The Pi-Tan. -99. Privatization Challenge A Strategic, Legay ,d Institution"" A nlalysis of Ite t'onEl xExperience PIERRE GUISLAIN The Privatization Challenge WORLD BANK REGIONAL AND SECTORAL STUDIES The Privatization Challenge A Strategic, Legal, and Institutional Analysis of International Experience PIERRE GUISLAIN 'fhc World Bank Washiniqton, D.C. (© 1997 The International Bank for Reconstruction and Development / The World Bank 1818 H Street, N.W., Washington, D.C. 20433 All rights reserved Manufactured in the United States of America First printing January 1997 The World Bank Regional and Sectoral Studies series provides an outlet for wvork that is relatively focused in its subject matter or geographical coverage and that contributes to the intellectual foundations of development operations and policy formulation. Some sources cited in this paper mav be informal documents that are not readily available. The findings, interpretations, and conclusions expressed in this publication are those of the author and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to thc members of its Board of Executive Directors or the countries they represent. The material in this publication is copyrighted. Requests for permission to reproduce portions of it should be sent to the Office of the Publisher at the address shown in the copyright notice above. The World l3ank encourages dissemination of its work and will normally give permission promptly and, when the reproduction is for noncommercial purposes, without asking a fee. Permission to copy portions for classroom use is granted through the Copyright Clearance Center, Inc., Suite 910, 222 Rosewood Dr., Danvers, Massachusetts 01923, U.S.A. Pierre Guislain, a lawyer and economist by training, is Principal Private Sector Development Specialist at the World Bank. Since 1984 he has advised many governments in Africa, Asia, and Eastern Europe on the design and implementation of privatization programs. In his current assignment he promotes competition and private participation in infrastructure sectors. Cover design by Sam Ferro and Sherry Holmberg Library of Congress Cataloging-in-Publication Data Guislain, Pierre, 1957- [Privatization. English] The privatization challenge: a strategic, legal, and institutional analysis of international experience / Pierre Guislain. p. cm. - (World Bank regional and sectoral studies series) Rev. translation of: Les privatisations. Includes bibliographical references and indexes. ISBN 0-8213-3736-X 1. Government business enterprises-Law and legislation. 2. Government ownership-Law and legislation. 3. Privatization-Law and legislation. 4. Government business enterprises. 5. Government ownership. 6. Privatization. 1. Title. II. Series. K1366.G85513 1997 346 '.067-dc2O [342.667] 96-34223 CIP Contents Preface xi Introduction I Historical Background 3 Explanatory Factors 6 Definition of Privatization 10 Structure of the Study 12 1 Defining a Privatization Strategy 15 Objectives of Privatization 16 General Country Characteristics 20 Political Setting 20 Economic and Social Setting 21 Institutional Setting 22 Country Risk 22 Characteristics of a Sector 23 Sector Structure 23 Other Sector Features 23 Can All Sectors or Activities Be Privatized ? 24 Characteristics of the Enterprise 26 Legal Status of the Enterprise 26 Size of the Enterprise 28 Defining an Approach 28 Regional Trends 29 Sequencing Reforms 30 Communication and Public Relations 30 Conclusion 31 2 Privatization and Basic Legal Norms 33 Constitutional Requirements 33 Limits on the Scope of Privatization 34 Parliamentary Approval 36 1 vi Thil Privatization Challengc Limits on the Discretion of the Government 38 Control of Constitutionality of Privatization Legislation 39 International Law 40 Conclusion 43 3 Privatization in a Market Economy 45 Property Rights 46 Past Nationalizations 48 Future Expropriations 52 Intellectual Property 52 Protecting and Promoting Competition 53 Nondiscrimination against the Private Sector 53 Price Liberalization 54 Monopolies and Antitrust Provisions 54 Deregulation 55 Foreign Trade Legislation 56 Major Aspects of Business Law 56 Contract Law 56 Company Law 57 Accounting Law 60 Liquidation and Bankruptcy 61 Transfer of Liabilities 66 Foreign Investment Legislation 67 Securities Legislation 68 Banking 71 Taxation 72 Currency and Foreign Exchange 73 Social Legislation 73 Labor Legislation 74 Employee Ownership 77 Pension Entitlements 78 Pension Fund Reform 78 Social Safety Net 80 Environmental Law 81 Dispute Settlement Mechanisms 83 Foreign Legislation 85 Conclusion 86 4 Privatization and Public-Sector Management 89 Identifying the Legal Owners 89 Exercise of Ownership Rights 91 Alienation of Public Enterprises and Shareholdings 91 Alienation of l'ublic Assets 92 Prohibition of Alienation 94 Prior Restructuring of Public Enterprises 95 Contractual Obligations 96 Financial Restructuring 97 Abolishing Discriminatory Practices 99 Contents vii Corporatization 101 Breakup of Public Enterprises 105 Prior Restructuring: Lessons from Mexico 106 Liquidation of Public Enterprises 107 Public Finance Legislation 107 Conclusion 108 5 The Privatization Law 111 A Law or Subordinate Instruments? 112 Scope of the Legislation 115 General Legislation 116 Specific Legislation 118 Valuation and Sale of Enterprises to be Privatized 118 Valuation 119 Authorized Techniques 121 Selecting Buyers 124 Restrictions on Buyer Selection 127 Special, or Golden, Shares 129 Preferential Schemes 132 Preemptive Rights and Other Employee Benefits 132 Advantages Granted to Other Categories of Buyers 135 Choice of an Equitable Scheme 136 Financing 137 Financing Arrangements 137 Debt-Equity Swaps 138 Allocation of Privatization Proceeds 140 Transitory Provisions 143 Amendments 144 Conclusion 145 6 Institutional Framework for Privatization 149 Role of Parliament 149 Institutional Structure 152 Political and Implementation Bodies 154 Privatization Agencies and Units 163 SOE Management and Restructuring Bodies 164 Valuation Bodies 164 Local Governments 165 Other Bodies 167 Coordination of Implementation Authority 167 Control of the Privatization Process 170 A Posteriori Controls 170 Prosecution of Fraud and Corruption 171 Compliance with Buyers' Obligations 173 Staff of Privatization Bodies 173 Recruitment 174 Incentives 174 Conflicts of Interest 175 viii The Privatization Challenge Financing the Privatization Process 176 Privatization Funds 177 Privatization Funds in Mass Privatization Programs 179 Establishment of Privatization Funds 184 Purposes of Privatization Funds 185 Regulation of Privatization Funds 186 Preliminary Lessons 188 Role of Advisers 190 Economic, Financial, and Technical Advisers 190 Legal Advisers 192 Conflicts of Interest Facing Advisers 196 Conclusion 198 7 Privatization of Infrastructure 203 Historical Overview of Infrastructure Sectors 204 Water 204 Energy 205 Transport 206 Telecommunications 209 Market Structure, Competition, and Divestiture 211 Unbundling a Sector 212 Yardstick Competition 214 Structural Reforms in the Water Sector 215 Structural Reforms in the Energy Sector 217 Structural Reforms in the Transport Sector 225 Structural Reforms in the Telecommunications Sector 228 Range of Organizational Options 242 Special Issues in Infrastructure Privatization 242 Techniques for Infrastructure Privatization 242 Constitutional and Legislative Restrictions 246 Legislation for Infrastructure Privatization 247 Prior Restructuring and Corporatization 250 Choice of Strategic Partners 251 Public Flotation 255 Golden Shares 256 The Regulatory Framework 258 Objectives of Regulation 258 Enterprises Subject to Regulation 259 Activities Subject to Regulation 260 Award of Concessions and Licenses 260 Content of Concessions or Licenses 262 Tariff Regime 265 Consistency between Regulatory Reform and Privatization 269 Regulatory Institutions 271 Conclusion 283 8 Meeting the Privatization Challenge 287 A Strategic Challenge 287 Three Tiers of Privatization 288 Conitents ix Changing the Role of the State 289 Defining Objectives 291 Decisions Based on Thorough Analysis 291 A Clear Strategy and Clear Priorities 292 Protecting Stakeholder Interests 294 A Political Process 295 Is a Privatization Law Necessary? 296 Role of Advisers 298 A Multidisciplinary and Empirical Approach 299 Appendix: Privatization Legislation, by Country 301 Glossary 335 Bibliography 343 Geographic Classification of References 369 Specialized Journals 379 Internet Resources 381 Subject Index 385 Geographic Index 393 Index of Enterprises, Agencies, and Other Organizations 397 Figures 1. Range of Privatization Techniques 12 7.1 Unbundling Sectors into Their Component Activities 214 Tables I Large Privatizations in Industrial Countries, 1991-96 4 2 Large Privatizations in Developing and Transition Countries, 1991-96 5 5.1 How Some Countries Have Overcome Specific Obstacles to Privatization 113 5.2 Privatization of Ministry of Defense Enterprises in Argentina 123 6.1 Institutional Framework for Privatization in Argentina and Peru 156 6.2 Institutional Framework for Privatization in Malaysia and the Philippines 158 6.3 Institutional Framework for Privatization in France, Germany, and Poland 160 6.4 Features of Privatization Funds in Selected Countries 181 7.1 Infrastructure Networks: Privatization Mode and Sector Reform in Selected Countries 245 x The Privatization Challenge 7.2 Constitutional Restrictions on Infrastructure Privatization 248 7.3 Prequalification Criteria for Privatization of Telecommunications Companies 254 A.1 Country-Specific Privatization Sites on Internet 382 Boxes 1 Positive Results of Privatization 9 1.1 Privatization and Economic Reform in Peru 16 1.2 Objectives of Privatization 18 1.3 Legal Status of Public Enterprises or Shareholdings 27 2.1 Principles Guaranteeing the Rule of Law 34 2.2 Ownership Provisions of Socialist Constitutions 35 2.3 Impact of International Agreements on Privatization: The Case of KLM 42 3.1 Compensation of Former Owners in Hungary 51 3.2 Bankruptcy Law: Hungarian, Czech, and Polish Approaches 64 3.3 The Flotation of Slaski Bank 70 3.4 Company Valuation by Advisers to Potential Investors 88 4.1 Public Domain Legislation in Morocco 93 4.2 Corporatization in New Zealand 103 5.1 The Bolivian Capitalization Law 125 5.2 Restrictions on Foreign Participation in Privatization 130 5.3 Golden Shares in France 131 5.4 Preferential Allocation of Shares to Employees 133 5.5 Allocation of Privatization Proceeds in Selected Countries 141 6.1 Blocked Institutions in Bulgaria, 1990-95 153 6.2 Privatization Mutual Funds 178 6.3 Advisory Fees in Privatization Transactions 193 7.1 Telecommunications in Chile, 1880-1996 210 7.2 Recent Privatizations in the Telecommunications Sector 233 7.3 Basic Features of a Telecommunications License or Concession 264 7.4 Impact of Regulatory Changes on Share Price 272 Preface This book builds on my earlier work, in particular, Les privatisationis: un defi stratgiqtluc, juridique et itstituttionnttel (Brussels: De Boeck Universite, 1995) and Divestiture of State Enterprises: An Overv,iew of the Legal Framework (World Bank, 1992). It is primarily a reference document for professionals and poli- cymakers who design or take part in privatization programs-government officials; staff of privatization agencies; managers of public enterprises; investors; and legal, economic, financial, and other advisers. The privatization of public enterprises, economic sectors, or entire econo- mies raises strategic, legal, institutional, and economic issues and chal- lenges. This book approaches privatization from a multidisciplinary and multisectoral point of view, with an emphasis on the legal and policy dimen- sions of the process. It draws on the experience of countries on every conti- nent to illustrate specific problems, issues, and solutions. The aim is neither to extract universal lessons nor to present a how-to manual for privatization. Rather, this book seeks to reveal the dynamic character of a process that is still relatively new, demonstrate the complexity of the problems that can arise during this process, and examine the efficacy of solutions that have been attempted. I wishl to thank Celine Levesque and Michel Kerf for their invaluable con- tributions. Cline did much of the research that went into this book and updated the bibliography and the legislation listed in the appendix. Michel contributed extensively to the earlier French edition and provided useful comments on this updated and revised edition. I am grateful also to the many other people who helped in the preparation of this work, especially Donna Verdier, who copyedited the final manu- script; Lucy Foit, who handled the composition; Alex Green for his transla- tion work; and Warrick Smith for comments on chapter 7. Thanks go also to De Boeck Universite for its publication and successful marketing of Les pri- vatisations and to the World Bank-in particular, Magdi Iskander, Michael Klein, and the Office of the Publisher-for supporting this long-term project. Finally, this book would not have been possible without the support and patience of my wife, Marie-France, and children, Charles and Anne-Sophie. xi xii The Privatization Challenge The views expressed in this book are my own, however, and should not be ascribed to those people whose assistance is acknowledged above or to the organizations that offered their support. Introduction In recent years privatization has expanded at a pace that would have been hard to predict only ten or fifteen years ago. More than 100 countries, across every continent, have privatized some of their SOEs. Argentina, Chile, Colombia, Mexico, and Peru in Latin America; Malaysia, Pakistan, and the Philippines in Asia; France, the United Kingdom, and Central and Eastern European countries in Europe; as well as Cote d'Ivoire, Morocco, Nigeria, and Togo in Africa are but a few examples. Equally striking is the sheer volume of transactions. In 1994 and 1995 annual gross revenues from privatizations worldwide were estimated to be on the order of $80 billion.1 Five years earlier (in 1989), the total was $25 bil- lion. Between 1988 and 1993, over 2,600 privatization transactions with sale value exceeding $50,000 were recorded worldwide (excluding eastern Ger- many); these generated receipts of $271 billion, far in excess of the $150 bil- lion that such operations brought in up to 1988. Of these 2,600 privatization transactions, close to 900 were carried out in 1993, against only about 60 in 1988. Developing and transition countries accounted for much of this tre- mendous growth (see Sader 1995). To these figures must be added tens of thousands of local transactions, many of them relating to small businesses, restaurants, and workshops,2 together with tens of thousands more enterprises transferred to private share- holders under ambitious mass privatization programs implemented in many transition countries, notably Russia and the Czech Republic. In just over two years, Russia succeeded in privatizing between 12,000 and 14,000 medium- sized and large enterprises with a total of over 14 million employees-that is, about half of Russia's industrial labor force. In the process, about 40 million 1. All dollar amounts are current U.S. dollars, unless otherwise specified; a billion is a thou- sand million. 2. Nearly 100,000 small businesses and enterprises were privatized in this way between 1991 and 1994 in Russia alone (see Lieberman and Rahuja 1995, p. 25). l 2 The Privatization Challeng,e Russian citizens became shareholders for the first time (see Lieberman and Nellis 1995, p. 1). In Germany, as part of the radical economic transformation that followed the fall of the East German communist regime and reunification, over 15,000 enterprises were sold or liquidated between 1990 and 1994. An additional 91,000 transactions involved restitution of property to former owners, as well as the transfer of real estate, shops, and restaurants. New investment commitments stemming from the program implemented by the Treuhan- danstalt reached about $130 billion.3 Privatization in one form or another has been undertaken at all times. In Thailand, for example, the prime minister issued regulations concerning the sale of SOEs or SOE shares in 1961. Chile launched a major (though not very successful) privatization program in 1974.4 The British program launched in 1980 by Margaret Thatcher, however, is the major forerunner of the current privatization phenomenon, and it has so far raised about $100 billion. Successive trends or waves may be observed in privatization worldwide. In the first wave, privatization focused largely on industrial, financial, and commercial ventures. Infrastructure sectors and activities followed in a sec- ond wave, starting near the end of the 1980s; a third wave, touching munici- pal or local services, is gaining strength. The next wave is only starting to emerge, reaching the social sectors, including health and education, and administrative activities, The privatization phenomenon has not been confined to countries with a liberal ideology. Major privatization programs are found in countries with a long capitalist tradition and in countries in transition from a centralized to a market economy, as well as in developing countries, including some that remain under communist regimes, such as China and Cuba. The pro- grams of the transition countries are, as would be expected, often much more ambitious. Nevertheless, some industrial countries, including New Zealand and the United Kingdom, and several developing countries, including Argentina and Mexico, have implemented privatization pro- grams that are radical in terms of scale as well as scope. Nor have privatization programs been homogeneous. A variety of strate- gies have indeed been adopted and implemented. A wide range of tech- niques has been used, most drawn from experience with corporate mergers 3. It should be noted that the overall deficit of the Trcuhalndatnstalt, caused primarily by the high cost of physical and financial restructuring, severance paiyments, environmental liabilities, and other obligations of the former state-owned enterprises (oys), exceeded $160 billion by the time the agency closed its doors at the end of 1994. 4. The first privatization program of the Chilean military government was an econlomic and financial failure. Owing to the economic crisis of the early 1980s, the governlment had to take back many enterprises that had been privatized just a fv w years earlier, between 1974 and 1979. This was due in large part to the excessive concentration of shareholders within a few large con- glomerates that were deeply in debt as a consequence of, in particular, the acquisitions carried out under the privatization program. These enterprises taken back by the government were later reprivatized, beginning in 1985. Introduction 3 and acquisitions, though some are truly new techniques designed to meet specific privatization objectives. Widespread share ownership has thus been promoted directly or indirectly through mass privatization programs in transition countries, through a capitalization program in Bolivia, and through financial incentives offered to emplovees and small shareholders in many countries. Finally, privatization affects practically all economic sectors. Even activi- ties traditionally reserved for the public sector are increasingly being entrusted to private operators.5 As tables 1 and 2 illustrate, almost all large transactions of the past six years have occurred in "strategic" sectors that traditionally used to be publicly controlled: utilities, such as telecommunica- tions, power, or gas; natural resources, including hydrocarbons and mines; railways; steel; and financial services, including banking and insurance. Despite this worldwide explosion of privatization, the state sector remains strong in many countries, in particular in developing countries where SOEs drain national budgets and continue to dominate many activi- ties. A recent study published by the World Bank found that "notwithstand- ing the sale of some very large firms, the state-owned enterprise share of developing market economies has remained stubbornly high since 1980, at about 11 percent of GDP [gross domestic product], even as it fell in the indus- trial countries from about 9 percent to less than 7 percent." Further, "The state-owned enterprise sector is larger and the problems associated with it are more severe in the world's poorest counitries, where SOEs account for 14 percent of GDP," and "in sum, although the potential gains from privati- zation and other reforms are substantial, only a few [developing] countries have reformed their state-owned enterprises successfully" (World Bank 1995b, p. 2). Privatization has been on the agenda of many governments for over a decade now and is likely to remain a key policy instrument in many countries for decades to come. Historical Background The current wave of privatization follows a long period characterized by nationalization and growth of the size of the public sector in the economy. Like today's privatizations, these nationalizations took place in practically every area of economic activity and in a great majority of countries. The United States is among the few countries that was only marginally affected by this trend. In western Europe, the surge in nationalization began in the years imme- diately preceding the second world war and continued after the war ended. In France, for example, the first nationalizations took place under the Front 5. The privatizations carried out in these sectors often exhibit special features, which are addressed in chapter 7. 4 The Privatization Challenge Table I Large Privatizations in Industrial Countries, 1991-96 Percentage Amount Country Sector Enterprise (date) private ($ billion) Australia Electricity Five distribution 100 6.2 (Victoria) companies (1995) Two generating companies (1996) 100 3.8 Belgium Telecom Belgacom (1995) 49.9 2.5 Denmark Telecom TeleDanmark (1994) 48.3 3.3 France Petroleum Elf-Aquitaine (1994 100 8.8 and 1996) for 47.7% Banking BNP (1993) 100 4.8 for 72.9% Insurance UAP (1994) 100 3.3 for 50.3% Steel Usinor Sacilor (1995) 64 3.0 Germany Telecom Deutsche Telekom 26 13.3 (1996) Italy Energy ENI (1995-96) 31 9.8 Insurance INA (1994-96) booa 6. la Japan Railways JR East (1993) 62.5 8.9 JR West (1996) 68 4.5 Tobacco Japan Tobacco 33 7.7 (1994 and 1996) Netherlands Telecom KPN (1994-95) 55 7.8 Spain Petroleum Repsol (1989-96) 90 >5.0 United Telecom British Telecom 100 22.8 Kingdom (1984-93) Electricity National Power 100 10.0 and PowerGen (1991 and 1995) Scottish Power 100 3.7 (1991) Railways Railtrack (1996) 100 3.2 United Telecom 102 PCs licenses 100 7.7 States (1995)b 493 PCs licenses 100 10.2 (O 996)b a. Includes a $2.1 convertible bond issue representing the remaining 34.4 percent state shareholding (June 1996). b. Through federal auctions for personal communications svstem licenses (see chapter 7). Sources: Public documents. Introduction 5 Table 2 Large Pnvatizations in Developing and Transition Countries, 1991-96 Percenttage Amou nt Country Sector Enterprise private ($ billion) Argentina Telecom Telecom Argentina 100 1.8 (1990-92) Telef6nica de Argentina 100 1.5 (1990-91) Electricity SEGBA, Hidronor, AEE 51-100 > 3.5 (1992-96) Gas Gas del Estado: split into 70-100 > 2.9 ten enterprises (1992-95) Petroleum YPF (1993) 61 3.0 for 45.3/ Brazil Electricity Light Servicos de 51 2.2 Electricidade (1996) Steel Usiminas (1991-94) 9( 2.0 CSN (1993) 81.9 1.5 Cuba Telecom Ectesa (1994) 49 1.4 Czech Telecom SPT (1995) 27 1.5 Republic Germanya Mines Mibrag (1993) 100 1.9 Laubag (1994) 100 1.4 Electricity VEAG (1994) 100 5.2 Tourism InterHotel Group (1992) 100 1.3 Hungary Electricity Two power generation 34-49 1.3 and six distribution companies (1995) Telecom MATAV (1993-95) 75 1.7 for 67% Indonesia Telecom Indosat (1994) 32 1.0 PT Telkom (1995) 19 1.7 Malaysia Electricity Tenaga Nasional Berhad 23 1.2 (1992) Mexico Banking Banamex (1991) 70.7 3.2 Bancomer (1991) 62.6 2.5 Telecom Telmex (1990-94) 100 7.5 for 51lS Railways Northeast Line (1996) 80 1.4 Peru Telecom CPET and Entelperu 95 3.1 (1994-96) for 59% Singapore Telecom Singapore Telecom (1993) 11 2.7 Taiwan Steel China Steel (1989-95) 52.5 3.0 Venezuela Telecom CANTV (1991 and 1996) 100 2.9 a. Former German Democratic Republic. Sources: Public documents. 6 I he Privatization Challenge Populaire governments of 1936-37 (armaments, aviation, railways); the movement resumed immediately after liberation withi the nationalization of coal mining, air transport, electricity, gas, banks, and insurance companies. In Italy, too, state control of the economy tightened before the outbreak of the second world war: in 1933 the government created the Istituto per la Ricostruzione Industriale (ORI), a public holding company which by 1939 had absorbed the biggest banks and held large shareholdings in the iron and steel industry, among others. In the 1930s nationalization was directly linked in many countries to the rise in nationalism. In central and eastern Europe, nationalizations were imposed under Soviet influence after the second world war. During the same period many Latin American countries also decided to base their development strategy on state-owned enterprises. In Argentina, for example, the government nationalized the telephone company in 1946 and at about the same time acquired six railway companies owned by British, French, and Argentine investors. The power sector was nationalized later. Similarly, the decolonization movement in Asia and later in Africa fos- tered growing nationalization as the new states sought to regain control of their productive assets from foreign enterprises. In the 1960s and 1970s, on the morrow of their independence, most African countries, including many with socialist or Marxist-Leninist regimes (such as Angola, Benin, Congo, and Tanzania), undertook large nationalization programs. Over the past twenty years, however, we have witnessed a sharp reversal of the nationalization trend, spurred by a new international economic and political environment and by other factors described below. The average number of annual nationalization operations, which peaked in the first half of the 1970s, has fallen steadily since then and is now extremely small. Over the same period, the volume of privatization operations has accelerated, surpassing the volume of nationalizations around 1980 and growing expo- nentially in the past few years. Explanatory Factors The reasons for the decline of nationalization activity vary, of course, from country to country and even from one enterprise to another. One reason, however, stands out: SOEs have generally posted disappointing perfor- mances (see World Bank 1995b; Muir and Saba 1995; Shirley and Nellis 1991; see also chapter I in this volume). Although some of them function well, many others are notoriously inefficient. They manage to survive through tariff protection against competing imports, preferences in public procure- ment, exclusive rights, preferential access to credit (often at state-owned banks), government guarantees, tax exemptions, and public subsidies. Cre- ated to alleviate the shortcomings of the private sector and spearhead the development of the national economy, many soEs in fact helped stifle the local private sector and fostered economic stagnation. They often serve lfltrwt)lctioll 7 political objectives or purposes and consequently suffer frequent interfer- ence by government and bureaucrats. In somt countries they have also con- tributed to income redistribution in favor of the relativelv well-off over the poor, who generally lack access to both the jobs the SOEs provide and their products. Almost everywhere, the burden SO5 s impose on state finances has become untenable. Was privatization the only way to redress this state of affairs? Several empirical studies have compared the performance of public and private enterprises, but the results vary. Some conclude that an enterprise's effi- ciency is determined not so much by its public or private character as by the regulatory structure and the degree of conmpetition under which it operates.6 Others find tllat private ownership leads to greater productivity.7 Some reforms designed to give SOBs greater autonomv and expose them to stiffer competition, without privatizing their ownership, have produced encouraging results. In most cases, however, such reforms have proved impossible to sustain, and after initial improvements the situation of the SOEs consequently deteriorated further (see, tor example, Kikeri, Nellis, and Shirley 1994, pp. 246-47). The challenge is to bring about sustainable improvements in enterprise performance, and many governments today regard privatization as the only means available to accomplish that. Another important reason for the move to privatization is that most gov- ernments find themselves facing deep budget deficits and public finance cri- ses. The state no longer has the financial resources either to offset the losses of SOFs or to provide the capital increases necessary for their development. Privatization can be the answver, as illustrated by the United Kingdom, where in 1981 Solis that have since been privatized cost the treasury £50 mil- lion a week; these same companies nowv contribute £55 million a week in taxes (see Elmvnioc1tl, February 1996, p. i). A radical reform of public finances, involving an overhaul of the public sector, may also be needed to satisfy international obligations or aspirations. This applies in particular to member states of the European Union (t U), wlo are constrained by EU rules 6. See, for example, Borcherding, Pomnmerehiln, and Schneider 1982; De Alessi 1482. For a survey of the litterature on the effects on economic performanice of privatization, deregulation, and competition. see Kwoka 1996. The importance ot competition and of an overall environ- ment conducive to economic efficiency and de\ iLIopnient of the private sectoir is furtlher dis- cussed in chapters 3 and 7. 7. A study' on productivity growth and firm owner>hip in the airline sector looked at 23 air- lines withl varying levels of private and public ownership over the period 1973--83. The authors indicate that their "empirical analysis shows, indeed, that a switch from state to private owner- ship unambiguously raises the rates of productivity' groLWth, or cost decline, whereas its effect on the levels of productivity and unit cost may be ambiguous in the short run. It further indi- cates that partial privatization of fully state-owned enterprises would produce a substantially smaller marginal improvement ir, productivity growtth than complete privatizationi would. The estimates show that a full switch from state to privati ownership mav increase the rate of cost decline by as much as 1.7 percent per year" (Ehrlich and others 1994, pp. 1007-0)8). See also note 91 in chapter 7. 8 U/ic Priuratizatioti Challecnge in their ability to subsidize state enterprises and must comply with strict fis- cal requirements imposed by the Maastricht treaty to qualify for member- ship in the monetary union. It also applies to countries that have committed to structural adjustment programs with the World Bank or the International Monetary Fund. Rapid changes in the international economy have also helped hasten the decline of the typical SOF. Globalization of the economy, accelerated techno- logical innovation, and growing integration of markets compel businesses to adopt highly flexible strategies and continuoutsly adjust them to changing cir- cumstances. That may, among other things, require the formation of alliances with foreign partners in the area of technology, procurement, or trade, or even through cross-shareholdings or integration in initernational groups. SOEs are notoriously ill-placed to function so flexibly and to forge such alliances. Furthermore, the ideological debate on economic management and priva- tization has evolved substantially in response to the growing globalization of the economy and to the end of the cold war and confrontation between socialist and capitalist models of development. This narrowing of ideologi- cal schisms has produced a more pragmatic approach to economic reform, of which privatization forms part. This trend has been strengthened by the positive experience with privatization, as described in box 1. Finally, in some economic sectors the reasons evoked to justify state inter- vention no longer exist. In infrastructure sectors (telecommunications and electricity generation, for example), technological and other developments have made it possible to introduce competition into activities formerly thought to be natural monopolies, thus obviating the justification for the survival of large public monopolies (see chapter 7). In other sectors, such as air transport, the rules of the game have simply chaniged and SOEs have been unable to adjust.8 The foregoing explanations for the surge in priv-itizations all relate to the supply side. To these must be added demand-related factors, namely, growing investor interest. Detailed analysis of this emerging demand is beyond the scope of this study, but it is clear that it stems, first, from the globalization of the economy and the sharp growth in foreign investment flows, especially toward developing and transitioni countries, and, second, from the advent of new types of investors. These include in particular large infrastructure companies, which until recently were almost all national 8. The European airline industry offers a telling example of the burden SOES place on govern- ments and taxpayers; it also illustrates the relative inefficiency of sots and their handicap in operating competitively An article in the Waill Strect Journal ranked the ten largest European air- lines by level of state ownership and profitability. The fivc (southerni European) airlines with majority state sharelholdinig all posted losses in 1994, while thc five privatelh run airlines all posted profits. Meanwh1ile, state subsidies to state-owned airlin,'s have been staggering: "In the past four years, Air France, Olympic, TAP, Iberia and Sabena of Belgium received subsidies totalinig $9.2 billion" ("Among European Airlines, thet Priv'atizedl Soar to the Top. Government- Owned Carriers Milk State Subsidies but Still Struggle," Wall Si r''t Journal, 19 uly 1995). Initroductioni 9 Box I Positive Results of Privatization In a study published in June 1994, Galal, Ione, Tandoni, and Vogelsang per- formed an in-depth analysis (about 600 pages) of the effects of twelve privati- zation operations carried out in Chile, Malavsia, Mexico, and the United King- dom. They studied four airlines (Aerorncxict). British Airways, Malaysian Airline Systems, and Mexicana de Aviacion); three telecommmunications com- panies (British Telecom, Compania de Telefonos de Chile, and Telefonos de Mexico); two power companies (Chilgencr and Enersis); a carrier (National Freight); the container port of Kelang; and a lottery (Sports Toto Malaysia). The purpose of the research was to compare circumstanices before and after privatization by factoring in a hypothetical model representing what would probably have happened without privatization. The authors sought to distin- guish the gains and losses due to privatization from those attributable to other factors. They calculated the impact on the selling counitrv; on the buyers (domestic and foreign); on workers, user<, and( consumers (domestic and for- eign); and on the competitors of the privatiztd SOI-. In eleven of the tvelve cases examined, the net effects of privatization were positive for the enterprise, as well as for the national economy and the wnrld economv. The exception was the privatization of the airline Mexicana, where the nega- tive effects on buyers and users outweighed tlte benefits to the governlmelnt; the net effect on the employees of the compan\ w\as zero. This operatioll nega- tively affected the entire economv and foireign buvers atid Llsers (see also note 28 in chapter 3). In none of these twelve cases did the wvorlers as a whole find themselves worse off upon completion of the process. The study also stresses the major benefits of the economic liberalization measures that accompanied these privatizations and those of the regulatory framework set up for the privatita- tion of the infrastructure companies. Yet one cannot extrapolate to conclude that privatization will always have a positive effect. The situation of thle four countries in question (one industrial country and three of the most prosperous developing countries) may, for exam- ple, differ greatly from that of a poor country or one in economic transition. In another study published in 1994, Megginson, Nash. and Van Randen- borgh compared the pre- and post-privatization performance of 61 enterprises in 18 different countries, which were privatized between 1901 and 1990) by public offering. The authors conclude that these enterprises, as a whole, posted substantial performance gains (increases in sales, investment, produc- tivity, profits and dividends, and reduction in d1ebt) following theiir divestiture. These gains were accompanied by an increasiI nmIber of jobs. monopolies or quasi monopolies that invested little if at all abroad but today aggressively invest outside their countries of origin. They also include private investment funds and institutional investors who allocate part, or even the entirety, of their resources, to acquiring holdinlgs in priva- tized companies (see box 6.2 on mutual funds that invest in privatized companies). 1 ( 'le Priu'otizati (ol Chalhulge Growing privatization offerings by governments around the world and growing private investor interest and experience are clearly reinforcing each other. Definition of Privatization The term "privatization" can have different meanings. At one level it refers to the privatization of a public enterprise, whether through divestiture or other techniques. In a narrow sense, privatization implies permanent trans- fer of control, whether as a consequence of a transfer of ownership right from a public agency to one or more private parties or, for example, of a cap- ital increase to which the public-sector shareholder has waived its right to subscribe.9 A broader definition of enterprise-level privatization includes any mea- sure that results in temporary transfer to the private sector of activities exer- cised until then by a public agency. Such definition therefore also covers: * Subcontracting, whereby the public agency that previously conducted the activity now subcontracts its execution to a private party; this subcon- tracting can cover an entire public service, such as trash collection, or only part of the activity, such as water or electricity meter reading and billing * Management contracts, which may or may not be performance-based; in these cases there is a temporary transfer of management responsibility without transfer of owniership or real transfer of (ontrol (see, for example, World Bank 1995b) e Lease of state-owned enterprises, equipment or assets, including lease- and-operate or affl rnage contracts in the infrastructure sectors; if the lease includes an option to buy, however, the operation could be regarded as a divestiture * Concessions (see chapter 7), as well as build, operate, and transfer (BOT) contracts (see Augenblick and Custer 1990), often used for the privatiza- tion of infrastructure sectors with monopolistic characteristics. At another level is privatization of a sector. Sector privatization is predi- cated on the introduction of private entry, often by abolishing public monopolies or other barriers to entry. It often includes, but does not have to, privatization at the enterprise level. The award of a cellular telecommunica- tions license or of airline routes to a private firm may not be accompanied by 9. It matters little whetlher the assignment or transfer takes place by payment (sale) or some other means (free distribution of shares, for example). Nor does it matter whether the public agency is the state, the government, a ministry, a governmenit department, a local authority, an enterprise effectively owned or controlled by the public sect(or or any other public entity. The term divestiture is sometimes used restrictively to refer to a transfer of securities (sol. shares) or assets from the public sector to the private sector; a capital inc.rase by an soF may thus qualify as a privatization though not as a divestiture. Introduction 11 the divestiture of all or part of the incumbent operator, for instance. Simi- larly, independent power producers may be invited to build and operate power stations without any change in the ownership of the state utility.)0 This opening up is often, but not always, accompanied by the introduction of real competition among operators in the market (see the section in chapter 1 on the characteristics of a sector and chapter 7). At a third level, the term privatization can have an even wider connota- tion, to include the privatization not just of enterprises and sectors but of an entire economy. The degree of privatization of a given economy wil]l depend on the extent of prior state ownership and control and the scope of the reform program undertaken. Transition countries have by necessity embarked on the broadest programs of this kind, of which enterprise and sector privatizations form an integral part (see the section in chapter 1 on general country characteristics, and chapter 3). But other countries have also undertaken farreaching reforms to transform their economies. In New Zealand, for example, the government program addressed the liberalization of foreign trade, financial markets and labor as much as it did the reform of the telecommunications and air transport sectors and the restructuring and privatization of many public enterprises and activities (see Duncan and Bol- lard 1992). Although each is separate and distinct, these three tiers of privatization are by no means sealed off from one another. On the contrary, there is close interaction among them. First of all, the strategy adopted for the upper lev- els will largely determine that applied at the lower levels. A privatization strategy for an SOE must be consistent with the country's sectoral and mac- roeconomic strategies. Often, the privatization of an enterprise will make sense only as a component of a sectoral or macroeconomic program. Privati- zation is thus an instrument of these more comprehensive approaches rather than an end in itself. Furthermore, a dialectic movement is at play: specific divestiture experiences contribute to the development or fine tun- ing of sectoral and general strategies, which cannot be defined unalterably at the start of a reform program. These privatization techniques can also be classified according to the level of investment responsibility and the degree of risk transferred to the private sector, and to the relative irreversibility of the privatization transac- tion. These factors are in turn directly and positively linked to the magni- tude of the financial commitment made by the private operator and, where relevant, to the duration of the tran5fer of responsibility to the latter. Figure 1 illustrates the gradation of different techniques for private sector participation, ranging from subcontracting, which requires very little 10. BOO (build, own, and operate) contracts may also be an instrument of sector privatization. Boo contracts are usuallv based on a license to build an infrastructureand to supply the related services. Unlike BOT contracts, ownership of the plant remains in private hands. When BOO (or BOT) contracts are accompanied by an exclusive purchase contract awarded by the local public service enterprise, they are more a form of subcontracting. 12 The Privatization Challenge Figure 1 Range of Privatization Techniques \SupplyTechnicala Sub- Manage Perfor- and civi)assistance) contract- )ment mance- Leasg- DoT n works cntracts ig contracts based cfrtae) ss cntracts (MC) MCs Public -- - Responsibility for investments and risk allocation -- 1' Private o 0 Duration (years) of private involvement cc o investment, involves little risk and can easily be terminated, all the way to total divestiture, in which the activity and its assets are permanently trans- ferred to the private sector.11 To the various forms of privatization depicted in this figure must be added joint-venture companies, which can be cocontractors in any privatization arrangement; the private shareholding in these companies may range from under 1 percent to over 99 percent. Other techniques of sector privatization exist as well, such as the promotion of new entry through licenses, permits, or authorizations of varying duration granted to private operators. Finally, it should be noted that what we call privatization goes by other names in some countries, often because privatization was deemed to be politically too delicate a term. Thus, for example, one speaks of capitalization in Bolivia (see box 5.1), peopleization in Sri Lanka, and equitization in Viet Nam. The terms "commercialization" of Canadian National (the railway company) and "strategic consolidation" of Belgacom (the Belgian telecom- munications company) were used to refer to the recent privatization of these companies. In the Netherlands, on the other hand, the term privatization has been used not only to designate what is classified here as such but also to describe the process of corporatizing an SOE that continues, however, to be owned by the state (see chapter 4 for a discussion of corporatization of SOEs). Structure of the Study The sequencing of the chapters of this book follow the sequence of steps in preparing a privatization program. First described is the backdrop to priva- tization, followed by a discussion of the broad principles of design of a privatization strategy. Next examined is the constitutional, legal, and regu- ll. It should be noted that this work does not emphasize actual sale techniques or transac- tional issues. That is not, of course, to detract from the importance of the transaction aspect of privatization. On the contrary, selecting and implementing the appropriate techniques is extremely important. A good strategic, legal, and institutional framework will serve little pur- pose if the actual transactions are handled unskillfully by inexperienced or inadequately quali- fied officials. That said, the innumerable problems that can arise when structuring a privatiza- tion operation and during the ensuing negotiations are, by and large, similar to those encountered in the course of corporate mergers and acquisitions. Introductioni 13 latory framework: what was it before privatization began, and how much must it be altered to allow or to facilitate privatization operations? Follow- ing this in-depth diagnosis is an analysis of the key provisions that autho- rize and regulate the privatization process and a description of the institu- tions and actors involved. A discussion of the privatization of infrastructure sectors, a very topical subject, precedes the concluding chapter. The main themes and issues of the book are presented as follows. Chapter 1. Every strategy must start by clearly stating the objectives that are being pursued, because these determine the approach taken and choices made. The political setting and the specificities of the concerned country, sector, and enterprises similarly have a decisive impact on the nature of the program. Chapter 2. A country's constitution and the treaties to which it is a party can limit the privatization options available to it. They cannot be ignored. Chapter 3. If it is to succeed, privatization must place the divested enter- prise in a stimulating economic environment. Clear rules are needed to gov- ern the functioning of a market economy. This often means amending exist- ing rules or even creating them from scratch. Examples are the basic rules recognizing private ownership, protecting competition, permitting the establishment and winding up of commercial companies, and regulating financial markets. Some of these rules, such as the provisions governing public offerings, also have a direct bearing on the privatization process itself. Chapter 4. Privatization deals with transferring to the private sector SOEs or activities hitherto carried out by the public sector. The rules governing the conduct of these activities by the public sector hence also must be examined. This applies in particular to legislation concerning public property, SOEs, and public finances, which often also determines the steps the government needs to take to prepare the SOE for privatization. This chapter completes the overview of the environment that exists before privatization yet still directly affects efforts to privatize. Chapter 5. The decision to privatize having been taken, it is important to ensure that the process is duly authorized and regulated. In many countries this is done by enacting a privatization law. This law may be either general or specific and may contain numerous provisions relating, in particular, to the topics discussed in the preceding chapters. Chapter 5 is devoted to the basic enabling provisions of privatization legislation, that is, those authoriz- ing and regulating the process and defining its scope. Chapter 6. The institutional framework for privatization, usually pre- scribed in the privatization legislation, is studied in chapter 5. An entire 14 rhe Privatization Challenge chapter is devoted to this subject in view of its importance and the great diversity of approaches taken. Even the best privatization legislation is worthless without a suitably designed institutional framework for imple- mentation. In addition to national privatization agencies and committees, chapter 6 deals with privatization funds, which play a major role in mass privatization programs. The final section is devoted to privatization consult- ants, including legal and financial advisers. Chapter 7. Some sectors have features that affect the way in which they can be privatized. Chapter 7 explores the special case of the privatization of infrastructure sectors, with special emphasis on telecommunications. Since the specificity of these sectors is (or was) due mainly to their monopolistic features, the analysis focuses on the strategic and economic issues that must be considered before addressing legislative and legal questions. Chapter 8. In this concluding chapter the many facets of the privatization process are reviewed. The main challenge facing policymakers and govern- ment officials is not so much to sell an enterprise at a good price as to use this opportunity to achieve broader objectives such as a more competitive national economy. The main body of the text is followed by detailed references to privatiza- tion laws and regulations enacted in over 100 different countries (appendix); a glossary of legal and other terms used in this book; a four-part bibliogra- phy (by author, by country or region, specialized journals, and internet resources); a subject index; a geographic index; and an index of enterprises, agencies, and other organizations. 