Investor Protection: The Czech Experience
When TV Nova launched as the first private television channel in post-communist Czechoslovakia, few anticipated the business drama behind the scenes. HBS professor Mihir Desai explains what managers can learn from one unlucky investor's experience. Key concepts include:
- Think hard about partner selection, deal structuring, and operational decisions when expropriation is a key risk.
- Well-constructed joint ventures should embody the notion of "Trust, but verify."
- Seek partners with experience with foreign companies and a track record of good behavior.
When TV Nova launched in 1992 as the first new television channel in post-communist Czechoslovakia, few might have imagined the joint-venture drama unfolding behind the scenes.
Distinguished for bringing Baywatch, soccer matches, and sexy weather forecasters to the nation's television screens, TV Nova lived up to its moniker, nová meaning "new" in Czech and alluding as well to a bright star. Its wide array of programs provided a spicy alternative to the tired fare offered by the two prevailing state-run channels whose names were as uninspired as Nova was fresh: One and Two.
The drama behind the scenes, however, ultimately eclipsed the programming at TV Nova.
Despite the eventual 99-percent stake held in the channel by Central European Media Enterprises (CME), the holding company of Ronald Lauder (one of the heirs to the Estée Lauder cosmetics fortune), the Czech partner—Vladimír Železný, an experienced and politically connected television executive—managed to divert the entire value of the underlying entity for his personal benefit.
After court battles escalated to the level of international tribunals, and high-ranking American officials intervened, Lauder won a landmark victory from the Czech Republic. Železný somehow managed to turn the loss to his advantage and ended up a member of the European Parliament.
For business managers and investors, the story of TV Nova and the joint venture that spawned it is a cautionary tale: It highlights the risks of expropriation not just in (what is now) the Czech Republic, but also in any country that lacks strong institutions and investor protections.
As HBS professor Mihir A. Desai and the Monitor Group's Alberto Moel explain in the Review of Finance, in their paper "Czech Mate: Expropriation and Investor Protection in a Converging World," the expropriation and its aftermath "illustrate the interaction of property and contract rights in a global setting, how corporate control is shaped by geography, and how multinational firms may be advantaged by availing themselves of stronger investor protections than local firms." With Kathleen Luchs, Desai and Moel also wrote a series of case studies on the topic, titled "Czech Mate: CME and Vladimir Zelezny [(A)-(E)]."
Desai recently shared his impressions with HBS Working Knowledge.
Q: The TV Nova tussle was a notorious case with colorful characters, and its resolution was not really satisfying, given that the Czech public ended up paying (literally) for the weakness of their country's property and contract laws. How did you become interested in this story, and what broader themes did it highlight for you?
A: I think the Lauder-Železný saga is notable for several reasons. First, it's a cautionary tale for managers about an expropriation in an emerging market where the value of an entity can be diverted to insiders. In this case, the "tunneling" of the enterprise was accomplished by an insider with a very limited ownership stake but with control of the political environment. The legal documents surrounding the case provide a unique perspective on the methods of tunneling and provide lessons on how to prevent, or at least mitigate, the risks of expropriation by business partners. As such, it's an opportunity to think hard about partner selection, deal structuring, and operational decisions when expropriation is a key risk.
Second, it's an instructive example for economics and legal scholars who have begun to emphasize the role of institutions in determining the nature of financial markets and economic outcomes. This literature has emphasized local investor protections and the contractual environment between private parties as being of critical importance. The Lauder-Železný saga demonstrates that this emphasis may be misplaced for two reasons. First, as other scholarship has also begun to show, property rights institutions that restrain the state can be more important as they provide the foundation for contractual institutions. In short, the ability to contract effectively between private parties is meaningless unless you can be assured that the state won't interfere for its own interests. Second, the emphasis on local laws as being all-important may be misplaced given the large role of foreign investment in emerging economies and the ability of these investors to avail themselves of nonlocal laws. The web of bilateral investment treaties and the growth of supranational forums for dispute resolution is a critical and underappreciated aspect of global capitalism today.
CME viewed a local partner as a substitute for a local presence—I think this is a critical mistake.
Finally, it's an enormously entertaining story filled with bizarre twists and colorful characters that combines the worlds of business, politics, and media. Two of my favorite quotes in the case come from Železný. First, when defending the controversial means TV Nova employed to capture large market shares, he stated, "The intellectuals believed Czechs were special, more sophisticated. We proved they were wrong. We showed that Czechs are like all other Europeans, whose first interest is soccer, with erotica a close second. For that, we will never be forgiven." Second, when Lauder tried to fire Železný from TV Nova, Železný responded by declaring, "I am Nova," and then published a book entitled We Shall Not Surrender this Television Station. As Tom Wolfe says, who needs fiction with reality like this! Writing and teaching a case with material like this is a real pleasure.
