 2003. Federal Law on the Federal Tax Police Bodies, June 24, 1993, No. 5238-1 (Russ.) (ISI Emerging Markets, Garant Database), available at www.securities.com.
77. Evidence for this is provided by the Yukos case. The Russian tax authorities adjusted their claims whenever it suited their needs in order to ensure that the company would end up in bankruptcy, which allowed the state to get control over these assets rather than allowing the company to use future cash flow to pay back past debt. For a detailed account of the Yukos case, see CURTIS MILHAUPT & KATHARINA PISTOR, LAW AND CAPITALISM (forthcoming 2008) (manuscript at ch. 8, on file with authors).
78. Presidential Decree, Mar. 11, 2003, No. 306 (Russ.) (ISI Emerging Markets, Garant Database), available at www.securities.com.
79. The first Russian bankruptcy law of 1992 lists in addition to the debtor and creditors only the Procuracy, an organ comparable to an attorney general with extensive criminal and civil enforcement powers, but does not explicitly mention the tax authorities. Federal Law on Insolvency, Nov. 19, 1992, No. 3929-1, art. 4 (Russ.) (repealed 1998) (ISI Emerging Markets, Garant Database), available at www.securities.com. Article 11(3) of the 1998 Insolvency Code declares that the rules on creditors should be also applied to tax authorities. In addition, the same provision mentions the Russian Federation and its subjects as potential initiators of bankruptcy. Federal Law on Insolvency, Jan. 8, 1998, art. 11(3) (Russ.) (amended 2002) (ISI Emerging Markets, Garant Database), available at www.securities.com [hereinafter 1998 Federal Law on Insolvency]. The power to represent the interests of the Russian Federation was delegated to the relevant state authorities in separate decrees (in 1998 to the Federal Service of Russia for Financial Recovery and Bankruptcy (FSFO)). Government Decree on the State Body for the Cases of Bankruptcy and Financial Sanitation, Feb. 17, 1998, No. 202 (Russ.) (ISI Emerging Markets, Garant database), available at www.securities.com [hereinafter Government Decree on Bankruptcy and Financial Sanitation]. Art. 7 of the 2002 Insolvency Code allows authorized state agencies with monetary claims against the debtor to file a bankruptcy case. 2002 Federal Law on Insolvency, supra note 44, art. 7.
80. See Act IL of 1991 on Bankruptcy Proceedings, Liquidation Proceedings and Voluntary Dissolution § 22 (Hung.) (ISI Emerging Markets, Hatályos Magyar Jogszabâlyok database), available at www.securities.com (hereinafter Hungarian Bankruptcy Code).
81. See Act XCII of 2003 on the Rules of Taxation § 150 (Hung.) (ISI Emerging Markets, Hatalyos Magyar Jogszabályok database), available at www.securities.com.
82. For Hungary, see id. For Russia, see Nalogovyi Kodeks [NK] [Tax Code] art. 73 (Russ.), which requires an agreement between the tax authorities and the tax subject for a pledge to arise. Note, however, that the Russian tax authorities have the power to initiate enforcement actions against a defaulting taxpayer by seizing bank accounts and property outside a court procedure. See Nalogovyi Kodeks [NK] [Tax Code] art. 46 (Russ.).
83. Note that when comparing these data with filing data in the US, reorganization appears to be very low, as by far the majority of filings in the US are for Chapter 11 proceedings. However, over 60 percent of these filings are thrown out and end up in liquidation. See Morrison, supra note 45 at 3.
84. TAX & FIN. CONTROL ADMIN., BULLETIN: INFORMATION ON THE OPERATIONS OF APEH IN THE YEAR 2003 32 (2004), http://www.apeh.hu/data/cms1549/ bulletin_2003.pdf.
85. See 1998 Federal Law on Insolvency, supra note 75.
86. See 2002 Federal Law on Insolvency, supra note 44.
87. 1998 Federal Law on Insolvency, supra note 75 art 6.2.
88. See Government Decree on Bankruptcy and Financial Sanitation, supra note 75.
89. Government Decision on the Approval of the Regulations on the Federal Tax Service, Sept. 30, 2004, No. 506 (Russ.) (ISI Emerging Markets, GARANT database), available at www.securities.com.
90. See Arbitration Courts in the Russian Federation, http://www.arbitr.ru: (arbitrazhnaya praktika; itogi raboti; various issues) (last visited Nov. 10 2007) (report of the activities of the Arbitrazh Courts in the Russian Federation) for data 2002-2006; and Supreme Arbitrazh Court, VESTNIK VYSSHEGO ARBITRAZHNOGO SUDA ROSSIǏSKOǏ FEDERATSII (various issues published once a year) for data 1992-2002.