1 Defining a Privatization Strategy Developing a strategy is often regarded as the first step in a privatization program. In fact, since most privatization programs are an integral part of more comprehensive economic reform, the first step should be to define the key objectives driving the government's overall economic program. The privatization strategy then becomes a substrategy geared to the objectives of the broader reform program. Most former ct ntrally planned economies, as well as, for example, Argentina, Chile, Mexico, New Zealand, Peru (see box 1.1), and the United Kingdom, opted for radical economic reform witl privatization as one of its main pillars.1 Moreover, the sale of SOEs should rarely be an end in itself, but rather one instrument of economic policy among others. Some authors argue that privatization can be an objective in itself for transition countries on the road from a command economy to a free market economy, particularly the ex- Comecon countries. If privatization is understood in its broadest sense as the privatization of the economy, then this would indeed be right. If, how- ever, it is understood as simply the saIt of s,UEs, then it should be seen as a necessary component of a broader program aimed at establishing a market economy. In transition countries, the sale of SOEs is essential for the forma- tion of a market economy, whereas in manis other countries governmiients may feel that they have other optionis available to achieve their policy objectives. Developing a privatization strategy involves identifying government objec- tives, analyzing the existing constraints on execution of the program, and decid- ing on an approach to achieve the objectives whlile taking the constraints into account. The next section of this chapter is devoted to defining the objectives of a privatization program. The section that follows deals with political con- straints, and others address the constraints specific to the concerned country, 1. See the geographic listing in the bibliographv fl r turtlher reading oi each of these counl- tries. On central and eastern Europe and tht former S, Oviet Uniioni, see, in particular, World Bank 1996b. 16 Flite Privatizati(an Challenge Box 1.1 Privatization and Economic Reform in Peru In "Peru Opens Up Economy with Deluge of Laws," the Fiiniacial Dimes wrote that a "1 0-day deluge of 126 laws, more than half of them intended to stimulate private investmenlt, has brought about the most radical reorientation in the 1'eruvian state for more than 2(0 years.... State monlo?opolies have been elimi- nated, private individuals and companies may now compete directly with the state in such varied areas as telecommunications, the generation and transmis- sion of electricity, and the provision of postal and railway services. They may apply for concessions to administer state-owned hospitals, airports and even schools. There is what ministers call an aggressive plan to sell off public compa- nies, whiclh have drained the Peruvian exchequer of iup to $2.5bn annually." The article also quoted tlen-prime minister Alfonso de los I leros on the impor- tance of these reforms relative to Peru's terrorism problem: "Much more impor- tant is an adequate legal framework. If these decrees suirvive, then investment, both national and foreign, will come" (Finaacial Timies, 2(1 November 1991, p. 8). The reforms have indeed survived: many SOEs, including the telecommunica- tions and power companies, have been privatized, raising over $4 billion and generating investment commitments or plans of equal magniitude; SOE subsi- dies have been cut from their astronomical prereform levels ($4.2 billion in fis- cal 1989-90); interest rates and exchange rates have been liberalized; the quota- tion of Peruvian debt on secondary markets has risen from 5 percent to 60 percent and more of face value; the securities exclhange index has soared; inflation has been brought under control, dropping from over 7,00() percent in 1990 to about 11 percent in 1995; foreig investtmienit has risen substantially, and real GDI' rose by ain average of more than 8 percent a year from 1993 to 1995. These impressive results, however, lhave been achieved at the cost of severe restriction of political freedoms: in April 1992 parlianment was dissolved, half the members of the Supreme Court were dismissed, an.d strict control was insti- tuted over television programs, all in the name of [he fight against terrorism. It is said, also, that income distribution worsenied ovrer this period. Soirces: I'I' licaiioni isI 1 Decem ber 1993, pp. '0(-9 1[ 1'ii itin i , (st Vim's, 211 November 1991, 19 February 1994, and 7 March 1996. sector, and enterprise. The final section briefly describes regional trends and discusses issues concerned with implementation of a privatization) strategy. Objectives of Privatization Defining privatization objectives is an important exercise that should be under- taken as early as possible. Many privatization programs have foundered when clear objectives were lacking or where conflicting objectives were simulta- neously pursued. The definition of objectives is not an easy task, however, and it is made no easier by the multiplicity of possible objectives and actors with different, often conflicting, interests. A list of the olbjectives most commonly pursued, explicitly or implicitly, by privatizing governmiiients is given in box 1.2. Definiing a PrivatiZation Strategy 17 As mentioned in the introduction, the current wave of privatizations is largely a response to the financial crisis facing many governments. Conse- quently, budgetary matters and short-term revenue maximizationl tencd to be high on the list of governmental objectives. These may, however, lead to sub- optimal policies and privatization techniques. A recent editorial stated that "privatization carried out just to raise monev-not based on1 a broad vision of how the economy should work-is a recipe for failure" (Eutroinoncly, Feb- ruary 1996, p. 5). Privatization is also a response to the unsatisfactory performance of S.)Es and to an increasingly competitive international environment. Raising enterprise and economy-wide efficiency should hence rank higih among the objectives of a privatization program, and priority should be given to meth- ods that maximize such efficiency. Opening the economy to domestic and international competition, removing barriers to entry, and breaking up out- dated monopolies are important measures in this respect. Governments should select the techniques and approaches that are best suited to their objectives. Where efficiency and maximization of privatiza- tion revenue are sought, a call for bids is generally preferable to direct nego- tiations witlh a single investor. As for privatization techniques, free vouchers or discounted employee shares may not be appropriate instrumenits if the main objective is to maximize revenue, but they may well serve the political objectives of the program. Similarly, a public flotation may be the right tech- nique to promote widespread share ownerslhip and stimulate financial mar- kets, but that course involves the risk of diluting share ownership and thus control of the enterprise, and it will not ne essarily generate optimal tech- nology transfers. Mass transfers of shares to all citizens may achieve the objectives of widespread share ownerslhip ind, where appropriate, speed, but not promote those of efficiencv, revenue maximization, foreign invest- ment promotion, or technology transfer. The chosen objectives will have significant implications not only for the choice and structuring of legal instruments and techniqutes but also for the need for measures preceding privativation.2 Maximizing economic effi- ciency will often call for preprivatization reforms that, for example, break up the SOE to foster competition, eliminate monopolies and other barriers to entry in the sector, and, in cases of privatization of monopolistic sectors, establish a regulatory framework. Although maximizing economic efficiency will normally be one of the main objectives of a privatization programi, in practice other considerations of a political, social, or financial nature also influence the choices of the authorities. The debates aroused by the L .K. privatization program illus- 2. The choice of objectives is not the only dLe terrining factor. S.o too are the time frame adopted for implementation of the privatization proce>s, the scope of the priv,atization program (number of enterprises, aggregate value of the program, and size relaitive to that of the private sector in the economy), the specific target lev els for eal h of these objet ives, and a series of otlier factors discussed later in this book. 8 f'lhc Privatization Challengc Box 1.2 Objectives of Privatization Efficiency and Development of the Economy * Create a market economy-the key objective in economies in transition * Encourage private enterprise and expansioni of the private sector in general * Promote macroeconomic or sectoral efficiency and competitiveness * Foster economic flexibility and eliminate rigidities * Promote competition, particularly by abolishing monopolies * Establish or develop efficient capital markets, allowing better capture and mobilization of domestic savings * Improve access to foreign markets for domestic products * Promote domestic investment * Promote foreign investment * Promote integration of the domestic econonmv into t he world economy * Maintain or create employment Efficiency and Development of the Enterprise * Foster the enterprise's efficiency and its domestic and international compet- itiveness * Introduce new technologies and promote innovation * Upgrade plant and equipment * Increase productivity, including utilization of industrial plant * Improve the quality of the goods and services prodiuced * Introduce new management methods and teams * Allow the enterprise to enter into domestic and internationlal alliances essential to its survival Budgetary and Financial Improvements * Maximize net privatization receipts in order to fund government expendi- tures, reduce taxation, trim the public sector deficit, or pay off public debt * Reduce the financial drain of the SOEs on the state (in the form of subsidies, unpaid taxes, loan arrears, guarantees given, and so on) * Mobilize private sources to finance investments that can nlo longer be funded from ptublic finances * Generate new sources of tax revenue * Limit the future risk of demands on the budget inherenit in state ownership of businesses, including the need to provide capital for their expansion or to rescue them if they are in financial trouble * Reduce capital flight abroad and repatriate capitfl already transferred Income Distribution or Redistribution * Foster broader capital owniershlip and promote popular or mass capitalism * Develop a national middle class * Foster the economic development of a particulkr group (ethnic or other) in society * Encourage employee ownership (also important for efficiency reasons) Defining a Privatization Strategy 19 - Restore full rights to former owners of property expropriated by previous regimes * Enrich those managing or implementing prixatization projects (rarely an admitted objective) Political Considerations * Reduce the size and scope of the public sector or its share in economic activity * Redefine the field of activity of the public sector, abandoning production tasks and focusing on the core of governmental functions, including the cre- ation of an environment favorable to private economic activity * Reduce or eliminate the ability of a future government to reverse the mea- sures taken by the incumbent government to alter the role of the state in the economy * Reduce the opportunities for corruption and misuse of public property by government officials and SOE managers * Reduce the grip of a particular party or group (communist party, iornen lkla- tura, or labor unions, for example) on the economy * Raise the government's popularity and its likelihood of being returned to power in the next elections. trate rather well the tension between conflicting goals. Many of the larger companies that were privatized were sold as monopolies or near-monopo- lies (especially British Telecom and British Gas) or with a dominant position in their market (British Airways). Reasons commonly given for this approach include the desire to proceed quickly, to secure the cooperation of SOE managers who otherwise might try to obstruct privatization, to attract large numbers of small shareholders, and to maximize sales revenue. Many commentators think that the U.K. government should have created greater competition in the concerned sectors before privatization, even at the price of a longer preparation period or lower sales proceeds. Later privatizations, such as those of the electricity and water companies, were preceded by breakup of the sector in order to create a more competitive environment.3 Similarly, postprivatization intervention bv U.K. regulators reduced the scope and duration of the monopolistic privileges originally granted to the privatized enterprises. Privatization objectives need to be consistent not only among themselves but also with other objectives of the government. For example, some countries 3. The competition in question is yardstick competition rather than true market competition, because the water and electric power distribution enterprises were granted a monopoly. Com- petition in the market was established in power generation, however. On this topic, see chapter 7. See also Yarrow 1986, Graham andi Prosser 1 S9 1, pp. X9 ff. 20 The Privatization Challenge discriminate against foreign investors by barring or restricting their participa- tion in the privatization program, and they simultaneously adopt new legisla- tion to promote foreign investment and send cabinet members or other digni- taries around the world in quest of fresh foreign capital. Such discrimination in the privatization process may even be contrary to the provisions of the country's own foreign investment law. The multiplicity and sometimes mutually incompatible nature of the objectives make it essential to rank them. Setting objectives, however, is not a purely abstract exercise. It is primarily a political matter, requiring specific tradeoffs. Social or political concerns may, for example, dictate second-best solutions, which are still worth pursuing when the first best approach, from an economic point of view, is not an acceptable one politically. Nonetheless, privatization is often not the best or most efficient policy instrument to pur- sue social or political objectives.4 A privatization strategy has to be assessed in light of the objectives pur- sued. Most privatization methods and techniques are not inherently good or bad, but merely more or less well suited to the pursuit of one or more spe- cific objectives. The more objectives there are, the more complex the entire privatization process. Flexibility must be built into the system, especially at the implementation level, when multiple objectives exist. This calls for transparent procedures and accountability of decisionmakers. General Country Characteristics Privatization strategies need to be pragmatic and tailored to the specific cir- cumstances and characteristics of the country concerned. The political, eco- nomic, social, and institutional setting and the risks associated with the interaction of all of these must be carefully analyzed. The great variance in the privatization experience of transition countries illustrates this rather well (see also chapter 3). Political Settinig As privatization is above all a political process that can radically disrupt the sit- uation of various stakeholders, one should anticipate possible or likely obsta- cles to the program. Indeed, reluctance or resistance both within and outside the government and the privatization agencies can often hinder the privatiza- tion process or limit its scope. Such opposition can stem from a variety of con- cerns, including: (a) the preservation of national sovereignty or independence; 4. Yarrow observed ten years ago that "privatization is also advanced as a weapon for reduc- ing trade union power, encouraging wider share ownership, redistributing wealth and improv- ing the public finances. However, there are other policy instruments better suited to achieving these objectives" (Yarrow 1986, p. 323). Defining a Priz'atization Stratnegy 21 (b) the desire to retain national control over certain activities or interests per- ceived to be strategic; (c) the sense that state ownership is needed to safeguard the "public interest"; (d) the fear that wealth might become concentrated in the hands of a few private parties; (e) a distrust of the private sector or certain seg- ments of it; and (f) the protection of bureaucratic or other vested interests. Since new laws tend to reflect existing political forces, most of these considerations will be addressed in privatization legislation, as the following chapters show. An in-depth study of these political arguments would exceed the scope of this book. It must be stressed, however, that minimizing political constraints and building a consensus are crucial to the success of privatization opera- tions. That success depends above all on a firm commitment on the part of the country's leaders. Many commentators have made the point, for exam- ple, that Argentina's ambitious privatization program could not have been carried out with such success had President Menem and his government not espoused it so clearly and supported it so vigorously (see, for example, Alexander and Corti 1993, p. 3). Similarly, the roles of Margaret Thatcher in the United Kingdom and presidents Fujimori in Peru and Salinas de Gortari in Mexico were critical to the success of ambitious liberalization and privati- zation programs in their countries. Econaomic anid Social Setting Many countries consider the privatization route to be a way to extricate themselves from an often prolonged recession or from a severe public finance crisis, characterized by large budget deficits and a growing public debt. Not surprisingly, these countries resort to privatization mainly for budgetary reasons and tend to choose approaches that maximize revenues in the short run, sometimes to the detriment of more efficient and competi- tive solutions. The urgency of financial needs also explains the lack of medium- and long-term economic analysis in many privatization strategies. As for the social context, here again short-term constraints tend to domi- nate. The potential social impact of privatization is often calculated in terms of layoffs or lost jobs, yet the problem of excess labor, which is often caused by poor public management, would have to be remedied even in the absence of a privatization program. Moreover, the social factors usually taken into consideration focus more on short-term job losses resulting from necessary restructuring than on longer-term job creation generated by a more flexible and dynamic economy Even so, the potential short-term social impact of a major economic reform and privatization program, as well as its political consequences, should not be underestimated. Governments will often have to prepare and adopt support measures to dampen the restruc- turing shock and help workers manage the transition to other jobs. Involv- ing workers in the privatization process by seeking their inputs and giving them incentives to support the program has also proven useful (see chapters 3 and 5). 22 The Privatizat ion Challengec Institutionial Setting A country's institutional setting is determined by its administrative, com- mercial, and legal traditions and practices; the competence of its public administration; and the degree of corruption in the system, among other things. The preparation, implementation, and follow-up of privatization programs may be quite taxing on a country's institutions and civil service. Privatization is primarily a public transaction or process initiated by a gov- ernment and conducted by politicians, civil servants, and SOE managers, all of whom have little or no relevant experience and many of whom may not have the right incentives to carry out the program. Institutional and human factors, absorptive capacity, and the way in which a government attempts to overcome its inexperience in these matters all play a decisive role in the suc- cess or failure of a privatization program (see chapter 6). Country Risk In a country with a weak or otherwise unattractive political, economic, social, and institutional environment, the government, in the role of seller, will have to develop a long-term strategy to reduce the risks run by investors. The level of risk that investors face determines their interest in the privatization pro- gram. The higher the perceived risk, the more difficult it will be to implement the program. In the short run, measures may have to be adopted to encourage venture-capital investment at the cost of lower privatization revenue because such investment can help rekindle the economy and establish a track record. The longer-run objectives of the strategy will be to reduce uncertainty and risk levels, eliminate the main obstacles to the development of a market economy, and create an environment conducive to private sector investment. The gov- ernment's credibility is vital to the success of such a strategy, and that credibil- ity must be earned. Each successful transaction contributes to a positive image. Although some countries, such as Argentina, Colombia, or the Philip- pines, seem to have succeeded in moving up this ladder, others have been less successful. Indeed, some former Soviet republics and a few central and eastern European countries, as well as several African countries, have suf- fered fickle policies, internal unrest, programs called into question or can- celed, and a certain distrust of the private sector in general and of foreign investors in particular. This has greatly reduced their credibility and compli- cated and slowed the implementation of their privatization programs. More technical, or at least less political, country risks should also be noted. In a country whose accounting rules and practices do not conform to international standards, for example, buyers will be less willing to take over the liabilities of an SOE, and the government may have no choice but to privatize the SOE by sell- ing off its assets and liquidating the remaining shell. Similarly, the absence of organized capital markets or weak financial institutions may make it more dif- ficult to privatize by way of a public flotation or even to rely on domestic sav- ings. In countries with nonconvertible currencies, an SOE with foreign exchange earnings will be easier to sell than one with only local currency revenue. Dcfinihzg a Priz'atizatioti Strategy 23 Characteristics of a Sector Privatization techniques are influenced by market structure, as well as by other sector-specific characteristics. Most sectors or activities currently man- aged by the state or other public entities can be privatized. Sector Stryuctuire, The structure of a market or sector may be determined mainly by economic or by legal variables, as the case may be. Legal variables dominate, for exam- ple, in the presence of legally sanctioned monopolies; in this case, the law forbids anyone except the holder of the monopoly franchise to engage in specified activities. The economic side dominates in cases of natural monop- oly, where only one company could survive. The two do not necessarily overlap, however. In some countries natural monopolies are not legally pro- tected, whereas elsewhere activities that are not natural monopolies are shielded by the protective barrier of a monopoly franchise. If increased efficiency is a primary objective oJ privatization, then the options for restructuring a monopolistic SOE should be examined first. One way might be to divide the SOF into several competing entities. When legal or regulatory provisions are responsible for the monopolv position and prevent or seriously restrict entry by new businesses into the protected sector, these should be repealed or relaxed. Where it is not practical or desirable to eliminate the monopoly before privatization, it will often bc necessary to enact provisions regulating the conduct of the enterprise after it has been privatized. These laws may take the form of general rules of conduct prohibiting uncompetitive behavior (as was the case in New Zealand, wlhere ordinary competition law limits the power of all enterprises, including infrastructure companies, to abuse their dominant position) or of sector-specific regulations governing pricing and other critical aspects of the monopolistic activities (see also chapter 7, particu- larly the section dealing with market structure, competition, and divestiture). Other Sector Featutres Until recently, in every part of the world the telecommunications sector was dominated by national or regional monopolies. As a result, most countries lacked domestic investors with relevant sector experience. Countries such as the United Kingdom, which had a national company that inspired investor confidence and operated in a relativelv mature market, have opted for a public flotation. Other countries have generally sought a strategic investor with the required experience and have therefore had to focus on foreign companies. For their part, these foreign companies were often limited in the scope of their activities and investments bv their owI1 regulatory frame- work. The likelihood of finding private investors with experience in running a telephone company in a country other than their own, particularly in a developing country, was rather slim until the earlv 1990s. The situation is 24 The Priatizatiou Challengte different today, however, because of the recent worldwide trend to deregu- late and privatize telecommunications (see chapter 7, including box 7.2). In many infrastructure sectors, such as toll roads or water distribution, for example, operating receipts are mainly, or even solely, in local currency. That situation could constrain financing options for a privatization operation. In many service activities, including software or data processing, profes- sional services, the media, and some skilled repair aind maintenance activi- ties, for example, fixed assets are of secondary importance. Instead, the staff, trademark, and license to exercise the activity represent the core of a com- pany's value. In these cases a privatization operation cannot be imple- mented successfully without the support of the employees, the principal asset of the enterprise. Privatization of state-owned banks also raises a host of specific legal issues that are often settled by special legislation, is was the case in Belgium and Italy, for example. Specific approvals must be sought from the national banking regulatory agency and, if foreign subsidiaries are involved, from foreign regulators as well. These few example;s show how the SOF's sector of activity may inifluence the privatization process. Can All Sectors or Activities Be Prizmatized? Different terms are used to refer to sectors or activities that are deemed to be ineligible for privatization. In some countries, reference is made to strategic or vital economic sectors or activities. In others, the view is that natural monopolies should not be privatized. The magic word, in particular in Latin countries, may be public services, a concept that may embrace the large infrastructure sectors discussed in chapter 7, as well as commercial services like the postal service and such functions as education, health, social secu- rity, justice, and national defense. The term "public service" itself is ambiguous, to say the least; it has never been precisely defined and it is often used stubjectively 5 To some, privatizing a public service is tantamount to selling off the lamily jewels or abandoning a key role of the state. Confusion very quicklv surrounds the distinction 5. The term public service has bten used to describe, among other things, services provided by public-sector entities (for example, public administrations and SoEs); services provided under the control, regulation, or jurisdiction of the government or a public agency; services paid for, financed, or guaranteed by the government or a public agelncy; and services provided to the public or in the public interest. The debate on the evolving nature of public services is particu- larly heated in France, where case law of the Conseil d'Ftat often determines the attributes of public services. "Depending on the meaning gixven to it, thl concept of public service is more or less extensive" (leanl Rivero, Droi adminiistratif, 11 th c1 ., sec 448, Paris, Dalloz). A report submit- ted in February 1996 by a special task force on the specificity of French-style public services set up by .lrime Minister juppO concluded that Fran(e should uiot hide behind doctrinal quarrels on the notioni of public service; instead, more competitio'n is needed in these services and France must undertake reforms matching EuRmpe's overall liberali/,ition trend. See Fina7ncital Tincs, 28 February 1996. Defining a Privatization Stritegi/ 25 between the concept of services rendered to the public and accessible on a nondiscriminatory basis, and that of services provided by the government or a public enterprise. This semantic drift, this merging of two different con- cepts, unnecessarily complicates the debate about how certain services should be provided to the public. This is particularly the case in countries with an administrative traditiojn influenced bY the French and in formerly socialist countries.6 In addition, wvhat is subsumed under such terms changes over time, even within the same country. In Peru, for example, President Fujimori and his privatization minister have argued that privatization of utilities and natural resource companies would not endanger national security or strategic inter- ests, as had been previously argued, but that on the contrary those interests were threatened most of all by the huge losses and liabilities built up by SOEs (see Financial Titmies, 17 March 1996). Setting aside terminology and its political or emotional overtones, one can venture that all activities that can be adequately described in contractual terms and whose performance can be measured can also be privatized. Tllis includes a priori all production of goodds and services, even structurally money-losing activities, provided the requLiredL subsidies can be channeled to the private provider. A few examples may illustrate the far reaclhes of privatization. Consider postal services, organized in most countries as a core governmental monopoly. The Netherlanids has already privatized KPN, a holdinig company tha t includes the postal service as well as the telecommunications company. Argentina, Ger- many, Lebanon, the Philippines, the United Kingdom, and otlher countries are also working on the privatization of their postal svstems; and, on March 1, 1994, Swveden abolished its postal monopolv and opened the sector, including basic letter delivery, to competition; five private conmpanies have since been registered and entered the market to compete vx itlh the incumbent SC11.' 6. The econormic literature is more precise and usefil in the definition of tlhe coimcept of public good, whichi applies to oinly a few public services. To quallify as a public good, an asset or ser- vice must possess certain features. For example, it niust be impossible (at least in practice) to exclude specific people from using it (nonexcludabilitv), ind there nm,ust be nonlrivalrv in con- sumption, which implies that its consumptioni by onl per-am in ino wav prevents its consump- tion by others (no crowding-out effect). Few infrastructure activities can be regarded as public goods: examples include traffic signaliig, street lightiig, and traffic control (see Kessides 1 943) However, the fact that a service is indeed a public good in no wa vimplies that it should be pro- vided by a public agency. See the example of T'riitx House, a private corporation with public duties established in Britain in 1566 to build and operate ]ighthouse> (or franchise private par- ties to do so), withi light tolls or fees being collected at ti e poirts bv cu>toms officials (Samuel Brittan, "Symbolism of Lighthouses," iii Fiunoicil siici', 6 November 1 9t5). 7. Sweden l'ost remains an sorL corporatized inl 19194 see also the rulinigs of the European Court of Justice and the decisions of the Furopean Comnmission limiting the area reserved to national monopolies by excluding express shipping servi, es. among others, and also the Com- mission's green paper on partial devgulation of postlI services ( oiM 91 476 final). 'here las also been much talk about privatizing the postal service in the United States, whiere mail delivery became a government monopoly folloinvig the enactment n 1845 of the P'rivate E.xpress Statutes. 26 The Priz'atization Challigt'n't Administration of justice would seem to be the perfect example of a pure state function, but even here private provision is a viable and often-used option, as evidenced by, for example, the frequent recourse to private arbi- tration and other alternative dispute resolution mechanisms. In France, the United Kingdom, the United States, and other countries, privatization has spread also to the management of prisons, and private security companies are growing at a rapid pace all over the world, oftein substituting for or com- plementing the state's police force. Publication of a country's official gazette is another example of an activity that can be privatized. Social security (see chapter 3), air traffic control (see the section in chapter 7 on the transport sector), or regulatorv activities (see the section of chapter 7 on regulation) provide other illustrations, as does tax or customs administration. Customs administration was privatized in Indonesia and Latvia. Customs warehouses are managed by private operators in an increasing number of countries. In Mexico "banks are entrusted with being the sole receivers of tax payments and with putting all the information from the returns on tape. Moreover, the private sector was authorized to print and distribute tax returns, registration and notice forms" against a fixed fee schedule (Jenkins 1994, p. 78). Withholding of income taxes by employers or of taxes on interest or dividends by financial institutions are other examples of partial privatization of the tax function. Even tax collection can be priva- tized in some cases, with public authorities selling their tax claims to private collectors (see Byrne 1995). Saying that something can be privatized does not mean that it should be privatized, however. In each instance, one should analyze the costs and ben- efits of public versus private provision of a given service, including the asso- ciated transaction costs, as well as economic, financial, political, social, and other aspects. Characteristics of the Enterprise Characteristics specific to an enterprise can also dictate, up to a point, the measures that need to be taken to prepare for and implement privatization of an SOE. Some of these characteristics, such as the nature of government ownership, the financial situation of the enterprise, and any applicable envi- ronmental or labor obligations and constraints, are developed in the follow- ing chapters. This section deals with the legal status and size of SOEs. Legal Status of the Enterprise The legal status of SOEs to be privatized varies greatly and affects the choice of privatization techniques. Box 1.3 distinguishes between three types of SOEs and state holdings, going from entities with limited autonomy from the government to companies in which the government is an ordinary, noncon- trolling shareholder. Entities organized under public law range from minis- Defining a Priviatizatio,o Strategy 27 Box 1.3 Legal Status of Public Enterprises or Shareholdings Public-Law Entities * Government departments or ministries, and divisions thereof, without dis- tinct juridical personality * Autonomous entities with their own budget but without separate juridical personality * Public agencies with juridical personality * Statutory corporations, public establishnments and national corporations, which may be subject in part to private-sector laws SOEs Organized under Private Company Law * Joint-stock companies wholly owned by the public sector (state and/or public agencies) * Joint-venture companies whose shareholders include public entities and private partners (local and/or foreign) * SOE subsidiaries organized under private law Minority Shareholdings * Private enterprises in which the state or other public entities have a minor- ity or noncontrolling stake. tries without distinct juridical personality to public-law companies with juridical personality; state-owned enterprises organized under private law include joint-stock companies and subsidiaries of other SOEs;8 and compa- nies in which the state or public sector is a shareholder, though not a control- ling one, are usually not included under the heading of SOF-." This classification does not necessarilv imply, however, that public-law bodies are subject to public law in everv aspect of their organization or operations, nor that private-law SOEs are totally outside the jurisdiction of public law. The main question this classification raises is whether owner- ship of the enterprise to be privatized can be transferred without its prior transformation into a new legal entity. Public-law bodies are usually set up as such by law. They may have to be made subject to company law (that is, private law) before they can be transferred to the private sector as legal S. Some legal systems allow public-law enterprises to ertablish subsidiaries organized tinder private law. In France and countries with legal 5ysterms based on the French system, etablissc- metits poU/iCs (public establishments) are often authorized to set up such subsidiaries. This allows them to circumvent restrictions imposed on public-law entities. 9. The name given to a particular form of s5F v.aries from one legal system or country to another. What matters is nOt what the class of enterprise is called but xvhat its intrinisic charac- teristics are. In this book, public enterprise and -( I are svIonIvmous unlless otherwise specified. 28 The Privatization Challenge entities.10 Another available option is to sell the assets of the SOE to private buyers without transferring the SOE itself. There are many other types of SOES that may be governed by special rules. These include (a) municipal enterprises, which may be organized under public or private law; (b) party-owned enterprises, which raise special prob- lems, especially in one-party states with a certain degree of confusion between party and state, particularly with respect to ownership rights; (c) socialist cooperatives, which may be deemed to be public or private; and (d) armed forces enterprises, which often have a privileged and sometimes secretive status. The legal status of an SOE may have a bearing on the applicability of many other laws, particularly in the areas of labor, social security, and taxation, which can themselves affect the course of the privatization process. This matter is considered further in the chapters that follow. Size of the Enterprise Finally, and rather obviously, the size of the SOE to be privatized is critical, too. The issues involved in privatizing, say, a small restaurant or grocery store are far different from those that arise when a national telephone com- pany or a major cement works undergoes privatization. Many transition countries have adopted a two-stage method of privatization, focusing first on small privatizations before moving on to larger operations (see World Bank and CEUPP 1994; Earle and others 1994). Cze(hoslovakia, Ukraine, and other countries have even enacted separate laws providing for different privatization techniques for each group (see the list of privatization laws in the appendix). Defining an Approach Once the objectives and constraints have been identified, the next step is to ascertain what reforms need to be undertaken to achieve the government's objectives. In every country a multitude of measures could be adopted to improve the environment for economic activity in general and the imple- mentation of privatization projects in particular, but not all reforms can be implemented at once. Measures essential to the success of the privatization process have to be given priority. Pursuit of the i.leal environment can only lead to endless delays and gridlock. 10. The law organizing such public bodies or the specitic law governing the public-law sok to be privatized usually precludes transfer of ownership to the private sector. In that case the law in question will have to be amended or abrogated to allow the SOE to be privatized as a legal entity. See the sections of chapter 4 dealing with the exen ise of ownership rights and the restructuring of public enterprises. Defining a Privatization Strategy 29 Regionial Trends Broadly speaking, countries in different regions of the world have adopted different approaches. Former socialist countries have had to privatize their entire economy. A market economy had to be created almost from scratch. The need to create a shareholding class and the political imperatives of the reform process, together with the difficulty of arousing investor interest in turbulent times, has led some countries in central and eastern Europe and in the former Soviet Union to adopt a completely novel approach to privatiza- tion. First, private ownership had to be authorized and encouraged. To facil- itate large-scale and speedy transfer of productive assets from the public to the private sector, the traditional privatization techniques had to be supple- mented by new techniques, such as transfer of SQE shares to the entire popu- lation under mass privatization programs (see chapter 6). The French and British privatization programs also aimed at widespread share ownership. Both countries, however, could rely on established capital markets and securities exchange mechanisms. Thanks to the substantial financial and human resources at its disposal, the United Kingdom was able to undertake from 1980 onward a particularly innovative privatization pro- gram affecting nearly all sectors, including the most strategic ones (see chap- ter 7). In the United Kingdom, privatization was part of an ambitious eco- nomic reform program, whereas the French program was more self- contained and limited in scope: utilities and transport sectors were not included, for instance. Other European countries, including Italy, Portugal, and Spain, have also relied heavily on public flotations. In Latin America the existence of major bottlenecks caused by the inade- quacy and poor state of public infrastructure has led some countries, such as Argentina, Chile, and Peru, to set up major programs of deregulation and privatization of so-called strategic sectors, such as telecommunications, elec- tric power, banking, and natural resources. These three countries and Mex- ico have also integrated their privatization programs into much more com- prehensive economic reform packages. In Asia the divestiture trend has not been as pronounced. Few countries there have adopted or implemented large divestiture programs,1l although some, including the Asian "tigers," a few traditionally socialist countries such as India, and countries still under communist svstems, such as China and Viet Nam, have adopted broader privatization approaches. These have included 11. The Philippines is among the leading Asian countries in terms of number and volume of divestiture. Since its inception in 1987, the privatization program has brought in about $6.5 bil- lion through transactions covering hundreds of enterprises and nooiperforming assets. The big- gest divestiture so far is the sale in 1994 of the oil comnpany Petron for a total of close to $1 billion, including about $575 million for 40 percent of the shares sold to Aramco and about $270 million from a public flotation of 20 percent of the shares that followed the Aramco deal. See Fioiiacial Timtics, 12 September 1994 and 30 November 1495. See also the section on recruit- ment of staff of privatization bodies in chapter o. 30 The Privatizatiot7 Challenge macroeconomic liberalization and opening of certain sectors (including infra- structure) to private investment through BOO, BOT, or concession contracts. In Africa, where most SOEs were in a state of virtual bankruptcy and lacked financial statements worthy of the name, privatization has often had to be effected through liquidation, thereby allowing buyers to acquire SOE assets without incurring the risks of large, uncertain, or contingent liabili- ties. Leaving aside the Middle East, which has lagged even further behind in this respect, Africa is the continent where, on average, the least progress has been achieved in privatization.12 Seque7tcing Reformts When the privatization strategy has been adopted, the timetable for the nec- essary reforms needs to be drawn up. The sequencing and pace of the priva- tization program will have to be thought through from the outset. Interac- tion with macroeconomic, sectoral, and SOE-level reforms, synchronization with any necessary support measures, congruence with adopted objectives and priorities, and compatibility with the absorptive capacity of institutions as well as markets all need to be considered. The nature of accompanying reforms and support measures may determine how well the main stake- holders and the public at large accept the privatization program. Some reforms may be prerequisites for the use of given privatization techniques. Where, for example, the government intends to sell an SOE as such, it may first need to corporatize the enterprise. If a public flotation is proposed, it may be necessary to strengthen the country's capital markets (these and other reforms that may be necessary are described in detail in subsequent chapters). On the other hand, some situations may accommodate privatization without the need for any other reform. In particular, the privatization of a limited number of industrial or commercial enterprises in market econo- mies, where shares can easily be sold on the securities exchange or through other well-established mechanisms, may fall inlto this category. Communication and Public Relations Having a good reform program may be a necessary condition for successful privatization, but it is not a sufficient one. One should also be able to sell the program to the major stakeholders. When preparing for privatization, the government and its advisers should try to involve the parties most directly 12. According to UNCTAD, Sub-Saharan Africa accounted for only slightly more than I percent of the $113 billion volunie of privatization transactions carried out in developing countries between 1988 and 1994. Notable privatizations include the successful flotation in 1994 on the London and Accra stock exchanges of over half of the governument of Ghana's shareholding in Ashanti Goldfields, which raised over $300 million, and the two-stage privatization of Kenya Airways: the Dutch carrier KL.M acquired a 26 percent stake in 1995, followed by a flotation on the local stock exchange in early 1996 (see Oxfo(rd Anolytica, 12 July 1996; see also the introduction.) Defitini,g a Prizvatization Strategy 31 affected as much as possible. It will take a substantial effort to convince political parties, SOE managers, unions and workers,13 civil servants, busi- nessmen, potential purchasers, and the population at large of the benefits of the program. Although achieving a broad consensus will not always be pos- sible, informing and educating the public and stakeholders about the priva- tization program and its effects is often a condition of success. A sustained effort on the part of government to explain the expected ben- efits of the privatization program and the reasons for choosing specific approaches and techniques can help greatly to build a relatively wide con- sensus. This public relations operation, whose importance is unfortunately not always recognized by governments and bureaucrats, should be system- atically integrated into the reform strategy On this point, recent studies have shown that privatization frequently benefits the majority of the parties affected, even those often described a priori as victims or losers (see box 1). That having been said, there will often be losers, especially when economies, sectors, or enterprises in need of radical restructuring are privatized.14 In these cases not even the best information campaign will succeed in persuad- ing those that will be most adversely affected. The government can, how- ever, hope to reduce their opposition by incorporating the necessary support measures into the privatization program and publicizing such measures. As the following chapters explain, a number of measures can be taken to address the concerns or dampen some of the most common objections of opponents of the transfer of SUEs to the private sector. To take only one example, transparent and competitive sale procedures should reassure peo- ple who fear that public assets are being transferred to private operators at prices well below their true value (see chapter 5). Such measures can effec- tively assuage these fears, however, only if their adoption is preceded by adequate publicity and discussion. Conclusion The wide diversity of possible objectives under privatization programs and the mutual incompatibility of some of them compel governments to make 13. Unions and workers are often opposed to privatization. However, this is not always the case. In Romania, unions were in favor of privatization and felt that the government was drag- ging its feet. The two main unions even organized a nationwide strike at the end of February 1994 to protest governmental delays in implementing the privatization program and reforming the social security system. The president of one of these two unions stated in an interview that he "very, very strongly supportlsl privatisatio-the taster, the better" (Friancial Tioncs, 3 May 1994). Trade union leaders in other transition countrie> have often supported privatizationl, whereas in industrial and developing countries opposition seems to be more common. 14. The program of restructuring and privatization of the East German economy was attended bv large-scale layoffs. Of the 4.1 million jobs in the enterprises in the Treuhandan- stalt's portfolio in 1990, only 1.5 million remained four vears later. Set Nen' 'llork Tinies, 12 August 1994. 32 Thc Pri vatization Challetige choices and define priorities. In the absence of explicit ranking of objectives, the default setting should be to give priority to economic efficiency. To that end, transfers of ownership from the public to the private sector should be accompanied as much as possible by action to open these sectors to domes- tic and international competition. After objectives have been defined, the constraints that could hinlder the process must be assessed. Each country will have a distinct set of con- straints, and it is important to tailor the privatization program to its specific environment. As experience has proved, even governmlents with identical objectives cannot pursue them with the same instrtuments in every case. Once adopted, the strategy needs to be operationalized. This calls for good sequencing and coordination of the variotus reforms and activities. Finally, the quality, timeliness, and presentation ot the government's public relations effort will often be decisive to the success of the operation. Privati- zation is, after all, as much a political as a commercial undertaking. The privatization challenge is first and foremost a strategic challenge. Indeed, the significance of privatization cannot be limited to the transfer of assets from a public sector owner to a new private one, nor to the revenues generated in the process. The real challenge of privatization is not so much to sell off an SOE, but to seize this opportunity to introduce much-needed economic reforms, whether of a macroeconomic or a sectoral nature, and to redefine the role of the government. This strategic approach can help change perceptions about privatization. Instead of a static process or a zero-sum game in which some win and others lose with no net benefit for the nation as a whole, privatization should be seen in a dynamic perspective in which the objective is precisely to increase overall social welfare. The emphasis in this chapter has been on tht formulation of a strategy rather than on the actual contents of one. The substance of privatization strategies is discussed in more detail in the following chapters. 