Q: Can you identify the key miscalculations made by CME and similarly by the local partner? How, broadly speaking, would you advise foreign investors to protect themselves?
A: CME viewed a local partner as a substitute for a local presence—I think this is a critical mistake. Remarkably, CME had no local presence and no independent sources of information other than the local partner. Well-constructed joint ventures should embody the notion of "Trust, but verify," and CME couldn't do that without a local presence. This illustrates, more generally, that control has a geographic component because ownership shares or contracts can't substitute for the information gleaned by close contact.
The other mistake made by CME is that it confused ownership with control. It continued to increase its ownership stake all the way to 99 percent, thinking that it was getting more and more control of the entity, while in reality the opposite was happening. As CME increased its ownership stakes, other important constituencies—Železný and the Czech people—had interests that were no longer congruent with CME's interests. CME could have spun off a piece of CME to the Czech public to create more public support for its interests.
Finally, I think CME illustrates the critical nature of partner selection in emerging markets. In settings where contracts are weakly enforced, opportunistic behavior by partners is more likely. While most people emphasize having local partners that are well connected, this can backfire in these markets because such partners can more easily rewrite the rules of the game in those countries. I think having local partners with experience with foreign companies and a track record of good behavior is underappreciated relative to a partner's political connections.
For Železný, the lesson of course is simpler: He was on the verge of receiving a $150 million payment and ended up with close to nothing because he could only be satisfied with complete control of the entire enterprise. He also chose a foreign partner that was well connected politically and willing to expend large amounts on legal remedies.
Q: "Czech Mate" ends on a somber note, with weak local laws permitting expropriation and the Czech people paying a large price for the misbehavior of Železný and politicians. Is there a silver lining to the case? Also, could you expand upon the "uneven playing field" idea you describe in your paper concerning differential investor protections for multinational and local firms?
A: While it's certainly a disheartening outcome on the surface, there are some silver linings. The costs associated with weak institutions are usually hidden—companies that don't go public, financings that don't happen, lost economic growth. The Lauder-Železný situation makes the costs of having weak institutions much more tangible. The desire of the Czech Republic to join the EU made it more willing to pay the settlement and adhere to the international standards of protections for foreign investors. An underappreciated benefit of globalization is that it makes the costs of inefficient institutions more transparent; at the same time, globalization means that the foregone benefits are even greater in those markets that do not provide or enforce protections for international investors.
As the students read the case series, they almost feel like they're watching a car wreck in slow motion.
The protections afforded international investors in these environments stand in contrast to the treatment of local investors and firms. This highlights another way in which global investors, particularly multinational firms, can avail themselves of global resources while local firms are unable to do so. This is something we see in the large-sample evidence as well. Local distortions are borne disproportionately by local firms since global investors can often circumvent those distortions.
Q: Have you taught "Czech Mate"? If so, how did it go? How did MBA or Executive Education students respond to the management issues?
A: Students enjoy it immensely. As the students read the case series, they almost feel like they're watching a car wreck in slow motion. Many students, particularly Exec Ed students, sympathize with CME and its sense of helplessness when dealing with Železný, as it echoes their own experiences with local partners. Students are also pushed to extreme sentiments as they realize how poor the position of CME is despite its large ownership stakes; some students have gotten sufficiently exasperated to suggest fairly unethical resolutions to the partnership with Železný.
Q: What is your next project?
A: As I mentioned, I think political risk is underappreciated relative to contractual risks. In a recent project with Fritz Foley and Jim Hines, "Capital Structure with Risky Foreign Investment," we've tried to understand how political risk influences the financing and operational decisions of U.S. multinational firms both at the subsidiary and firm-wide level. Several interesting results are emerging from this work—first, multinational firms economize on equity in politically risky environments by levering their subsidiaries more. The effort to economize on equity extends to operational decisions as firms choose to serve such markets with exports rather than a local presence.
These changed financing patterns at the subsidiary level, however, do not result in greater firm-wide leverage for firms with lots of political risk exposure. Instead, exposures to politically risky environments are associated with reduced borrowing overall. In short, some of the political risk borne by multinational firms is shifted to local lenders through changed subsidiary financing decisions, but the rest is borne by the company, and this reduces their overall borrowing. While folks have conjectured that exposure to business risks is associated with lower leverage, it's been hard to find evidence of this relationship between risk and capital structure. We think that the multinational setting is a particularly useful setting for isolating these effects.