91. Id. Data on the size of companies that have been targets of state initiated bankruptcies are also not available. However, there are some indicators that the bulk of companies that have been liquidated or auctioned off as the result of enforcement actions are not marginal players in the economy. Available data single out state owned enterprises, monopoly companies, farmers, and individual entrepreneurs, among others, to assess the impact of bankruptcy on the economy. These companies, taken together, account for only 9 to 14 percent of all bankruptcy cases in a given year.
92. This calculation obviously overstates the likely recovery rate, as it uses only bankruptcy cases, not other tax enforcement actions.
93. Russian Tax Service to Meet 2005 Collection Target, Says its Chief, BBC MONITORING FORMER SOVIET UNION, Apr. 26,2005 (ISI Emerging Markets, BBC Monitoring Database), available at www.securities.com.
94. Jason Bush, In Russia, The Taxman Cometh-Again and Again, BUSINESS WEEK ONLINE, Mar. 7,2005, http://www.businessweek.com/magazine/content/05_10/b3923093_ mz054.htm.
95. See Desai, supra note 18, at 592.
96. Lucian Arye Bebchuk & Jesse M. Fried, The Uneasy Case for the Priority of Secured Claims in Bankruptcy, 105 YALE L.J. 857 (19%).
97. See Erik Berglöf, Gérard Roland & Ernst-Ludwig von Thadden, An Incomplete-Contracts Approach to Corporate Bankruptcy (Apr. 2000) (unpublished mimeograph), available at http://papers.ssrn.com/so13/ papers.cfm?abstract_id=240048.
98. Mathias Dewatripont & Eric Maskin, Credit and Efficiency in Centralized and Decentralized Economies, 62 REV. ECON. STUDS. 541, 541-43 (1995).
99. Patrick Bolton & David S. Scharfstein, Optimal Debt Structure and the Number of Creditors, 104 J. POL. ECON. 1, 13-16(1996).
100. Id. at 2.
101. Id.
102. Id.
103. See Berglöf et al. supra note 93.
104. Id. at 3.
105. See Bolton & Scharfstein, supra note 95, at 19-20.
106. Russian Tax Code, supra note 72, art. 46(2) (tax authorities can forward a cash collection-order to the bank of the taxpayer or tax agent, ordering the bank to withdraw funds from the account).
107. 1998 Federal Law on Insolvency, supra note 75, art. 134.
108. Hungarian Bankruptcy Code, supra note 41, art. 57(1).
109. See generally MILHAUPT & PISTOR, supra note 64.
110. Western Creditor Banks Called YUKOS' Subsidiary Tomskneft VNK to Repay the Credit Granted to the Parent Structure, WPS BANKS & EXCHANGES, May 26, 2005 (ISI Emerging Markets, Russia, WPS Banks & Exchanges Database), available at www.securities.com.
111. Desai et al., supra note 18.
112. See Pistor et al., supra note 16, at 331.
113. See Steven Fries, Tatiana Lysenko & Saso Polanec, The 2002 Business Environment and Enterprise Performance Survey: Results from a survey of 6,100 Firms 22-23 (EBRD Working Paper No. 84/2003), available at http://www.ebrd.com/pubs/econo/wp008 4.pdf.
114. See Pistor et al., supra note 16, at 339.
115. See Desai et al., supra note 18.
116. Id. at 619 (quoting President Taft saying that "another merit of this tax [the federal corporate excise tax] is the federal supervision which must be exercised in order to make the law effective over the annual accounts and business transactions of all corporations").
117. Id.
118. Raghuram Rajan & Luigi Zinagels, What do We Know about Capital Structure? Some Evidence from International Data, 50 J. FIN. 1421, 1439-40 (1995).
119. See Aiiete Pajuste, Corporate Governance and Stock Market Performance in Central and Eastern Europe: A Study of Nine Countries 5 (2002), available at http://papers.ssm.com/sol3/papers.cfm?abstract_id= 310419.
120. See generally Erik Berglöf & Patrick Bolton, The Great Divide and Beyond: Financial Market Architecture in Transition, 16 J. ECON. PERSP. 77 (2002).
121. See Baird & Morrison, supra note 24, at 2316.
122. See Dewatripont & Maskin, supra note 94, at 555.
123. See Bolton & Scharfstein, supra note 95, at 20.
124. See Desai et al., supra note 18, at 595.
125. Note that private creditors of Yukos have still not found relief for their claims, which were ignored when Yukos was liquidated and its assets transferred back to state ownership. They sued outside Russia, however, and in 2007 a Dutch court deemed the bankruptcy of Yukos void under Dutch law. See Dutch Court Voids Yukos Bankruptcy in Netherlands, REUTERS, Oct. 31,2007, available at http://www.robertamsterdam.com/2007/10/ dutch_court_voids_yukos_bankru.htm (last visited April 10, 2008).
126. See e.g., Desai et al., supra note 18.