2 Privatization and Basic Legal Norms The success of a privatization program is often a function of the soundness of its foundation, especially its legal foundation. The objectives of the program must be compatible with the constitutional provisions that underpin the legal framework for business activity in general and privatization in particular. They must also be compatible with the general principles of law and other norms establishing the rule of law and with certain provisions of international law, which may be binding on the legislator. If these basic legal norms hinder achievement of program objectives, the government must determine whether they can and should be amended. If they cannot be amended, the government may have to reconsider the program objectives or the choice of specific privati- zation techniques in order to accommodate these higher-order constraints. Box 2.1 summarizes basic principles commnon to most legal systems, which guarantee the rule of law. These principles form the basis of relation- ships between private economic agents and between them and the state or any part of the public sector. They are the pillars of what is often referred to as the rule of law (l'dtat tic tireOt in French) and contribute to a legal environ- ment conducive to private investment and hence to privatization. This chapter examines how a country's conistitution and certain provi- sions of international law may affect the privatization choices available to a government or legislator. Constitutional Requirements A country's constitution or fundamental law, wvhere such a document exists, may contain provisions that affect privatization operations either directly or indirectly. In the absence of a written constitution, provisions of a constitu- tional nature may well have the same effect. I Provisions of this kind may I. See the section in this chapter on limits on the discretion of tlle goveornment. See also Prosser 194i0 and Graham and Prosser 1991 for an in-depth examination of the constitutional requirements regarding privatization in the United Kingdom, which hals neo written constitu- tion, and in Francc. .33 34 I-lit Privatization Chaflctgen Box 2.1 Principles Guaranteeing the Rule of Law * Publicity of laws enables all parties concerned to be aware of the laws with which they are expected to comply * A clear and unambiguous legal framework allows the parties to know which laws apply to their situation and what their specific meaning is * IPredictability in applying laws reduces the risks associated with changes in their interpretation, implementation, or enforcement * Nondiscrimination in the application of laws implies that all parties that are in the same objective situation will have the same substantive rules of law applied to them * Means of legal redress and respect for due process cnsure access to indepen- dent appeal and dispute settlement procedures * Stability of the legal, political, and decisionmaking systems assures investors that the state or government will not unilaterally aind unfavorably alter the basic conditions on which these investors based their investment decisions. limit the scope of the privatization program, determine to whom decision- making authority belongs, or impose certain controls on privatization authorities, or address all three. Limits on the Scope of Privatizationi The constitutions of many socialist countries provided that all productive assets (including enterprises) were the property of the state or "of all the people," and granted the state (or public sector) special protection and priv- ileges as further described in box 2.2 (see also the section of chapter 3 deal- ing with ownership rights). These provisions were generally based on the 1936 constitution of the former Soviet Union, particularly article 4, and had to be repealed to enable privatization. Portugal's 1976 constitution even declared irreversible the nationaliza- tions that followed the April 1974 revolution. It had to be amended twice, in 1982 and 1989, to authorize the privatization of these SOES. The constitution of Bangladesh also had to be amended, by a decree issued in 1977 under martial law, to authorize privatization. Similar sweeping amendments had to be made in most transition countries, but also in other countries moving away from strong state control of the economy. Some constitutions continue to prohibit all private-sector activity in what are deemed to be strategic sectors. Until recently, article 177 of the Brazilian consti- tution gave the state a monopoly on prospecting for petroleum, natural gas, and other hydrocarbons; petroleum refining; import and export of petroleum products; sea transportation of domestic crude oil, and pipeline transportation of crude oil and natural gas regardless of origin. This monopoly wvas repealed in November 1995, but the constitutional amendment required implementa- tion legislation which, eight months later, had not yet been enacted. Article 27 Privatization and Basic LegaIl Normis 35 Box 2.2 Ownership Provisions of Socialist Constitutions Soviet Untiotn. Article 4 of the 1936 constitutioni proclaimed: "The economic foundation of the USSR is the socialist economic system and socialist owner- ship of the instruments and means of production, firm]y established as a result of the liquidation of the capitalist economic system, the abolition of private ownership of the instruments and means of production, and the elimination of the exploitation of man by man." Bnilgaria. Until its revision in April 1990, article 13 of the constitution stated: "The economic system of the People's Republic of Bulgaria is socialist. It is based on the public ownership of the means of production." An',(ola. Article 9 of the 1975 constitution stated. "The foundation of econiomic and social development is socialist ownership, consubstantiated in state own- ership and cooperative ownership. The state shall adopt measures permitting continuous broadening and coinsolidation of socialist relations of production." Guinia-Bissaii. The 1984 constitution describei the country as "a sovereign, democratic, secular, unitary, anti-colonialist and anti-imperialist republic" (article 1); the latter two adjectives have since been deleted. Its article 12, whichi has since been amended, declared the following to be state-owned assets: "the soil, subsoil, water resources, mineral resources, main energy sources, forests, basic means for industrial production, mass media, banks, insurance, roads and essential means of transportation." Mozatamiqwc. Until it was revised in November 1990, the constitution, adopted in 1975, stated: "In the P'eople's Republic of Mozambique the State economic sector is the leading and driving factor in the national economy. State property is given special protection land] its development and expansion is incumbent upon all state agencies, social organizations and citizens" (article 1(1). of the Mexican constitution contains similar restrictive provisions for hydro- carbons. The Mexican constitution- also originally contained a provision, amended in May 1990, prohibiting privatization of public commercial banks. Such constitutional provisions covering the ene rgy, water, and telecommunica- tions sectors, as well as transport infrastructure, are reviewed in chapter 7. Elsewhere, certain types of activities are reserved to the state, though partici- pation by private entrepreneurs is permitted through joint-venture companies or under concession, lease, or management contracts (see also chapter 7). This is common in the hydrocarbons sector, as for example in Bolivia, where the constitution provides that petroleum deposits are the property of the state, which may nevertheless entrust exploration and production to private opera- tors under concession contracts.2 Article 33 of the Indonesian constitution of 2. See article 139 of the Bolivian constitution. other examples are cited in chapter 7. Eveni though it does not have the same legal force, the preamble to the French constitution of 1946 also might be mentionied here; it states that "all assets, all enterprises whose operation has or acquires the characteristics of a national public service or of a de facto monop(oly must become collective property." The preamble to the 1958 constitLtlon explicitly refers to and confirms the principles set forth in the preamble of the 1940 con"titution. 36 The Privatization Challenge 1945 (reinstated by a 1959 decree) declares that "branches of production which are important to the State and which affect the life of most people shall be con- trolled by the State"; needless to say, such ambiguity regarding the covered sec- tors or activities, as well as the meaning of state control, has created problems.3 Finally, some constitutions may include other restrictions, such as limita- tions on foreign investment in specific activities (see also the section of chap- ter 5 dealing with restrictions on foreign participation). These could clearly also hinder privatization programs. Until its repeal by constitutional amendment of August 15, 1995, article 178 of the Brazilian constitution reserved coastal and internal shipping to national vessels, meaning vessels whose carriers, ship owners, captains, and at least two-thirds of the crew are Brazilian. Similarly, article 176, which restricted mining (exploration and production) to Brazilian-controlled firms, was modified on the same day and now requires only that the firm be established under Brazilian law and have its headquarters and management in the country; subsidiaries of for- eign companies qualify under these new standards. More generally, the same amendment also eliminated the constitutional discrimination in favor of "Brazilian firms of national capital," hence removing the basis for prefer- ential treatment of Brazilian-controlled companies in public procurement and other matters. Specific legislation had to be enacted to implement these amendments; provisional measures (that is, executive decisions to be later confirmed by parliament) for implementation were expressly disallowed. Parliamentary Approval The constitution or constitutional traditions of a country may provide that privatization must be approved by parliament. This is the case with article 34 of the French constitution of 1958, which states that the rules governing nationalization of enterprises and transfer of ownership of public-sector enterprises to the private sector shall be set by law. IThe constitutions of Benin, Morocco, Senegal, Togo, and other countries with a French legal tradition similarly require that the transfer of majority state-owned enterprises to the private sector be authorized in advance by parliament, by means of a law.4 3. This constitutional clause was used in 1980 to question the legality of a 1967 agreement between the government and ITT, which gave the local subsidiary Indosat a twenty-year exclu- sive operating license for international telecommunications, and to iustify the takeover of Indo- sat by the Indonesian government. See Wells and Gleason 1995, p. 48. 4. Benin: Article 98 of the constitution provides that the rules pertaining to nationalizations and transfers of enterprises from the public to the private sector are a matter of law. Morocco: Article 45 of the 1972 constitution (preserved in the 1992 constitution) declares that "the nationalization of enterprises and the transfer of entcrprises from the public to the private sector" are matters of law. Senegal: Article 56 of the constitution of March 7, 1963, statt s: "The National Assembly shall hold the legislative power. It alone shall vote the laws. The rules concerning ... nationalization of enterprises and transfer of enterprise ownership from the public to the private sector shall be established by law." As mandated by the constitution, law no. 87-23 of August 18, 1987, per- mits privatization of the SOEs listed in a schedule annexedL to the law. Priz'afization nonzd Basic Legal Norms .37 In some countries the role assigned to parliament is defined more pre- cisely. Not only must a law be enacted but it must also contain certain spe- cific provisions. The Paraguayan constitution, for example, requires that the law spell out the procedures for granting the preferential right to shares in the privatized enterprise to which its employees are entitled.5 The constitutions of other civil-law countries are silent on the subject. The principle of parallelism of forms, whiclh requires that the same instrument be used to undo something as was used to create it, would imply, however, that a law is needed to liquidate, and possibly also to privatize, an SOE that had been established by law (see also the section of chapter 1 on the legal status of enterprises). A country's constitution, legislation, or legal traditions may allow the government or other public agencies to priv,ttize without intervention by the legislature. In that case, no enabling legislation is legally required. This is the situation in most of the common-law countries, such as Australia, Malaysia, New Zealand, and the United Kingdom.6 In such systems it is generally considered that, in the absence of explicit prohibition, the govern- ment possesses inherent power to privatize public assets and enterprises without the need for special legislative authorization.7 It must be stressed, however, that enactment of a law may be necessary even when it is not required by the constitution. As the following chapters suggest, a law may be essential in order to amend certaini legislative provisions in force. Tlogo: Privatizations had been carried out without any special enabling legislation. Trte 1979 coLnstitution did not list privatizationi among the matters that are withiin the exclusive juris- diction of parliament. This situation changed, however, witlh the constitutional revisioni of October 14, 1992. The constitution's new article 84 provided that "the rules concerniing . .. nationalization of enterprises and transfer of ownerslhip of public-sector enterprises to the pri- vate sector" shall be set by law. The government prepared a draft law to that effect in 1994. In the end, a privatization ordinance "executed as a law of the slate" was adopted on June 10, 1994. 5. Article Ill of the 1992 constitution stipulates: "Whon the State decides to transfer public enterprises or its shareholdings therein to the private se, tor, it shall conler a preferential right on the employees and other operators directly connected wvith those enterprises. The manner in which this preemptive right is granted shall be regulated bv law." 6. "In New Zealand, unless there is specific legislation to the contrarv, the Government anid individual Ministers of the Government are regarded as having power to sell Government assets. A notable exception is section 11 of the Se) Att, which prohibits the sale or other disposal of shares in companies named in a schedule to the Act (heing the soFs established by virtue of that Act). This schedule included Post Office Bank l.imited and Telecom Corporation of New Zealand Limited, which have since been sold. Before their sale, the SoE Act was amended (in the case oLf Telecom, by the Finance Act 1990) to remove the name of those companies from the schedule to the SOE Act" (Williams and Franks, 1992, p. t 7, para. 200). 7. "The natural reaction of government lawyers is to legislate to achieve the result desired bv the Government. Commercial lawyers, on the other banld, do not normally have that luxury and therefore seek more commercial means of achieving their client's objective. With privatiza- tion, the Government is seeking to turn a Government Business Enterprise into a commercial enterprise operating in the market place in exactlv the same way as other corporations. .. When it comes to legislation, we should legislate to the ininimum degree necessary, rather than the maximum possible" (Sly and Weigall 1991, pp. fi6, h.7). 38 The Privatizat ion Challenge Malaysia and the United Kingdom, for example, had to enact laws to corpo- ratize SOEs organized under public law, so they might later be privatized.8 On the other hand, the objectives of privatization can sometimes be achieved without a law, despite explicit constitutional language requiring special legislation.9 Limits onz the Discretioni of the Goverintet Constitutional provisions may also help limit the extent of the government's discretionary powers regarding privatization. Comparison of the French and British examples is particularly instructive. II) First, the constitutional requirement that implementation of a privatiza- tion program be authorized by law subjects the French government to prior parliamentary control. In the United Kingdom, where this obligation does not exist, the government can sidestep such control unless a law is necessary for some other reason, which has most often been the case (see note 8). Valuation of the assets to be privatized also demonstrates an appreciable difference in constraints imposed on the French and U.K. governments. In France, the Constitutional Council, which is responsible for verifying the constitutionality of laws before they are promulgated,11 has ruled that the constitutional principle of equality among all citizens and article 17 of the Declaration of Human Rights, which mandates the payment of just com- pensation when property is confiscated, prohibit the transfer of public assets to private investors at less than real value. The council judged that enterprises to be privatized therefore had to be valued by independent 8. United Kingdom: Most privatizations have required legislation to turn the SOE into a limited liability company whose shares could then be sold (see the appendcix for a list of these laws). For SOEs already organized under company law, this conversion was not required, and privatiza- tion could proceed without prior parliamentary authorization, as was the case for British Petro- leum (see Graham and Prosser 1991, p. 83). Malaysia: For the partial divestiture of Port Kelang Container Terminal in 1986, special legis- lation "was passed by P'arliament to enable and facilitate the privatization exercise." The port authority did not possess the needed powers under the Port Authorities Act of 1963 to create a subsidiary governed by company law. The act therefore had to be amended to authorize the establishment of KC l (Kelang Container Terminal) as a subsidiary, a preliminary step to the sale of 51 percent of the capital of the new company to KK, jointly owned bv KN (a public enterprise, 80 percent) and l'OAI (an Australian private company, 20 percent). In addition, the Pensions Act of 1980 had to be amended to allow employees of the new company to keep their pension bene- fits accrued while working for the port authority. Seejones and Abbas 1992, chapter 13, notes 13 and 17; see also chapter 4 concerning the corporatization of soI s. 9. In cases where divestiture would require enabling legislation, but the government's pri- mary concerns are speed and ease of implementation, or whiere it wishes to avoid seeking parlia- mentary approval, enabling legislation may sometimes be dispensed with by using a method of transfer to the private sector other than divestiture, such as concessions or leases (see table 5.1). 10. This comparison draws on Prosser 1990(and Grahamii and Prosser 1991. 11. Article 61 of the constitution provides that a law may be submitted to the Constitutional Council by the president of the republic, the prime minister, the president of the assembly, the president of the senate, or a group of sixty deputies or senators. Prizatization annd Basic Legal Normt s 39 experts and that no sale be allowed at a price below that determined by these experts. In the United Kingdom, in contrast, privatization transactions are examined only after the fact by the National Audit Office and the Public Accounts Committee.12 Finally, the French Constitutional Council intervened again to try to regu- late use of the golden share technique by the minister of the economy (golden shares are discussed further in chapters 5 and 7). The privatization laws enacted in France in both 1986 and 1993 provide that, in any company to be privatized, the government may be granted a golden share that would enable the minister of the economy to reject any sales allowing a shareholder to amass more than a given percentage of the company's capital (see box 5.3). The council accepted the constitutionality of these provisions, but only on the condition that the minister justifv each use of this right of veto and the judiciary be empowered to overrule the minister's decisions. In the United Kingdom, where privatization conditions and procedures need not be authorized by law, the rules governing the use of golden shares are con- tained in the articles of association of the enterprise concerned. This contrac- tual arrangement limits the basis for judicial intervention. Some articles of association also contain provisions ruling out appeals of any kind (see sec- tion 40.12 of the British Gas articles cited in Prosser 1990) and explicitly stat- ing that no justification need be given if the government exercises the pow- ers conferred on it by such golden shares (see sections 43.k and 44.m of the Rolls Royce articles cited in Prosser 1990). Clearly then, there is no equivalent in the United Kingdom for the provi- sions in the French constitution that grant the parliament and Constitutional Council some control over the government's privatization activities. The benefits of the French system must, however, be weighed against the costs of procedures that could become cumbersome and lengthy. I3 Cotntroil of Conistitutioniality of Priv'atiZationi Legislationi In France, as illustrated in the previous section, a constitutional court may reviewv legislation before its promulgatioin. In Poland, President Lech Walesa referred to the constitutional court a new privatization law that had been approved by parliament in Julv 1995 over his earlier veto; grounds for referral were that it violated the separation of powers between the executive 12. The distinction between the French and British procedures is narrowing, however, under the influence of European law. For example, the financial terms of privatization transactions can be examined beforehand by the European Commission, pursuant to article 93 of the Treaty of Rome concerning state assistance. Thus the British government, wvhich had undertaken to inject £547 million into the Rover Group at the time o'f its buvout by British Aerospace, was compelled to limit its assistance to £294 million after intervention by the commission. 13. One may, for example, questioni the usefulness of the requirement found in some laws to carry out a systematic valuation of the enterprise in every privatization transaction. These issues are examined in greater detail in chapter 5. 40 S lite Privatizantiou Challc'n'< and legislative branches by requiring specific parliimentary approval for privatization transactions in numerous "strategic" sectors (see box 5.4 and Borish and Noel 1996, pp. 69, 156). The court ruled that this new law was indeed unconstitutional. Constitutional challenges to privatization legislation have become a regu- lar feature in Turkey. In July 1994 Turkey's constitutional court ruled that privatization enabling Law no. 3987, which authorized the government to privatize through the issuance of statutory decrees, was illegal because this power belonged exclusively to parliament. As a result of this ruling, the stat- utory decrees already issued to execute this law also become null and void, and the whole privatization program came to a new halt (see Finainlcial Times, 13 July 1994; Prizvatisation Yearbookk 1995, p. 158). A pruvious privatization law had already been struck down by the constitutional court. On February 28, 1996, the constitutional court annulled parts of Law n1o. 4000 authorizing the sale of up to 39 percent of the shares of Turk Telekom (see Middlet, East Eco- n1om)1ic Digest, 8 March 1996). In India, members of parliament, public interest groups, labor unions, and operators filed petitions with the supreme court contesting the govern- ment's telecommunications privatization policy and the award of specific licenses. The court ruled in February 1996 that policy matters were in the ambit of the legislative and executive branches, not of the courts. It rejected the petitions against the privatization program and upheld the validity of the bidding procedures and the government's powers to grant the disputed licenses (see Jouriral of Coinmmerce, 18 January 199h and 22 February 1996). Lawsuits contesting the constitutionality of privatization legislation or specific provisions thereof, or the government's right to privatize without enabling legislation, have also been filed in other countries. In Colombia, for example, the constitutional court ordered the suspension of the privatiza- tion of financial SOEs in the absence of enabling legislation (Wrivatisation Intcrinational, January 1996, p. 29). International Law The conduct of privatization transactions in a given country can also be affected by the international treaties and agreements to which it is a party.14 Many countries, on all continents, have entered into regional agreements on 14. The text or overviews of international economic agreements can be found in a number of publications, including: Inter,natiooal Economic Lawm Basic Docmi ments, I'hilip Kunig, Niels Lau, and Werner Meng (Eds.), Berlin-New York, Walter de Gruvter, 1989; Basic Documnents of hiterna- tional Economic Lau,, Stepheni Zamora and Ronald A. Brand (EdA), Chicago, Commerce Clearing House, 1990; and Accordis cc(monoiqtes ioternati onaux. RWpecrtoir e s accords et dcs inistittiioi is, l3er- nard Colas (Ed.), Notes et Etudes Documentaires, La Documentation Francaise, Paris, Wilson & Lafleur, 1990, whichi is a useful guide to such treaties and includes the countries that have acceded . Prizatizatiai anid Basic L.egal Nonrms 41 trade, customs controls, or broader economic integration. Examples are the European Union (EU), Mercosur (Latin America), Caricom (Caribbean), NAFTA (North America), and ASEAN (Southeast Asia). Such regional agree- ments often generate supranational law or foster harmonization of legisla- tion in their member countries. The impact on privatization of legal obligations deriving from the EU treaty, for instance, is verv significant, even though the treaty itself is neutral regarding type of ownership.15 The abolition of customs barriers, the liberal- ization of formerly monopolistic markets, and the imposition of common competition rules on private as well as public enterprises all foster the entry of private operators. Privatization is one of the options most governments must consider in order to reduce public-sector debt and deficits and meet the macroeconomic criteria set by the Maastricht treaty for joining the new European currency. Similarly, the scale of investmenits needed to upgrade water and sanitation systems to the newv European standards is such that many governments must draw in the private sector to help pay for and carry out such investments. Furthermore, manv provisions of European law will apply to the implementation of a privatization program. Examples include the rules on merger controls, the prohibition) of state aid to enterprises, and the prohibition of discrimination among nationals of member states of the European Union, which means, for example, that foreign nationals must be allowed to acquire holdings in the capital of privatized enterprises on the same footing as local citizens. Portugal and France were told to amend their privatization legislation to abolish limits imposed on shareholdings by investors from other EU1 member counltries (see box 5.2). Bilateral agreements may also raise special privatization issues. This is the case for the privatization of airlines. Bilateral agreements governing air traf- fic between the signatory states often require that "substantial ownership" or "effective control" of the designated coimpaniies be held by a signatory state or by nationals thereof (see Rapp and Vellas 1992, p. 51). An airline privatization that would transfer control to foreign investors could hence block the application of these agreelments anid result in the loss of some of the airline's main assets, that is, its routes. Thlere are wavs to limit this risk. For example, when British Airwavs wvas privatized a golden share was awarded to the government, which allowed it to oppose anv foreign acquisi- tion of shares. In the case of KLM, particularly strict measures were taken, as indicated in box 2.3: the government holds a call option thiat allows it to regain a majority shareholding if needed; in addition, the bylaws of the company provide that a majority of the members of the supervisorv board shall be nominated by the government. For similar reasons, the Belgian government limited the 15. Articleo222f theTreatv of Rormestates: "Thii Ire.itvs hall in no wayprejudice tile rules il Membesr States governing the systemn of propert, 'e rnership.` See als.o the section of chapter 7 regairding the European policv in the telecommunication'; sector. 42 7 he Priv'atizationl Chal'icige Box 2.3 Impact of International Agreements on Privatization: The Case of KLM K1LM was created in 1919 on a purely private basis. It was not until 1929 that a majority of shares was transferred to the state. In March 1986, on the eve of privatization, the state held 54.9 percent of the company's capital. The privati- zation procedure was original: the company bought back a portion of the state's shares and undertook to resell them, together with 12 million newly issued shares, to a bank syndicate commissioned to place them. This reduced the share of the state to 38.2 percent of the capital. In addition, specific mea- sures were taken to strengthen the government's control over the company, with the purpose, in particular, to prevent jeopardizing the bilateral air traffic agreements concluded between the Netherlands and other countries. The Dutch government signed an agreement with KI-M providing that the state would lose its majority interest in the share capital of KI M as a result of the issue of common shares by KLM and of the sale of common Kl.M shares by the state. A provision was included allowing the state to regain its majority interest at short notice, if that were desirable for reasons of air transport policy or to prevent an undesired accumulation of power in the general meeting of sharelholders. Under the agreement KLM granted the state the option to purchase 1 8,000,000 B preference shares. The State could exercise this option if necessary and rea- sonable, in particular when (a) "under one or more international agreements or one or more licenses granted by whatever country, liimitations or aggravating conditions would be imposed on the operation by KlM of scheduled services because substantial or majority ownership of KLNM would no longer be demon- strably Dutch"; or (b) it is necessary to prevent one person or company or a group of persons or companies from acquiring a stake in KLM that would result in an undesirable balance of power in the general shareholders' meeting. In addition, the government was granted, by virtue of an amendment to the company's articles of association, a majority of the seats on the supervisory board of the company, even though it is only a minority shareholder. The new paragraph 13 of article 20 of KLM's articles of association provides that "the State of the Netherlands shall appoint the smallest possible majority of the Supervisory Board". Source: Rapp and Vellas 1992, pp. 61-91. stake of Sabena it sold to Swissair in 1995 to 49.5 percent of the capital, with an option to increase it to 62.25 percent after the year 2000, when more lib- eral international rules may be in place.16 Techniques of this sort have the merit of allowing airlines to be privatized without requiring renegotiation of the many existing international agreements. The fact remains, however, that 16. See Fintancial Timnes, 28 February 1996. This takeover was approved by the European Com- mission in July 1995; one of the conditions was that new entry take place on the Brussels-Zurich route, wlhere the Swissair group (including Sabena) wouldl othecrwise have had a near monopoly. Privatizatioti tnd Basic Legal Norms 43 the limits they impose on shareholding by foreign investors may well reduce the benefits, in terms of revenue or efficiency, that such privatizations could otherwise vield.'7 Bilateral agreements in many other fields (concerning, for example, dou- ble taxation or investment promotion) can also affect privatization transac- tions by, say, partly covering gaps in the legislation of a signatory country, at least for investors of the other country. Finally, an interesting, if highly unusual, international agreement is the German Unification Treaty of 1990, which pursuant to its article 25 incorporates the East German privatization law, with some amendments, into German law. Conclusion The norms examined in this chapter are generally considered to have prece- dence over ordinary law. They are by and large binding on legislators and governments and cannot be amended except through lengthy and arduous procedures. Specific constitutional provisionis and certain treaties might therefore have to be amended, no matter how onerous this procedure might be, to facilitate implementation of the privatization program. This is particularly so for countries with socialist constitutions. Moreover, constitutional provisions may prohibit the privatization of an economic sec- tor such as natural resources or infrastructure, subject it to special rules and limitations, or restrict foreign investment. In many cases, however, suitable legal techniques are available to allow the legislator or government to cir- cumvent obstacles that may appear to be major constraints. Other constitutions allow privatization but make it conditional on partic- ular safeguards. Thus the constitutions or constitutional principles in many countries prescribe that a law be enacted to authorize the privatization of SOEs (or some of them). Privatization programs may be subject to control by the courts of their constitutionality. Nor should the importance of treaties and other international agreements be underestimated. Witness the impact of bilateral civil aviation treaties on airline privatization and of many provisions of EU law on privatization in member states. Finally, basic legal principles, including constitutional principles, matter because they establish the framework within which all activity (economic or other) takes place. They may inspire confidence or they may promote 17. A government preparing an airline privatization would rarely have the time to renegoti- ate all these bilateral air transport agreements in advance or to agree on a new interpretation. In some cases governments may agree to give a relatively wide interpretation to the terms 'sub- stantial ownership" and "effective control" contained in the agreements they have signed. A lower domestic shareholding could be regarded as adequate in certain circumstances (for example, when it constitutes a minority holding sufficient to block important decisions) See Rapp and Vellas 1992, p. 57. 44 The Privatization Challenge skepticism. A legal system that functions efficiently and guarantees respect for the rights of citizens and economic agents, especially regarding owner- ship and contracts, can only facilitate successful development of a market economy and the privatization process itself. 3 Privatization in a Market Economy A legal environment that fosters private-sector development is essential to the success of a privatization program.1 For example, rules defining and protecting ownership and ensuring fair competition among economic oper- ators, commercial law provisions affecting the privatization process itself (directly or indirectly), or legislation governing the functioning of the priva- tized enterprises wvill all have a substantial imnpact on the implementation of the privatization program. Because of their importance, some of the legal provisions examined in this chapter may need to be amended, suspended, or repealed to permit or facil- itate privatization. For example, measures that discriminate against the pri- vate sector will have to be abolished. Many countries have radically rede- fined the role of the state in the economy to create and maintain a level playing field that allows private entrepreneurs to engage in economic activ- ity free from unfair competition or interference from government agencies. In doing so, they have shifted the focus of state intervention: the public sec- tor is no longer directly involved in productix e activities; it now plays regu- latory and promotional roles.2 As mentioned in the introduction to this book, such a change is equivalent more to privatizing the entire economy than to privatizing an enterprise or a specific economic sector. It calls for major adjustments at all levels; hence, a strong political commitment is 1. Some counltries have attempted to privatize in the absence of minimum rules governinlg the functioning of a market economy That happened, for example, in Guinea immediately fol- lowing thie Sekou Toure era. A fairly large privatization program was implemented in 1XS8-87. In view of the uncertainties of the legislation in force, the privatization agreements had to be ratified by presidential ordiniance, giving theml force ot law. Despite this legal protectioni, the success of the program was less than complete: manv pr vatized enterprises ran inito difficulties in restarting productioni and achieving financial viabilitv. The countrv's generally unfavorable business climate played a considerable role in this outconie. 2. Even in core public services, the traditional role of the state has been radically revisited in many couuntries, with increasingly stronig participatioll Iw private operators in the provisioni of such services. On this subject, see chapters 1 and 7 4. 46 Thev Primatization Challenge essential not only to push through a legislative reform program that includes privatization but also to ensure its effective implementation. Rules that govern business activity in a country need to be reviewed before the launch of the privatization program to determine whether they are compatible with the proposed measures. This analysis should clarify whether the proposed divestiture program can be implemented within the existing legal framework or whether legislation must be modified to allow or facilitate privatization. Ideally, all the laws described in the following sec- tions would already be in place, providing a legal framework favorable to private-sector development in general and to privatization operations in particular. In practice, however, especially in developing and transition countries, the reform effort must focus on the core part of the legal framework that must be in place if the privatization process is to succeed. Any other approach would cause endless delay. The scope of such essential legal reforms will depend on the specific characteristics of each country and each privatization program. The relative importance of the shortcomings or inadequacies identified in relation to this ideal environment must first be established. Needed reforms should then be undertaken by directly amending the per- tinent legal instruments or by incorporating amending provisions in the privatization legislation. These amendments can be either general in scope or restricted to the privatizations carried out pursuant to the law. Many of the topics examined in this chapter have been covered by special provisions of privatization laws.3 This overview of the overall environment for economic activity starts with property rights, followed by competition policy and law. A broad range of laws affecting business activity is then covered, including contract law, com- pany law, accounting, and so on. A special section on social legislation cov- ers labor issues, employee ownership, and pensions. The chapter concludes with sections on environmental legislation, dispute settlement mechanisms, and foreign legislation. Property Rights Property rights are the backbone of a market economy and are normally pro- tected by a country's constitution or constitutional tradition. As discussed in chapter 2, some constitutions or legal systems, especially those of commu- nist countries, do not recognize the right to private ownership. In such cases the constitution will have to be amended to allow privatization to take place, 3. Chapter a deals only with the basic enabling provisions of such laws, namely those that authorize and govern the actual privatization process. Specific provisions enacted in many countries to remedy the deficiencies of the existing legal framnework are addressed in chapters 2 and 4 as well as this one. Priz?atizatiwi i ij a Markct Ecowwmlfnt 47 as happened in recent years in central and eastern Europe (1989-90), the former Soviet republics (1991-92), and other countries, such as Viet Nam (1992) and Guinea-Bissau (1991). In essence, privatization is the transfer of ownership over given assets from a public entity to a private one. Ownership rights are therefore vitally important.4 They encompass a bundle of legally recognized rights, in partic- ular the right to use and control assets (including voting rights), to draw eco- nomic benefits from ownership (return on assets, including rent, interest, or dividends), to dispose of such assets (for example, by selling, donating, or destroying them), and to transfer any of the above rights to others. These rights may be restricted by law, but not to the point where they would become meaningless. Hence, one can speak of full ownership only if the owner is able to exercise these various rights. Earlier reforms in many transition countries carried out before privatiza- tion exacerbated problems with property rights. Under the pure communist model, all property belongs to the state, vet during the transition process various stakeholders were given increasing elements of property rights. Managers and employees of SOEs were, for instance, given control rights that elsewhere would belong to the owners. These acquired rights could not be ignored at the time of privatization. In Poland, for example, the government could not sell SOE assets without the agreement of the workers' council of the SoE. "Attempts by the government in 1990 to abolish this right of veto through changes in the enterprise law provoked strong resistance by the Councils and could not get through the parliament. This shows that the question of ownership was by no means clear and that workers reasonably expected a preferential treatment in the course of privatization" (Albrecht and Thum 1994, p. 714). As part of the corporatization policy of Poland's 1990 privatization law, the state treasury became the legal owner of enter- prises while the workers' councils were dissolved. Successful privatization depends on the ability to transfer free and clear ownership titles. In preparing a privatization program, several items must be unambiguous: how ownership rights are defined in the country con- cerned; how private ownership rights are recognized and protected; what restrictions, if any, are placed on the transferability of those rights; how the titling, registration, and cadastre mechanisms function (or in what ways they are deficient); what enforcement mechanisms exist to protect the rights of individuals, and, particularly, how effective the judicial system is; what restrictions may be placed on foreigners with respect to the acquisition and exercise of ownership rights for certain types of property, such as land or other real-estate assets; and so on. It is important also to ascertain whether proper procedures exist to establish mortgages and other forms of collateral and to determine how effective foreclosure procedures are. 4. This section addresses private ownershiip; i,sues relating to public ownership are dealt with in chapter 4. 48 rhe Prizvaf ization Chlnllegllg Privatization legislation should remove any obstacles that arise when a country's property regime is unclear, ownership rights are not properly pro- tected, or restrictions are imposed on the acquisition of property by foreign- ers or other groups. If that is not feasible, or if doing so would excessively delay startup of the privatization program, other methods for circumvent- ing these obstacles might be considered, including contractual methods such as leasing (see also table 5.1). Past Nationalizations As noted in the introduction to this book, the current privatization wave fol- lows a long period of nationalization of private enterprises and assets. Privatization often reverses these transactions. Ascertaining the rights of former owners whose property was confiscated, expropriated, or national- ized may require detailed investigation. Did expropriation take place legally,5 and do the former owners (or their heirs) still possess legally pro- tected rights over the assets to be privatized? Were they properly compen- sated or indemnified, or do they have outstandinig financial claims against the state? Are there various categories of previous owners, and, if so, have they all been treated in the same way? Are the claims subject to a statute of limitations or some other time frame? This section focuses on the situation of former communist countries, where these have been particularly thorny issues, especially in view of the sheer scope of past nationalizations and the variety of nationalization regimes involved. Should a detailed analysis of these issues be required, and should it reveal that the previous owners still possess enforceable legal rights, a fair balance must be struck between these rights and those of other parties, such as cur- rent occupants or new owners in good faith, taking into account also the potential cost of restoring the situation that prevailed before expropriation. These matters will often have to be clarified or settled by means of law. Some countries have opted for restitution as a way to redress expropria- tions that took place illegally or without proper compensation. This formula may work satisfactorily where the expropriation laws were limited in scope and were applied relatively recently. In most other situations, however, assets are likely to become the subject of conflicting claims that will need to 5. Unfortunately, laws are not always fair. In sonie legal systems, unfair laws may also be ille- gal undercertaincoiiditions. Thietermn legally" mneansin iaccol dance witlh thc laws of the coull- try, whetier they are fair or not. Legality and justicea re two ditterent concepts. 6. In East Germany, for example, some assets were expropriated by the Nazi regime, othiers between 1945 and 1949 under the Soviet military goxvernnment, and still others after 1949 by the East German communist regime. Sonic of these expropriations were carried out pursuant to law and others by arbitrary decisioni of the governminct. Apprepriate compensation was paid in some cases but not in others. Statutes of limitation may appiv. Depending oln the circumstances of each case, the expropriated owiner (or the owiner's heirs) nia' or may not have legally pro- tected rights. Privatization il 7 a Market ICo17oiuly 49 be resolved. In some cases, titles or other documents evidencing previous ownership and transfers will no longer exist. Moreover, the previous owners may be deceased and different heirs may claim the same piece of property. The assets may have been developed, destroyed, or even leased or resold to a private party acting in good faith.7 In Romania, for example, no fewer thani 300,000 claims were filed in the courts as a result of restitution of alternative plots of land to former owners whose original land had, since expropriation, been converted to nonagricultural use (see World Bank 1996, p. 59). To make matters worse, the judicial systems of these countries are rarely able to ad ju- dicate the multitude of claims that restitutioni laws generate. To avoid over- loading the courts and to ensure more uniform treatment of claims, some countries have set up commissions or other special bodies to examine claims made by previous owners.8 Finally, because they foster substantial uincertainty about ownership rights, restitution laws can discourage investment, particularly foreign investment)9 It was mainly this consideration that led the German authori- ties to amend their system of restitution. Indeed, the German privatization law of 1990 initially made restitution the primary method of redress for owners whose property had been unjutstly confiscated. This formula proved to be impossible to apply, however, because most assets were the subject of conflicting claims; the privatization process ground to a standstill. The Ger- man parliament had to enact a "law to remove the obstacles to privatization of businesses and promote investment" tlanN of March 22, 1991). That law added a new article 3 (a) to the 1990 law on the settlement of disputed own- ership issues, authorizing fast privatizationi of assets essential for invest- ment or business purposes, regardless; of outstanding restitution claims. In a statement made in Washingtoni, D.C., on November 14, 1991, Birgit Breuel, then president of the Treuhandanstalt, stressed that new investors able to preserve jobs or provide additional investment should take precedence over former owners. Special provisions authorized the Treuhandalnstalt, for a specified period (to the end of 1992), to sell disputed assets while limiting the rights of the former owners to monetarx compensation from the Treu- handanstalt. This amendment substantially speeded up implementation of Germany's privatization program. 7. As Vaclav Klaus, then miniister of finance of ( ,ech,oslovakia, stated in a letter of June 21, 1991, to a Czech emigre, "It is not possible to ask for the, urrender of property from people who have acquired it from the State in good faith, i e. not through illegal means." S. See, for example, Ghana's 1479 d1ecree setting up a 'Confiscated Assets (Recovery and Dis- posal) Committee." See also Horn 1992, p. 2e, concerning East Germany: "Successful restitu- tions, however, amount onlv to 5 percenlt ofall restitutioll claims Ifiled bvl Spring 1992. More than one million of such claims have been filed, and the great majority has still to be channeled through a special bureaucracy, the offices on open question" of property." 9. See, in particular, Gelpern 1993, ppF.32; 2(-, which refers to a joint statement made in Czechoslovakia in February 1991 by 27 economist. deiouncing the burden placed on foreign investments by restitution laws. 50( The Primtizat inM Challengc Any country that opts for restitution must set a deadline for filing claims. After that deadline, it should be possible to privatize unclaimed assets with free and clear title; the rights of previous owners would either lapse or give rise to monetary compensation by the government."t' Such a measure would limit the spate of postprivatization suits by former owners against the new owners that occurred in Czechoslovakia and other countries, to the detri- ment of the privatization programs. In practice, the choice between restitution and compensation will be based largely on political and historical considerations. In Czechoslovakia, for example, where several laws have been enacted to deal with this matter, restitution was considered necessary to mark a definite break with a com- munist regime which, after the Soviet invasion of 1968, had become one of the most conservative in eastern Europe.'1 The laNw concerning the allevia- tion of certain injustices regarding ownership was probably one of the most popular and least controversial restitution laws, because it aimed at restor- ing assets confiscated from numerous small owners under nationalizations imposed on the morrow of the Soviet intervention of 1956. In Poland, on the other hand, the lack of special legislation concerning the rights of former owners is explained in part by the power of the unions, which are tradition- ally opposed to restitution on grounds of equity. Granting compensation makes it possible to indemnify former owners, who had been illegally or unjustly dispossessed, wvithout all the drawbacks associated with restitution. This route does, however, present other prob- lems. Budget constraints, in particular, can prevent governments from prop- erly compensating former owners, as has been the case in Hungary, for example (see box 3.1). This explains the low popularity of this system with dispossessed owners. Generally speaking, though, compensation is usually preferable to restitu- tion. Paying compensation is often both more efficient and more equitable than restitution. All affected parties can be treatedi in the same way, regard- less of the eventual disposition of the assets they *nce owned. By separating the assets to be privatized from the claims to which they give rise, compen- sation formulas allow the government to privati/e previously nationalized assets unencumbered. The buyers receive clear title, and any residual claims are pursued against the state (or another public entity), not against the new owner. Where appropriate, this system can be supplemented by granting the 10. The Bulgarian privatization law of April 1992 follows this procedurL: previous owners can file a restitution claim withini the two months following the date of publication of the deci- sion to privatize an enterprise. After that deadline, owners can no longer ask for restitution but only for compensation by the state. 11. Law no. 403/90 of October 2, 1990, pertaining to the allex iation of certain injustices con- cerning ownership (the small restitution law) dealt with prnperty confiscated after 1955; Law no. 87/91 of February 21, 1991, known as the extrajudicial rehabilitation law, or large federal restitution law, set February 25,1948 (the first day of the cmrnmnunist regime), as the relevant date for restitutioni purposes; and Law no. 229/91 of May 21 1991, diealt with the adjustment of rights pertaining to land and other agricultiral assets. Privatization in a Market Economy 5l Box 3.1 Compensation of Former Owners in Hungary Hungary is one of the few central and eastern European countries not using resti- tution. Owners of assets expropriated by the state after June 8, 1949 (that is, under the communist regime), had to be compensated under the 1991 compensation law. However, total compensation was capped at 5 million forints (about $50,000) and calculated at regressive rates, using a formula that takes account of location and size in the case of land and buildings and of number of employees in the case of businesses. Moreover, the government did not pav the compensation in cash but in the form of interest-bearing bonds negotiable on the securities exchange and usable for buying privatized public assets (including company shares). A 1991 article in the Washingfton Post, "Hlungary's Compensation Promise Proves Hollow for Many Claimants," stated: "The 'compensation bonds' are viewed skeptically because the government has not specified which companies or apartments they can be redeemed for. Manv Hungarians concluded that they would be offered only the worst of the state's assets. And just getting the dubious bonds is difficult because the government is demanding stringent documenta- tion for each claim.... Applicants must provide an array of documents that are difficult to obtain. Land deeds are essential, but many families lost them over the past four decades. Often the deeds were taken by the Communist authorities." Claims are examined by regional compensation offices whose decisions can be appealed to the courts. In addition, the former owners enjoyed a preemptive right to purchase their former assets when these were put up for sale by the government or some other public agency, except in the case of rental housing, where priority for purchase was given to tenants. Moreover, part of the equity of newly transformed enter- prises or of the proceeds from privatization was allocated to a compensation fund. The choice of compensation over restitution was explained in the preamble to the Hungarian law by the need to develop a market economy, which makes it necessary to minimize uncertainty about ownership of assets. The preamble also points out that former owners are not the only people to have suffered under the old regime. It is estimated that, as part of this program, compensation coupons with a redemption value of over 200 billion forints (over $1.5 billion) were issued to over one million Hungarians. The supply of state assets for which such couponls could be exchanged was, however, quite inadequate for some years, which severely depressed their market value. In early 1994 they were trading at about half their nominial value; brokers or other intermediaries bought them at a dis- count, hired people to stand in line at privatization auctions, and participated in such auctions using the compensation coupons at their face value to pay for privatized assets. On January 25, 1996, whenl Al'\ IR, the state holding alnd priva- tization agency, decided to set aside for coupon holders about 8 percent of the shares in the country's six power distribution companies and smaller percent- ages of other major energy companies, the price of the coupons jumped from 35 to 195 forints; by February 6, they had reached 257 forints, which wvas still only about a quarter of their face value. Soutrces: Finait cc, East E irope, 9 February 19'J%, pp. 9-0(1; Prica (>sa(ioti Xi'srbook 1995, p. 53; Eiromnonuc'i, March 1994, pp. 15-16; Wasihugton Post, 26 October 1991, p. A14. For a study of the main judicial means of redress before the enactment of this law, see "Hun- gary: The Constitutional Politics of Compensation. Soziet & East lErlincwani Lim' 2 (4), Colombia University, June 1991. 52 The PriVmatizotiOln Challen¢ge former owners a preemptive right to, for example, buy back their assets at the price offered by the highest bidder at auction. Future Expropriations Depending on specific country circumstances, investors may demand guar- antees against renationalization before they will commit themselves finan- cially. Acceptable legislation on the eminent domain right of the state, which spells out the government's expropriation powers, is crucial in this respect. In practice, all countries reserve the right to expropriate property, against fair compensation, if the public interest so requires (for the construction of major infrastructure projects-roads, ports, railways, airports, and so on- for example). These expropriation rights must, however, be limited in scope and subject to judicial review. The existence of suitable expropriation legislation does not in itself guar- antee that unfair or politically motivated expropriation will not take place: the legislation may be suspended or amended and the authorities may decide to ignore it. Investors will take due account in calculating their risk of any uncertainty about the powers that the authorities retain to expropriate assets or to amend this legislation. 12 Intellectual Property Investment decisions, whether made by foreigners or nationals, rely on the existence and effective enforcement of laws protecting intellectual property, including international agreements to which the country is a party and domestic laws concerning patents, trademarks, copyright, trade secrets, know-how, and licenses, among other things. The tax laws determine the extent to which revenue from the transfer of technology (royalties, for exam- ple) is taxed by the state. Many countries also have specific laws or provi- sions for the protection of intellectual property in specified sectors of the economy (pharmaceutical products, for example). In privatization transactions, investors will seek not only reassurance con- cerning the overall legislative framework for protection of intellectual prop- erty but sometimes also supplementary protection, which will not necessar- ily be consistent with the country's competition laws. Investors may also resist attempts by the privatizing government to compel them to transfer specific technology or licenses to the privatized enterprise. It is not uncom- mon for countries to simultaneously pursue a privatization program and a program to strengthen protection of intellectual property. For example, in 12. Insuranceagainst political and noncommercial risks can be obtained from the Multilateral investment Guarantee Agency (MIcA) anid also fromi nationIl or private insuranice entities. The World Bank (iioRD) also has a guarantee program covering political risks in the broader sense, including expropriation and noncompliance by a government or other poblic agency with its contractual obligations. Prin'aiz:ationt i/1 a Malarkct Eclmoim 13 1992 Peru embarked on a major privatization program; toward the end of that same year, it also set up a new agencv responsible for the protection of competition and intellectual property. All was part of an ambitious policv for economic deregulation and modernization.1 Protecting and Promoting Competition Yarrow made the point a decade ago already that "in general, competition and regulation are likely to be more important determinanits of economiiic performance than ownership. Hence, wh1ere there are deficiencies in these areas, the policy priority sh-ould normallv be to increase competition and improve regulation, not to transfer productive activities to the private sector. Indeed, preoccupation with the ownership question is likely to be damaging if it distracts attention from the more fundamiiental issues" (Yarrow 19'f86, p. 364). The protection of competition and, more generally, the creatioln and enforcement of a level playing field in the marketplace are among thle mnost important and complex functions of government, affectin,g many differenit areas of economic policy and law and calling for aI higl level of bureaucratic competence. Ireprivatization reforms and restructuring measures wvill often be required to create the requisite competitive environment (see also the sec- tion in chapter 4 on prior restructuring of I{M s). Nonid isc r itiitottiot asgainst the Private Scctor Absence of discriminatio)n between the private and public sectors is an essential part of competition policy and a particularly important factor in privatization transactions. The private sector must be allowed to compete with the public sector on an equal footing. This implies, among other things, removal of subsi- dies, including public loan guarantees, at least in the case of SOEs operating in competitive sectors (public finanice and 'i legislation); harmonization or alignment of the tax systems applied to SOI-s and private enterprises (tax legis- lation); uniform application of environmental law, labor law, and other legisla- tion affecting areas of economic life important to all enterprises; removal of entry barriers hanmpering the private sector (sector legislation); and equal access to public contracts (public procuremiienit regulations). Establislhment and main- tenance of this level playing field must be protected bv law. In some counitries- Brazil, for examnple-this type of guarantee is even found in thl con1stittution. 14 13. 1'ressure b tIhe U.S. government plaved m, sm,11 part in Peru- cftoron. to -trriAgtllLn mechansniss for the protectioll of intellectual p roperk l e A,dc Wall/ s /1r t s1ir, a, F; April 19'4, p. A9. Seealso bo\ 11. 14. Article 173 of th e 198S coinstitutioln pros idis tIhat urL hOC corporatlionl . joint-ven ture coni,- panies, and uther public entities that engage in economiic activitv are subject to the same legal system as private companies, inclucing labor and ta\ tule> (paragraph I ); in addition, public corporations and joint-venture compa nies shall niOt 'Injor ariv tax privileges that are 001 extenidetd to the private sector (paragraph 21 54 Tl17t Priz)atizatio" Chalk',izgt Abolishing preferential treatment for SOEs in public procurement is often a vital component of good competition policy. The public contracting system is important not only from the standpoint of public finances (cost control) and public ethics (fraud prevention). In most countries, the state and the public sector in general, including municipalities, SOEs, and other public entities, are by far the largest potential customers for goods and services. Retaining access to this market is of vital importance for an investor in a newly privatized company. A fair and transparent public procurement sys- tem, consistently applied, is the best guarantee for that investor. Price Liberalizationi Free and autonomous price setting by businesses-subject only to certain limits to prevent or penalize abuses-is essential to the sound functioning of a competitive market economy (see the section btelow on antitrust legisla- tion). Price liberalization should normally precede privatization, especially in countries witlh heavy price controls (central and eastern Europe in the early 1990s and India, for example). Without freedom to set prices, few investors would be interested in acquiring SOI s. Moreover, if an SOF were sold at a relatively low price because price controls were hampering profit- ability, subsequent price liberalization could produce windfall profits for the investors. This outcome would inevitably reflect badly on thie authorities, who would be accused of having sold off the SUE at a bargain price. Moiiopolies andl Anititruist Provisions To deter attempts to restrict competition, it may be necessary to enact laws applicable to public and private enterprises that would prohibit the estab- lishment of cartels, trusts, monopolies, and other restrictive business prac- tices. The introduction of such legislation might block certain privatization transactions that would have otherwise proceeded. For example, the acqui- sition of an SUO or other state-owned asset by one of its competitors could result in excessive concentration. The privatization process should not nor- mally lead to the simple conversion of public monopolies into private ones, or to the formlationA of monopolistic or oligopolistic situations whlere onle or a few companies control the relevant market without any countervailinig checks.15 Nevertheless, the formulationi and enforcemenit of competition rules involve a cost that sometimes outweighls thL benefits they produce. 15. Where natural monoppolies are privatized as such, thev wvill generally need to be regu- lated. This topic is examinied in greater detail in chapter 7, which deals with the privatization of infrastructure. Account also has to be taken of any es1isti1g tarift protecti(oin in evaluating mnioiopolistic or oligopolistic situations (see the section telxLMs oin foreign trade legislation ). Priviatiza th inl a M rAkct Frn mt in 55 The breakup of monopolistic SO;Es prior to their privatization, sometimes called demonopolization (see chapter 4), ought to be considered whether or not antitrust laws exist. This route, where feasible, is generally preferable to setting up a complex system of regulation to prevent abuse of dominant positions; this is especially true in couLntries with less than satisfactory administrative and judicial capacities. 1 In the presence of natural monopolies, regulation will often be indispens- able to prevent the monopoly company from extracting rents by restricting supply of its services and selling them at high prices or otherwise abusing its exclusive market position. In many countries public monopolies have not been subject to regulation, precisely because thev were thought (often wrongly) to serve the public interest rather than the profit motive. Privatiz- ing these monopolies calls for the establislhment of a regulatory framework for those activities that cannot be exposed to competition (see chapter 7). Where antitrust legislation does not exist or is ineffective, specific compe- tition rules mav also be inserted in tender doctuments and privatization con- tracts. Privatization agreements therefore sometimes include provisions that prohibit or restrict the company's potential for horizontal or vertical integra- tion through takeovers. Finally, it is worth noting that enforcement of antitrust or antimonopoly legislation is often entrusted to a speciali/ed competition commission or office, such as the German federal cartel office or the U.K.'s Office of Fair Trading and Mergers anid Monopolies Commission. Sector-specific competi- tion rules, on the other hand, are often subject to special regulatory bodies, as further discussed in chapter 7. Dclrcgiilat7ioii Many countries are burdened by a multittude of rules and institutions gov- erning the exercise of all economic activities. If these countries wish to attract investors, they should streamline these regulations and procedures for obtaining licenses and other official permits required to conduct busi- ness. For example, a rule that required the use of products of domestic origin might prohibit an investor from using traditional suppliers (including com- panies controlled by the investor); the investor might therefore lose interest in participating in the privatization programn. lb. In an article entitled k iforcmigri Ati7iw 7i act Le Ccidral [r Frpc , Michael Reynolds wrote thatdespite the recent enactment in Poland. lungarv and C'echoslovakia of competitioin laws modeled ojn European Communlitv legislation, newly-privatized enterprises will continue to operate in the cOntext of a heavily concentrated distribution system . It wvill take a long time to shake off bad habits acquired over orme 40t ve,1r, in a A stem rXwhere markets were shared out w,vith impunity, complete sector-, were dominated bx a s1cgle monopoly and eiterprrises traded on agreed pricUs fixed bv government ... fundunindeintal question is how effective will the enforcementofthese lawsbe? Many countries bave onipetition laisson the statutebook which are often quietlv ignored or eiforcedli half-eartedlyv F,iucil l,oici S, 26 September l91) , p. 14. 56 The PrizatiZation Challenge Since 1991 India has abolished many industrial licensing requirements in pursuit of its liberalization program. Similarly, as part of a broader economic reform program that includes privatization of most of the country's SOEs, President Menem of Argentina signed a decree in October 1991 abolishing dozens of government agencies, including some of the 36 or so agencies involved in regulating foreign trade, and eliminating the often petty con- trols that beset private business activity (see Financial Times, 1 November 1991, p. 8). Foreigni Trade Legislation Low or moderate external protection (for example, through low tariffs and nontariff barriers) fosters competition through imports. In their negotiations with government, however, investors will often try to have foreign trade legislation either applied or amended to their advantage, something that may conflict with the objective of an efficient and competitive economy. As an example, many investors have sought special protection against compet- ing imports. If a buyer is indeed granted exemption from the normal provi- sions of a country's foreign trade legislation, this should be done transpar- ently and factored into bid appraisal. An investor will obviously be willing to offer more for a company that is protected against competition from for- eign operators on the domestic market. This higher sale price, however, will normally be outweighed by the cost to the economy of granting this protec- tion.17 Investors will factor in more than tariffs and quotas; among other for- eign trade-related issues, they will consider export subsidies, import and export technical controls, and shipping formalities, as well as bilateral, regional, and multilateral trade agreements. Major Aspects of Business Law Laws governing business activity determine how attractive a country is for private investment. They also affect privatization operations directly. Conttract La0t Contract law and enforcement mechanisms for private contracts are a cor- nerstone of the legal framework of a market economy, because they deter- mine how ownership rights are transferred. One of the basic concepts of any legal system is described by the rule of pactc? so lit servanda, which reflects the obligation of the parties to honor the agreements they make. The subject is 17. Guinea, [ogo, and other countries have granted Xvery generous protection in certain priva- tization operations-for example, in the form of high import tariffs oni competing products. Prim tizatit)))ill a Ml7rket Eca tam ii 57 too broad to be studied here. Suffice it to say that contract law is crucially important to private-sector development and to privatization operations, which are always executed by means of contracts, typically tlhrouglh a com- plex set of closely interlocking contracts.1 8 COMn1 porn, a177 1 In principle, company law sets the basic rules for establishing, managing, operating, and liquidating companies. Company law authorizes the creation of companies with different types of legal status (with and without limited liability, joint-stock companies, and so on), grants them juridical personality, sets minimum capital requirements, lays down rules governing the sale or transfer of shares, defines the principles governing the distribution of pow- ers within the company (notably the functions and powers of the sharehold- ers' meeting, board of directors, managemenit, and employees), and so on. Generally speaking, company law empowers companies to depart from cer- tain default provisions of the law and to devise their own method1s of opera- tion, provided the company's shareholders ancd creditors are adequatelv protected. The importance of a good legislative framework governiing the operation of companies cannot be overestimated; this point is illustrated by the difficulties many transition countries have encountered because they lacked such a framework (see Gray and Hanson 1993). Privatization can be facilitated in some instances bv unbundling the rights deriving from SOE shares, for example, bv separating dividend and other income riglhts from control and voting rights, or by limiting the riglhts attached to certain classes of shares. Such modalities mav or may not be allowed, howvever, under existing companv or securities legislation. In some countries, such as Mexico and Jamaica, differenlt categories of shares hiave been issued with different rights; some of the holdings retained by the state in partially privatized companies have been stripped of voting rights wlhile they remain in government hands. A formula of this kind is particularly useful where the government wants to transfer an SOE to private conitrol but does not wish to divest the majority of its shares all at once, either because the capital market is insufficiently developed or because it is couniting on the new private management to improve productivity and boost the value of the stock before it puts a second tranche on sale.19 Likeivise, although 18. Moreover, in some econormic sectors, sLch am h0tel nagement, succestuJ pri\V.ti/tion may depenid on the possibility of concluding and enforcing special types of business contracts, such as management contracts, leasing, or franchi>ing. 19. Some investors may also think that continued state hareholding in thie privatized comil- pany gives them additional comfort by reducing the risk that the companly mav be alfected by adverse governmental measures. No general answ,ver can be gi% en to the qtuestion of Whether continued state participation in the capital oif a privatized companv has a positive or negative effect on investor confidence and therefore on share pri. es. That will diependt largelv on the degree of control the government retains and on its reputation with investors. 58 Thc1 PriuatLatioo Challknge investors may in some instances not wish to mobilize funds sufficient to buy outright control, they may not invest at all tunless they have the right to appoint the company's management team and to designate a majority of board members and are protected by other special provisions, such as a higher quorum and qualified majorities for decisions at shareholder meet- ings. Company law should permit the adoption of such modalities, either by allowing the creation of different classes of shares or througlh other mecha- nisms. This techlnique has been applied in some piivatizationis of large infra- structure companies.2t0 Another technique, one that is much less reassuring to private investors, is the allocation to the state of golden shares, whichi confer powers exceeding those that exist under ordinary company or securities law even though the state may have a minority holding of only one share (see chapters 5 and 7). Another form of unbundling of rights (found in I rance, for example) is that of investment certificates issued by SOFs, wlhichi can be compared to preferred shares without voting rights. The purpose of these certificates was to raise private capital by offering investors an opportunity to share in the enter- prise's profits, but without granting them a correspondling share of control. Private shareholders in a joint-venture company with the government may be entitled, under company law and the company's owni articles, to approve all transfers of slhares to nonshareholders if the government chooses to divest itself of its holdings. They may also have preemptive rights. Where this is the case, the government may wish to consult the other shareholders first to explore the available options for restructuring or priva- tization. Moreover, some privatization laws provide for express derogation from ordinary company law to deny minority shareholders the right to block privatization transactions. 21 It mav be preferable to avoid provisions of this kind, however, because they amount to ii unilateral amendment by the government of a commercial agreement. Privatization can instead be an excellent opportuniiity to protect the rights of minority shareholders. This is particularly important where SOPs are privatized in full or in part by public flotation. I ack of proper protection of minority shareholders, especially small ones, mav either deter their partici- pation or create important political problems down the road. This is true whether the state (or public sector) remains the controlling sharelholder, whether the privatization includes the transfer of a controlling block to a 20. Examples include the privatizationi of Telmex (Mexl(o), MAIAV (Hoingary), and (iANrI'V (Venezuela), three telecommuniicatioiis companiies in wlhich, following a competitive bidding process, a private consortium was selecte d to take over control of the company withi a minority shareholding, with the state remainiing, at least in the iiihtial tage, the maajority sharelholder. See also chapter 7 on the choice of strategic partners. 21. See, for exampil, article 15 of Senegal's 1987 privati/.tion law, wLhiich provides that the provisions of tihe Civil Code requiring prior approval lby the other sharelholders of all sales to nonshareholders shall not apply to share transfers carriod out pursuant to thie privatization law. Priz'atization in a Mnthl-kt Eco mutt(iy 59 single shareholder or group of shareholders, or whether that controllinig stake is acquired on the secondary market following the flotation.22 Preemptive rights can be exercised bv the private as well as public share- holders in a joint-venture company. When public sector shareholders have such rights, one may encounter situations of privatization by omission. The government may decide to waive or not to exercise its right to subscribe to a capital increase in a company; where it has a majority shareholding, that omission mav even allow the company to pass into private control, as occurred in the privatization of Lufthansa, for example. The share of the German state in the airline fell from a controlling 51.4 percent of the capital before the 1994 capital increase to a miniority 41 percent afterward. The rules pertaining to the creation, operation, and sale of subsidiaries, affiliates, and branclhes also influence the choice of privatization technliques. This issue is an important one for maniy reason,s, amiong tllem: (a) the prolif- eration of SOE subsidiaries, subject in manv countries to ordinary company law;23 (b) the existence of state holding companies that are shareholders in a whole series of S(Es; and (c) the fact that private buvers of S(Es are often existing corporations, whlich) may vwish] to imnAe the aCqolired company a subsidiarv. On this point, it is interesting to note that the Treuhandanstalt has been involved in legal controversv concerninlg the extent of its liability for the debts of companies under its control. Indeed, according to German jurispru- dence, a parent company is liable for the debts of its subsidiaries if it inter- venes in their business affairs or fails to keep its assets clearly separate from those of the subsidiaries (see Horn 1992). The situation is more clearcut in 22. A case in point is the gradual divestiture b ts etwn 1987 and 1993 ot the Turkish goverin- nient's shareholding in (;ukurova Elektrik o. r,J,0, an inte! rated power utility. Shares weresold in several tranches, somes through the Istanbul stock exchange. others bv subscriptioin or through block sale. The government's retmaining shires N% crc sold in early 1993 to Rumeli Il-old- ing, a Turkishi family group with broad business interetsts. V A!S became onec of the counitry's most active stocks. In November 1995 management of th compaLny was placed undler thIe coni- trol of the energy miniistry following allegation, of widespread irregularities, incluLinig breach of its license and violation of the rights of minority hareholders The coi trolling Uzani family had used ( r,s's cash flow to) finance its other business interests, includiig the acquisition of cement factories and a mlobile telephone company, whilt dListributinig little or no dividends to minority shareholders. The investigatioll becaC me '- path-tinder cast inll Ipho0lding miinoritty sharehl)]der rights, as well as in regulatio if privati ed t mprani es" tfF,iu;t-kizl 'Jim , 7 No V't' - ber 1995). The Furkish capital markets board appOiintelt a new board, but following a deal struck between the government and the Uzan familk the latter regained conitrol of ci \S in lanti- arv 1996. A monthi later, a Turkish court suspended the new board following a clainm filed by the capital markets board as part of an attempt to force Rumili Holding to buv back the shares ( J,L bought in the cement and telephone companies. See P'ol i I-iic (s'i En,ftii( Tic'l,), 26 Januarv 1996; Powverv A.g ntumaber of countries. Potential buyers in privatization transactions are often less interested in the official accounts of an SOF than in a precise statement of assets and liabil- ities. They wxill in any event want to perform their owni valuation of the com- pany. Thley will waant to undertake a thorough audit of the financial situation of the SOr and will usually place little faith in its official accounts for several reasons: because the country lacks adequate accounting regulations, because the potential buyers are n1ot familiar witlh the accountinig standards (which may vary greatly fronm the standards tlhev are used to), or because the SOF's records and accounting practices are unIsatisfactory (see also the sec- tion on1 valuationi in chapter 5). In the case of a public flotation, on the other hand, individual investors lack both the opportunity and the means to examine the company's opera- tions and accounts personally. They have to rely on financial statements audited and certified by reputable indepenidenit auditors. Moreover, such PrivatiLati Wi in a a Marklt IEc iioiii t l auditing is normally a prerequisite for listing of the company's shares on a stock exchange. The example of Chinese privatizations is interesting. The Chinese authorities have opted for a nunmber of privatization techniques, including public flotations. When a companiv is to be listed on the Shanghai or Shenzhen securities exchange, the accotunts have to be reformulated for that purpose. For companies listed on the Hong Kong or New York exchange, the accounting and auditing rules are far stricter, with the result that the company must take much longer to prepare the accounlts and must seek assistance from internationial accountinig firms. The existence and effective enforcement of accounting rules consistelnt with generallv accepted international accounting principles will improve the prospects for success of the privatization program by increasinig trans- parency and predictability, and thereby reducing the buyers' risk.24 Liquitidatio/i i//Ili Ba7otkr-upl tculz Liquidation and bankruptcy are market-exit mechanisms throutglh wh1ich1 less efficient enterprises can be wound upL and resources released for more productive uses. They are also often used as privatization techniques. Though the two concepts overlap,25 they should be looked at as distinct privatization techniques. The term "liquidationi" applies to the wrinding uip of anl enlterprise wihenl, for whatever reason, its owners have decided.1 to dispose of it by selling its assets, paying off its debts, and sharing the proceeds among themselves pro rata to their respective shares. Throuiglh the liquidation process a gov- ernment can dispose of an SOE by transferring the ownership of its assets (and liabilities) rather than the enterprise itself. In most countries, liquida- tion is regulated by companv law.26 In the voluntary liquidation of a coim- pany, the owner is usually liable for any debts of the company outstandinig after the liquidation and dissolution procedure has been completed. Liqui- dation often facilitates speedy and efficient privatization bv avoidiy,g the formalities and complications of bankruLptcx. For that reasoni it is the pre- ferred privatization technique in manv countries, includ1ing Mexico in the initial phase of its privatization progranm and manv Sub-Sahiaran Africanl 24. For a more detailed discussion of aCcouing Iss us in Frin p)iza /ion, see bdideti/h i 1lon ot Acc'omitii7g Pr1-ollcms Alribig uittriois Pric'ati_c itcou i;i '-lir Coittiwni, Report of thie Secret. r''- General, United Nations Fconomic and Social Council. } /C lI//AC 3/I1L)92/5, 4 l2ebhrUaV 1 '92. 25. The term "liquidation" is used also to describe the stage of the hankrnptcv process in which the assets ofan insolventcompand .re' sold a nid he proceeds distribu led toits creditOrs and, where appropriate, its sharehiolders. 26. Il this context, investors will want to know tisiat ri tes would applI if they decided to liq- uidate their company voluintarily. Would they,, tor eta.nple, encounter restrictions oin sale' of assets or on repatriation of sale proceeds? Restrictioins ,t this kind, which are found in certain regulations relating to foreigin inveL'stmenIt or for-eignj; exchange operations, cai hinider the implementation of privatization operations. 62 The Priniti-fatio ho Cludlenge countries. Liquidation also tends to be the most practical privatization technique for SOEs witlh poor accounts or with unknowni, uncertain, or con- tingent liabilities. Bankruptcy, on the other hand, is not a recommenided privatization tech- nique.27 It has nevertheless been used in privatization operations in Mexico and other countries.28 Bankruptcy differs from liquidation in several ways. First, the bankruptcy procedure is managed or supervised by the courts, usually witlh the assistance of court-appointed trustees or receivers. Second, bankruptcy usually implies that the company is insolvent. The company's managers are sometimes required by law to file for bankruptcy if the com- pany loses the bulk of its capital or is unable to cotntinue to make payments; failure to file for bankruptcy may give rise to prosecution and penalties. Third, the procedure can be initiated by the creditors or the courts (or the public prosecutor), even over the objections of the ownier. The use of bankruptcy proceedings as a privatization technique assumes the existence of a smoothly functioning court system, a requirement that is lacking in many developing or transitioin countries where incompetenit, underequipped, or corrupt judicial institutions often hamstring this critical market-exit mechanism. Lengthy litigation is not uncommono in this area. In addition, many countries lack properly trained bankruptcy receivers to whom the courts can entrust the nmaniagemenlt of companies during bank- ruptcy proceedings. Moreover, since a companiy'.s creditors generally play the leading role in bankruptcy proceedings, choosing bankruptcy as the privatization technlique can hinder the pursuit of objectives otlher thani reve- 27. In Colombia, the assets of f'apelcol, a major paper manii tacturer that was placed under 'concordato" (similar to the "concordat" system in Frenchi commnercial l aw and the U.S. chapter 11 bankruptcy procedure), had to be taken out of bankruptcy proceedings by the ownier itself, a state-owned holding comiipaniy wlhich had becomne Papilcol's main creditor, before they could be transferred to a private company. 28. Aerormbxico was declared bankrupt in April 1988. In September 1988 a new compaly, Aerovias, withi capital of about 544,000(, was created with the bankruptcy receiver and the pilots' uinionl as shareholders. Aerovias took over the airline's operationis and conlMu3ded new contracts witlh the main unions, wlhichl represented a drastikally reduced work force. In the same month the receiver put Aerortnxico's assets up for sale The wiining bidder offered to buy miost assets, wvith tile exception of the aircraft, engine- anl uninleeded spare parts, together with 75 percent of Aerovias, leaving the other 25 percent t(i the pilots' uni)l. The bid also included leasing of the necessary aircraft. The bid was acCepted, and the sale contract was signed in Novemilber 1988. Adapted from Galal and other> 19914 (see also box I ). Followving their privatization, Mexicana and Aeromexico embarked on a commercial battle intensified by the arrival on1 the market of new air carriers. Mexicana rapidly rv into financial difficulties, bur- dened by the heavy debt incurred for 36 Airbuses. In Februar' 1993 Aeromtxico acquired cotl- trol of Mexicana, but did not succeed in restructuring and inte';rating it, and in turn found itself unable to meet its pavienwts in September 1994. The company was theni taken over by a conlsor- tium of crediitor banks, whiichi put in new management In lune 1996, following government approval, the two companies were merged; the government .ppeared to be concerned mainily with the health of the ban ks, whichl converted about SI bilIio n of debt into all equ1itv share of over 70 percent in the new company. See N 'i York 6im'> 6 Se ptember 1994; Will Streit iltuiriial, 3October 1994 and 4 June 1996; Joim nial ilm ebru ,rv 1995. Prinitizatiof ill (7 Mark-et Fojiotiitl p63 nue maximization]9 Finally, in manly countries, including those with cen- trally planned economies, where the great majority of SOE creditors are other public enterprises or agencies, distribution of the assets of a defunct enter- prise can be performed more effectively by the government, which is directly or indirectly the principal shareholder and creditor. It is important to ascertain whether the ruiles governing commercial liqui- dation, bankruptcy and insolvency effectixely applv to SUEs.3i1 If they do apply, one should ensure that these provisions are adequate to deal with potential SUE liquidations, especially from the standpoint of protection of private SOE creditors. The government mav decide to waive certain claims it may have against anl SUE (for example, tax arrears), to the benefit of the SOE's private creditors, especially its secured creditors; or it mav opt to remain legally liable for claims not honored bv the former SOE, including claims filed after it was dissolved. SOEs should as far as possible be subject to the same liquidation and bank- ruptcy laws, regulations, and practices as private enterprises. There is a dan- ger that more lenient rules or unequal application of rules common to both types of enterprises could allow loss-making UOEs to compete unfairly against other enterprises.31 Sudden application of commercial bankruptcy legislation to the entire SOE sector, however-unless preceded by in-depth financial restructuring of the soEs in question (especially those with nega- tive net worth)-could trigger a cascade of bankruptcies that threaten the survival of the government and its reform program.32 The challenge, then, is to strike the right balance between immediate and strict application of the bankruptcv rules to all troubled enterprises, onl the one hand, and a special regime that would allow teclhicalv bilankrupt SOUs to survive indefiniitely, on the other. Hungary, the Czech Republic, and Poland have attempted to meet this challenge in different wavs (see box 3.2). Hun-ary has accorded priority to 29. It should be noted also that effective bankrupti y legislation can represent a threat (or an incentive to perform vwell) for managers of both private lnd public enterprises. This threat or incentive dles not, however, come into play until theI emparnv s situation has deteriorated to tihe p(oint thilat it effectively faces the threat ot bankrupt_C 30. If commercial rules do not apply; the liquidation of si nF may be reggulated by a specialI law. See the section in chapter 4 on SOiI liquidatioin. 31. Crediitors, particularIv state-owned or state-conitrolled banks, may hovever be reluctant to initiate bankruptcy proceedings against w Ws Similarl i- ;it managers and board members often have., nio incentive to initiate liquidatiion procedure-. even it required to do so by law. In many countries, if they fail to comply wvith these legal obligations thevare unlikely to be pun- ished, whereas thev know that initiatiig liquidation will \ erv probably cost them their jobs. 32. Such could be the indirect result of a large-scale prt gram of corporatization of Sotis. The eftect wouuld not be simply to subject these enterprises to private company law; it would also bring them under other areas of business law; such as the bankruptcv laws. This fact is oftenl overlooked, how,vever. by advocates of across-th,-board serporaitization. Ate chapter 4 on corpo- ratizatiOn of 'sl-sh 64 I'~~~~~~~~~~~~~~~~~~lWlt, Privatiza7tion1 Chalclngi,} Box 3.2 Bankruptcy Law: Hungarian, Czech, and Polish Approaches Hungary: The Judicial Route Hungary opted to apply strict judicial bankruptcy procedures to enterprises in difficulty. The law of September 1991 on bankruptcy procedures, liquidation procedures, and settlemenit of accounts required managers to initiate bank- ruptcy proceed1ings as soon as an enterprise fell more than 90 days in arrears in the payment of any of its debts. The law provided for two alternative proce- dures: reorganization (called, deceptively, "bankruptcy") and liquidation. The reorganization procedure gave a debtor 60 days to prepare a plan for regaining solvencv. This plan had to be accepted unanimously by all the creditors, failing wlhich the liquidation procedure would automatically apply. The number of cases submitted to the courts soared from 528 in 1991 to 14,30)0 in 1992, and the increase in the number of enterprises forced to close their doors was manyfold. Of these 14,300 cases, onlv 4,400 related to reorgani- zation procedures; the rest were liquidation casts. Moreover, only one-third of the reorganization cases dealt with by the courts in 1992 effectively led to acceptance of the proposed plan by the creditors. Cascading enterprise clo- sures and bankruptcies had disastrous consequences for the commercial banks. Furthermore, as a result of the enormous increase in bankruptcies filed the courts became completelIy swamped. The lack of qualified bankruptcy judges and receivers-eight judges were responsible for 4,000 cases in Buda- pest in mid-1992-led to substantial delays in handling the cases. To address this situation, the law was relaxed through a September 1993 amendment: the bankruptcy procedure is no longer mandatory but only optional in cases of payment delays; and, for a reorganization plan to be adopted, it needs to be accepted by one-half of the creditors, provided they hold at least two-thirds of claims on the enterprise. By the end of 1994, the assets of about 510( medium or large SOES had alre,idy been transferred to the private sector by way of insolvency procedures. Czech Republic: Temporization In 1991 Czechoslovakia enacted a bankruptcy law, but the law had not, practi- cally speaking, been applied when a moratorium was imposed up to April 1993 on suits filed against state-owned enterprises (this protection was later extended several tirnes). Several technically bankrupt enterprises were included in the mass privatization program, hence the problem was transferred to the new shareholders. The bankruptcy law,,, hoxvever, could not be applied speedy application, by the courts, of strict bankruptcy rules. The procedure prescribed in the September 1991 law had to be relaxed in 1993, however, in an effort to reduce both the mountain of cases submitted to the courts and the number of enterprises compelled to close their doors. In the Czech Republic, the main focus has been on seeking solutions outside the courts and allowing troubled enterprises to be restructured. The risk here is that Prizatizat ion in a Market EcnowniiI p. to enterprises privatized by means of coupons in the two months follo wing privatization. With respect to other enterprises, rather than enforcing the bank- ruptcy laws, the Czech authorities chose to invite investors interested in buying SOEs to propose restructuring plans. The advantage of this svstem is that it does not overload the courts and tribunals and does not trigger mass liquidationis. There is a clear risk, however, of either shifting the restructurinig burden to investors ill-equipped to manage it (the voucher-holding public) or, for those SOBs not included in the mass privatization program, of failing to attract inves- tors and prolonging the burden of the soF on the state. As a result of these poli- cies, few bankruptcy procedures were initiated and even fewer completed. Between 1991 and 1995, only 282 bankruptcy proceedings were completed in the Czech Republic and a further 2,274 cases had been initiated "in stark contrast to the situation in Hungary and Poland, wvhere the number of insolvencies are up to 10 times higher" (Finianitcc Etst Europe, I December 1995). The low Czech num- bers have been attributed to lack of political will to force bankruptcies, ineffec- tive implementation of the laws, and lack of detail'd court procedures. Poland: An Alternative Approach The main Polish bankruptcy legislation dates back to 1934. In addition, the 1981 law' on SOEs, as amended in 1991, and the P'J90 privatization law provide for administrative procedures for SOE liquidation. These laws did not, how,- ever, contain provisions triggering compulsory recourse to bankruptcy pro- ceedings. The courts have had to deal wArith relatively feWv bankruptcy cases under the 1934 law. Significant changes were brought by the 1993 lavw on financial restructuring of state enterprises and banks, which gave banks the principal role in the restructuring of insolvent SOEs. Under the aegis of the banks, creditors are given four months within which to draw up a restructuring programn (concilia- tion procedure), typically involving debt-for-eqniity swaps, or to recommend liquidation through conventional bankruptcy proceedings before the courts pursuant to the 1934 legislation. The creditors' decision is bindinig provided it is supported by creditors with more than 50 percent of outstanding claims. This scheme provides real incentives for out-ot-court reorganization and allows state claims on the SOE to be included in the reorganization plan. Among the advantages of the Polish approach are that it avoids overloading the courts, sets a deadline for formulating a restructuring program, and enables the banks to gain experience in debt valuation and recovery. Souirccs: Gray IYY3a; Nestor and Thlomas 1q,,I ()[( 1) 1)99a: ft,iaiaic E(W P1frop., 1 December 1995. the reallocation of resources to more productive activities may prolong the survival of unhealthv or loss-making enterprises. Poland has opted for an intermediate course: banks with debtors in arrears can choose between (a) a conciliation procedure of limited duration that must culminate in a restruc- turing agreement and (b) application of the bankruptcy legislatio(n by the courts. 66 The Privatiztlti(lo ChInl'1ge Nestor and Thomas 1995 comment thus: "From a comparative point of view, there seems to be a tradeoff between the implementation of effective bankruptcy procedures and the adoption of mass, or 'voucher' privatisa- tion programmes. Where mass privatisation has been chosen, as in the Czech and Slovak Republics, application of effective insolvency procedures has been left to the 'post-privatisation' stage, so as not to delay transfer of ownership. Countries which have followed a more traditional 'sales' approach to privatisation, on the other hand, have been forced to introduce insolvency procedures at an early stage, as an alternative means of enforc- ing discipline on companies which have not vet been moved into private hands." In summary, worldwide experience indicates that recourse to court-led bankruptcy proceedings is not a particularly effective way to deal with insolvent SOEs. In many cases, especially where the creditors are other public sector entities, administrative liquidation is mor' effective and expedient. Where private creditors are involved, safeguards will be needed. Voluntary, creditor-driven reorganization plans may be the most promising approach. Indeed, liquidation of insolvent enterprises is a critical market mechanism, which, unfortunately, courts in most developing and transition countries courts are ill-equipped to administer. Transfer of Liabilitics Most legal systems specifically regulate the transfer of debts and obliga- tions, including contingent liabilities deriving, for example, from ongoing or potential litigation. In civil-law countries, debt transfers are normally sub- ject to the creditors' approval, without which the original debtor continues to be liable. Where privatization is carried out through sale of the original SUE (that is, the legal entity that incurred the debt), -whether by call for bids or through transfer of shares, the privatized company continuties to be the debtor and the situation of the creditors is not fundamentally altered. In some countries, such as Bulgaria, commercial law requires the seller of a company (the state in the case of privatization of an SOE) to give the companiy's creditors prior notice of the upcoming sale; unless the creditors agree otlherwise, the seller remains liable, even after the sale, for debts of the company contracted before privati- zation (see article 15 of the Bulgarian Commercial Code of May 16, 1991). If, on the other hand, the legal status of the SUE is changed-for example, through its corporatization (see chapter 4)-the creditors may not be satis- fied with their new status. The conversion of the original debtor from a pub- lic company with unlimited liability, implicitly backed by the full credit of the state, to a limited liability company organized under company law may reduce the security afforded to its creditors to the amount of the new com- pany's declared capital. Nonetheless, in Sri Lanka, Poland, and other coun- tries, laws governing the corporatizationi of public enterprises expressly call Prieatizatimii ill a Market Ectmnom 6 7 for the transfer of the former SOE's liabilities to the new company.33 On the other hand, Italian law stipulates clearly that in the case of a breakup or demerger of an SOE, for example, the state "shall be jointly and severally lia- ble for any debts of the company involved in the diemerger which have not been paid by the company liable for the debts." 34 Since in many instances sOPs that carry their existing debts antd obliga- tions would not attract any buyers, governments often prefer to clear off these debts either before corporatization of thc Sol (see, for example, article 62 of the Britislh Telecommunications Act of 1084) or as part of the prepara- tion or negotiation of the privatization transaction.39 Moreover, w here the SOF's original obligation was guaranteed by the state (as in the case of a World Bank loan, for example), this guarantee remains in force even if, following privatization, the newv owner is a private entity. Here again many legal systems do not allow th-e state to assign its guarantee obli- gation to a third party without the consent of the creditors. 3h If privatization takes place through the transfer of assets and liabilities and not of the com- pany itself or shares therein, the question of debt transfer may have to be set- tled case by case. For1'ipi bwe'tst,it'ent Letislation) Some aspects of the foreign investment regime concern all foreign investments, wvhile others apply to privatizations in particular. It is important tt) determine, among other things, wlhether the constitution ainld laws of the country properly 33. Si- Lai,,k: The corporatization law ot 19X7 autito,lZes conversion) of SiiFs into joinit-stock companies by adnministrative decision and provides that the liabilities of tht sotl are deemed liabil- ities of the new companv In practice, however, net privatization proceeds in Sri Lanka were lin- ited "because the government incurred considerable costs in settling the accumulated liabilities of PEs ipublic enterprisesl and1 paid compeinsationi to di'.placed workers prior to privatization" (UNCIADo 1995, p. 273.). Peilni,l: Article 8 (2) of the 199(o privatization law pro% ides that a company formed by conver- sion of a state enterprise assumes all the riglts a,nd liabi lities of the enterprise so converted. Ni'i zcahlntd See box 4.2 describing the State-Ow% ned Finterprises Act of 1056. 34. Article 11.1I e of Decree-Law nio. 332 of lay *1 19'I4. On the extent of state liability lor oS debts, see also the section on company laws above. 35. In an address to American, investors give-n in Wash iiigton. D.C., on November 14, 1091, Bir- git Breuel. then president of the Treuhlandanstalt, stated: "With respect to existing debts and envi- ronmental liabilities lof public enterprises to be privati/ed I, we will also nlegotiate flexibly. The exten tof our generosity will depend on the aftractis ene- of y sour proposal.... In and of itsi1f, the purchase price will not be the sole decisice2 factor The arnount of planned investment anld the number of guaranteed jobs is also important to us... t-lince its inception I in th' fall of 199t1. the Treuhanid has on average assumed S5' of the existing debt of businesse which hl.te been prn .va- tized." The Tretilianidanstalt ssas authoriied by the de.bt relief decree of September lo9t) to assume debts contracted by sotis before Julyl 1, lOot) Sealso chapter 4 ,n prior restructurilg. 36. In the privati/.tion of v st' the airline of thi, tate of 73o P'aulo Brazil. this dlifficulty was avoided by recquirinig the buver to repavy sssLts c-redit rrs and isYuIe .a counterguarantee backed bv hard assets to indeminnifv the state in the( event t1he state guarantee ss'as called 68 TIce Prin7fiot"in Cllallk'l;lgt protect foreigni investors;37 whetlher the current systemn discriminates against foreign investors by capping their holdings in local companies (to, for example, less than 20 or 50 percent of capital), ruling out foreign ownership of land (as does article 22 of Bulgaria's 1991 constitution), or prohibiting or restricting their activity in some of the sectors to be privatized;3s wliether the svstem guaran- tees repatriationi of profits and capital; wlhether the foreign investmelnt regime introduces undue discrimination against domestic investors by granting for- eigners tax and customs exemptions not available to domestic investors; whether the rules applicable to foreign investors arc stated in clear terms or wlietlher they are ambiguous and leave the administration wide roonm for dis- cretion;39 whether the regulations governing the relations between a parent com.pany and its local subsidiary are likely to deter foreigners from participat- ing in privatization; wlhether the benefits of the investment code (or similar leg- islation) apply to privatization transactions involving the transfer of ownerslhip of existing assets or only to investments involvinig the creation of new produc- tive assets; and, finally, whether the foreign investment laws and the privatiza- tionl laws of the country concerned reinforce or contrAdict each other. Srvcuritiu's legislhtion, Capital market development is a common goa] pursued by governments in privatization programs. When the program includes share flotations to the 37. Bradil: Article 5 of thie 1988 conlstitution guarantees a vast array of social, econtomic, and political rights, includinlg the right of private Ownership mnd the right to) fair prior compensa- tioni in the event of expropriation by the goxernmenit, but oniv lor Brazilians and aliens resident in Brazil. Nonresident aliens are nolt protected. Article 172 of the constitution provides that "the law shall regulate foreign capital investments, encourage reinvestment and regulate the repa tri- ation of profits, all on the basis of the national interest." Thes'e conistitutional provisions and various other provisionis of the privatization laws and regulations that discriminate against for- eigners have created difficulties for the implemientation of the government's privatizationi pro- grami. In respoise tio the low foreign participation alid disappointing receipts of the first priva- tization transactions, the government relaxed the restrictions (in participation by foreign investors. An'gola: Provisions like thlse of article It) of the 1973 coistitutiol are not particularly reassur- ing for foreign investors either. The article states: "The P'eople'' Republic of Angola shall recog- nize, protect and guarantee private activities and propertI, ev0n those of foreigners, as long as they are useful to the couintrv's economy and serve the interests of the Angolan people." On constitutional restrictions, see also box 2.2, box 5.2, and tiable 73. 38. As part of the preparation of its privatization program, Morocco repealed regulations adopted pursuant to the 1973 "moroccanizatiin" Ian l bV OpCinIg Up the banking, insurance, real estate, and livestock sectors, anid certain commercial and transportation activities, to for- eign investnment. As a result, foreign investmenit rose by 7 percenit in 1991 and a further 3;) percent in 1992. In 1993 the government decided to also lihb ralize tht petroleum distribution sector. See World Equity and tF( 1993. 39. In an article on flungary, the Fiuaulicial TPl's.^ reported that "government publication of a list of strategic companies in which foreign cointr(il would not be permitted may paradoxically have haid a beneficial effect. Clarifying the rules has made Officials less hesitant." Fillnmcial Timc1's, 301 October 1991, special section oni fHungary, p. VI I. PriVl tiZiltio)l ill a Markct Ecouoinyif 69 public at large (or at least to a large number of investors), buyers should be able to trade their shares on a secondary market. This does not, however, necessarily call for an organized securities exchange in the conventional sense of the term (that is, one with a trading floor, and so on). All that is required for a secondary market to exist is a system that allows private par- ties to transfer shares freely to one another and to obtain registration or rec- ognition of the transfer bv the issuing company. This market also needs to be regulated to protect investors.4') Although an established and properly structured financial market can facilitate privatization, it is not essential to the success of a privatization pro- gram. The absence of such a financial market will, however, narrow the range of available privatization options. Trying to set up such a market as a financial intermediary for privatization transactionis wvould usually mean deferring privatization longer than authorities can wait. On the other hand, it would be desirable to enact basic securities legislation oni the issuance and trading of shares and also on the operations of financial intermediaries (banks, brokers, traders, and so on). In the United Kingdom or France, w here structured financial markets already existed, privatization was instrumental in further developing and deepening of these markets by boosting total market capitalization, transac- tion volume, and liquidity and by encouraginig participation by new share- holders. France demonstrates also how special provisions might be inserted in securities legislation to facilitate the privatization process. The French securities exchange regulations have been amended to authorize the proce- dure knowni as book-building, whlich lets the investment bank or financial intermediary selling the state's shares obtain revocable commitments (decla- rations of interest) from potential investors before the actual subscription period. Preliminary approval can now be issued by the securities agency, allowinig the book-building operation to begin; a second authorization is issued only when the prospectus is finalized and the selling price of the share is determined. Reciprocally, the development of local capital markets can foster the suc- cess of privatization, especially by boosting the ability to mobilize local savings and therefore reduce dependenice on foreign capital. It is impor- tant, however, not to try to go too fast by flooding a newvly organized and small financial market with shares. The flotation of shares in Poland's Slaski Bank, described in box 3.3, illustrates the point. For lack of sufficient staff, registration of the shares of the Slaski Bank-a prerequisite for the sale of shares-fell far behind schedule; hundreds of thousands of share- holders found themselves prevented from selling shares when the price of 40. Under Crechoslovxakia's mass prix atization program (see chapter 9), a large number of shares had1 been placed on the market before Januarv I, 1993, the date thie securities law entered into force, without any accompanying prospectus fr the information of investors. Subse- quentlv, however, companies responsible for these share issues were forced to regulari/e them by publishing a prospectus a posteriori (see Goldstein ,nd H lorakova I993)3 7() TIit' PrivatiZation Challicgt' Box 3.3 The Flotation of Slaski Bank The privatization of Slaski, a major Polish bank, was one of the largest opera- tions in Poland's privatization program. Nearly 8&)(),0 persons bought shares in Slaski Bank, and these were listed on thie WarsaW securities exchange on Jan- uary 25, 1994. Very few investors were in a position to trade their shares that day, however Indeed, shares could notbe sold unless they had been registered, and the registration process had fallen far behind schedule. This delay was caused by a shortage of qualified brokers able to perform the registration (fewer thani 4(0 broker licenses had been granted in Poland). The delay was largely responsible for the substantial fluctuations that occurred in the value of Slaski shares. Owing to the lack of tradable shares, oniv (0.35 percent of the total shares changed hands on the first day, while the valuie of the share rose more thani thirteenifold. The price theni fell, causing frustration among many share- hiolders who had becn unable to sell. For hiaving floated these shiares on the exchange before most of the share- holders had an opportunity to register them, Slaski Bank, which itself lheld a broker's license, had its license revoked bv the securities commission. The commissioni gave Slaski six monthis to terminate its brokerage operations and asked the remaining brokers, wlho) were alreadv having enormous diffi- culty satisfying their owin clients, to continue Slaski Bank's activities in this field. Sortnrc': Fiuit(itc 01 Ttc,>, 7 FebrLary 1994 anL1 18 I r ikbur I 994. these shares was fluctuating widely. Problems of this kind hurt the credibil- ity of the privatization process in general, and they may alienate private investors. Measures can be taken to strengthen financial markets. Several govern- ments have decided, for example, to promote the development of large domestic institutional investors that can participate in the privatization pro- gram as buyers. In Italy various legislative measures were enacted to allow finanacial markets to play an increased role in the privatization process: pri- vate pension funds were authorized; a new Law nio. 344 of August 14, 1993, regulates the creation of mutual funds; and amendments were made to a 1936 banking law to allow banks to acquire Lup to 15 percent of the shares of industrial companies. The role of pension funids in this context is discussed further below. More generally, reforms that increase seconidary market liquidity and remove barriers to corporate takeovers should coontribute to better corpo- rate governance. Such reforms may be particularly relevant for countries with large mass privatization programiis or employee ownership schemes, wvhere established managemenit teams may have few incentives to provide value to their atomized shareholders (see also ESBLD) 1995, chap. 8). Prizvti:a tizOio iin a Ma t i rkctEontiit ,1 Banking Financial legislation diealing not only withl banking but also with collateral and sureties, credit, leasing, insuraice, and so on may affect the success of a privatization program. A sound comnmercial banking system is essential for mobilizing savings and financing economic activity. Efficient banking Imlecih- anisms make it possible, in particular, for investors to finance tiheir opera- tions and working capital and make speedv payments.41 Most privatizing governments have had to Strengthen their bankinig legis- lation so that commercial banks can play their role in a market econlomv; stronger mechainisms for bank supervision and adherence to interinationlal standards (including key prudential standards established by the Bank for International Settlements) have often been part of such reforms. I3anking legislation may also need to be amended to facilitate the implementation of the privatization program, for instance, bv enabling commercial banks to act as financial intermediaries for share issues in countries whiere no formal securities markets exist. Furthermore, banking laws mav need to be amended to allow the privati- zation of commercial banks themselves. In Pakistan, for example, the bank- ing law was amended to allow the privatization in 1991 of Muslim Commer- cial Bank and Allied Banks of Pakistan. On the other hand, the 1990 law that authorized bank privatization in Italv wvas not followved by Imluchl action to remove the Italian banking sector from overwhelming state control. In most socialist countries, the centrail bank acted as a commercial bank and no private banks were allowed. New legislation typically remiioved thie central bank's commercial banking activities and transformed state-oxwned banks into corporations. In flu-ngary, for example, bankiig reform vwas initi- ated in 1987 with the transformation of the lend1iniig departments of the ceii- tral bank into separate new state-owned bainks, which togethier vith two preexisting large state-owivned banks domi nated the commercial banking sector; 1987 also saw the first foreign-oxvned banks established in Hungary. The new law oni financial institution,s enacted in November 1991 authorized the privatization of state-owned banks, while limiting ownership by any one shareholder to a maximum of 29 percent (see sectioni 18.1 of Law, no. -r9 of 1991 on financial institutions). Restructuring of the banking sector is often hindered, especiallv in counI- tries whlere state-owned banks dominate, by luge noinperforiniig loanis t often insolvent public enterprises anid agenicies. In suchi cases bank reform becomes closely associated withi sOr reform in genieral. sot; rehabilitationi or privatization programs usually call for hardening the soi: s soft budget con- straints by ending privileged access to credit from banks controlled or guar- anteed by the state and bv forcing comimlercial banks to bear the full risks 41. An analvsi-, of the main issues in bankimg-wector reformi and privatization exc\edvd I he scopeofthivs ork but see Borish, Long, and Nocl NI' Lhorne I1'3; arllresnc 92). 72 Thc Pri'at tizati(v, Cl elult'l,t' associated with SOF lending. Restructuring and privatizing the banking sec- tor can hence greatly facilitate the entire privatization program by limiting the ability of soEs to incur additional debt. Meanwhile, a solution needs to be found for the banks' existing portfolios of noniperforming loans. Some countries, including Hungary, have cleaned up their banks' balance sheets by creating special-purpose companies to take over nonperforming loans, either as a self-standing restructuring measure or as a step toward subse- quent bank privatization. Others, such as Slovenia, have created a bank rehabilitation agency to take over all the troubled banks, while vet others have recapitalized the existing banks. Restructuring and privatizing banks should normally take place at the start of the reform program, for a healthy and dynvamic banking sector should contribute to the development of economic activity. Doing so, how- ever, can be complicated, politically difficult, and expensive, a fact that explains why some governments have preferred to leave the banking sector untouched in the initial stage. If not properly designed, bank privatization could cause privatized banks to become overextended, which might prompt another takeover by the state in order to avoid a major crisis in the financial sector, as happened in Chile and Mexico, for example. Taxation Investors and potential buyers are naturally concerned about the overall corporate tax burden and the predictabilitv of interpretation and enforce- ment of the tax laws. Businesses should be able to determine what taxes apply to them and to estimate the amount of the taxes they will have to pay. Certain techlnical aspects can also be important. They include the rules gov- erning transfer pricing between enterprises of a group (for example, betweeni a local company and its parent or sister companies established abroad); the rules governing the carrying forward of tax losses, which can greatly influence the choice of privatization technique;42 the tax treatment of loan interest and dividends; the tax implications of employee shareholding plans, leasing, franchising, and other privatization mechanisms, which in many cases will determine the chosenl technique; and, finally, the rules relat- ing to double taxation. The tax laws should be applied uniformly to private and to public enter- prises and tax advantages granted to SOEs in the competitive sectors of the economy should be abolished. Whether governnmenits should give special tax advantages to privatization transactions-for example, in investment legislation or in express provisions of the privatizatioln law-is a question that might arise. Although exemptions from stamp and registration duties oni share transfers will not usually affect governmnent reveenues seriously or 42. If the newv owniers are eligible for such carryovers, a loIss-making sol can be quite an attractive prop(osition. From the government's point of v iew, hiowvever, the highier sale price is offset by lower tax receipts in subsequent years. Prim tizatioui in a Marike!t Ecnom wny 73 give the beneficiaries a major competitive advantage (see, for example, arti- cle 15 of France's privatization law of August 1986), the same may not be true of temporary exemptions from corporate income taxes. Such exemp- tions are granted, for example, in Tunisia, where article 31) of Law no. 89-9 extends very generous tax benefits to privatized enterprises, notably exemp- tions from corporate income and capital gainis taxes (see also the section of this chapter on foreign investment). Similar provisions exist in the Philip- pines and other countries.43 ClurrencYa in!it Forcigni Exclhnalge Restrictions on foreign-exchange transactions, including allocation, availabil- ity, convertibility, repatriation, or registration of foreign exchanige, will gener- ally hamper efforts to attract foreign investors. In countries that dco not have a stable and convertible currencv, restrictions on domestic payments in foreign exchange, particularly remuneration of expatriate staff, pavments to domes- tic suppliers, and payments by customers ma' also be cause for concern. In the specific context of privatization operations, some governments have felt the need to establish a special, less favorable exchange rate for for- eign investors bidding on SOIs or their assets in order to offset what they perceived as an artificially depressed exchanlge rate, whichi would allow for- eign bidders to buy assets significantly below their value. Formulas of this kind should be avoided; they tend to be easy to circumvent and difficult to administer. This is true also of multiple exchanige rates of the kind applied in Russia, where the rate for foreign investments was about ten times higher than the market rate.44 Social Legislation The social climate of a country, including its labor legislation, pension regime, and social safety net, and of an enterprise is among the major deter- mining factors in any investment decision.45 The privatization program may contribute to a healthy climate bV involving emplovees in the preparation for privatization (see chapter 1), giving them the opportunity to become shareholders in their enterprise, and protecting workers' rights, while 43. Section 35 of the 1986 privatization law exempts the Asset l'rivatization Trust from all taxes and duties (including stamp aLid registration fees, trantfer taxes, and capital gains taxes) on the transfer of assets from government institutionlls to the trLut andl from the trust to private huvers. Thearticlealsoexempts such sales or transfers from all n -tnctions orconstraints that could derive from "the existence of any liens bv t,av of ,ave, chl,rge, or other assessmllelnts in favOr of the gov- ernment at the time of sale or transfer: provided, that the proceeds from such sale or transfer shall be subject to a tax len and first be applied to satisfx uch obligations, secured bv said liens." 44. If the purpose is to give domestic innvestors tl edge over toreign investors, this could also be achieved by' assigning a margin of preference to di(ttle%tlc bidders. 45. See World Bank I 995a, especially part fottr, fion' Calo Policy Cthoices Hlelp Workers in Periods of Major Change? 174 Hi,' Privatization Clfcny,alin avoiding unsustainable settlements or labor standards. Privatization can also be an opportunity to strengthen social legislation. Labor Legislatitl The labor regime applicable to SOF persoinlnel can be more or less conducive to implementation of the privatization program.46 First, public sector employees often enjoy special civil service benefits.47 These will normally have to be repealed and may be replaced by other, private-law benefits granlted by the nevw company. Plension entitlements are a case in point (see below). Similarly it may be necessary to confirm or modify other contractual (or statutory) rights of employees, including, in particular, wage levels, seniority rights, and other benefits. In manv cases the relevant legal princi- ple will be whletlher or not the employment relationslhip continues.48 Privatization agreements for enterprises or activities that are not trans- ferred as a going concerni-an SOF that will be liquidated, for example-may nonetheless provide for continuation of the contracts of selected employees. Under existing labor legislation in some countries, employees could be enti- tled to severance pay from the sot even if they are immediately rehired by the new company. In others, the above-mentioned principle of continuity in the employment relationship, legislation embodyinlg that principle, or spe- cific contractual provisions may prevent such double-dipping. Employees not relhired by the new company would continuLe to be formally employed by the old sol, wlhichi continues to exist legally uLntil it is dissolved even though it does not carry on any activity; thleir contractual or statutory rights are then settled as part of the liquidation process (see chapter 4). Labor law provisions determine the flexibilitv the investor has to set employee salaries and benefits, to hire and lay oft staff (including foreign staff), 46. In Brazil, ports wvere governed by 1937 legislation that ledl toCosts among the highiest in the world In January 1Q92, referring to privatization of the ports, tlie president of tNID\7S (the agency respolnsible for coordinatinig Brazil's privatization progrim) stated that the first priority was to modtierniie tile legislation 'or we shall never find huvets." In Februarv 1993, after two years of discussion, parliament enacted a new ports law. More than a year later, little progress had been made. implemilenitationi of the lawl had been frn en perlding a Ullionl appeal to the Snupreme Con rt on the constitutionality of the law. The on ilnS ale topposed to tra usfer of control of he ports to thIe Users, w I ich xvonIICd reduce tle uli Lioii role to le sOlIe function of representing their memribers in cotllective bargaining. Under the prnviou. regime (which is still being applied), the Unions decide the number andi identitv of the dcok kers assigned to loadi or uniload each vessel, and only affiliated dcockers can oibtain wN ork See I nanciti Timns, 21 January 1992, p. 24; lcilol of C,m,ncrcc, 15 April 1994. 47. In France, tor e xample, employees of thie n,ttional electri, ity company 0lt it) and of other SOI5S, i-sunlike their private sector colleagues, pay sociil se, urits taxes oin their base salary only and 110t o1n their iitv add itional benefits. 48. In Moroc co, for exawmlple, there is a legal presuimilptioIn ot continluitv of the employment relatiolshilip, despite ch1an1ges in the employers status, le it as a result of successioni, sale, tierger, split-up, a b-orphoiini transformati on, or othernviss "alt la bor contracts in effect on the day of sucih change remiain in f(orce betwveen the newVN emploeVr anld the staff ott tht enierprise" (article 734 of the O bligations and Conlracts Code). Priva tizathioh ihi a Markct FcI '111(11 i, 75 and, in general, to manage the enterprise's human resources. If overstaffing is severe, potential investors may well require that the government or the SOE lay off redundant employees before privatization, e specially if the legislation or the social climate makes it difficult for private employers to dismiss workers.49 The rights of laid-off workers, inclucdilng severance pay and1 unemploymelt benefits, mav vary significantlv depending on whether tlhey were laid off by the new private owners or by the ScOb before privatization; in the latter case, there will also be a difference depending on wvhether these workers were gov- erned bv general labor legislation or bv special puiblic-sector legislation. Tradeoffs may be necessary between the protection afforded by labor law to incumbent workers and the need to create nevw jobs. In Germany, for example, ordinary labor law restricts the acceptable grounds for dismissal; parliament has granted buyers of privatized eniterprises temporary exemp- tion from such restrictions, however, to facilitate implementation of the privatization program.5() On the other hand, the Treuhand has inserted a binding undertaking in many privatization contracts, unlder whichi the buyer guarantees to keep or create a specified nuLmber of jobs in the priva- tized company, subject to penalties (with the penialty amount specified in the contract) in the event of default (see Horn 1992, p. 19). Such a negotiated formula is generally preferable to protecting jobs by prohibiting all dismissals following privatization. In Pakistan, for example, under an agreement between government and unions, new owners were prohibited from laying off any emplovees in thie 12 months followinig priva- tization of an sor.5t In Malaysia, buvers oould neitlher modify the terms of 49. Staff reXductions at the P'eruvian airlint Aeroperu to ok place bef,,re privatization: its wvork force of 2.3ff)) for sv\ aircraft in 1 99l0 (a ratio of over Isto employees per aircraft, compared with a normal ratio of l(ott or 1 5( to oine) was reducedL to 901S b1y thIe time Of its privatiZation in January 1993. Also in Peru, the staff of the Cerro Verde miniie was reduced by1 half before its privatization in November 1 9-P. See wislimt,tou Post, 8 Deceniber 19-1 ilIe work force of thieM VeneZuelal air- line \ i AC 5, whichi had no less than 45tl emrpliv ec per ai rraift hti ir it' pvri-atizatii in i1n 19 had been reduced to 215 ;per plane two yearrs later R). A March 1901 law proviies for temporart exemption 1romm 'section lf 3 (a of thie (ernial Civil Code, which provides that the purchaser of assets constituting a husiness assumes, by operation of law, the employmiienit rights and obligation'. exiSfing at the time of the purchase. A change in control through an acquisitioin does not clnstitute 'cause' for thle dismissal of emplovees... The above-mentioned exemrption pr sIde'. that through DfeceLmrbr 31 I19'2 Sec- tion 613 (a) will not apply' in the case of acquisition' (it insoilvent eastern ( erma n busiitesses'' (Jones Day' 19, p. 3). See alIso note 14 in chapter 1 51. This prohibitioni, which ran through Pakistan's enritire 109)]-9* privatization program, stenimimed froiml an agreeiment betveenl government and unions, thie terims of wvlhichl were then) incorporated into bidding conditionsand sale contracts. Similar agreements were reached in 10]95 to stem laboro pposition to privatizatio n of parts of n sit theu wnaterriad powerstit ); for instarnet' the goverilmienit guaranteed the jobs of all tnmplovy,s of t' first power plant to he Oltld fit Kot Addu) and improved their pav and other working C0nditionFs before privatization. Tt'F situation was eveln miore acute wvith the second phase of the pri\ oi/ation of Sui Noirtherin Gas l'ipchlne, where tht' financial advisers COmplaillned about "substalntial politically inspirtd recruitmenlit" in 1995 antd wrote tfi the privatization commission about thl lir "'inlbility to explain such larget-scale job-crea tuin to prospective invt'stors" f()rt Ic/iI'i/U!. \ i N,tmbe'r I 905) 76 Tlhe) PrivatiZatimi Challcnge the employment contract nor dismiss employees of the privatized enterprise for five years after privatization. Similarly, in Sri Lanka, since March 1992 new owners lhave been required to extend the same benefits to employees, up to retirement age, that they enjoyed before privatization.t2 Uniform requirements of this kind make the privatization process unnecessarily inflexible and expensive. Nevertheless, some governments see them as essential for gaining the labor support deemed necessary to push through privatization. But the impact of uniform requiremnents has to be analyzed also in terms of the sometimes unsustainable precedients set for the economy at large, including the private sector. This mav be less of a problem, how- ever, where SOE wages are low in absolute terms as well as in relation to wages paid in the private sector. In industrial countries, labor legislation has been at the center of contro- versy in privatization programs. The case of France Thl6com is instructive. This enterprise, a central government service before 1991 and an autono- mous public-law establishment since then, is being transformed into a lim- ited liability company as a first step toward partial privatization. The con- version of France Tel6com's personnel from a civil service to a labor code regime and the fear of privatization-related layoffs have been a major stum- bling block, as evidenced by the postponement of the submission of the cor- poratization bill to parliament, following strong union opposition sup- ported by a strike in October 1993. The governmenit tried againi to take steps in preparation for privatization, which led to new strikes in December 1995 and April and June 1996, though each successive strike was observed by a decreasing number of employees, reflecting in part the concessions already made by the French government, including gtuarantee of civil service status and job security for employees and a commitmetnt that the company will remain at least 51 percent state owned.53 In Italy, a similar labor issue was settled at the time of transfer of the activ- ities of ASST (a government service) to Iritel (a private-law company) by 52. At the start of its privatization (peoplei/ation) program, Sri Lanka opted for a volunitary resignation bonus formula. This contributed to a drop in productivity because the best workers opted for the scheme and moved on to other jobs; the scheme had to be abandoned because too many employees wanted to avail themselves of it. The number of categories of eligible employ- ees was then reduced, an action that created social tension. The government finally decided to introduce a two-year protectioni against all dismissals, before extending this protectioti up to retirenmen t age. See UNC IAD, Report to) the Third MWstin1 of the W'rking Cormnroittei on Privatiza- tmos, Geneva, November 29-December 3, 1993; l'rokopenko 1995. 53. France is n(ot the only country whose telecommllunicationls privatizationi program has been blocked by social action. Other countries where this has happened include Colombia, where the discussioni of a bill to privatize the telecommunications comprany was suspended in April 1992 following major strikes bv the company's employees; Germany, where the posta1 service unioins held demonstrations and strikes to protest restructuring and.l privatization of postal services and telecommunications; and Greece, whiere unioni oppositioin and industrial action blocked theprivatizati(n of,49percentofoire in 1993, contributed to [tie failureofa subsequentattempt tO sell 25 percent in 1994, but failed to block the flotation ot S percent of o lts stock in March 1996 (see also the section on public flotation in chapter 7). Privatizatioin in a Markt-t Ecot trinn 77 allowing the personnel affected to choose either to join Iritel or to be reas- signed within the civil service. Of the 12,600 employees, 2,600 chose to remain in the civil service, about 1,000 took early retirement, and the rest opted for transfer to Iritel (see Gioscia 1993). In Belgium, the maintenance after privatization of the special civil service status of Belgacom's existing employees, national labor laws perceived to be restrictive, strong unioniza- tion of Belgacom employees, as well as unfunded pension liabilities exceed- ing $3 billion, were mentioned to explain BT's decision to withdraw from the bidding, but did not prevent two other consortia, including one led by win- ner Ameritech, from making bids (see Fiinancial Tinies, 12 December 1995). Finally, the scope of the employees' rights in the company, notably union rights and representation on the board of directors or on other managemenit organs, mav also affect privatization and investment decisions. If regula- tions governing union representation in SOEs differ from those governinig private companies, it may be necessary to negotiate transitional arrange- ments with the unions concerned. A major reason for initial union opposi- tion to Mexico's rail privatization program, for example, was the govern- ment's proposal to set up separate unions for each privatized rail company. Most privatizing governments have tried to involve workers and their unions in thie preparation and implementation of the privatization process. Enmployee, O 'nersiNp Whereas potential layoffs have tended to create labor opposition to privati- zation, potential employee owi-nership has hadl the opposite effect. A recent study on privatization in Poland illustrates the link between worker support and the extent to which employee ownership is likely to yield tangible bene- fits. Workers' councils in poorly performing firms (with a higher likelihood of bankruptcy or liquidation) generally opposed privatization and pursued aggressive wage policies. In the better performing SOIS, however, "the promise of participation in the privatized firms reduced the incentives for workers to carry out an excessive wage strategy" (see Albrecht and Thum 1994). Employee participation led not only to support for the privatization program but also to more reasonable xvage demands. Legislation may provide tax or other incenitives for the establishment of employee stock ownership plans (ES01's) or encourage other forms of worker participation in the ownership or control of their enterprise.54 Fur- thermore, many countries have earmarked a block of shares in enterprises to be privatized for subscription by their employees, antd in some cases 54. "Typically, an rsoll is structured as a separate legal entity to which a corporation sells shares.... What distinguishes an 11EOI' from other einplovee ownership programns is that shares are paid for partly or fully out of future corporate earnings-.. An ESOI' is largely a set of 'nles' governing the acquisitioni, allocation, and management of shares held for emplovees" (Gates and Saghir 1995, pp. v, 1). These authors mentioni lamaica, Hungary, and Pakistan among the countries that have used the FsAI techliique in their privitiiatioi program, See also Silithi 1994. 78 Th) Prtri ati ZtiO CIiallhtgc employees hiave been given incentives to take over their company. Employee participation in privatization typically figures among the key provisions of a privatization law (see chapter 5). Pension DEutitfflcnfts Investors also need to ascertain the situation of sol employees who contrib- uted to public-sector pension and insurance schemes. The conversion of their accumulated rights and benefits to a private scheme may be required as part of the privatization process. This often becomes a major stumbling block, especially wlheni the public pensioni system is not vested and self- financing and the government lacks the funds to transfer accumulated staff benefits to a pension fund. Some Latin American counitries have dealt with this problem by issuinlg state bonds anid hianding them over to the private pension funds. In Germany, a dispute between the government and Lufthanisa concerniing financing of the company's retirement obligations had to be settled before the privatization of the airline could proceed.55 And pensioni financing turned out to be one of the most delicate issues in the restructuring of the German post and telecommnuniications company (see the section on prior restructuring in chapter 7). The problem of transferrinig staff from a public to a private retiremenit system is a common one in privatiza- tion operations.56 Penisiotn Funditl Reforuii A privatization program can also provide the impetus to transform a typi- cally state-run, centralized pension system into a private, more decentral- ized one. The portability or transferability of pensions of employees moving from the public to the private sector or from one private enterprise to another may need to be facilitated. More professional and efficient manage- ment will often need to be broug,ht in to manage these growing finalncial assets.57 55. Nonparticipation by' the state in the increase in ILufthansa's capital would reduce its share in the companiy's capital from 51 4 percent to 41 percent. Once this share falls below 5() percent, the government is no longer under the obligation to contribute to the employees' retiremenlt funid. The agreement reaclhed provides for withdrawal by L ufthansa from [he public pension fund and the creatioln of a new fund, to be financed bv l.ufth unsa. The amount of the capital to be invested in Lufthansa's pension friid to enable it to mieet its existing obligations was of the order of i)m 4 billion (over $2.5 billion). The government agreed to provide half of this, with the other lhalf to be borine by the company. See Fiu,c(iui 7Tiun>, 5 May 1994 and 201 September 1994. 56. See, for example, the Canadian law of January M3,1 19')1), authorizing the divestiture of Nordion International Inc. and Theratronics Internation,al limited; articles 19 through 11 contain transitory provisions oni retirement benefits. 57. The followinig sources were used for this section on pelisions funds: Vittas 1996; Conlrad1t 1993; Cioscia 1993; Sharma 1992; LatinFiniance 1992, p 6,2; litiilFinaucc ('supplemnent), Septellm- ber 1995, pp. 45-49; Fimoaulh Timut's, 31) June 1993, 17 Mairch 1944, and 18 JanIary 199h, ( t)Ji of A)ildi utica, 11 August 1994; Th on ticnomsist, II December 1')93. Priza tiza t bin in a Ma rkl't FE IXIIii 7 Chile has plaved a pioneer role in this field, In 1981, Chile privatized its pension system and entrusted management ot social contributions to pri- vate companies (tciniStradiraS d/' tmldos tit, pc'isioiit's, or AH's) owned bv domestic and foreign investors. Incumbent wo rkers could opt to stay in the state pension system or switch to an AF.l. Inl 1)8, the law on pension funds was amended to allow the AF['s to invest up to 30 percent of their funds in the equity of privatized enterprises. The pension funds became by far the largest institutional purchasers of shares of -s)Fs privati/ed between 1985 and 1990, including major companies such as CThilmetro, Endesa, Schwager, and CTC. In 15 years the AF's have come to manage accu mulated assets total- ing about $25 billion, which is eqLuivalenit to close to half of Chile's GDP' (up from a mere I percent of CDI' in 198 l ). The \MPs are "commonlv credited with plaving a central role in more than doubrling domestic savings, froIml around 14 per cent at the beginning of the l9l)s to 27 per celit" in 1995 and with the development of a stronig domestic capital market (Fiinacial Timl(es, 18 January 1996). Chile's large social security dLeficit has fallen by two-thirds. Workers can choose their AFI' and freelv switch their pensioni accounits. Competition among funds has kept commissioins relativelv low and has encouraged good overall performance relative to the stock market. Yet despite these impressive results, problems remaii. Manv employees are not current in their payments to their plans. Intenie competition betweeni funlds and legal restrictionis on loyalty bonuses have resulted in high turnover, with people switching from one plan to another (in Chile about a third of all accounts are switclhed each year). For the first time in their historv the Altls made negative real returns of 2.5 percent in 1995; pensioners who opted to take programmed monthly withdrawals from their pension fund account rather than convert their accumulated benefits into a fixed annuity from a life insurance company may therefore see a nignificant drop in their retire- ment income. Chile's experience has encouraged other countries, including 1'eru, Colombia, and Argenitina, to follow its example, A similar schemlie was intro- duced in Peru in September 1993, in parallel wvith the country's ambitious privatization program. The director of the regulatorv agency for Chile's peni- sion funds was in direct contact withl his Peruviani counterpart, and the' eighlt AFl's competing for the contributions of Peruvian emnplovees are all linked to companies or AFPs operating in Chile. There is an important difference, how- ever, between the two models: workers in Chile have beeni required since 1981 to belong to one of the private penision) funds, but Pertxvian workers affiliated with the public social security system can choose between) that sys- tem and the new private funds. The Peruvian private funds experieniced some initial difficulties: in the first year, some 800,000 workers-onlv two-thirds of the expected number- opted for the private funds. Low membership levels, delVs in the issuaLnce bv government of bonds representinig workers' share in the public penision scheme, an unfavorable tax regime, delavs in payment by emplovers and government, and high start-up costs an1d ad%vertising expenses fueled by 8(1 Thlex Priratization Challenige competition amoiig funds, caused the AFPs to post losses that were larger than anticipated. Some consolidation took place: two mergers reduced the number of Peruvian AFPs from eight to six, mostly backed by large interna- tional financial institutions. Moreover, the scarcity of financial instruments on the Peruvian market prevented AFP's from complying with the invest- ment allocation quotas imposed by law. Investment in Peruvian shares was hampered by cumbersome risk-classification procedures required by law: AFI's can only invest in securities rated by newly established rating agencies, whose assessment initially had to be confirmed by the AFP investment eval- uation committee. The enactment of Law nio. 265504 of July 18, 1995, which abolished some APP-specific taxes and put the AFPS on equal footing with the public sector pension system, gave the private funds a new start, however. Finally, Bolivia, Italy, and Singapore have also taken measures to stimulate capital markets by strengthening the role of pension funds in the broader context of their privatization programs.58 Social Safety Net Staff redundancies, as discussed above, are not so much a consequence of privatization as of poor SOP management leading to overstaffing. These SOEs would have had to be restructured and streamlined sooner or later, even without a change of ownership. In many countries, especially socialist ones, SOEs provided employees unemployment insurance (in the form of guaran- teed jobs) and many social services and benefits, inicludilng health, education, and housing services. As part of the transition to a market economy, these services and benefits have to be shifted from the enterprises to a national social security scheme, which does not guarantee employment or provide social services but instead guarantees a minimum safety net. Citizens falling below the thresholds of the scheme are eligible for support. Such a safety net and other social measures are often an essential component of the privatiza- tion program; unfortunately, their design and implementation are not simple matters, especially when public finances are in short supply. 58. 1/nivia: Article 7 of the 1994 capitalizationi law (see box *t 1j provides for the transfer to pension funds (to beset up for the purpose) of slares of the s( . referred tlin article2. Article 7 further provides that these pension funds will be managed by administrators selected follow- ing international calls for bids; a tender for the selectioni of twx private pension) fund adminiis- trators (AF'S) was launched in late 1996. Following an intern.itional competitive tender, Cit- itrust Ltd. had previouslv been choseni as the fiduciarv administering the pensionl funds pending such selection. About 3.2 millionl citizens will in this vniv indirectly become sharehold- ers for the first time; complemilenitary private pensionl plans will ailso be offered by the Alrvs. italy: Decree-L.aw nlo. 124 of April 21, 1993, authorizes the establishment of private pension funds. Singapor': The regulations governing use of the resource- of the central provident fulid (equivalent to a pension fLund) were amended in 198( toaillow withdrawals for the purchase of listed securities approved by the ci'F board. Prin tization in, a Market tEconota tl m1 Environmental Law Environmental law and privatization interact at several different levels. 59 How well the enterprises to be privatized have complied with the existing environmental regulations must be ascertained first of all. They may have been exempt from this legislation or, more simplv, they mav have violated it. In any event, buyers will have to find out what it will cost to compensate those who may have suffered from pollution, to correct the situation, and to end ongoing violations; they will also need to establish who will have to pay for this. Uncertainty about the extent of environmental liability was one of the main reasons for the slow start of the German privatization program. The legislation had to be amended to allow regional governments to release investors from liability for enviroinmental damage caused by SQEs before they were privatized, and the Treuhand had to absorb the bulk of the related cost.6") The same thing happened in Poland, where the government was sur- prised bv the number of investors demanding the inclusion of specific indemnitv clauses in SOQ takeover agreements (see Greenspan-Bell and Kolaja 1993, pp. 943-44). Potential buyers will want to ascertain the precise extent of their liability for environmental damage or violations of environmental legislation com- mitted by the former SOE, especially in polluting industries such as chemi- cals, mining, or steel. Some of these liabilities may be known and quantifi- able, while others may arise only after privati/ation.h1 Uncertainty about the extent of the environmental damage caused by the SOE to be privatized or about the buyers' present or future liabilitv explains the lack of interest by investors in some privatization programs)"2 59. See, in particular, World Bank 1994a; CGoldeniman 199L3 and 0'I94; Greenspan-Bell and Kolaja 1993. 61. "A strict application of West German environmental lawvs would have resulted in the shutdown of a major portion of East German industry v. The'Environment Framework Act' provides that purchasers of industrial plants or titler commercial real propertv in eastern Ger- many may be released from liability for environmental llamage s caused by the operation of the plant or use of the property before July 1I 199). Applications for such releases must be filed bv March 29, 1942. A release will be granted if it is justified in lighit of the interest of the inivestor as balanced against the public interest in env irotnmental protection. The IMlarch 1991Q privatiza- tion Amendments now prlvide for the release Jf civil la,w claims of private partiesas well asd public lawv claims of the government. Previoiusly, liabilities for civil lawv claims could not be releasedl in this manner. In addition to liability mrleases, which are issuable onlv after approval by the relevant German state, in estors can obtaii indemnification fronm the Treuhall- danstalt svith respect to past envirornmeintal liabilities" (lones Day 1991 pp. 1-2) 61. For example. thie companv's liability lto its elmploVees or to the local population for dis- eases ctntracted consequent upon acts of pollution coinniitted tiver a long ptriod or several years ago. 62. An example is the failure in May 1994 of the ittempt to privatize C'entromin.f a large min- ing enterprise in Peru. See Finanicial Timm's. 17 Mav 1994 Tn'o vears later the company still had no t been privatized. 82 Thc Priza tiZation Challciingt This problem can be resolved in several ways. The first and simplest alter- native is to exempt the privatized enterprise from all liability for the conse- quences of acts of omission or commission on the part of the sol, while leav- ing this liability with the old shareholder, that is, the state. A second alternative is to privatize the enterprise with all its rights and obligations intact but place a cap on environmental liability, above which the govern- ment would compensate the buyers, or else to negotiate some other division of responsibility between government and buver. In a third scenario, the buyers assume all the obligations of the enterprise they acquire and reflect the continlgenit liabilities risk by offering a lower purchase price. Each alternative has advantages and disadvantages that need to be assessed in light of the enterprise to be privatized, the privatization tech- nique to be used, and the sector and country conicer ned. Th-e first alternative will be the obvious choice wlhen dealing with polluting enterprises for wlhiclh it is difficult to assess the extent of environmental liability. The second alternative inv'olves somiie degree of negotiationi and therefore does not lend itself to privatizationi by public flotationi, for example. The third alternative is a good choice wlhen the enterprise is not a heavv polluter or the liability can be easily quantified; it will, however, usually be shunined wlhenl the envi- ronimental liability regulations and jurisprudence are either not very clear or not well developed. Even wlhere the law or the agreemiienits provide that the new owniers incur no liability, buyers would be well advised to ensure that the government will effectively assume its responsibilities as previous ownier. The next step is to ascertain what rules applv when an enterprise's plant is not in compliance with environmenital regulations. While buyers slhould not normally receive special exemnptions, they are often given a certain time limit witlini wlhich to make the necessary investmnents to bring the plant into compliance. The cost of these compliance measures is normally borne by the buyer. This was the approach taken in lPoland, among other countries (see Greenspan-Bell and Kolaja 1993). Finally, potential buyers will also want to know what new environmen- tal regulations could affect their future obligations. The greater the uncer- tainty on1 this point, the lower the price they will be ready to offer for the enterprise. l'rivatizationi can thus offer a uniqtue opportunity to modernize a counitry's enlvironimental legislation. This can he all the more desirable wlhere a transfer of activity from the public to the private sector could oth- erwise lead to increased pollution (for example. as a result of increased capacity utilizationi of the privatized plant) If such reform takes place before privatization, the costs it entails for private operators will be reflected in the amounts of the bids received. If reform is deferred, the new owners will tend to) oppose it, because it would raise their production costs. It should also be noted that the privatization program can have a very positive environmental impact by speeding up the replacement of obsolete and pollutinig techniologies with more recent "green" techllologies. Similarly, Priz,atiza ti ln ini a Markct Ecra,o mmy S3 by eliminating the direct and indirect subsidies often received by SOEs, privatizations can promote more rational utilization of resources with, once again, a beneficial impact on the environment. Moreover, privatization can foster better compliance with environmental standards; too often, SOEs were exempted from existing legislation or else got preferential treatment through lax enforcement. The issues raised in this section will normally have to be dedlt with through specific provisions in the environmental legislationi, the privatiza- tion legislatio n, or the privatizatio haid neverthele(ss been privatized, together witi 17, othercompaniies (see [atinbiniance 1 99, p. (>2). Rn;sia: 'ihe loans-for-shares scheme (see note 49 in chapter (t) is at the origili of some of those disputes. Following Une,simbank's takeover of Norilsk \ickel, management of the companv filed suit to invalidate the loans-for-shares scheime, lut their clamni was rejecteLd bv( tie Moscow arbitra tion court onF tebru,rv 27, 1l99h (see liat icst, ',n It 'l/tni; a?i, March I9)Y6, p. 231. 86l The I1ricat I i, Chat hi f s, through a public flotation on the Budapest stock exchange. The foreign shareholders feared that the public offering price would be lower thani the price they had paid, which would have forced Amt.ritech to write downi its investment in MATlAV and post a corresponding loss on its balance sheet to conform to U.S. accounting legislation. In December 1995 the cash-strapped Hungarian government finally sold an additional 37 percent to Deutsche Telekom and Ameritech, with the understanding that they would reduce their stake later througlh public flotation. Similarly, in the case of privatization of a banik with foreign subsidiaries, the government should normally consult the foreigni regulatory agencies, which may have to approve the effect of the cJhange in ownerslhip on the subsidiaries. More generally, privatization transactionis can raise problems in another country on competition grounlds, even whel the privatized comll- pany is not in violation of competitioni law in the country in whichl it is established. For large privatization operations that d raw on1 interniationial capital, shares of the enterprise to be privatized are sometimes placed on foreign capital markets either at the same time as the domestic market flotation or in a second stage. The securities regulations of the counitries concerned will then apply. Many privatization operations in the United Kingdom were accompanied by private or public placements in the United States using the American Depository Receipts (ADR) technique.")7 The same techniqLue was used in the privatization of numerous companies, particularly telephone companies, in Argenitinia, Chile, New Zealand, Indonesia, Mexico, and Vene- zuela (see A itcricaii Depository! Rcccipfs anid Prioatiul,ahs, Bank of New York, 1991). Legislative provisions have also been adopted in China to facilitate direct offering and listing of shares of Chlainese public enterprises on the Hong Kong securities exchange (see Salbaing 1993. and the section above on securities legislation). Conclusion This chapter has illustrated how various aspects of a country's legal envi- ronment not usually directly associated with privatization can nevertheless substantially affect a privatization program. lo trv' to privatize an enterprise in a general environment hostile to the private sector would usually be to court immediate failure. The factors discussed in this chapter that can con- tribute to the success of a privatizationi program include, among others, rec- ognition and protection of private owvnerslhip, elimination of all forms of dis- 67. An AN Di is a security issued by a U.S. bank in U .S. currency in exchange for shares of the foreigin company deposited with it or in a foreign bank. Fhik Security circulates as a bearer doc- unlclit representinig tHe shares deposited. Onlc Aiw )nm reprsent One share of tili foreign coml- pany or multiple shlares (for examiple, ten shares). Prizatnaizt aill a Aa M-rkcf Echiithitl S 7 crimination against the private sector, introdluctioni and protection of competition, a corporate law regime fostering the creation and efficient functioning of commercial companies (as well as the liquidation of insolvent ones), development of financial markets, strengtlhening of social security schemes, management of environmental liabilities, and settlement of dis- putes. For transition countries, in particular, reforms have been neededl in all or almost all categories reviewed in this chapter, amounting to the privatiza- tion of the national economy as a whole. Although some of these factors ma' affect the privatization process only indirectly, others will have a direct impact. 'roperty law is a case in point, as changes in legislation may result in transfers of assets from the public back to the private sector, especiallv in countries that have experienced heavy nationalizations. Moreover, many privatization transactions will be gov- erned by corporate law, in particular in the Lase of SUOts organiized under pri- vate law. Foreigni investment legislation mav well determine to wlhat extent foreigners can participate in the privatization process, whiereas securities legislation will normally applv to privati/ation throughi public offerinigs. Similarlv, labor and social legislation will often plav a kev role in privatiza- tion operations. One should, hlowever, bear in mind that it would be pointless to trv to document and remedy all the shortcomings id.entified in all of the areas dis- cussed in this chapter. The scope of the retorm program to be undertakeni will depend mainly oni each country's specific situation: a co untrv emergilng from a centrally planned economic system, for instatnce, wvill have to create a whole new framework for economic activitv. The government's legal advisers will need to id1entify the laws, regula- tions, practices, and institutions that pose major obstacles to privatiza- tion. Once these problems have been identified, their eliminationi mullst be assigned high priority. This will be achieved in some cases by repealinig or amending the relevant legislationi, and in otlhers by inserting specific provisionis in a privatization law. Other problems will inevitably arise during implementation of the program: tht-duia: Clt lari fyi ng Ow nershi p right s is a partici a rly difficult problem in the suc- cessor states ot the former Yugoslavia because (if th ditffuse nature of owniersh-ip of public enterprises. Article I of the privatization law of the RepubliR of Slovenia (November 11, 1992), is oiforma tive oni this point: 'This law regulates the owe rshil tr,)nsformnation of enterprises with social capital into enterprises witth knov\ n Owners. 3. Consider, for example, the case of the Iast (ermanl municipalities whichi claimed, ulsuccess- fully, ownership ol the electricity companies established on their territory The power contract (Stromnvertrag) concludI1d bv the two preunification f (nainat governments prescribed that onxlv 49 percent of the capital of these comnpanies could be helld bv municipalities, the majority holding of 31 percent belonging, pursuanit to this agreeteullt, to the Wist German electricity companies. The Triuloh latdtalusil ac ordiiigl'v comrpletedi thle sale If ihei ponier distribution compi lies of the foitrmer Fast Gierm,any in FebrUary 1994 by selling the thre( companies of Ihuringia to iayerni- werk, West CGe;rmaiiv's third electricity ( ompatly; the sille ol the East German electricity gelnerat- ing cotmpanv ,1(v to a consortium cOrimprisiig Ba verniverk oind P'reUssell Elektra was completed in Septemhber 109-I. See also table 2, andt 1 juiit1 I' lic,i, I( F biruarv 1994 and 7September 1994. Pri.n7tizatioi ii aiid PVilclw-Scctor Ma,miagcoci i 91 often complicated by past nationalizations or expropriationls (see chapter 3). Prior clarification of ownership rights is obviously critical for a smooth implementation of the privatization process. Exercise of Ownership Rights Once the legal owner is identified, the next step is to ascertain who has the power to exercise the owner's rights. Two separate questions are involved here, though the distinction betweeni themii is not always well understood: Which entity is authorized to exercise the ovx'ner's rights? And, which offi- cial(s) within that entity has such authority? Indeed, the state, public bodies, and public enterprises are able to exercise their riglhts only through the agency of dulv authorized persons. For a privatization transaction, it must be clear to w*hom the power to alienate or transfer ownerslhip has been coIn- ferred (see also chapters 5 and 6). If no provisions in the legislation governing public enterprises or assets spell out who has legal capacity to sell soi\, otlher parts of the country's legal framewvork miglht provide guidance. In Ne,x Zealand, for example, in the absence of specific legislation to the contrarx, thle governmenet or specified ministers are deemed to be authorized1 to sell public assets (see chapter 2 anl box 4.2). The same situation prevails in m)ost (ommunon-lawv countries. No matter wlho is authorized to sell in the namne of the state, that authlori- zationi (whether express or tacit) slhould blce unambiguous in order to pre- clude legal disputes on the subject. Aliin i atitu) of Pii (lic En7torprises a7ln Sliatrcli/ldi . s The legislation governing SlOEs sometimes explicitly authorizes their privatization bv subjecting it to specific, antd usually verv basic, rules. The Mexican program, one of the most ambitious an1 successful privati- zation programs, is based largely on the provisions of the public enter- prise law of 1986.4 Article 32 of that laws provides that wvhen an sol ceases to be of strategic importance, or when the public interest or the natiolnal economy so requires, the minister responsible for privatization shall, tak- ing into account the views of the concerned sectoral ministries, propose to the government the sale of the state's holdings in the enterprise. Arti- cle 32 further provides that in the evenit of such a sale, the employees of the SOE shall enjov a preemptive riglht. Article 68 states that thle sale of shares mav be carried out through1 the stor k exchanlige or througlh finan- cial instituLtions, on the basis of guidelines issued jointly bV the minister 4. More [han St percenit of the 1,15i st it . in the g' Vri-rTm.1t's portfolik) at the beginniniig of the prOgram were liquidated or Lold in thi\ wav, bringin ,g in tot,l receipts of over 521 billion bet ween 1988 and 1i ) (I te most active period otf the piogrna). L,oe Nci, Yiork 7ilillt , 27 October 19 a3. 92 Ti' Prizatizalimio Chall'on'e of programming and budget and the minister of finance and public credit. These two articles form the legal basis for most Mexican privatiza- tion operations. Similar provisions are found in the SLUE legislation of other countries; in some cases, they have been replaced witlh more spe- cific privatization legislation.5 Existing legislation may also impose specific legal forms. The principle of parallelism of forms, according to whiclh the same legal instrument that was used to establish an SOE should be used to abolisli or transform it, could mandate the use of specific and sometimes different legal instruments to privatize SoEs in a given country. This principle, wchich is not universal, is sometimes given legal sanction. An exanmple is found in Togo, where article 36 of Organic Law no. 82-5 of June 16, 1982, on joint-venture compa- nies, states that "if an SOE has been established pursuant to a nministerial decree issued by the Council of Ministers, it can only be privatized or liqui- dated followiing the same procedure." Moreover, SUE laws often contain provisions governing (a) the acquisi- tion and transfer by the state (or other public agencies) of holdings in joint- venture companies and (b) the creation and triansfer of subsidiaries of SUEs. These laws may also limit the right of SOES to bIuy or sell slhares of other companies. Although such restrictions can slow the privatization process, they may be essential in order to prevent abuses, to avoid creeping rena- tionalizations, or to subject such sales to commnon rules and regulations. Privatization laws sometimes carry these restrictions, too (see chapter 5). Alienation of Puiblic Assets The alienation of public assets is often governed by administrative law, spe- cific legislation on public property or public finance legislation. In countries with French legal influence, such as Morocco (sce box 4.1), a distinction is 5. In Biirtmili, for example, article 6 of Decree-l-aw nio 1/)27 of September 1988, wlich sets the legal framewvork for public-law companies and joint-veniture companies under private law, provided that state participations can be alienated onEl by presidential decret issued on the advice of the minister of finance and of the minister with jurisdiction over the soit to be priva- tized. This general provisioni was replaced by Decree-Law uvo. 1/21 of August 12, 1991, oni privatization of public enterprises, whicl delegates the pow 'r to privatize to the governimlenit, regulates the privatization procedures, and empowvers t[ie mmi ister of finance to sign the deed of sale on behalf of the government In Gnim'a, article 7 of Ordina nce no. 91/0)25 if Marclh 991 n the instituLtiollaI frarmew,ork for public enterprises provided that "the state's shares in public eniterprises are managed by a spe- ciali/ed department of the Ministry of f coniomic Affairs aid Finance. This department may transfer all or part of these participations to private persels), and turned Yilr into one of Latin America's most efficient energy producers. After losing $6 billion betweeni 1981 and 1989, YIPtl posted a net profit of 5706 million in 1993 despite a fall in oil prices. YIVF's public flotation, com- pleted in July 1993, Was an enormous success, bringing in ox er 53 billion. Jose Estenssoro died in a plane crash in May 1995. See International Fi, sunny Rei 'itii, Rkci'ia'v of the Year 199.3, p. 168; tIn' Vcoloeoliot, 2 lulv 1994, pp. 62-63; liill Stnrftc IJonal, 5 May 1195. Prizntiwtitoni invd Public-Sechtor Maniagiement 97 owed to the former SOE: the benefit of state guarantees regarding obligations of the SOE; and so on. Such universal succession could jeopardize the success of some privatiza- tion operations. Indeed, buyers may be unwilling to assume certain obliga- tions of the former SOE, even if they are giveni recourse against the seller. This would be the case in particular for continlgent, uncertain, or undisclosed obligations. This problem can be circumvented, however, at the corporatiza- tion or privatization stage by limiting the new company's obligations to those expressly listed in the agreements setting it up; the state would remain responsible for residual obligations. Changes in labor regime or levels are often required as part of the prior restructuring of an SOE, whether because the SOE was overstaffed, civil ser- vice or other exceptional elements were part of the SOE personnel regime, or other reasons. As mentioned above, the managers of an SOU will occasionally have to be terminated either because they do not support the restructuring and privatization program or because they do not have the skills required to manage the process. Where layoffs have been necessary, the choice has been between dismissing redundant employees before privatization or letting the new owner eliminate the redundancies and pay the required severance com- pensation, in return for a lower sale price. These and other labor issues aris- ing in the context of privatization have already been addressed in chapter 3. Some ongoing contracts may also need to be renegotiated to allow or facil- itate privatization. These may range from management or operating con- tracts to simple procurement contracts. As an example, one of the first steps taken by Germany's Treuhandanstalt in preparation for the privatization of Interhotel was to cancel an operating contract betxveen that company and a hotel group from the western part of the country; the contract was worded so that the hotel group could have obtained control of Interhotel for a very mod- est initial investment (see Financial Timiies, 22 November 1991). To avoid such problems, some privatization agencies or holding companies require that an enterprise to be privatized submit all major contracts for prior approval. Fiinancial Restructuring Public enterprises are often technically insolvent or in a state of bankruptcy. Financial restructuring may thus be needed before privatization. The prob- lem arises especially with corporatization, when SOEs are transformed into companies organized under private, commercial law (see below in this chapter). That transformation means that the public enterprise immediately becomes subject to existing business legislation, including the provisions on maintenance of social capital and bankruptcv. As a result, neither corporati- zation nor privatization may be sustainable if not preceded or accompanied by in-depth financial restructuring. Financial restructuring,7 will typically involve cleaning up the balance sheet by removing excess debt; deciding on the treatment of state-guaranteed obli- gations; renegotiating ongoing agreements with banks, donors, and other 98 Thc Privatii tiMl C7inll7t' lg, creditors (particularly wlhen these agreements contain clauses limiting the transferability of the SoI or its assets); and setting up financial systems and preparing new financial statements in accordance with generally accepted accounting principles. In order to attract private investors, a government will sometimes have to consider writinig off all or part of the SOE's debts to the state or other public entities. I SuchI debt write-offs were commoni, for instance, in many of the large U.K. privatizations. An empirical study' of Mexican privatizations showed, however, that debt reduction programs had no impact on net priva- tization proceeds; in other words, the hig]her sale price was canceled by the cost incurred by the government in absorbing the debt (see Lopez-de- Silanes 1996). Prior debt reduction, thouLgh often neutral from a financial point of view, may be needed politically. Indeed, success is often judged by the amount of gross privatization proceeds rather than by net revenue. Also, giving buyers moniey to take over an SO) witlh negative net wortlh may not be politically palatable, whereas a positive cash sale after debt restructuring may not be froxvned upon. In some cases the state may also have to take over or guarantee some of the debts contracted by the SOU with third parties, or guarantee that the obli- gations to be borne by the privatized company will not exceed a specific ceil- ing.12 The impact that Paris and London club agreements on public and commercial debt rescheduling have on such imeasures, as well as the conse- quences of such1 measures on the market discounit of soU and state debt, must be carefully considered. Although creditors often prefer sovereign debt to nonguaranteed debt of an SOU, this is not always the case. This issue has created some controversy in the preprivatizationi restructuring of some African telecommunications companies. The question was whiether debt of the former telecommunica- tions department of the central governm-ent slhould continiue to be treated as state debt (trading at deep discounts) or be transferred to the books of the newly established and corporatized teleconmmll Liicationis company. A trans- fer to the new company would m1ost likely have increased the market value of the debt significantly, because claims against the telecommunications company could be enforced more easily anid from abroad. Some have suggested that in transition countries debt should be added to the balance sheet of SUEs before their privatization. This somewhat unortho- dox approach may be justified in those countries wlhere the state corpora- tized its enterprises witlhout transferring the related outstanding debt to the SOFs, which meant that the balance sheet of man v corporatized SU)Es was not I I Where the state continues to be a creditor ol a privatliedi 5013 som0 governmenits hdave kept a certain diegree of conitrol over the manigemnitI of the privati/ed elterrprise, through a 'olderi share or othier tec(hniques, in order ito ciiu ; repa.ynwii (,ee note 32 in hapter 5). 12 Such a garanitee will usually be requested whelin tle magnitude of il heLs's liabilities is inot precisely known at the timile of privatization, is str es-ed in the section ot ci hpter . on enlvi- ronmental law. Prini tiza_,7oii inldlt lh0fic-SctOr Mal,i,7cnc ott 99 sufficientlv leveraged.'3 This outcome should, however, lead to a higher sale price at privatization and thus would not reqtuire the addition of debt. The problem is more serious during the period leading up to privatization, wlhell SOE managers may have too much free caslh flowv and few incentives to use it in the best interest of the companv or shareholder(s); weak corporate gover- nance of S(ls further compounds the problemil. In Germniay, nearly all public enterprises vwere converted to private-law companies as of Julv 1, 1990 (see articles 11 ancd I 2of the June 1990 privatiza- tion law). The Treuhandanstalt became the sole shareholder of the former combines (the equivalent of holding companies or conglomerates) reorga- nized into joint-stock companies, wlile the component enterprises of the combines wvere converted into limited liabilit\ companies held by these new joint-stock companies. Under a separate 1990 laws the new companies were required to drawt up their opening, balance sheet in deutsche marks (see Horn 1992, pp. 15-18). This involved revaluing all their assets anid liabilities. If their liabilities exceeded their assets, the shareholder (the Treuhandanstalt or a joint-stock company belonging to it) had to dLecide whether or not to cover the shortfall. If it decided to cover the losses, the shareholder then had to replenislh the new companv's capital to bring it up to the minimum level required by law. Accordingly, the Treuhandanstalt had to take over a large amount of debt and inject fresh capital into manv SOEs, a fact that helps explain its large borrowing requirements and a deficit exceeding 250 billion DM at the end of its term (see also note 35 in clhapter 3 and the sectionl in chapter 6 on1 finanicinig the privatization proce ss). In New Zealand also, the privatization of many SOks was preceded bv financial restructuring carried out as part of the corporatization process. One of thie purposes of this restructuring was to start off the corporatized "CEs wvith opening balance sheets and accolunits conformiiing to generally accepted accounting principles and subject them to the same financial disci- pline as enterprises in the private sector (see Franlks 1993, and box 4.2). Abcilithing Discu imiuitonit Prancti,s An essential objective of prior restructuring should be to abolish all preferential treatment or exceptional rights and obligations of S;ors. The playing field should be level for these enterprises and those in tlhe private sector (see the section in chapter 3 on protecting and promoting competition). All special privileges granted to the SUEFs to be privatized wvill need to be abolished, includinig subsi- dies, tax and customs exemptions, state guaran tees (express or implied) on their borrowinigs, preferential treatment in the award of public contracts, access to 13. Ill aditlion to being onaorthodox, this approach mv in some coiunitries be illegal, espe- cially if creditors are exposed to additional rkk,i,k a r, still of Ihi transfer. See a15s the section above in this chapter diealliig ih iai sOtid1st a cti i)tt1 pra ittices, as wetl as t . thetit ,L chap- ter 3 oin franufer of IiJblifiel. I(O( Hic Priz'oati:_ation C11l1111cligi reduced prices for specific inputs (utilities or petroleum, for example), exemp- tions from the application of competition law, special labor law provisions, and any other advantage or form of protection. This policy was followed in most privatizations carried out in New Zealand.14 Similarly, in Belgium the state's guarantee of the public-sector financial institutions was removed and these insti- tutions were integrated in the deposit insurance sclheme covering private banks before their privatization (royal decree of March 1, 1995; see Vincent 1995, p. 12). Obligations borne by SCUEs but not by their private competitors should also be eliminated. In many countries, SOYs have traditional]v performed social or noncommercial functions without adequate government compen- sation, such as supplying goods and services to specific regions or categories of customers at a loss; or providing health, edtucatioin, 1ousin1g, and other social services to employees and their families and sometimes even to an entire village (especially in the formerly communist countries). These social activities, generally performed at a loss, are often cross-subsidized by earn- ings from other activities. Subsidies of this kind are possible, however, only when the enterprise enjoys a monopoly or some other form of protection. Without protection, competitors of the SOE could stipply goods and services at a lower price and thereby undermine the verv base of the cross-subsidiza- tion system. Where such social functions are assigned to an SOE by law, these legal provisions will have to be abolished before privatization. These func- tions can either be assigned to other public entities or dealt with by way of service contracts between the government aind private providers. 15 Finally, in order to bring the status of the SOEs to be privatized int) line witl that of private-sector enterprises, it may be necessary as part of the restructur- ing process to limit government interference in CIEO operations. General or specific SOF legislation sometimes includes provisions that limit S. In the ( iech Republhk and Germany, however, the same agency combined both functions. 1(06 rle' Prinitizatiolt COa(l 'i(i ','t SOEs and established new companies to which assets and liabilities of the former SoEs have been selectively transferred; in exchange, the funds received shares in these new companies. fin a second stage, the fund in turn transferred these shares to private investors. This twvo-stage procedure offers many advantages. First, it eliminates the need to draw up a detailed inven- tory of the assets and liabilities of the old solE before privatization. Second, it makes it possible to divide the old SOE into smaller companies, consolidate the assets of different enterprises into one company, and sell separately any real estate not essential to the operations of the enterprise. Third, it assigns to the fund the legal responsibility for laying off redundant employees and for doubtful debts, environmental obligations, and so on. Fourth, the fund assumes responsibility for any remaining obligations, known or unknownl, of the old soEG, henice obviating reliance on burdenisomne bankruptcy or liqui- dation procedures. The new companies established by the fund can then start their operations and be privatized under good conditions. Prior Rcstr icti riiiig: Lessoins froin Mcxice In a recent empirical study of the privatization of 361 Mexican companies, Lopez-de-Silanes 1996 analyzed six areas of SOF restructuring before privati- zation-namely, management, labor, debt, efficiency programs, investment, and deinvestment-and their final impact on net prices. This study provides some interesting guidelines for wliat type of prior measures might be worth undertaking. "For instance, the results suggest that it is worthwhlile to replace the CEO wvith a 'privatizer' whose task is to clean up the company, to reduce the waste of resources, and to get the firm oni the block as quickly as possible. Labor downsizing before selling has a positive marginal effect on [net pricel, while debt absorption has no impact. Investing or embarking on efficiency programs before the sale actually decreases Ithe net pricel; the government does not get its money's worth and the performuanice of the company remains the same. In contrast, cutting the flow of resources and postponing large investment programs, or de-investing, fares better in terms of premiums." The author also found that "direct costs of prior restructuring policies are quite substantial, amounting to an average of 30'4, of the sale price. Addi- tionally, restructuring measures such as efficiency and investment programs slow privatization. Delays in privatization come at a substantial cost, partic- ularlv when subsidies poured on SOms can quickly add up to outweigh privatization revenues.... The empirical estimates in this paper point to a premium for speed and restructuring measures that expedite privatization and halt the drain of resources. The key lesson is. do not do too much, sim- ply sell" (Lopez-de-Silanes 1996, pp. 3, 29). Liquidation of Public Enterprises Liquidation of an SOE is a common (and ultimate) form of sot restructuring. It is also a widely used privatization techlnique. It often refers to the disposal Priuntatzt i iniillt Vi'li ic-Scc torF Matigcini1111i11 (7 of the shell, consisting mainly of debts and other obligations remaining after the core assets and selected liabilities of the former SOE have been trans- ferred to one or more new companies after corporatization, breakup, or privatization.24 It may also refer to thie winding down of an entire SUE, whether or not it was still a going concern. Different laws may apply, depending on whether the SOE was governed by private law, in which case liquidation usuallv takes place under company law and commercial banikruptcy law (see chapter 3), or bv public law, in which case bankruptcy is not possible and liquidation is governed by other rules. Some countries, including Senegal, Togo, and Viet Nam, have enacted specific legislation governing the liquidation and banikruptcy of SUEs. 2 Elsewhere, for example in Guinea, where liquidationi has been the main privatization teclhniique, or in Italy (see Decree-Law, no. 340 of July 1992 con- cerning liquidation of EPIM), a law may be required to liquidate certain SOEs.2' Finally, in other countries suchi as 1'rance case law is the main source of law applicable to the liquidation of various tvpes of public establishments (see Bienveniu 1993; Conseil d'Etat 1989). Public Finance Legislation Budget and public finance laws may also contain provisions governing privatization. For example, the Canadian finance legislation requires that a law be enacted by parliament before an sUE can be privatized.27 In other countries, suclh as Malaysia and New Zealand, the discussion and approval of the budget or annual finance law is the main vehicle for parliamentary involvement in the privatization process; the privatization strategy of the New Zealand government established after the 1990 elections tllus consti- tutes ann1ex 5 to the 1991 budget law submitted to parliament. In addition, a country's public finance regulations may apply to the allo- cationi or use of receipts of privatization. Even where the privatization laws 24. As part of the privatization of the teleclri-muIlIcati,,ns compan)v the Argentinie fderal government enacted Decree no. 2762/91(1 etting up a liquicdaltion comnmis-ion responsible for ensuring fulfillment of the governmenit's remainin,g ablicatioits lter transfer of IEN I' Is staff and main1 a1ssets to the private sector. 25. See Senegal's Law nto. 84-64 concerning the 1ILuldatIon) of M1 ALigust 1, I1 94), Togo's Lawi no. 82-5 oni joint-venture companies llti is II, 1482), and ResoIlution no. 388 of Viet Nam's Couuncil of Ministers concerning the estalihisrnent andLl liquidatioin If so s (November 20, 1991). 26. See Guinean Ordinance nL. 3()6 PRG-Y5 ot Decemiler 12, 1985, mandating the closing down and liqluidation of 12 enterprises specified tlterein, and Ordinance no. 315 'RTG-85 of December 21, 19X5 maInMdating the liquidation of 14 miial retail stire.. Under the militarv regime in force in Guinea at that time, anl ordinance vas e juivalent to a lass. 27. See UN( IA.n, Ad Hoc WVorking GroIp on ( Conparati%e Eperiences Ivith Privatization, third session, November 2-December 3 1993.c,uLIntrv pre-entatil slibmltted bv Canada, p. 12. 1(IS Tinc Privatiztofino Chalh' 1c1i specify how the proceeds shall be allocated, other finance laws may apply (see the section in chapter 5 on allocation of privatization proceeds). In many countries with budgetary systems modeled on that of France, for example, public expenditures cannot be deducted from public revenues because the law does not allow either offsetting or contraction of expenditures and receipts; all public expenditures have to be authorized by parliament and committed, disbursed, and controlled by authorized officials pursuant to public expenditure regulations.28 Finally, public procurement regulations mav well apply to some contracts concluded by governm11enits as part of the preparation and implemlienltationi of the privatization program. Concession contracts or contracts for the recruitment of experts to advise the government on privatization (including attorneys, auditors, investment bankers, and other consultants) are likely candidates. Conclusion In the area of public-sector maniagemient and public law, just as in other areas discussed in earlier chapters, the privatization process is affected, directly or indirectly, by a multitude of rules and regulations. I'rivatization is a public act involving a transfer of assets ownedl by the public sector. It is also a public process managed by public agencies and officials. An important distinction needs to be drawn between the public agency with the right of ownership over the enterprises or assets covered by the privatization program (the state, municipality, or another agency or public entity), on the one hand, and the authorities enmpowered to exercise those ownership rights-in particular, the right to alienate enterprises and assets-on the other. The legal status of an ScE, as discussed above and in chapter 1, determines in part the measures required before privatization. Thus, if an SOI is already governed by private law, prior restructuring wvill likely address manage- ment, staffing, and finances (including appoinitinig a new c F0, dowinsizinig or "riglht-sizing" the labor force if necessary, cutting off subsidies, andl clean- ing up the accounts and balance sheet). The object is to be able to privatize a viable enterprise. It may also be necessary to renegotiate certain contracts or 28. in its 199i) annual report, the French (Cnur des t omptlvs (equivalent to the U.K. NAO or U.S. ( .AO) criticie.ed thie wa' in whiichi certaini expetnditurs t or public flotations and othier priva- tization operations (mainlly commissions, reioiburenwints , f expenses to financial intermediar- ies, and taxes) had beten deducted directly bv the finarcial intermediaries from the gross amount thiy received. Only the net proceeds of privatization wLre ultimately paid into thie trea- suryvs special privatization account, in direct violattiwn ol lji pronvisions of article 18 of the organic law relating to finanice laws" (Cour des ( oplt~ IOtl'l(, pp. 24--25). The Cour des Comptes a1su criticized the la,Lk O f traospari nc in Hie i naticial a.spect, oi debt-swvap opera- tions, particularlY the losses incurred in the redeto1ptioll ot 1,old-itdexed bon1ds. P riIfi:atimi: I 1 1i Pill ic-S ccor Mnalnagol,l cit 1(9 obligations. Similar issues arise wlhen the enterprise is governed by public law; in that case, it may also be necessarv to choose whether to corporatize the enterprise or to liquidate it. In all these cases, the old SOI maya have to be broken up to some degree and some of its activities or assets separated or demerged from its main activity. Existing discrimination toward the private sector, whether to the advantage or disadvantage of the S()E, will need to be eliminated. And proper attention will have to be paid to the management of the SOEs durinig the transitioni period leading to their privati/ation. The privatization process can be affected by other public-law provisions, such as public finance rules. Also in the domaini of public law are constitu- tional aspects of privatization (chapter 2), matters concerning the immunity of the state (chapter 3), and the privatization laws themselves, whlicil form the subject of chapters 5 and 6. This chapter ends the broad overview of the existing legal framework that may affect the privatization process, w1hich started with constitutional and international law (chapter 2), continued with thc analvsis of a broad range of laws affecting private business activity (chapter 3), and concluded with this discussion of legislation governing the public sector and its activities. A proper understanding of this preexisting legal framework and of its limita- tions is essential. The laws discussed heretofore often preclate privatization programs and were not enacted primarily for thie purpose of the privatiza- tion program. The following chapters will focus mlore directlv on1 the privati- zation process itself. 5 The Privatization Law Whether or not a country needs to enact a privatization law depends on its legal and political situation and the specific characteristics of the enterprises to be privatized. In some countries the governlment does not need any spe- cial enabling legislation tt) privatize, either because constitutional principles do not require a law (see chapter 2) or because SOE legislation or other laws provide the necessary legal framework (see chapter 4). Issues discussed in this chapter are germane wvhere a special privatization law is legally required or deemed to be politically desirable.2 Whetlher legally required or not, a law offers several advantages: it represents an immediate and concrete statement of explicit political support for and commitment to the privatization process, increases the accountabilitv of the executing agency, makes it more difficult to undo the reforms beiing implemenlted, and provides an opportunity to change (and improve) the existing business environment to facilitate privatization. Disadvantages comprise often lengthv delays in secur- ing parliamentarv approval, the possibilitv that the law's provisions may be too restrictive or inflexible, and the risk of parliamentary micromanagement (see the section in chapter 6 on the role of parliament). The contenit of privatization laws mav vary substantially. The core ele- ments of privatization legislation, namelv, the enabling provisions authoriz- ing and organizing the privatization process, are handled very differently from one law to another. It is essential that the law define in clear terms the respective spheres of responsibilitv of the various authorities that play a role in the privatization process, such as parliament, the governmeint, the privatization minister or agency, the management of the SC)Fs or other institutions involved. Mecha- nisms must be set up that make these aUthorities accountable for their 1 Moreover, public enterprises do not as a rule need .pccial laws to be able to privatize thieir assets or subsidiaries, as nzoted in chapter 4. 2. Even Nwhere privatization is legailvl authorized nolid r u (irrenit law a government wvill sonIe- times wvish to cover itself politically bv obtaminig tihe apron al of parliameint. Illl 112 Tlet Priz'atization Challetnge actions and create appropriate incentives and penalties to ensure proper execution of the privatization program. These questions, which are covered by almost all privatization laws, are examined more closely in chapter 6. Many privatization laws also contain provisions to remedy specific short- comings in the existing legislation, of the kind discussed in chapters 3 and 4.3 These can be described as facilitating provisions of the law, as opposed to enabling provisions. Furthermore, constraints that may rightly be regarded as obstacles to privatizatioin can sometimes be circumvented with a little imagination and creativity, as table 5.1 illustrates. Where the constraint was of a legal nature, it was circumvented without recourse to a law. [n some of these cases, such as the one involving coupons for the Pakistanii telecommunications com- pany, the chosen shortcut turned out not to be particularly successful. The issuance of coupons, vouchers, or bonds convertible into shares of a com- pany scheduled to be privatized later may unnecessarily complicate a priva- tization. Indeed, this technique, which is sometimes chosen to collect priva- tization revenues in advance of the actual transaction, creates new ownership rights that cannot be ignored at the time of privatization and may limit the available options. This chapter deals with the enabling provisions most frequently found in privatization laws.4 After a discussion of the maini legal instruments to effect privatization and of the scope of privatization laws, the following topics are addressed: the valuation of SOEs to be privatized, the selection of buyers, preferential schemes, financing of share purchases, allocation of privatiza- tion proceeds, as well as transitory provisions and amendments to privati- zation laws. A Law or Subordinate Instruments? Where privatization legislation is required, it mav be preferable to limit the provisions of the law to broad principles and leave the details and modali- ties of its application to subordinate instruments or decisions. No universal recipe exists, however, to determine which privatization provisions should be left to the discretion of the parties involved and which should be 3. In Peru, for example, article 7 (a) of Decree-Law no. 2612() of December 28, 1992, amending the privatization law of 1991 (Decree-Law no. 674), introducO,s an exception1 to ordinlary labor law for soi-s to be privati/ed, aimed at facilitating the personnel cuts that have to be made as part of the preprivatization restructuring process, whileartict, 7 c) provides for thieadoption of measures to allow regularization of ownership titles, permit>, licenses, and so on, of sotis. In Romania, article 73 of Law no. 58/1991 om privati/ation reluired the government to prepare a bill for the creation of a securities exchange; a low oUl securities and stock exchallges was enacted in August 1994. See clapters 3 and 4 for additional esamples. 4. A nonexhaustive list of worldwide privati/ation laws, dLcrees, and other regulations, cov- ering over 1I (1 countries, is given in the appendix. The Priva fiza fioi La zt 113 Table 5.1 How Some Countries Have Overcome Specific Obstacles to Privatization Conlstr azint Solution lColwitrl/ Ownership of land cannot Established joint-venture Viet Nam be transferred to a private companies whose public- enterprise sector partner held Lhe rights to land u-se Granted long leases Socialist cou ntries The state's ownership titles Concluded lease-sale contracts Nicaragua to certain assets are allowing assets to be trans- imprecise or disputed, ferred witlhout Immediate sale; making sale of these lessee was given an option to assets to private purchase these assets at the investors more difficult end of the contract The exercise of certain Conjcluded a concession contract Brazil, activities cannot be trans- providing for the transfer of Mexico ferred permanently to the assets to the concessionaire for private sector the duration of the conicessioni; assets shall be returnied to the contracting authority at the end of the contract The legal framework for The president of the republic ratified Guinea privatization is the privatization agreenlen ts ambiguous Privatization requires enact- Used a method other than divestiture China, ment of an enabling law, to transfer enterprises to private Viet Nam but the government does management (lease or concession not wish to support such contracts, for example) a law politically Privatization of the national Sold public coupons entitlinlg the l'akistan telecommunications holder to shares in the future priva- company requires a long tized compan,v with the under- period of preparation and standinig that the government would enactmenit of a law buy the coupons back at a specific price if the company was not privatized withinl two years Privatization of a company Planned to iSSule' state bonds conver- Turkey is blocked by political tible into shares of the new opposition and/or by company when it has beenl the courts privatized The government wvants to Sold a convertible bond with the Italxv sell a second tranche in conversion price set at or above a company whose market the 1'o price is below the original initial public offering (11i') price (tItl, &t)IIt IUII I1W1 to eI Mcolf1eool' /Ing p) 714 The Prinlt izatinl Challlelhge Table 5.1 (con tinued) Conistraint Solltionl Countrut A law is required to Public-law enterprise created sub- France privatize a piublic-lalw sidiaries organized Under private enterprise law, which can be privatized without any neted to alter their legal torm Shares have to be granted Issued nonvotinig shares for Bulgaria to the employees of the employees privatized enterprises, but the interested buyers do not want to share control The law provides that a By firm underwriting, a bank or lolanid capital increase that is other financial entity uLndXer- not fully subscribed took to acquire all the newly must be deemed issued shares, organize their resale null and void to third parties, and beir the attendanit risks included in the privatization law, in implementing decrees or regulations, in decisions of the competent authority (for example, the minister of finance or the chairman of the privatization agency), or in general guidelines. This decision will depend partly on the counitrv's constitutioinal, legal, and politi- cal system and traditions and partly on current political concerns, notably the degree of confidence parliament places in the government. The choice of the legal instrument to be used will also depend on several other factors, such as the objective to be promoted; customized and flexible approaches, as opposed to standardized and uniform ones; cenitralization, or some degree of decentralization, of the process; and a priori controls or accountability of the executing agencies through a posteriori conitroIs, These choices will have to be made at the start of the process, because thev will largely determine the design of the legal framework for privatization. The Frenchi legislation of 1986 affords an interesting, thouglh very specific, illustration of how identical provisions can find a place both in a privatization law and in implementing regulations. Article * of the first privatization law of 1986 authorized the government to legislate by ordinanice, pursuant to article 38 of the French conistitution. President Mitterrand (of the socialist party) refused, howtever, to sign the ordinance prepared by the government of his prime minister, Jacques Chirac (of the conservative majority coalition). To cir- cumvent this obstacle, the Chirac government submitted the text of the ordi- nance to the National Assembly in the form of a bill, that is, a draft law. This explains whvy two consecutive laws had to be cnacted, one in July and the other in August 1986, to enable the privatization program to be implemented. T/ic Privn tLtit)iu Lawzi, 113 Furtlhermore, a law should not be used to subtstitute for a proper privati- zation strategy, lest it be loaded with many considerations better left to sub- ordinate legal instruments. Some aspects of privatization, though essential from a strategic point of view-speed, timing, or the choice of a privatiza- tion technique-should normallv not be regulated bv law. Legislating such matters could easily become a straitjacket: a strategy can be adjusted fairlv easily to tailor it to changing circuimstances or to factor in the lessons drawn from new experience; a law cannot.5 Scope of the Legislation As the appendix illustrates, most privatizing countries have enacted specific privatization legislation, whether or not required to do so by the con1stittu- tion or by law. In the process thev have bad to choose between general legis- lation applicable to all SUEs to be privatized and a specific law for each suchl SOE or group of SOEs. In some cases the targeted ',Es are specificallv named; in others, thle law, addresses one or more categories of enterprises withlout naming themii. The scope of some laws, and henice the privatization mandate of the gov- ernment may also be limited in time." Restrictions of this kind, whiclh are usuallv found in laws with a positive list of privatizable enterprises, can have adverse effects. They can easilv weaken the government's positionl in negotiations with potential buyers, especiallv \heln the legal time limit is nearing expiration. 5. The l'uerto Rican Telephionie Autthoritv Act of April 1, 1'I)91) affords a goodl example of a privatization law that goes ijto excessive detail It included a Lnumber of higihly restrictive pro- visions, For example. it specified the minimiumi net proceeds fromil the sale of the comiipaniy, in this case $2 hillio mi net of the total debt at the date of sole and the sale costs; prioliibitedi aniiy increase in basic teleplihone service chargeos withiii three yeairs following privatization; prohib- itedi the buyer from dismissing any employee as a direct result of the sale; aid, as a condition for the sale, required parliament to enact laws establishing ai Permanenit FunId for the Develop- miiit ofEEducation, a Permanent Infrastructure Fund Li ee bx( 5), and thel 'uerto Rico Telecoiim- munications Regulatorv Commission and to ad opt a re(s Iution proposing a constitutional amenidmeiit. These reqluirements, particularIv the ni lini ifii sole price (which anionii tedl to about $3 billion), prevented corrpletion of negotiations xsith h interested bidders. Since the gov- ernmenit lacked room for miraneuver to accommodate ilte coiiceriis of bidders, it hiadi to take the company off the market. In February 1992 the I'uLerto Rican inthorities concluded an agreemeiit on privatization of II 1i the company providing iteriiatioiial and long-distance services, with Telef&inica of Spain, whichl thus became majority sharelhold,r in I 1 i 1179 perceiit of the capital). 6. See, for exaIIple, article I of the Moroccani privati/atii n lai of April 1qY9t, which sets the deadline for completion of privatizations at Deceimbtr 31 9t1 Ihe law was amended in Janu- ary 1995 to extend the deadline to Decemiber 3 1, 199ld, i thihi add tWO new 0enterprises to the list. See also article 4 of thie Frencih privatization law of JLilv I-in n, xhicli gaVe NMarch 1, 1 91 as the deadline. A new priVatl/ation la Wvas enactd in Io-n3 grintirig the government authiritv to pri votitac o ii et, set of sil ) an id modify mig tile I 96sf legslat tli i 116 Tlhe Priaittiojfio ChallenNte General Legislation A law of general scope should be considered if comzmon rules for all privati- zation transactions are deemed important. Such a law may confer a general mandate on the government or an agency to privatize SIOFs. This happened in the Philippines, where the law provides that it is up to the president of the republic to decide which state-owned assets or enterprises shall be priva- tized (see article IV of Presidential Proclarmation no. 5() of December 8, 1986). A law that confers broad authorization to) privatize without specifying the enterprises in question will generally define its scope of application either by defining "privatization" or other termns or bv prescribing inclusion or exclusion criteria.7 The privatization mantdate may thus be limited by excluding particular sectors or SOEs, as happened in the former East Ger- many, where the privatization law excluded, among other sectors, transpor- tation infrastructure, the postal service, and muniicipal enterprises. Another possibility is to specify the sectors in wllicih priv.atization is permitted with- out naming any particular enterprise.8 La desitgnatitig priV7tiable eCCterpriscs. A general law may list the SoFs that are to be wholly or partially privatized. Thlec government's authority to privatize is then usually limited to these-listed SOrs. Examples are found in Argentina (see the annex to Law no. 23696 of August 18,1989), Burkina Faso (12 SOEs), France (65 sovs in 1986 and 21 in 1993), Morocco (112 soms), Nige- ria (110 SOBs), and Senegal (27 SOis).9 Listing privatizable SOEs in the law is not necessarily a good solutioin, how- ever, because such a list limits the flexibility of the governm11ent. Constantly changing domestic and world market concdition,s may dictate priorities other than those originally prescribed in the law.. Moreover, designating specific enterprises can create uncertainty amoong the nmanagement and staff of the SOE. In the absence of schemes and incentives ensuLring their continued moti- vation and of strict corporate governance or control procedures, this uncer- 7. When a law states that it governs the transfer of assets, enterprises, or activities from the public sector to the private sector, these terms may need to be *tefined. P'rivate sector may, for example, be defined to exclude public enterprises, other punlblic entities, or state-controlled bod- ies from acquiring shares in the privatized enterprises. Somre definitions of public sector may lead to the inclCusion or exclusion from the scope of the law of categories of public enterprises, such as municipal enterprises or subsidiaries of public enierprises, for example. See also notes 27 and 54 below aind the glossary at the end of this book. S. See, for example, Bulgaria's Council of Minister- Decree no. 36 of A\pril 1t), 1991), authoriz- ing privatization of stores, workshiops, hotels, restiuranits, and other establishments in the trade, tourism, and service sectors. This decree has sinlceC been rescinded. 9. The list appended to the Frenchi law of IulV 2, 1 c56, comprised 65 enterprises, whlichi in fact constituted 28 different public groups. Of these, I3 grotup' wvere privatized between November 1986 and lanuary 988. This left 15 groups to be prisatized, whose number had fallen to 12 by 1993 following certain mergers. The 21 enterprises listed iii the annex to the law ofJ uly 21, 1993, comprised these 12 groups plus 9 new enterprises. The Prizvatization Lawzb 177, tainty can lower productivity or even trigger fraudulent activities. Long delays between the designation of an SOt to be privatized (or even rumors of such designation) and the actual implementation of the transaction have indeed led to a deterioration of the condition of the SOE, and sometimes even to pilfering and misappropriation of SOF assets by workers and managers. Some countries have issued decrees pursuant to the privatization law that list the enterprises to be privatized. In Mozambique, for example, an initial list of six SOEs was adopted by a decree of November 1991, with new SOPFs added in 1993 and 1994 by decrees taken pursuant to article 14 of the August 1991 privatization law. This method offers more flexibility than the designa- tion of SOEs in the law itself. By reducing the time between the annlounice- ment of privatization and the actual transaction, it also reduces the risk of deterioration in the SOE's situation pending privatization. Provisions applying to certaii tyiptes of privatinatioiis. A general law may apply also to privatization operations carried out by SoEs or state holding compa- nies, that is, to situations where the seller is not the state but a public enter- prise. In this case the law may provide for derogation from ordinary SOP or company law-for example, by requiring that all or part of the proceeds of privatization operations carried out by SOEs shall accrue to the national bud- get (see chapter 4 and the section in this chapter on allocation of privatization proceeds) or by conferring to the government the right both to sell shares held by an SOP in other companies and to receive the proceeds of that sale (see Gra- ham and Prosser 1991, p. 82, with respect to the U.K. oil and gas law of 1982). A general law may also subject different types of privatization to different regulations. In France, for example, the privatization laws of July 2 and August 6, 1986, as amended by the law of July 19, 1993, authorize three differ- ent privatization procedures. The procedures set forth in these laws apply to the enterprises listed in their annexes. The other enterprises fall into two cat- egories. First, prior legislative authorization is required to privatize majority state-owned enterprises (state ownership of 517 percent or more) and enter- prises that entered the public sector pursuant to a lawiY1 Second, an executive instrument suffices for enterprises in which the state directly holds less than 50 percent of the shares and for enterprises that became part of the public sec- tor without legislative approval; an executive instrument is used also in the case of the partial sale of shares of public enterprises in which the state is the majority shareholder and remains the majoritv shareholder after such sale.1 I 10. With the exception, however, of enterprises that became part of the public sector pursuant to legislative provisions but are held, directly or indirectly, bv enterprises included in the liist appended to the law of July 19, 1993. The transfer of enterprises ot this kind to the private sector must also take place in conformity with the prov isions of the law of July 1493 See article 2.1 of Law no. 93-293 of July 19,1993. 11. See Decree no. 91-332 of April 4, 1991, which lavw down the conditions under wvhich minority shareholdings in public enterprises canl be soldl See also Debene 1991; Richer and Viandier 1991; Saint-Girons 1991. 118N Flthe Prin'af ti:at"i Cha/lleng Specific Lcgislatioi Specific laws authorizing the privatization of one or more SOFs or of an entire sector have been enacted in Argentina, Belgium, Brazil, Canada, New Zealand, the United Kingdom, and several otlher countries.12 Such precisely targeted privatization laws tend to be used where the scope of the privatiza- tion program is limited or an SOE or group of SOPs poses special legal prob- lems that cannot easily be resolved in a general eniabling law.13 This would normally apply to the privatization of an entire sector, especially a higllly regulated sector such as the financial, natural resources, or infrastructure sectors (see chapter 7). In addition, some countries with a weak legal framework have turned to a very special tvpe of privatization law. Th-us in Guinea agreements for the sale of particular enterprises have been ratified bv presidential ordinance in order to give them full effect, notwithstandinig conflictinig provisions of other legislation. This enabled Guinea to start privatizing SOrs in 198f6 withi- out having to wait for a complete overhaul of its business legislation or the enactmenit of a privatization law, whiclh occurred only in 1993. Valuation and Sale of Enterprises to be Privatized Parliaments and governments often build safeguards into their legislation to ensure transparency of the process and reduce some of the risks typically associated witlh privatization.14 The law comnmonly imposes basic rules to be followed by the implementing agencies, particularly regarding prior valua- tion of SOFs, the use of specific sale techniques, and the procedures for select- ing buyers (see the following section). 12. Arg'citima combined both procedures: a general lawa +1f 1989 applying to the enterprises named therein, followed a few years later by specific law, for certain individual enterprises such as et: (thie oil company), Gas del Estado, and certain financial institutions. In (lgipuml, arti- cle 9S of the law of July 22, 1993, authorized the government to transfer the shares it held in four public financial ilnstitutions. In Bra_7/, a law was n)ot 1ne0eded legally speaking, to privatize VASP, the Sao Paulo state airline, but it was d1ecided for political reasons to seek the approval of the legislator in order to secure the Sao Paulo state government s cooperation, because it was feared that this operation wsoeIld meet with spirited politicca opp,isitio n (see I aw no. 0629 of Decem- ber27, 1989). See the appendix for a listingofotler specifik privatiation laws. 13, In the case of Petro-Canada, for example. the Canadian governnment did not wish to priva- tize 'CIA(, Petro-Canada's international assistan(e subsiliary. The specific law provided for the transfer of Petro-Canada's 1 IAC shares to the governmenil be fore privati/ation See the P'etro- Canadia P'ublic Participation Act of February I.9 I 14. lruguay s privati/ation law of October 1c)01, for ex,imple, sets forth a number of princi- ples that must governl priV atiza tioni operations: freedlomii if choice for consurmers, abolition of monopolies, fair competition, and adequate publicitv to ( nsure transparency of the privatiza- tion program. The' Prit'a I7inzttioi Laic 11' Valhationi Valuing public enterprises or public assets is a delicate operation, notably because public officials wish to avoid being ac( used of givinig away the fam- ily silver or selling off the crown jevels. Valuatioll affords theni political pro- tection in the event that the decision to sell at a given price is disputed ("It is the price at which the enterprise was valtuedi tv the auditors"). In practice, however, the valuations that hiighlv skilled eNperts proffer are often far off the enterprise's true market value, even in industrial countries. In some cases, overvaluation of the Su1lC has forcedl the cancellation or postponement of its privatization; this happened, for e\aimplc, in the cases of VSm., the Indian international telephonie company, and the Puerto Rican telecommu- nications companty. While setting a reference price is undeniably useftl, it may be preferable to obtain the right price through competiti\ e, transparent, and open sale procedures with wide disseminationi of informiation. A competitive proce- dure usually offers the governmenit better guarantees than does an expert valuation performed before the sale .1' Comlpetitive biddinig by several potential buvers, each of wvhich will perform its own valtiation of the enter- prise, should more accuratelv reveal thie true value of the eniterprise. This procedure is also speedier and clheaper. Maiiv countries have nevertheless enacted laws requiring prior valuation in all privatization transactions. Some tvpe of prior valuation may be justitied, however. In the case of an auction sale, the seller may want to set a reference or reserve price below which it does not wish to sell. For an initial ptublic offering (illo), prior valua- tion is needed to set the share price; this w,%as dotiei in most Fresnchl, Malaysian, 15. The public flotation otf \.NL Was canceled on M vlav 1, 194, in respoinse to negative reaction to the highi share price following market oMnidingss. Fhis price, which w-as set bv the govern- ment before the fall inl Indiani share prices, nvas appanrentl% nl the ranlge Rs 1,400-1t1 61)0, wliere,s the goverrimentNs financial advisers thought that thii, iu,rket was prepared to pay only Rs ,I111). The goivernment did nlot wish to lower its priLt for fetar f be ille accused o1 t sellilng tilh company at a discount to foreigners. This was a parthcularl\, .ensliv e issue tor thC governnrlet beCause a parliamentarv committee had just accused it of -,ellig certain holdings in 19 02 and 1993 at below their true nalue. Five months 1later the IIotation n-as rela unched the government instructed its bankers to) obtain a price of RIZs lii)-) 21) or 2 i percent less thanl the previous price, despite a rise in the' Indian stock exchanige of al,ut 2`3 percent since Mav. 'his second attempt also faltered. See Will Stlit Jiiiuinial, - Moii n 1904; Ft.ini,'iiigklm k4ikt- We-k, 26 September 1944; l4 i i 'niwk, 30 September 199Q4- With re.pcit to, w P'tierto Ricaii telephi1inC privatizatiin, see note 5 in this chapter. Ih-i. This metheod was chosel, for examiple. or Itie pi i ati/a ltions by auction of the municipal enterprises of the city ot L'viv, uwhichi mirkcd the .tart oif F krain<'s privatization program. The list of enterprises to be privatized w as published ea, I1 mnioth in the pres, to en1sure that invxes- tours were infOrmed (see article 5.2 of the prigrami it pirivati/ati,in ot municipal enterprises ot the city of L'viv for 1992, apprive-d by- rea nlUtiOll nt tin - mu1n1cipal c iii incil of the citn' fI'vlw on Septemiber NS, 1992). The value ofeach enierpris- ians lin deterimined exclusiely bn' the high- est bid made at the auction; the offering price wva, dclehllrate- -et relatively lont (ets article 6.13) of the above-mentiined program) Se e a,i, oi( I " Fl 120 The Privtfization Chall h'ge' and U.K. privatizations, for example.17 Th-e share price should be fixed as close as possible to the flotation date.18 This may require that the price result- ing from these valuations be adjusted in light of the results of a market sounding-for example, by means of the book-build ing procedure.19 In addition, rigorous valuation is absolutely essential when the enterprise is sold through a directly negotiated deal, and particularly when it is sold directly to its employees (employee or management buyout). Indeed, the government must arrive at a valuation without recourse to a market test. In many cases the initial valuation may be performed by the management of the enterprise itself, which has strong incentives to underestimate the value (for example by using the book value of the solt., whiclh is often only a frac- tion of its true market value). This has happened in many transitioni coun- tries, including Hungary and Viet Nam. Where a valuation is required, it should be car-ied ouit by independenit and qualified experts and in conformity with generally accepted valuatioin principles. The cost of the valuation should niot exceed the benefits it is expected to yield. Some countries have establishedl valuation commissions or other special bodies responsible for setting minimum prices; these are fur- ther discussed in chapter 6. Their common drawback is that members of such commissions have no real stake in the success of the privatization pro- gram; they tend to be concerned only about not selling too cheaply, and they often end up setting price floors that are too high. Valuation rules and principles established at the time of nationalization can also be helpful, at least where they were developed with due respect for the rights of expropriated owners (as in the case of the French nationaliza- tions of 1982; see Israel 1986). It is unwise, however, to try to prescribe a gen- 17. Both in Malaysia and in the United Kingdom, shares of otl s to be privatized appear to have been deliberatelyi uiderpriced. This was done in part to gna rantee the success of the flota- tion and enhance the popularity of the government. In M'lalaiia, one of the e xplicit objectives of the privatization program was to increase share ownershiip and redistribute wealth toward the Bumiputra maiority (as opposed to the Chiinese miiority, whi:h dominiiates businiess). ('airt of the shares had been reserved for Bumiputra investors. "On the basis of first-dav share price pre- mia, the average amounit of underpricing has been over 1(l7'. " and on the basis of the share price three monitlis after flotation the premiums still stood, on average, at 93 percent ()xtord Awdlyitica, "Malaysia: P'referential Privatisation,'" 27 Novemi'ber 19951. In thi t fritcd Kitigdotfl, after better-than-average performance in the initial years. total returns on shares in privatized companies haIve roughly kept pace with overall stock market performance. In Fraiic', where the government's tendency has been to maximize the sale price. shal- prices of privatized compa- nies have not fared as well; they are in mans' cases lower than a' wo anid have oin average under- performed the rest of the market. 18. The flotation by the Portuguese governmentit oit (IM'or, tiie country's largest cement pro- ducer, was a flop largely because the issue price hadi been set two months earlier. Meanwhile, the Lisbon stock exchange had dropped 15 percent. See fi't!,,'il f'ii,'(, 18 April 1995. 19. The book-building procedure is commonly used by invcstment banks in tihe United States to sell shares. It was also used in the public flotations of the Argentine petroleuni company Yl'l and in some French privatizationi operations, for example p 8ee, the section in chiapter 3 on accoulntilng law. The Priva?ti01io1 L1w 1721 erally applicable method of valuation. On the contrary, the method adopted will have to take into account the specific characteristics of the country, the sector to wlhich the SOE belongs, and the nature of the assets. The usefulness of a valuation performed in a country or sector where prices are not freely set by the market may, for example, seem rather dubious. Valuation methods used in privatization transactions are generally a combination of those com- monly used in corporate mergers and actluisitions-for example, net present value of an estimated stream of future cash flow (discounted cash flow analysis); replacement value of the enterprise; its book valuc; the liqui- dation value of the enterprise; comparisons with prices fetched in similar transactions or wvith market valuation of comparable (publicly traded) com- panies; and so on. To summarize, where a valuation is made, it should serve only as a guide to the selling agency. Legislation should not prevent this agency from con- cluding a sale at a price below the estimat e if, following a competitive selec- tion procedure, no acceptable bid lhas been received at or above the estimate. Prior valuation by independent professionals may, however, be useful by providing the sellers a reference price that can help them decide whether to accept the bids received, Independent valuation may also reduce the risk of collusion between the buyer and the officialN in charge of privati7ation. It should be required if the privatization is carried out without effective com- petition (see also the section in chapter 6 on valuation bodies). Autlhrizcd Tcchiiiquics All too often privatization laws and regulations prescribe the authorized privatization methods and techniques in restrictive terms. The better approach would be to investigate wlhat techlniques would be legally autho- rized in the absence of restrictions in the privatization legislation. Any nec- essary provisions authorizing other techniqLues or restricting the use of cer- tain methods, as the particular case may require, can then be added to the legislation. Implementinig regulations often prescribe the circumstances in wvhich particular techniques may be used. In practice, the legislator is usually neitlher familiar with privatizatioln techniqlues nor in a position to predict the various circumstances that may necessitate special methods for this or the other specific operation. The privatization law should therefore be drafted in broad terms, leaving the executing authority free to choose the appropriate methods of privatization or, at the least, authorizing a range of privatization technliqtues to fit the spe- cific needs of each case. Sales of shares held by the state or other public entities should be allowed, as well as capital increases, even without divestiture of state shares. A capi- tal increase, witlh or without accompanvijng sale of public holdinigs, would be called for, for instance, where the stI to be privatized urgently requires a new cash infusion. Liquidation should not be excluded from these options, because it is sometimes the only wav or the best way to privatize some SOES 122 fih IPrivatizatwio Clia'lleti' (see chapter 4). Privatization through public flotation on the stock exchange, although an option in the more sophisticated countries, would not be practi- cable in most developing or transition counitries. [he use of convertible bonds may also be on the menu of available options.-') And so on. Where, however, the law prescribes specific tecimiliques, the use of other techniques (not provided for in the law) should be allowed, subject to com- pliance with minimum conditions. One could, for instanice, require the prior approval of the competent minister or eveni of the council of ministers if noncompetitive privatization procedures are to be followed (for example, sale by directly negotiated contract). Such provisions are found in the legis- lation of Argentina, Czechoslovakia, France (see note 23 below), Nigeria, Poland, and other countries.21 The Argentinle example slhowvs h1ow' imp)ortant it is to avoid unduly restricting the range of privatization techniques that can be used. The diver- sity of legal status and economic cliaracteristics of the enterprises to be privatized has compelled authorities to res(rt to a wide range of techniques. This poinlt is illustrated byi table 5.2, which covers o(Ily a small portion of the privatization program, i ana ely, that relatin g to tlhe ministry of niational defense. Most privatization techniiques hlave been borrowed fron private comnmer- cial practices, where mergers and acquisitions are commiiion. Othier methods, however, are specific to sor privatization and miay have to be included in the privatization law if the governmenit intendcis to use' them. Privatization by free distribution of shares to the populationi, or b issuance of privatization vouchiers or coupons, are excellent examples (on this subject, see chapter 6). 20. Convertible bonds anid state bonlds With LLleiit wairrant- have been issued by various governments, redeemaible for shires Of the followving companies, aniong oti ers: Telmex (see note 49 in chapter 7), Italian insurance COmIpanv IN \ (see nite a1 in table 1), Brazilian power company c,Mm (iln lanuary 1994), Televisa o(t Mexico (in FcbrUdrV 1993), anid China Textile Maciniilery (in November 1993). Fhey have also been plannted otor the Turkish telecommunica- tiolns company. In addition, partially privati/zd s,01 such as 11 lekoni Mailay-i (in September 1994) hlave also issued convertible bonds. 21 Atr'5ctiua Article 17 of Law ni. 23hs9 of 1')89 sets forthI, non restrictive list of privatiza- tion methods, while article 1X prescribes the selection procedres toi be followed in all cases, laying particular emphasis on competition and transparellyc C7/(isl'ac,-iwkid: See article I() ot the La xof Februarv 2hI (91i oin the conditions of transfer of public assets to third parties. Nigerin Article 4 (3) of the P rivatization mni dCon mierci lii/, io Deccree of 19X8 provides that "whenever the Technical Commuittee is of thIe view that 11it *nterprise is not suitable for dis- posal by public issue ol shares, the echilni(al Committee haIll re, ommend to tle Fedceral Mili- tary Government the mode of disposal of suich enterprise Ilo tiditi Aiticle 23 (2) of the privati/ation lIa proviles I hat tine council of mi iiisters, actiig On the recommendation ol the iminiister of Ownership tranistfer s, tte axtithorize privatization proce- dures other than those proVideld for in article 23, nam1x,1Li V .L at aUction, public flotatiOn of securities, and compet1tive tender. Pursuant to this irti( 1e the council of ministers granted spe- cial aItthori/ataion allowilng the sale of twvo-thirds (if the sdwnr's of I'ol,t m Pila, a proxiucer of elec- tric light bulbs, t ithe tuDutch cm immlpa V l'hilips (See li.t i h)il s u iii Lie,, Uilv I 991 , p. 6). The Prinitiza ion Law, 123 Table 5.2 Privatization of Ministry of Defense Enterprises in Argentina Statits of (lit, soIl Examiplc Sale t'cchiq)ac Minority state participa- Petropol, Mononimros State's shares sold en bloc tion in the SOE's Vinilicos, Induclor, and to a private investor capital Polistir (all part of the Bahia B3lanca petro- chemicals cornple\) Majority state participa- Tandanor shipvard Differenit blocks of shares tion in the se F's sold to dlifferent investors capital Enterprises forming part Area Material Cordoba Corporati/ation to allow of the armed forces aiation ctompanx later salet of state's shares Unprofitable enterprises, Hipasam (mining) L)irect sale of SOE assets heavily subsidized by to the private sector the government Heavily indebted enter- Somisa (a large iron and Creation of a newv company prises steel enterpri',e) to be privatized, to) whici some of the assets and liabilities of the former enterprise were tranOs- ferred; other assets of the former sol% wvere sold directx,, and the debts not transferred to the newk entity continueLd to be tht government's responsibility Enterprises that do not Tamse Use of lease contracts own the land they occupv Large multipurpose Altos Hornos de Zapla Restructuring, before priva- enterprises that do (an iron andi steel tization, into V'arious not possess juridical company withi forest commercial companies, personality cesources for produc- eachi operating in a tion of blast furniace separate area of activity charcoal) Seofirc: De Kessler 19)t3, p 1 35. In addition, different techniques can be conmbined within) a given privati- zation operation. In France, a public offering was typically combined with a separate sale of a core shareholdinig to a grouip of strategic or institutional investors (see the next section). Many governments have tried to combine the benefits of transferring managemenit control to experienced in ternia- tional investors with national participation, especially in the case of large high-profile companies. To do so, Argentina, Mexico, and other coiuntries 124 The Prizvatization Challenge have used a staged approach to privatize their telecommunications compa- nies, first selling a controlling interest to a group of investors (including a telecommunications operator) and following this with public offerings (see the section in chapter 7 on special infrastructure privatization issues). For its part, the Bolivian capitalization law of March 1994 took an original approach: a capital increase to be subscribed by strategic investors who were selected competitively, accompanied by a transfer of the existing state shares to a new privately managed pension system, as further discussed in box 5.1 (see also the section in chapter 3 on pension fund reform). Selecting Buyers Selecting buyers is delicate, especially given the problems caused in many countries by corruption, nepotism, and discrimination against foreigners and certain minorities or ethnic groups. The law should lay down the broad principles for the selection of buyers, typically by mandating a competitive and transparent process. This involves rules on advertising the sale, eligibil- ity requirements, disclosure of information to investors, amount of time given investors to prepare bids, evaluation and selection, and so on.22 The selection of buyers may derive directly from the choice of privatiza- tion technique. If a company is privatized by wvay of public flotation, the selection process will be anonymous; all investors can subscribe and be allo- cated shares (with some exceptions, as noted below). If mass privatization is chosen, all eligible citizens will have the opportunity to buy or receive shares or coupons. Still, rules are needed to govern these processes; for public flota- tions, they derive from the securities legislation in effect (see chapter 3); for mass privatization, a specific legal and regulatory framework will be estab- lished (see chapter 6). Under other privatization techniques, the government or privatization agency may have more discretion in the choice of buvers. This is the case, in particular, for trade sales and for the selection of strategic or core investors, which are the preferred privatization technique for many SoEs. A tradeoff exists in these cases between tight rules that limit the discretion of the priva- tizing authorities and flexible processes which allow for negotiation between 22. PIuhlicitl: See note 23 below on reqluirements in French law Lligibiliti,: Article 5 of the Czechoslovak law on small privatizations provides that all persons wishing to participate in the sale at auction of a given e nterprise must, to be eligible, furnish a deposit of at least 10 percent of the offering price. Most privatizations of large infrastructure enterprises, for example, are subject to prequalification and other eligibility criteria prescribed by the lavw or its implementing regulations (see chapter 7 and table 7.4). Timectable: In Hungary, a tight bidding timetable leaving o nly 45 days for bidders to prepare and submit proposals, combined with repeated changes to the tender documents during that period, were said to be among the reasons for the cool response given by investors to the priva- tization of the electricity sector in November-Decernber 19X15 (see Finaicticl Timesn, 4 December 1995 and 6 D)ecember 1995). The Privatin:atioo Law 125 Box 5.1 The Bolivian Capitalization Law In light of the failure of past efforts to improve the performance of monopoly SOEs wvith performance contracts, the Bolivian government that took office in August 1993 opted for a more radical reform. It prepared a privatization pro- gram that was given legal status by enactment of Law no. 1544 of March 21, 1994, on capitalization. Article 2 of the law provides for the conversion of Yl'FB (hydrocarbons), ENTEI. (telecommunications), ENDE (electric power generation and transmis- sion), ENFE (railways), LAB (national airline), and ENAF (smelter) into compa- nies organized under private law, in which emplovees may become sharehold- ers. Article 4 provides that these new comiipaniies shall be 'capitalized" by means of a capital increase subscribed by private investors (domestic and for- eign). The number of new shares may in no circumstances exceed the total number of shares that existed before the capital increase; this means, in effect, that new investors cannot hold more than 5) percent of the capital of the com- panies privatized in this way. The new shareholders must be selected and the amount of their contribu- tions determined following international calls for bids (article 4). In June 1995 three of ENDE's power generation units were transferred to as many consortia, all led by U.S. power companies; EN1TEL was privatized to a group led by STET (the Italian operator) in September 1995; VASI' (a Brazilian airline) acquired the control of LAB in October 1995; Chilean investors took over ENFE in early 1996; and YI'FB was broken up and three international consortia were selected in December 1996 to take over the transportation unit (Enron/Slhell) and two oil and gas fields (Amoco, YPF), respectivelv. Article 6 empowers the government to transfer the shares it holds in the above-mentioned companies to the Bolivian adult population, free of charge. Article 7 states that this transfer must be carried out to the benefit of retirement funds that have to be set up pursuant to a special law on pensions (Lawv no. 1732 of November 29, 1996). The same article providees for a trust arrangement to be established pending the creation of these private pension funds. Two private pension fund administrators selected on a competitive basis will manage the collective capitalization fund and the individual pension accounts (see p. 8t). Through capitalization, the government gives up any claims on privatization proceeds, but gets the private sector to subscribe to capital increases whichi, owing to the state of public finanices, the government is no longer able to funtd itself. Moreover, the creation of retirement funLds should contribute to the social security needs of the citizens, help promote the development of Bolivia's finan- cial markets, and facilitate access by enterprises to domestic financing. Article 10 provides that the sectors covered bv this law will be governed by sector-specific legislation, and that a regulatory entity will be established by laxv. seller and buyer. Indeed, the use of an auction-type process leading to the award to the highest bidder can work only when all key aspects of the trans- action can be identified and defined as part of the bidding documents. This is easily done for simple transactions in competitive sectors. The preparation 126 'I/c' Pri,a tiZlatio CiaIIcnoti' of suclh exhaustive bidding documentation may not always be feasible or desirable in other instances, hoxvever. If all key aspects of the transaction have not been set and shared with all bidders before they submit their offers, postaward negotiation and modifi- cation of the bidding terms will render an auction-type award meaningless. If negotiations on substantive aspects of the deal take place after the selec- tion of the buyer, the emphasis should be on setting rules and procedures for evaluation, selection, and negotiation that are seen as fair and reasonably transparenit; privatization officials should be made accountable for their decisions; and they should be advised throughout this process by legal, financial, economic, and other experts wvith relevant experience and (1ualifi- cations. Examples of substantive aspects that are often negotiated after the award include the size of the labor force the buyer accepts to retain; invest- ment commitments; environmenital liabilities and:l commitmenits; payment terms; pricing formulas and other regulatory features (for regulated indus- tries); and so on. The use of nioytiaux dliirs in most Frenclh privatizations illustrates how the use of discretionary powers can easily become controversial. The govern- ment selected a core group of large in'dutstrial or financial shareholders (inot(auil diur) to wlhichi it sold a controlling stake in the company.23 The remain- ing shares were sold through public flotation. This procedure was intended to ensure a stable group of active shareholders and to preclude excessive shareholder dispersion as well as the risk of un conitrolled takeover. The core shareholders had to pay a premium above the pri( e at which the shares were sold to the public and they had to retain their shares for a specified period.24 Because the same hand-picked groups turned up in many of the core share- holding groups and, consequently, cross-sharehold ings were frequent, the procedure came under fire. It may be seen as a way for the government or a technocratic elite to maintain control over enterprises, even thouglh they have been privatized, and to keep the incumben)t management-typically recruited from the senior ranks of the civil servi( c-in place (see Le Mondte, 23. Iegally speaking, this was an exception, permitted bt article 4 oif the law of August 6, 1986, to the general rule of public placement of shares through the financial markets. It autho- ri/ed the minister of economy to choose the buyer without going throughi the financial markets, after consultation with the privatization commission and purua nt to a decree setting minimumii publicity conditions, including notification of the propo.ed privatization by publication at least one montlh before the deadline for receipt of bids in the official gazette (lournidl f?ficilt) and two financial newspapers ot wide circulation (Decree n1o. 86-114t) of October 24, 1 980). Article 4 wvas amended by article 5 of the law oftJuly 19, 1993, whichl strengtihened the role of the privati/atioll comm1ission byv providing that, in selecting buyers with0ut rnCOurSe to the m arket, the nisiister couldl heniceforthl act only in conformity vvith the advice given bv the privatization commission. 24. During the first privatitation wave of 1)986-58, the portion of the privatized company's capital sold to core shareholders was generally in the range ft 21-30) perceit of the capital, and the control premiumi1 remained modest, ranging from1 2i pen e nt above the pLublic offering price for l'aribas to 1(i percent for Matra. The premiuil lor XI I l (elevision network privatized pur- suant to a different law, was 73 percent (see Cour des ci (mphts 190), p. 27). Tle Priveti-iticii lainc 127 8 March 1994). It shields the enterprises frorm tihe rigor of mnarket discipline, in particular bv makinig hostile or foreign takeovers difficult or impossible. The core shareholding procedure was not popular with fund managers and other investors, who felt the interests of core shareholders and incumbenlt managers would prevail over thcose of noncore investors. Spain followed a similar approach wlhen it accompanied the sale of part of its remainillg shareholding in Telefonica witlh the creation of a group of core shareholders composed of three doomestic financial institutiolis. The selection process also affects o(ther a-pects of the privatization transac- tion: a traisparent, nondiscriiinatOr-, and competitive procedure for select- ing buyers should, for instance, vield a sellimg price in line witlh the current market value of the SOF and tlherebv obviate the cost of a prior valuation. It is important to let the implemenlitng agency adopt more precise regula- tions and tailor bid requirements to the features of each transaction.25 Dele- gation of these matters must, however, be accompanied by procedures ensuring accountabilitv of the agency and its officials, together with control and appeal procedures. Noncompliance witlh thie rules established for the bidding process may provide grounds for annulment of the selection. Rcstrictionis o)ni Bznyer Selectiton The privatization law should be free of unnecessary restrictions ofn the selec- tion of buyers. Some restrictions, suchi as the exclusion of public agencies as buyers of privatized enterprises, may, however, be nece,sary to protect the objectives of the program. Privatization laws often grant rights to SO() employ- ees and management, particularl, reserved share allocations and preemnptive rights, that may also conistraini the selection process (see next section). Restrictions on the buyer's nationality or other clharacteristics are found in a number of laws. Thev can often be circumivented by, for example, usinlg dummv companies; restrictions on tlle further resale of shares of privatized enterprises tend to be difficult to enforce. Some laws, nevertheless, intro- duce restrictions reflecting "national interests' or other government objec- tives (including industrial policy objectives), usuallv in the form of protec- tive measures against foreign takeover or control of privatized enterprises. Restrictions imposed on acceptable potenlial bLuvers lead to lower sale prices; they mav also scuttle the whole tran,s,iction.t, 25. For example, in certain rece,nt pn-vati/ati') operatioins n Argentita., bidders were required. to att.acli to their bid a1 signled C(lp it thlL o- inrj, t proposed to themn. iTh purpose ot this procedure was to avoid long anid difficult neghtiaritn, ,lter anniunincement of the winning bidder, as happenied in the privati/atioli of I NIl and the aiward oi the first railway' conces- sions. Such negotiationis canl substaiitialilx altter thill' 0iitioim Of YalIC an1d helceL itroLiuce new' factors n(ot taken iiito accouiit in bidder celection. ,ee \t(x\ander and ( orti jl)Q3, p 1t 26. Lopezc-de-SilanIeLs 10( f0ouiid in an (mpiricril tii'iv oo klexican privatization that restric- tions oi buver, InIcludingexclusion iof foreigi biu e,rs, ld iLIded lower thei alI price of priva- tied eriterprises 128 rin' Privatizati on Chalet/egt' Restitutionz of tnation?alized enterprises. Chapters 3 andi 4 explained the impor- tance of the existence of clear ownership rights to privatization and spelled out how these rights have been affected by earlier nationalization programs. As already discussed in chapter 3, in some countries the privatization law (or a separate "restitution" law) contains provisions entitling former owners or their heirs to ask for the restitution of their assets. This is, of course, the ulti- mate restriction on the selection of buyers for enterprises to be privatized. Exclusion of or limiitation on public-sector participation. In order to effectively reduce the role of the public sector in the economy, many countries, inctlud- ing Brazil, Bulgaria, Peru, Poland, Russia, and, indirectly, Jamaica have restricted the right of public-sector entities to participate in the privatization process by buying shares of other sOEs.27 The very object of the privatization law may also rule out the transfer of shares or assets to SOEs or other public entities. Thus, article I of the Moroccan privatization law of 1990 explicitly prescribes that the ownership of shares held by the state or other public agencies in the companies listed in an annex to the law shall be transferred from the public to the private sector. Moreover, some countries have inserted more restrictive rules under this head in their privatization laws to further support the objectives and consis- tency of the privatization program by limiting the creation of new SOEs. The same Moroccan law discussed above prescribes that, except when effected by law, the creation of any new public enterprise, subsidiary or secondary subsidiary of a public enterprise, and any new participation by a public enterprise in the capital of a private enterprise mtust be authorized, under penalty of nullity, by a government decree proposed by the minister for privatization (see article 8 of the 1990 privatization law). 27. Brazil: The steering committee set up pursuant tl) the privatization law adopted Resolu- tion no. 15 on August 19, 1991, setting an overall ceiting ot 15 percent on the proportion of the shares of a privatized enterprise that can be acquired by solts. Btulg7ria: Article 5 (4) of the privatization law of April 19'20 provides that public enlterprises in which the state or a muniicipality holds more than 51) perct nt ol the shares cannot participate in privatization operations withiout written authority, giveni on a case-by-case basis, from the privatii.ation agency. Pur[: Article 1 of Decree-Law no. 674 of Septemiiber 25, 1991, ( oniceriiing the promnotion of pri- vate investimient in s5ys, was amended by Decree-lIaw n). 261 21) ol December 28, 1992, by the addition of a second paragraph whichi defines "privaite investmiienit" as one that "derives from natiral or juridical persons, domilestic or foreign, publiic or priv. te, distitm( I front tiu' (criw I imi atfaf otd floiln tills' aclcnocica thlalt makc, upl ti nationalii publfic a or aiid til ftch'-oo'ncitl c)itcrpriscl (eirplia- sis added). This wording made it possible to excluIde the nlatiol df public sector withiout exclud- ing foreigin public enterprises. Russia: Article 9 of the privatization law provides that cntitics in wlhichi public sharelholders hold more thani 25 percent of the corporate capital cannot act as buyVers of privati/ed enterprises. Jtmlica1*7: T'he government pursued a similar goal, but indirecly: a law, abolished in 1991, lim- ited the share that any individual investor could acquire in the capital of the National ('ommer- cial Bank, which was partially privatized in 1986, to 7.5 ptercent with the object mainly, it seems, of preventing the government from regaining control of the ba uik in the future (see Plrivatisaitieu Ycbirlw)k 1992, p. 167). Tlhe Privatizatio)n Jaiz 129 Exclosions (o or liimlitationis oni foreign particih ition. It is not uncommon for legislation to include express restrictions on participation by foreigners, as illustrated by box 5.2. These restrictions are generallv detrimental to successful privatizati on operations. Tllis lesson has been learned by France and Brazil, among other countries: after introducing restrictions on foreign investors in privatiza- tions, they hadi to abolish theem. It is worth noting that the European Com- mission has exerted significant pressure on France and Portugal to lift such restrictions, which are contrary to EU law.28 1'he most stringent restrictions on foreign participation are found mostly in the ]egislation of countries whose privatization programs have not been particularly successful. Bv limiting the number of eligible buyers and excluding the potential buyers who typically possess the most resoutrces, these provisions reduce the likelihood of completing the sale on goo( terms. The situation is particu- larly paradoxical for poor or heavily indebted countries, which most need to attract foreign capital and often enact generous investment codes to appeal to those same investors (see the section in chapter 3 on foreign investment legislation). And restrictions are not limited to foreigni participation. In some coun- tries, the government excludes certain categories of citizens from the bene- fits of privatization by reserving sales to indigenous pOpulations.29 Spcecial, or Golden, Shores The "golden" share technique has been usetd by some countries, including France (see box 5.3), Belgium, Brazil, Malaysia, New Zealand, Spain, Turkey, and the United Kingdom, as a way to keep some degree of government coin- trol over a privatized company, mainly with respect to future transfers of shares.30t By allowing the government to veto some corporate decisions or 28. According to some observers, tihe French law also needed to be amended in view of thie absence of large private domestic institutional inv estors; raising foreign capital became a pre- condition of the success of a broad privatization program (see FinanicialT ouis, 30) June 1993). In Portugal, the former (social-democrat) governmeit used the option afforded by the 1991) priva- tization law to pot limits on foreign shareholdicng for specific privatizatioLns; legislation sub- mitted to parliament by' the newv socialist gox&ernment to abolishi these restrictions for n; inves- tors was, however, defeated in June 1996. The European Commissioln has threatened to take Portugal to the Europeani Court of Justice on this issue 29. In Malaysia, one of the main objectives of priv atizition, and mort generally of the govern- ment's economic policv, is to strengthen the economic power of the indigenous Malays, the Bumiputras, and to reduce the relative weight of thie local Chinese. Thus in most privatization operations only Bumiiiputra investors could act as buyers ot shares offered for sale by the gov- erinment (see Galal and others 1994; see also note 17 above). 30. In the case of British Airports Authority (BA), for example, the sale ofanairport by BA\ is subject to approval by the government1, whichi hold: the special or golden share. Generally speaking, this golden share empowers the government to block takeov'ers or foreign) sharehold- ing. See also the examples given in the sectioin ot hapt r, Ton golden shares. 130 TI,t' lit, 0 OtiZiatiol l C7alk cifgc Box 5.2 Restrictions on Foreign Participation in Privatization Brnzil. Article 13 of Law no. 8031 of April 1990) (and article 44 of Decree no. 724 of January 1993) limited hioldings by foreigners ito 40 percent of voting shares. This restriction has since been lifted, initially bv a provisional measure taken on October 26, 1993, and renewed every 30 days thereafter, allowing for- eigners to acquire 100 percent of the shares of privatized enterprises. More- over, the constitutional basis for discriminatinig against toreigi inivestors in certain economic sectors was abolished in August 1997*. The privatization pro- gram included other restrictions on foreign investments w;hen made by way of debt-equity swaps: funds invested throughl swvaps had to remain in Brazil for at least 12 years and foreign investors had to hold oni to the shares so acquired for at least two years, during whiichi they were not au thiorized to repatriate anly funds. In light of the low participation by foreigner- in the initial privatiza- tions, holwever, the Brazilian government reduced the 12-vear period by half and abolished the restrictiotn on transferability of shav es. Bit rkinulIis. Article l() of Ordinance no. 91 -0)044/1'IRES of July 1991 empow- ers the minister responsible for SOF1 supervision to rese rve in priority a share of each privatization for Burkinabe national1s. Cl,,7,. Article 9 of Ordinance no. 0 17/ lPR/92 of August 1992 on divestiture of SOF. holdinigs provides: "In the sale and/or transter of state-held assets, prior- ity shall be accorded to natural or juridical persons of Chad nationality. The regulation of the Minister of Commerce and Industrial Development issued pursuant to article 7 of this Ordinanice shall set the numilber or proportion of shares to be toffered in priority and als)l thle period of \ alidity of the olffer. Upon expiration of thiat period, sale of the remaining sharer sshall no longer be subject to this priority." C:ccIloslhc,akia. Article 3 of the law of October 199t) on small privatizations provides that only nationals of the Czech anid Slovak Federal Republic, and companies or othier legal entities wlhose owners or m iembers are all nationals, may become owners of enterprises and ass(ets pivati/Zed pursuanit to this law. The lavv on large privatization operations does nlot contain such a restriction. Irarnicc. Article 10 of the law of August 1980r lintited the total amount of shares transferred by the state to foreign per-ons, directly or indirectly, to 20 percent of the SOE's capital. This provision was first amnended by article 8 of the law of July 1993, wlhichi provides that this ceiling shall ntot apply to Euro- pean Union investors; an amendment ot April 12, 1 o9(, abolished the remain- ing restriction. Scnegai. Article 1 1 of Law no. 87-23 of August 1987 on sotE privatization pro- vides: "For each enterprise, the minister withi responsibility for the state port- folio shall set the proportion of shares that can be transferred in priority to nat- ural or juridical personis of Senegalese natinalihtv." share transfers, for example, this technliqu.qe prolongs state control beyond privatization, even though the state is nou only a minority sharelholder (sometimes with a single share). Golden shares are special shares created by law or by the company's articles of agreement lor the specific purpose of Tlt, Priz'atfLation Law 1,33 Box 5.3 Golden Shares in France Article 1() of the French privatizatioin lawv ot August 6, 198t6, authorized the minister of the econiomy to determinle, for eaich tof the 65 privatizable compa- nies listed in the annex toi Law,a nlo. 86-793 of July 2, 1986, wv hethfer protectioin of tihe national interest required that a special shiare be granited to the state alid, if so, to establish such1 a share. The companyv's articles then had1 to be amended accordingly. Article 1(1 provided: "Tlhe special share allows the Minister of thie Economy to approve shareholdings by any perso n or group of persons acting togethier exceeding 10'1Y of thie capital. The special share mav be permianentlv converted inlto an ordinary share at any timie bv order of the Minister of the Economiy. Such conversion shall normally take place automatically after five VearS. . . . In cases of violation of the provisions Of the first paragraph hereof, the holder(s) of the sharelholdinigs improperIv a quired may nlot exercise their voting rights and must transfer suc h shares withfin three monthis." In practice, however, there was little application of these pro isions in the period 1 986-88 and niost SlEs were privatized without recourse to this mechlanis. ()ther leg- islation in effect at the time empowered the government to co ntrol, and some- times block, undesirable takeovers (see p. S-319 above, aid Grahalnm and Prosser 1991, p. 154). Article 7 of privatization law no. 93-93 of July 1)9, 1993, widened the scope of application of the golden share provi9ions by abolishiing, fr exam- ple, the time limitation, It also) allows a referril to the ninestry of the econ- omy for approval in cases wvhere control threshiolds are exceeded by les than 1t) percent; these thresholds are no lonnger definied in the law but are prescribed by diecree on a case-by-case basis. In addition, one or two iionvot- ing representatives of the government cin be appointed by decree to the board of directors orsupervisory board ot pri( atized elterprises. Finally, the government can exercise a veto on comnpani decisioins concerning the trans- fer or pledging of assets, if such decisions hax e the potential to be detrimen- tal to national interests. The allocation of a golden share to the French government under the pro- poised Renault-Volvo merger was oine ot the reasons the VOIvo s1hareholders decided to reject the project in December 1993 On the other hand, it does lnot seem to have affected the success of the last privatization for whiclh a goldenl share was issued, namely that oif Elf in Mlarchl 199)4, although the presence iof two nonvoting government commnrissioneirs wi the board Of directors was, it seems, not well received by the international investors. according tlheir holder (the state or government) special rights that go well beyond those attached to ordinary shares. In some cases, they lapse at a pre- determined date. The rights attached to them nmust be describedl in the sale prospectus for the SC)E. The goldeni share technique has been frequ-ently used to enable govern- ments to conitrol future transfers of blocks of shares of privatized airlinies, so that anv future changes in shareholders do not brinig the' enterprise under foreign control, thereby causing it to lose the right to operate 732 The, Privatizationi Challenige certain international routes.31 It is also very commonly used in privatiz- ing infrastructure companies (see chapter 7). The rights conferred by golden shares are not, however, necessarily limited to controlling share- holder composition; they can extend to other decisions of the company, as they do in Senegal.32 Although they may be necessary in some cases (for example, airline privatizations), golden shares are by no means an essential feature of privatization laws. On the contrary, by interfering with the normal func- tioning of the market and blocking certain types of takeovers (their usual purpose), golden shares can diminish incentives for management performance and adversely affect the operating results of the privatized company. Preferential Schemes Privatization laws often allow or require the allocation of free or discounted shares in privatized companies to specific groups, including employees and small shareholders, as well as other special benefits. The reasons for such giveaways vary, but generally include the objective of winning the targeted groups over to the privatization cause. These benefits may, for instance, cre- ate worker support for privatization (or reduce their opposition) and favor- ably impress citizens before an election. Preenmptive Rights and Othier Employee Benefits NMany laws grant preferential terms to the employees of privatized SOES by earmarking part of the SOE shares, granting large discounts on the share price, or both, as illustrated by box 5.4. Some privatization laws encourage employee shareholding by authoriz- ing interest-free loans or deferred-payment plans for the purchase of shares; 31. The minimurn national shareholder percentage may vary from one treatv to anothier Brit- ish Airways, Malaysian Air System, VIASA (Venezuela), and Air New Zealand are among the airline companies privatized withl the allocation of a golden share to the government. See also the section of chapter 2 on interinational law and box 2.3 on tht privatization of KIM. 32. Senegal's privatization law authorizes the use of a special or golden share in certain cir- cumstances, mainly in order to protect the state's interests as c reditor of privatized enterprises that have repayment or guarantee obligations to the state. Article 14 of the law provides that "the Minister in charge of state holdings may decide by ministerial order that one of the shares held by the state in an enterprise to be privatizedl that has previously received loans guaranteed or onlenit by the state shall be converted to a special share carrying special rights.... The special share allows the Minister in charge of state holdings, uider conditiolis andl procedures to be prescribed bv decree, to ensure that the enterprise takes all necessary measures to provide for repayment of the loans guaranteed or oinlent by the state The Privatization Law 733 Box 5.4 Preferential Allocation of Shares to Employees In Ar'enftinn, a proportion of the shares, often about 10 percent, has generally been earmarked for employees under privatization operations. By May 1993 about 117,000 employees had acquired shareholdings in this way in 64 priva- tized SoEs. Employees are allowed to pav for the shares allocated to them out of dividends. The Banco de la Nacion Argentina is the depositary for these shares (see Prizvatisation Intcrntiional, May 1993, p. 31). In Bultkaria, articles 22 and 23 of the 1992 privatization law contain such pro- visions with respect to the privatization of SOEs organized under company law: article 22, which applies to SOEs organized as joint-stock companies, states that the discount is 50 percent and that up to 20 percent of the shares belonging to the state can be sold in this way; it caps the total value of the discount to which each worker is entitled at an amount determined according to the worker's seniority and salary and provides that these preferential employee shares will be nonvoting shares for the first three years. In Franicc, the privatization law of August 1986 prescribed that It) percent of the shares offered for sale had to be set aside for employees (and some former employ- ees). It authorized discounts for employees of up to 20 percent of the share price, with payment in installments over a maximum period of three years. Employees receiving a discount of over 5 percent could not, however, transfer their shares in the first two years, while those granted payment facilities were required to retain them until they had paid for them in full. In the case of Paribas Bank, for example. 10 percent of the shares sold were earmarked for employees (and former employ- ees); of these shares, one-third were sold at a discount of 20) percent with deferred payment (over two years) and two-thirds for cash at a 5 percent discount. In addi- ton, free shares could be allocated to employees who retained their shares for at least one year beyond the mandatory holding period (in the case of Paribas, one free share for each share bought and held for a year following full payment) and to small shareholders who kept their shares for a specified minimum period (18 months in the case of Paribas). Cour des Comptes 1990 (p. 27) estimated the total cost of these benefits to employees and small shareholders (in revenue forgone) at just over FF 1 billion for employee discounts and just over FF 5 billion for free shares, that is, total benefits of over FF 6 billion, equal to about $1 billion. The priva- tization law of July 1993 retains the discounts and deferred payment facilities for employees. It provides, however, that shares cannot be transferred for two years when a discount has been given (even of less than 5 percent of the share price). In Poland, article 24 of the privatization law provides that up to 20 percent of shares be reserved for workers of the company at a 50 percent discount on the sale price to the general public (Polish citizens). The aggregate value of the dis- counts granited to employees of a company is capped, however. A new privati- zation law was prepared by the government, enacted by parliament, vetoed by President Walesa, and reconfirmed by parliament overruling the veto on July 21, 1995. Feeling that the law infringed on the powers of the executive, the president asked the Polish constitutional court to review it. The court "ruled against a por- tion of the legislation that said the government must offer part of a company's shares to employees for free. Instead, the court said the government should sell the shares to employees for half the price offered to investors." Following this ruling the government announced that it would submit a new bill to parliament; the new privatization law was enacted in August 1996. See Ccntral European BuIsinecss WeckA-, 1-7 December 1995; see also pp. 39-40 above. 134 Tlit7 Pri'atizatiouti ChalIenge some even allow shares to be paid for out of future dividends. Loans and installment plans have drawbacks, however, and should not be granted for the bulk of the share purchase.33 These advantages are sometimes com- bined, as in Slovenia, wvhere managers and workers enjoy a very generous preferential scheme encompassing some free shares as well as discounts and deferred-payment facilities.34 Moreover, some countries have promoted the outright takeover of enter- prises by their employees (see EBRD and CEFIN 1993). Russian legislation has probably been the most generous in this respect. It offered the workers' council of corporatized SOEs three choices: (a) to receive 25 percent of the shares free of charge and 10 percent at a subsidized price; (b) to buy 51 per- cent of the slhares at a price equivalent to 1.7 times their book value (far below their true value, especially considering Russia's high inflation rate); or (c) for small enterprises only, to enter into a management contract enti- tling managers to obtain 20 percent of the shares at book value if thiey meet contractual terms and giving all employees the right to another 20 percent at a 30 percent discount to book value. This third formula was rarely chosen in practice. Since the second option was by far the o)ne most favorable to the workers, it is no surprise that more than 70 percent of the enterprises con- cerned chose it, thereby allowing employees Uiaid managers to acquire al percent of the shares at a fraction of their normal price and protect them- selves against any hostile takeover bv outside investors.35 Anothler 29 per- cent of the companiy's shares was typically sold in a second stage through voucher auctions. 33. The Slovak government lias been criticized fot- selling setls to managers and workers and giving them ten years to pay for their acquisition; this allows theml) to control these enterprises withi very little money diownI, while using the company's cash flow to pay tht government instaliliments. WVIhere the company provides loans to its enmployees to bue shares, the total amonlit should remain small relative to the company's ioverall eluity so that the interests of its creditors and its otlier shareholders are not adverselv affected. In the privatization of Telmex, the labor UnlioIn was able to borrow funds at a loss rate (6' ) from) Nafinsa, a puiblic financial institution, to fina nce the acquisitioni of 4.4'X of the conpan y's stock. See also the secti on on Argentina in box 5.4; the section below on financing; and the part of chapter 3 on employee ownershiip legislation, including i (11's. 34. See Fiticuit/ cI'iasl , 12 April 1994. The fact that the enterprises of thie former Yugosla- via were largely self-managed by their staffs helps explain this generosity. The previous regimes had vested employees with) quasi property rights thalt could not be ignored I'riva- tization througil maiiagemenit-employee buvouts ha, alsit been commio in Slovenia and Croatia. 35. See Lieberman and Rahuija 1995, pp. 13-15. A 199- studv by the London Business School, confirminlg the shift of control from the state to compan>y insiders, "founad that among a random sample of privatised Russian companies, workers held 48' otf the shares, managers 21'4 aiid outsiders 2()' In 65'.' of privatisetd firmis, workers held a dominanit share" (lit,' ICIotwin. 18 November 1995). This same scenario also took place in Kvrgyzstan anti other fornier Soviet republics that had baseti their privatization legislation on thie Russian model (see the sectiotn below on the cboice of an equitable schiemtand the section i l chapter 6 dealing with c n1fii ts of interest). The Primf izati iit Lawt, 1.35 In the United Kingdom, National Freiglht was sold to its emlplovees in 1982. In Mexico, the trade unions were given a preemptive right in privatiza- tions that allowed them to buv a conmpalnv bv matching thle hIighest bid obtained in competitive bidding.3At Legislation in Bulgaria andi Iran also pro- vide for employee buyout scheimies.-I Preferential share schemes for emplovees nmav be xvell suited for large enterprises organized as joint-stock companies. buit thev are less so for small firms. Employee buvouts, on the other hand, miav be put together for small firms more easilv than for large ones. Fuirth(ermnore, sonme investors maiy want to be sole owners or may not want emplovee particip.ation in the man- agement of the company, especially where a companv reqtuires a lot of restructuring." Other investors mavx view eimployee participatioil ill the company's capital as a contributioni to a better social climate, highlier producU- tivity, and sometimes also as a safeguard adgailst future renationalization (see Gates anid Saghir 1995, p. 8). Finallv, in most transitioni countries, prefer- ential rights may be a reflection or confirmatioin of thc rights wvorkers ancd managers already enjoy, whether de jure or citd facto, over their enterprise before its privatization (see Bovcko, Shlciter, adc Vishinv Ii'$,). Advma c l sGinsirt to h fi c) Ot r Ca tc\'aric's of. 8i/itlc Discounts, rebates, free share dlistribLutionis, concessional financinig facili- ties, or preemptive rights have been offered not only to emplovees. They have, for example, been granted to citizens as part of mnass privatization programs (see chapter 6); to lessees, as in Cztchoslovakia; or to tenants, as in Hunrgarv*.I9 A great many countries have granted suchI a1d1van1taMgCes to shareholders as well, including France, Indonesia, Italv, Spain, and the 36. Sixteen enterprises were sold to their respective eplt'x'ee1. u molts under this proxvision during the 1 980-'31 period . Resale of the enterprise wvas 'rohibItted tO avoid possible improper practices, such as ain agreemenlt betwVCeei an1 illtere'tt'ted l\'ver alnd the tl110in o llider Which tlie buver would purchaase the enterprise atter the urini hald e\rlcised its right, thurthvb guaraliltee- ing the acqiuisition of the enterprist withillt hiddlltg al ti the risk of r.i'.iig flxe aictioii prl( (see CGalal and others I994). 37. Article 31 of Bulgaria's 192 priexti/atioi It pl-L-re-trlhs thi., WhCere the enterprise to he privatized is neot incorporated unider private lawN, tIe cnmilivet' of the entterprise m,v hid bii in i auction or tencder sale, on the c(I dition that a t lea l *tl p-rceL lt iif the cit pllIOeVs participaIt . Ili the event that thev offer the highiest price, thex Will t' si IC( t(d Js bUh y'rs aiid iv Ill hi gru [i'd .a S3t percent disc, iLnt iOn their hi I price. In Iran, prik Atii itoii d eerie niii. .25 / F tlf I er marks 33 ptercent of the shlares of eniterprises pritaiti/cd in the iiUtoittrinig s't ,cr for tivt's .1 grants them ia right of first refusal ov er the renmainitg t0? p1 en i ut. 38. To add rt's such cotinceri , the l3 lgoirarim . i tr'ij% i1l wO, stJ. i pItdllt,.i tht a ris gi Vl)iiti empiloet' sn preterential terms Iwuld be no 'vo 'img ft r LI Ih-ret-Nv,r pt riol (articles 22 1, ud 23.2 of the 1)9) law ). 39. Sei' article 165 til ei [ii'mall-SCal,I' rlVi/ti/,tioll tt l Otec CiisltiV lkl.,il Which giV1 ti'sless a right f first refusal tvith respect to prOpertv the\ Irn' IL-sing l \ giVing Iltlm an (i ilp(rttinitv Ii' purchase it hietore it is put up tior auction The ile pri, e is the risirt e priCL'e thit Would haive been set t auiction (artli'-C St. tin Hungarv, see hi\) . I 136 Thc P rie)afiz titofil Challcng United Kingdom.4t1 Article 16 of Argentina's privatization law (-1989 law on state reform) lists six categories of buyers eligible for preferential treatment: in addition to employees, thie law lists current shareholders, habitual users of the services of the SOE to be privatized, producers of raw materials pro- cessed by the enterprise, and individuals and comnpanies that bring in new sales contracts to the enterprise. ChoicCof "t7i Equi,able Schenih The preferential-treatment schemes described above have implications for public finance and will therefore, as a rule, need to be autlhorized by or pur- suant to a law. The privatization legislation should set thle minimum require- ments applicable to these benefits or sclhenmes, because they involve not only a loss of revenue for the public treasury buti also a transfer of resources from the state to specific groups. If not properly designed, provisions of this kind can raise delicate prob- lems. The granting of benefits to employees, for example, raises questions of equity (why should employees of some SOF-s receive a benefit from the gov- ernmllenlt that is unavailable to the employees of other soFs, to civil servants, to farmers, or to the unemployed, to cite only a few), of efficiency (whether employee participation in thie capital of a company hielps boost efficiency), and of necessitv (whetlher benefits lhave to be granted to gain employees' sup- 40. Frooc: Biuyers who held their sliares for a specified period (lore or two years, deperiding on tht company) got additional shares distributed free oi chalge. ImlciiSii,: The sweetener used for the partial flotation ol P' kelkom included a 2.5 percenti dis- count for Indonesian investors and a one-for-ten bonis share redeemiiable after hlolding the stock f(r ole vear (see Fiiiaw iTinii sil ms, 12 September I Q9 and 2 November lc')5). Italti: In order to encourage small shareholders to participat' in the i NI pri\vatization, after the rather poor performance of other recenitly privalized compa,nies, the government offered a cre- a ive form offiraL urmce. "If the average IN share price in the 21 days at theenid oftlie 12-nmont l period following the issue is less than the issue price, the Trea-urV will reimburse the difference up to a tenth of the original price-provided that investors ht ve held their shares for the whiole period" (T'he itt 'omi;Is, IS November 1995). le-p te this eniticeimenrt, investor in terest turired out to be lowx'er than the) governmnent had hoped, and afte: -market performance was disap- pointilig, too. Spa il: InI the 1'995 flotationi of Tleftn ica shares, incentlv e, iir smallshareholders incltided, in addition to a 4 percent discouiint, one bonus share for tx erv iventy shares held for at least one 'ear followxing the flotation. Individual shareholders \x ho satbscribed to shares in Repsol, the energy company; were not only giv'en a 4 percent rebat( on the share price but also a guarantee by the state ItIat it would reimburse such investors (tip to 11 percent of the offering price) in case the share price dropped withinl the 12 months fol wing the offering (see Fi,iiicil T'imes, 2h January 1996). tUoitcd Kiiii(isum: Free shares were given to shareholders wiho kept their shares in electricity companies for three years, for example. Most large ptixati/ations were done through public offerings; many of these xvere also underpriced, wlhich is another way to provide immediate benefits to shareholders. )argely as a re.sult of the priX tiyiLio(n program, the number of share- holders roSe fromr about 2 million before thte 1984 BIritiIh Tl; tConi privati/atio n to ahout I m I- lion) in 1995. The Priz'atiatiau La 137 port and thereby ensure smooth execution of the privatization program). The difficulties are compounded when it comes to enacting detailed regulations.41 Preferential schemes and their related provisions are not essenitial features of privatization legislation. Nevertheless, provisiins allowing these benefits to be granted are found in many privatizatioin laws, because thev reflect the poli- cies of manv governments and are often intended to enlist the support and involvement of employees, other targeted groups, or the poptulationi at large in the privatization program. In some cases short-term electoral considerations will prevail over the broader efficiencv goals that should ideallv be central to the program (see chapter 1). Thus manv observers feel that the benefits granted in Russia to employees and managers of privatized enterprises were excessive and slowed the development of these enterprises by protecting and strengtlhening the positioin of the management teams of the former SOEis (see also the sectioin in chapter 6 on SOF managemenLt and restructuring bodies). Financing The rule in privatization programs should be thiat buvers of shares, assets, or enterprises pay for their acquisition in cash)42 Exceptions will normally have to be authorized by law, as thev represent beniefits or subsidies selectivelv granted by the government (see the section abNv e onl preferential sclhemes). Fi, in ci ig Arenmct ge tll UIts Almost all privatization laws or programs eimbody special finanicing tech- niques, wvhich can be divided into tw)o tvpes: deferred payment (seller financ- ing) and credit (bank financing). If the method of financing does not involve a subsidy-that is, if it has no adverse impact on public finances-no special leg- islation should be necessarv. When the concessional financing is available to all interested buyers, it forms part of the general terms and conditions (it becomes in fact a price factor) and no longer amOLun(ts to preferential treatment; therefore, unless the law provides ottherwise, no specific authorization slhould be reqLuired. Techniques have been developed to reduce some Of the risks associated with partial payment for shares. Where shares are paid for in installments, 41. Whicl emplovees should be eligibles for the (mnplovee shares cuirrenti einplislveL Eincludiing those hiredl recentiv; what should be the u etoft date?l; forrmer emplovees (minimuim number of vears of service'); retired staft; temporary staffo r nilv permanent employees; and so oin. flow many, shares will each emrpIltvee b.' entitle d to' [Vi thits depet1J onl leIngth of ser ve, salarv level, rank, or tither facto rs? Shoiuld the tra,ns brl litk o,f theste shir,s be reslricted (for exanIple, bv author/irig their sale only to othet emprnpiyi s, req uiring [hat the>' be relained for a miniimiuI periotd, requiring the holder to sel Ilie irars ton leaving h11e 1ompa ix,- and so in I Sh1Ould siares allocated without charge or at a 1nonmi ol pfICeJ be stripped oif voting rights? 42X See, fir examleI, article of the Senegalesi prix atiz,itioii aix which prsides that sax e or exceprtiona)lderogaition, authlorized bydecree, shares. itfcrdi Lorsale shall he pal for 0 cash' See alsol article 22 o f the 1 9(14 p ria atizatl ho Iav xx' f (i iong .is lt'ii h statets thdt th ftlusal parye shkill be) patid for in casl; the coi in iI if ministers mayt, liiixvev r, axih lxitt 'except tinls fr rsivi Ish,i reinlialdrs 138 The, Privnati- oltll Calle('11ng for example, the voting rights of shareholders who have not paid in full for their shares can be limited, and their shares may be, held in escrow until the last installment is paid. Dtf-VqiitfiY sicapJs P'ublic-sector debt instrumenits have been accepted in payment for privatiza- tion transactions, especially in heavily indebted countries, including Argen- tina, Brazil, Chile, Mexico, and the Philippines, but also in France and other less indebted countries.4) The key problem is to set the value of the debt (that is, for many developing or transition cotuntries, the discount rate that w,ill apply to securities that can be swvapped for shares). In Brazil, the dis- couint rate for debt-equity conversions was set at 25 percent in 1990.44 For the privatization of the Mexican steel companies, the conversion terms were set using a formula stipulated in the biddinlg documents. In France the privatization law stipulated that shares could be paid for by state debt secu- rities and investment certificates previoUsly issued by the soPs, the swap value of wlhichi wotuld be set by ministerial order.4 ' Each debt secuirity accepted in payment of shares will normally have its owjn swap rate, reflecting its market value Thle conversioni or discount rate slhould not include any implicit subsidy in favor of the buyer. It can be set either before thle privatization operation begins (for example, in the bidding 43. In addition, in the privatization of the Argentine Oil coiii polly YI' ^ a special tranche of 45 million shares ot A'r[ wais earmarked to be eechniged bx Argentinle pensioners for their ii(t(O\s, special obligations that had been issued by the stati at a favorable rate (15 percent above the average market valne at that time). The \ ic sha-res -iciluired in this way were held by a finiancial in,,titutiOcn and COLini n(ot be sold1 during the lirst vear. As a result, pensioners have acquired 13 percent of N ii anid the iioco\ discount has heen appreciably reduced. See nhtrolil- PanIII i,l,] Pionieiu Rex'ieX^i' Re2/'ieo a(f Pie '1Par ll '1 93, p . 171); World L.lutitv anld iii 993. p. 9). 44. Law no S031 of April 12, 1990), which regulates B)razil'-. privatizationi program, provides thadt, in additi(onl to) ca(Sh, s1hres in companies to be, priv tified may bhe paid tfr Using public sec- tor bonds or obl iga tions as well as fuLiids blocked in accou nt tit the ien tral bank. Re sol utioin nio. 14 ofilhe Denlationali/,ition i'rogra nr Stee ringC'ni miittec list t(het financial instrumenits thatca n be used to buy coixpanies being privatized and sets the rules [or thieir conversion into local cur- rencv. The, acceptable instlrtixntxs ilide blocked Itouds, x xioiIs public-sc(tor bonds, proiinis- sury niotes, pri-xii/za tioix certii ciC les, alnd stato r inrign .l i d onxistic detbt paper. l'rivati/atoin certificates, wihici (I-an be Lsedl only to p ax for shars In I I s b ewing privatized, were created pur- sualit to I ax no. S111 /90), xv"lich toreol t iixad n i-ia) alid o(her ixsiit-itioin to xcq)uire thenil (L egal l elter, P'inxleiro Neto Adcxogadios, Auigist lnxl Septe)ixlxer- 191.). O(n Septecxber 29, 1995, tlxe Central Baink lifled tlxe comnpulsory 25'; d iscouxnlt xffeo liixg >exeix types of loreign debt papers WIiheI used to pu rclI,ase state axssets", SU ch bonds I aUcl be a cepted ifi payixicnt at face value at certaini privati/axiii auctioixs; txis '"decision cLisLI a ix uxl-lediate appreciatioai of Brazilian debt papper inl th seconidarv marki et" r rwtti e tiisiis tiitc ru Ititio!a i), November IN 95, p. 7). 45 Article 5 of the law xof August 6, 1986, prox-iLles thlat th' swvap Value Of state txirds will be determixeLd lb\ theil- aVeLrage ixmarket vaxlie oii the stock eCxM 1ixge ovxer the precediig 20) market day,ys. Article c provxidcis tlxat tlxe ccixversiollx price of all iiixestincilt Icertificate of ali siL i (wlhicx ilwas isuxaly vtruct ured li ki a preferrod no invoti ug share) iito xix ordiniarv share of the co inparily will take inito accoiluit, oix thi one haxixd, the valui of vioting rights anki, xn tlIe tlxier, thi Vx1'xlu of the prefe'r- exci's altxdclxed to tHe corticicxtevs that nxxxv e' lo(st ill the cnvar ir- x. TPc Prki'tiafit Ha L a7 139 documentation) or at the payment date.46 Both methods involve difficulties. These include fluctuations in the market discount rate or exchange rate (or both) between publication of the bidding documentationi, opening of the bids, selection of the buyer, signature of the agreements, and the payment date; the effect of the privatization process on the discount rate itself; and, finally, the risks and costs incurred by the bidders who submit bids based on a debt swap, in terms of the possibility of obtaining the necessary debt instruments at the expected price, the availability and cost of risk-hedginig instruments, and the risk of acquiring debt securities without knowing whether the transaction they are intended to finance will actually take place. Debt-equity swvaps may be regulated by thle privatization law, public finance legislation (with respect to amortization of the public debt), a special law or regulations on debt-equity conversion (which may predate the priva- tization law and apply to the conversion of public-sector as well as private- sector debt), or provisions embodied in the bidding documentation for a particular privatization operation. The likelihood of carrying out these debt- equity swaps may depend on factors such as the specific terms of the origi- nal debt instruments being swapped (for example, loan agreements between the SC)E in question and its lenders, state debt to foreign banks, and1 state bonds) and the regulatory restrictions applying to the creditors (in many countries, for example, commercial banks are not allowed to hold shares in nonfinancial enterprises). The problem is a particularly complex one when foreign banks have to waive certain rights. Such a waiver had to be obtained, for example, in order to start the teniderinig procedure for privati- zation of the two Argentine telecommunications companies that succeeded ENTEL; 60 percent of their shares were sold in November 1990 for $214 mil- lion in cash and $5 billion (face value) in public-debt securities. Some countries have also issued special state obligations that can be either redeemed at the end of their term (as any other bonid or obligation) or used as payment for shares in enterprises privatized through public offerings. This was the case with the Balladur bonds in France in ] ')93 and witlh the 1996 Moroccan privatization bonds. Balladur bonds were four-vear bonds issued at a fixed rate (6 percent); they could be exchanged, with somiie tax advantages, into shares of the enterprises to be privatized. If trading above par value, their exchange value would be the market price, and thev could be exchanged at par if their market price fell lower; bonidlholders were given preference in the allocation of shares. The bond wvas a tremendous success, raising 31i) billion francs (over $20 billion). The interesting feature of the Moroccan bonds-a first tranche of whichl was issued in January 1996 and a seconid one in May 199h-is that pnivatizationi bondholders have an absolute prioritv in the allocation of shares. Privatization bonds are served first in case of oversubscriptiol. Cash sub,scriptions are served 46. The discount margin on th)e outstanding debt could also be inluded anmong the variables in the tendering procedure; this wvould unnece-sarilv oirmplicate the evaluation process, how- ever, bv making the comparison of the differen t thniln ci , bid, quite comple\. 140 The Privatization Challonie on a reduced basis to the extent that shares remain available, as happened in the public offering of 30 percent of the oil refinery SAMIR in March 1996. Privatiza- tion bonds of this type are a way to anticipate future privatization revenue, to raise funds at a lower rate than would be the case with a standard bond, and to strengthen the government's commitment to bring privatization transactions to the market. They also create a greater constituency for privatization, namely, bondholders who want to benefit from the conversion option. Allocation of Privatization Proceeds Many governments envision large receipts when they embark on a privati- zation program. The actual result is often disappointingly different. In many developing and transition countries, the net financial balance of privatiza- tion is likely to be negative; total privatization costs may well exceed the sale proceeds. In such cases the allocation of privatization receipts should not raise any controversy; all of the receipts are needed to defray the costs of the program, including, in particular, settling SOE debts, severance pay to redun- dant employees, and the services of advisers (see also chapter 6). Where total receipts exceed total costs, a prudent policy-bearing in mind that these proceeds are both nonrecurring and of a capital nature-would be to allocate net revenues to the reduction of public debt or possibly to other expenditures that may reduce the public deficit, such as the capitalization of social security funds, for example. Net privatization revenues should not, however, be used to finance current expenditures or the ordinary budget. The privatization strategy or program will usually specify how the sale proceeds are to be used. If the country's existing laws (including its public finance and public enterprise legislation) do not include such provisions, or if it is thought that they are not well suited to the needs of the privatization program, the privatization law should prescribe the allocation of proceeds. As box 5.5 shows, the allocation of privatization proceeds is often pre- scribed by law and hence is subject to control by parliament. Many countries have chosen to use the revenue from privatization to finance the costs of the privatization program. Allocation of net privatization receipts to debt reduc- tion is a sound policy pursued by some of these countries, as well as others such as Italy, where Law no. 432 of October 1993 creates a special privatiza- tion fund to be used to repay the public debt. Provisions in Bulgaria and Puerto Rico typify the illusions entertained by some parliamentarians regarding the amount likely to be raised through privatization. Defining the allocation of proceeds in such detail is ill-advised. It can create unrealistic expectations among the various categories of poten- tial beneficiaries. The actual amount available for allocation may very well be low, or even zero, because in many cases all or most of the sale proceeds will go to cover the costs of the privatization program. It also rigidifies the future financing priorities of the country, which can be detrimental to sound fiscal management. The Privaitizationi Law 141 Box 5.5 Allocation of Privatization Proceeds in Selected Countries Bulgaria. Article 6 (1) of the 1992 privatization law provides that privatiza- tion proceeds shall be paid into a special account to be used to finance five sep- arate funds: a privatization fund (to meet expenses); a mutual fund (whose shares shall be distributed to the population at large, to expropriated former owners, and to the social security funds); a social security fund; a reconstruc- tion and development fund; and an agricultural fund. France. Law no. 86-824 of July l , 1986 (first amendment to the finance law for fiscal year 1986), created a special treasurv account to receive all privatiza- tion proceeds. On the income side, the privatization account was to be credited with the receipts from the sale of shares, certificates, or other securities and rights concerning enterprises whose transfer to the private sector was autho- rized by law. This account was intended to receive only the proceeds of sale of shares or rights for enterprises covered by the privatization law, and not pro- ceeds of sales that could be carried out without parliamentary authorization, for example. On the expenditure side, the special account could be used for (a) public debt repayments through transfers to the national debt retirement fund, the national industry fund, and the national banks fund, and (b) capital contributions to SOEs through transfers to another special account. Of the 86 billion francs brought in by the 1986-88 privatizations, two-thirds was used to retire debt and one-third for SOF capital contributions. As in the other special treasury accounts, the transactions on this account were subject to parliamen- tary approval as part of the budgetary process. Including a special account of this kind in the ordinary budget procedure and subjecting it to scrutiny by par- liament were deemed essential to ensure transparency and compliance with the approved objectives and procedures (see Cour des Comptes 1990). Gcrmtianil. Article 5 (1) of the 1990 privatization law provides that "the Treu- handanstalt's receipts shall be used primarily for structural adjustment of the enterprises . . . and secondarily to make contributions to the State budget and meet the Treuhandanstalt's current expenditures. The receipts shall be used in agreement with the Council of Ministers." Article 25 of the August 1990 unification treaty provided that "the Treuhand's receipts may also be used, in individual cases, to alleviate the debt burden of the agricultural enterprises." Hjmogary. Article 6 of the 1993 finance law, enacted on December 17, 1992, provides that part of the receipts from privatization shall be allocated to the State Property Agency to defray expenses incurred in implementing the privatization program. It further provides that a share of privatization receipts shall be paid to three different funds: the employment fund, the regional development fund, and the fund for agricultural reconstruction and conversion. Mcxic). The sale of public enterprises yielded government receipts totaling over $21 billion, which were allocated practically entirely to repayment of the public debt. Newy Zealand and Unzitedl Kingdoim. The receipts from privatization operations are allocated to the national budget, allowing a significant reduction in the national debt of these countries. (box ctntln c's ()tI tIzt' t olloauItig page) 142 The) Privat izatiotn Chial o,v' Box 5.5 (contitiidt'ct) Philiplibics. Article 34 of Presidential Proclamation no. 50 provides that priva- tization receipts, net of the expenses incurred by the Asset Privatization Trust, form part of general government revenue and must be remitted to the treasury as soon as they are received. The trust is, lowever, "entitled to retain, upon approval by the Il'rivatization] Committee, suchi portion of the proceeds as may be necessary to maintain a revolving fund to be utilized for the payment of fees and reimbursable expenses and meetinig the costs and expenses incurred by the Trust in the conservation and disposition of the assets held by it." Puerto Rico. Thie law authorizing thie privatization of telecommunicationis provided that, out of total net receipts, at least $1 billion wvas to be allocated to the Permanent Fund for the Development of Edtucation and at least Si billion to the Permanent Inifrastructure Fund, the said funcds serving exclusively to finance projects in those two sectors. However, this triansactioin never material- ized (see note 5 in this chapter). Where special accounts or funds are established, the law or implementing regulations will prescribe how they are to be set up and the procedures for their operation and supervision. They will specify, for example, who decides on the use of these funds (parliament, the counlcil of ministers, a minister, the administrators of the fund, the director of the privatization agency) and how funds are to be invested. They will prescribe whether the funds shall be interest bearing and, if so, to wlhat account accrued interest shall be allocated and for what purposes it may be used. In most legal systems privatization receipts are conisidered to be public receipts governed by public finanice leg- islation, not receipts that the governiment can use without restriction. Expen- ditures financed out of these proceeds should iIhus be subject to public expenditure and accounting rules. The situation may be more complicated when it is an SOE itself that sells part of its assets-for example, a division, a plant, or a subsidiary-to private investors (see also the section in chapter 4 on exercise of ownerslhip rights). Under ordinary company law (and many public enterprise laws), the receipts belong to the seller-the SOE in this instance -which could defeat the purpose of the privatization program if, for example, the objective is to downsize the public sector or replenish the government's coffers.47 The state, as sole or majority shareholder of the SOE, should be in a positioni to recover the proceeds of these privatizations, of course, or at least part of them, in the form of divi- dends or repayment of amounts owed by the soi . In practice, however, this 47. Where the sale relates t(o shares newly issucd by the eniterprise unlder a capital increase, the proceeds of sale will of course accrue to the enterprise-. We can nonietheless spea k of privati- ation, even if this transactiocl does not in itself insolve m any sale of shares or assets by the gov- ernmenit. Moreover, if the privately subscribed capital increise dilutes sufficienitly the public sector's shareholIding, it may also result in the priv, tizati on of mia anagerient coiitrol. Ti, Priva tiza_h thm L a' 1 t43 may never come to pass if the mechanisms for corporate governance of the soF. are inefficient, the dividend policv is not clearly defined, or the board meem- bers and management engage in fraud or collusion. In some countries, the way in which the proceeds of sales of assets are to be distributedi is prescribed in the privatization rules.48 In othiers, including Brazil, the issue has sparked lively controversy between the finance ministrv anid the SOeP concerned.449 Transitory Provisions In view of thie complexity of privatization operations and their lengtlhy imple- mentation time, interim measures may have to be taken for the management of public enterprises and assets pending privati/ation. These mea1sures may1 include the replacement of the management team, possiblv by a new%, mana- ager or administrator with special powvers; a tran.sitionlal systemn to pllase out special SOF privileges and obligations; limitation- imnposed on ;ole managers' powers of alienation during the prepriv'atization period; modifications in the labor status of So)lu employees, includin,g layoffs biefore privatization; liquida- tion of what remains of the SOF. after its corporati/ation or its privatizationi through the sale of its assets; fulfillment of obligations for which the govern- ment continues to be responsible; and allocation of revenues and liabilities of the SOE that accrue during the transition period Ii-r between the signing of tlle privatization contract ancd the effective transfei of the eniterprise to its new owners, for exam?ple.5(t Such measures are ofteni ineluded in the legislation for a specific enterprise or sector, particularly w here- preprivati/ationl restructuLr- ing is required51 Tlhey may deal wvith different phases of the interim period1, from enactmient of the privatization law through corporati/ationi all the way to effective transfer of control over the eniterprise to its new owiners. Two or more privatization-relatetd law's could colntaill Iluttally contllradic- torv provisions, and newv laws could affect inpgling privati/ation procedures. 48. Bulgaria's transitional privta htiin legiI2,4kidln 0, rti 'I.11 ," (It Ire' HO ,,', l, 11 inilIJd Oll February 28, 1991) provided that, for ex,iiiple, 41) percent )Ii , pr *eds u t rto hi allicati'd (ii the enterprii', 3 perce1t hi a statedebt ,ervc fond,1, and 2i pwrczi't in. (hi Stat liii' 'tnwX'nrt l'nd. 49. Allocatioin of privalia tihin proceeds po ed mam, p ib em, in 13ra/il, uahere the giver n - ment's privati/tion prograim focused In the inlitial pldsC II the H',teel, t iI/er, aind p'tricherl.- ical sectors. 'etrobra s, the majority s iarhiholdir oft 1'etrLt ,rtiI ind Petroquisil Ia (the sol idilng comnpaniies for the fertilizer anLd petroLC hellmal c (Cti,ir rC's ti LCi\ lV ), (1hiM liI t [Iat it- a id I no t hi', treasury, should receive the sale procedbs. 5R. see, for examiple, Philippines Presiiiential Procla, ati, ino. 2O tf P IN,. whi,th containls e x- eral prroxisions, of this kilnd. Section 2'9 proxvidtis hamt a sse Iiiall,igericnnt d 3uri og tlie Lra nsitiomil period preceding privatization shall bh perforiiid hv th' vovie'rinet intituti(ni privlOUislV responsible for thoseassets, under terms and coinditioiis u -icd uipon with the goucrniiit. 51. The U K. Electricity Act otf 1989, for exa mpl', iicliid. i traniti[ioil prnoi isiiis coincerniniig, first, the prior restructuring ot power sector a-,si' hb cre,xting ieiw sucis-.or crompanis willch woultld theln be prixatiedi arnd, secolld, th' WavI ill who Ii the gWv' rni) iint ii ilterveene ii these newN companies w"hile i they are still whltillx isuied 1i t1i c rout n sui' thuO secLtiOins In1 chap1- ter 4 and chapter r onl prioir restructuring. 144 Pic Prituti:t ioJI Challellgc In Guinea, for example, a general telecormmunications law enacted on June 2, 1992, authorized the government to grant concessions for "the establishment, development, operation and maintenance of tbe pu blic network and tile provi- sion of all public telecommunications services" (article 5), and a new law laying downi the framework for SOE privatization was enacted on August 20, 1993. T'lhe question arose of the extent to which the procedures for privatizinig Sotel- guLi (the public operator) should conform to the riles laid down, by the new privatization law. The laws were interpreted in stuchi a way as to validate the steps alreadVy taken to initiate the privatizatiOn of Sotelgui before the new priva tiza tioa laxv entered in to effect, whiile subjecting all outstanding actions, including the organizatiozn of calls for bids and the ( onditions of sale, to the pro- visions of the new privatization law. Clear language in thle law can avert this type of ambiguity and uncertainity by specifying to) what extent earlier legisla- tion is abrogated, amended, suspended, or otherwi-.e declared not applicable. Amendments Although privatization programs are a relatively recent inlovation, many coun- tries hiave already amended their original privatization legislation. Already dis- cussed, for example, are the changes made to the Frencih legislation regardinig the privileges accorded to employees of privatized enterprises (box 5.4), the role of the privatization commmission in the selection ot buyers witilout recourse to the market (n(ote 23), the allocation of privatization proceeds (box 5.5), the limits imposed on foreign investment, and the features ot golden shares (box 5.3). The Frencih privatization law of July 19, 1993, makes firthier chaniges to the system institited in 1986, including provisions allowinig greater flexibility in privatiza- tion operations'52 The Czechoslovak and( Pc ruvlan legislation furnisih other examples of amenidimienits to privatization laws. In the first case, the amend- menits imposed new limits on the privati/ation process.54 In the latter, they were intended to make the process more flexible and expeditious.54 52. 'the 1'993 IaW aUtIlorizes transfer ut the capital Of I givU*n enterprise in successive trancles. It also authori/es installnaelt paymentts for shares, vvl. I.c, ing buver the optioll to transter such shares before fuilly paying for themil (see Report to the Scuoate ilo. 32-, pp. 32-33, 1992-93). 53. The Cz/echoslovak L.arge-Scale lprivati/ation Laxx ol I ebruary 26., 191, was anienided by another lawv dated Februiary 18, 1992. Thle latter provides iil pairtiCular (article I3) that, duriiig the first year followinig privati/ation, the privati/ed enterpr ise mav engage il only those activi- ties that thie t) i wa s antitiorioedi to carry out. Whc re thIn tr,tis;action relates to only one tillit of a privati/ed enterprise, thet law is even more stringent, proitibiting the pLursuit of any activity other thani that actually exerciseti within the s ot hefor' its priv atization. 54. In iPeru. rticte I of Decree-Law no 2n 12)) of )eceinber 28, 1992, arniends article I of Decree- tan no. 674 of September 25, 1991, ojn private invt-stnnitnt iAt -sit> to expres-lv allon' foreign sot-s to acqIuire shares in privatized enterprises (see note 27 abivce). In addition, article 4 of Decree- Law no. 2612t0 amends article 160 of Decree-l.aw no. h.4 it) illow '. otti!eniti.al decree torciin t to *sxvap at least 29 percent of tILir shares against privati/ation vom iiers diEtribute to all cltli/ens. l'arlia- ment aniounced that these vouchers couldi e repllaJ d hb 'pri\ atitation acountts (the work- inigs of wvhiichl were not defined) openied in sta t-o\% ned av\i11g1 banIks, T his 1nevxV caused the market Value of the privati/ation coupois to fall hV 2'i percent AlmCt i,ns ot shari's against vouchers were also suspended in the regiolns ot ( heIV,aht1i5 .1 k1d N ovi i virsk. sLe lI'rl. 'it ri_alioi litcrniatteodl Mav 1993* p. X; Tl, Lcouiiinnt, 24 July 1 -) 152 TIhe Privatization Challenge which culminated in the overthrow of the Supreme Soviet by force and the declaration of early elections in October 1993. The shutdown of parliament actually provided some momentum for privatization by forcing the stream- lining of the process. Before these events, the responsibilities for privatiza- tion had been divided between the Russian Federal Property Fund, respon- sible for sales and reporting to the Supreme Soviet, and the privatization ministry (GKI), responsible for policy and answering to the government. Fol- lowing the overthrow, the minister assumed the responsibility for oversee- ing both organizations and came to be in charge of both policy and sales. Much progress was made in this period. The Duma (lower house) that fol- lowed the Supreme Soviet in December 1993 was less powerful than parlia- ment had been, which provided more room for action on the privatization front. However, the communists' strong showing in the December 1995 par- liamentary elections and the hotly contested June 1996 presidential cam- paign increased the tension again between government and parliament (see Boycko, Shleifer, and Vishny 1995). Bulgaria provides another, less dramatic, example of the institutional stale- mate that can result from conflicts between government and parliament, as described in box 6.1. The French privatization laws of summer 1986 also offer an interesting example of conflict, this time between parliament and govern- ment, on the one hanid, and the head of state, on the other (see chapter 5). As a rule, parliaments will want to retain more control where the law gives a lot of latitude to the government. A law clearly limiting the set of enterprises that can be privatized and the privatization techniques and arrangements that can be used is less likely to contain provisions that allow parliament to inter- vene during implementation of the program. But a tightly drafted law con- straining the government's flexibility in implementing the program may well slow progress. A tradeoff exists, which will be particularly acute whlere politi- cal majorities in government and parliament dciffer and mutual trust is low. Institutional Structure Countries around the world have chosen a variety of institutional structures to implement their privatization programs. The role of the legislature and its interactioni with the executive were discussed in the previous section; the roles of the judiciary and specialized regulatory agencies are reviewed else- where in this book.(' 6. The respective conmpetence of parliament, government. anid oth-er bodies is sometimes dis- puted and referred to the courts for adjudication. Such clainms are often based on alleged viola- tions of the constitution, as discussed in the section on "onltrol ot constitLitionality in chapter 2. The importance of setting up efficient mechanisms to resolve disputes arising during or after privatization has also already been underscored in chapter 3. In addition, specialized regula- tory bodies may need to be established or strengthencd in the context of a privatization pro- gram, in particular in the infrastructure sectors (see the section on regulatory institutions in chapter 7). Instifuttioial Framnework for Privati_a tirn 153 Box 6.1 Blocked Institutions in Bulgaria, 1990-95 From February 1990, when Bulgaria's first post-Zhivkov government took office, privatization was a priority goal of successive governments. By May 1990 a privatization bill, drafted by the ministrv of economic reform, was ready. In addition, several decrees were issued in 1990 to allow the privatiza- tion process to be started without waiting for the new law to be enacted. Nev- ertheless, the lack of such a law and of an executing agency greatly hampered implementation of the initial phase of privatization. To speed the process, the council of ministers set up a privatization agency by Decree no. 16 of February 8, 1991. The agencv's function was ambigulous, however, and primarily of an advisory nature. A X\ear later the agenicy had still taken no major initiative, the smnall privatizationi program launched by the ministry of industry and commerce in 1991 had come to a halt, and the privati- zation law drafted in April 1990 and subnmitted to the national assembly in September 1990 had not vet been enacted, evein though the governnment had an absolute majority (over 80 percent from January to October 1991) in the national assembly. These delays were caused largely by political rivalries and compromises that reflected the lack of confidence among the groups involved: the parlia- ment, government, president, parties and factions, and privatization agency. The law wvas finially enacted bv the national assemblv on April 23, 1992, tvo years after the first draft was adopted bv the counllcil of ministtrs, and a neW privatization agency replaced the one set up in 1991. It then took several months to appoint the director genleral of the agency and the members of the oversight council. The year 1993 brought other institutional ups and downs. A new govern- ment decided to replace the members of the oversight council of the privatiza- tion agency who had been appointed by the previous government. The mem- bers filed suit against the decision. The court declared the replacement illegal because none of the causes for termination of functions (per article 12 of the 1992 privatization law) were present. The members were therefore reinstated, but then relieved of their functions once again by the government. Not surprisingly, Bulgaria's privatization program made little headwvay dur- ing this period. Only- two major privatizations took place betweenl 199(1 and 1993, both in the food sector: the sales of Tsarevi\ ni Produkti to a Belgo-Anglo- American consortium for $21) million plus 518 million in BulgarianL debt paper. and of Republika to Kraft Jacobs Suchard. Several factors contributed to this impasse, including intransigence on the part of the political authorities, precluding all compromise; conflict and mistrust between supporters and opponents ol the old regime; weakness of the two post-Zhivkov nonsocialist governments, vhich prevented them from dismantling the old communist networks; and commercial alliances among former comnmunist party leaders, formzer menmbers of the security forces, and SOE heads (party leaders and security personnel supplied the SOEs with raw materials and other goods in exchange for their products, which they then resold at colossal profits) In brief, these and1 other reasolns fostered the maintenance of the status quo, from wlhichi some reaped sub- stantial profits. (Nlly coWbltics imt f1lic tolic'u'lligq }(,l 154 T'lic Privatizatieu C/mile u' c Box 6.1 (coiitifilm'd) I'he following years (1994 and 1995) were, unfortunately, not much more pro- ductive, partly because of a new requiremenit to have eachl privatization deal cleared with the cabinet. The major deals of 1995 inclutded two breweries sold for about $5 million each and a cannerv. Governmnent turnover continued, leading to a total of half a dozen governments between 1989 and 1995. In June 1994 the privatization law was amended to) add a mass privatization program. A special agency, separate fromll thle privatizationa gency, waS set up to manage this voucher program; not mucih happenied in termis of actual privatizations, however, whether througih tradic sales or mass privatization. The list (If over 1,1()01 companies included in the mass privatization program was approved by parliament only in December- 1995, aiid the sale of privatization vouchers started in January 1996. During thlis period "thle Bulgarian state lost muLch of its capacity to monitor enterprise perfOrmance and management Managers ( hanneled enterprise assets and cash flow to themselves, leaving little to the state but liabilities. Losses of BiIl- garian state enterprises, w*hichi averaged mlore thin 12 percent of GDiP betweeni 1992 and 1994, were covered by loans fromii an increasingly insolvent bankinig system. Bulgarian observers concluded that unIclear property rights alrej turning from a legal to a major macroeconomic problem" (World Bank 1996b, p. 50). 'mla (Rex: Rva5 llu Findation I 994; WVaeim