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Spencer Jakab picks up a copy of the 1993 annual report for Zalakeramia, a Hungarian building tile manufacturer. He thumbs through its drab pages and winces.
Jakab, an equity analyst at CS First Boston Budapest, raises his eye-brows when he passes a page which features the pictures of the company's board of directors. Filled with mug shots of alternately glum or grinning men and women, this could be the faculty page from a junior high school yearbook. Further back in the report is an organizational chart generated by a dot matrix printer.
Jakab turns to the company's slick 1995 report. Gone are the board photos and the dishevelled organization chart. "Now, it's one of the best looking annual reports in Hungary. It's very nice looking. A huge difference," Jakab comments. Of even greater interest, the report contains the news that turnover doubled in 1995 and profits were up 85% over the prior year.
Annual reports for many companies traded on the Budapest Stock Exchange (BSE) have come a long way in just a few years. Their new sophistication reflects a more fundamental change management's new-found respect for the shareholder, say analysts and investors. As investors in other parts of eastern Europe and the CIS struggle for control of or even information about the companies they own, some international fund managers who have bought Hungarian equities have the luxury of worrying about what their companies' next quarterly IAS (international accounting standard) earnings will look like.
Many of the nearly 50 companies traded on the Budapest Stock Exchange have set up a shareholder relations department. Stock option packages for management are increasingly common, motivating managers to think in the shareholder's interest. And CEOs who once thought talking to investors was a distraction, now know it's part of the job. Of course, corporate governance in Hungary is still far from perfect, particularly outside the rarefied circle of companies traded at the Budapest Stock Exchange. The government's control over its own companies is shaky. And a corporate code that was the pace-setter for the region a decade ago is growing creaky and antiquated (see box below).
Still, all in all, Hungary's publicly-traded companies are among the best behaved in the region. Gabor Sitanyi, an analyst at ING Barings, says: "As far as the whole region is concerned, they are geniuses." He says: "If you look at the 15 to 20 most important companies on the Budapest Stock Exchange, 90% have IAS audited cashflow, profit and loss, the full accounting balance sheet normally all in English and some are even preparing quarterly [results] such as Pannonplast." These companies, he concludes, "are in line with western European standards".
CS First Boston's Jakab goes one step further, saying that "to some extent things are a little better than western Europe. The companies here would all be small cap companies in major western countries. The access you can get as a shareholder is much better. I can call the CEO of the biggest drug company in Hungary and ask him a question. But if you are an analyst covering IBM, your chances of doing more than shaking [chairman] Lou Gerstner's hand are pretty small."
Years of resistance
The shift in management attitude has been dramatic. Sitanyi remembers that in the early 1990s, as the government was pushing companies into publicly-traded ownership, "the attitude [among executives] was, 'I'm not going to publish anything, I'm not going to see investors, I'm just doing my job. I get a bonus on performance, not on share price'". Before 1990, companies were nominally owned by the state, but effectively were private fiefdoms of the management. Even after privatization, managers bred under this system "still thought that the company was owned by them, that it was their baby and everyone else should shut up", Sitanyi says.
He offers an example: when companies first began compiling IAS accounts, they found that the results were normally worse than those indicated by Hungarian standards, since IAS frequently requires higher provisioning and depreciation. "Many of the Hungarian companies happily published their results in Hungarian, but wouldn't publish the IAS. What is the point to pay for the audit and stick it into your cupboard? They told us, 'It's management information, you shouldn't ask for that.' We pointed out that, yes, management had asked for it, but the shareholders had paid for it."
"That sort of attitude has changed substantially," says Sitanyi, though not necessarily out of altruism. In part, management stock option schemes have motivated executives to focus on share prices. And managers have also watched as the market rewarded well behaved companies with more capital. "A couple have raised more than two times. They realize that it is in their best interest and that when they come to the market again, investors will remember," he says.
Finally, investors have rewarded cooperative managers with higher stock prices. Krisztina Kozma, a manager of CS First Boston's Central European Growth Fund, suggests that an uncommunicative but fundamentally good company might add 10% to its stock price simply by improving its shareholder relations. Her fund, which had $242 million in assets at the end of June, had 30.9% of its money deployed in Hungary.
Good corporate governance doesn't simply mean a communicative management, however. To earn the market's respect, management in turn has to be in control of its company's affairs. In this regard, oil and gas company Mol, Hungary's biggest enterprise, has seen some of its executives' attempts at openness backfire.
After flotation a year ago, the company created a shareholder relations department and now generally gets high marks for its openness. But the company has handed foreign investors and investment bankers some rude shocks. The first surprise came last summer after investment bankers had scoured the company in preparation for the state's sale of 20% of the company to international institutional investors.
Out of the ballpark
When analysts visited the company, managers said that it had made Ft8.1 billion in the first half of the year, recalls Jakab. "Then they said 'No, no, no, we made Ft6.7 billion' and then during the issue they said it was Ft4.1 billion. It's a huge difference." Double counting of revenues from one division accounted for much of the error.
December brought another shock, says Jakab. Zoltan Mandoki, president of the company, said he "was expecting net earnings of between Ft6.5 and Ft7 billion for 1995. He didn't specify Hungarian or IAS." By the time the numbers were totted up, earnings were actually Ft1.07 billion. "Between Ft6.5 billion and Ft7 billion is not in the general ballpark of Ft1.07 [billion]," recalls Jakab. "So you ask yourself how can a company, eleven and a half months into the year, predict it would make that much? What kind of controls do they have, what kind of accounting?"
Companies listed on the BSE may be at the cutting edge in the region, but that doesn't mean that institutional investors don't occasionally get mugged in Budapest. There is little legal protection for minority shareholders and the securities regulators in Budapest lack teeth.
Fotex has been foreign investors' roughest ride. Three year's ago, it was an emerging market darling, attracting early investments from everyone from George Soros to the US government-funded Hungarian American Enterprise Fund. Fotex offered a sophisticated pitch: glossy annual reports in English, full of pithy comments about the company's prime positioning as a retailer of up-market consumer goods to partake in an expected boom in the Hungarian economy. Fotex's huge retailing real estate holdings further stoked investor interest. Backed with such stories, the company did a large offering of shares at Ft500 apiece in April 1994.
It was downhill from there. The company's ambitions for profit were slaughtered by an 11% contraction in average real earnings in 1995. Moreover, some investors lost faith in management. A report issued by Nomura Research Institute in January 1994 highlighted a series of ambiguous transactions between Fotex and its biggest shareholder, a company owned by Fotex president Gabor Varszegi. Varszegi's behavior at the AGM last year reinforced shareholder uneasiness, when he engineered a series of measures which meant that without 75% of the company's shares no one could turn out the company's board. With Varszegi controlling roughly 30% of the company, the move effectively "cemented" Varszegi and his board in place, says Jakab.
Investors have voted with their feet, stampeding out of Fotex shares. At Ft120 a share (one tenth the issue price in hard currency terms) as of late August, Fotex trades at a deep discount to its potential value. It now trades at just twice net cash per share, notes Jakab. It has a very strong balance sheet and "the value of its real estate and leaseholdings probably makes the stock worth in the region of Ft400 at least. But then again what kind of value is going to accrue to the shareholder?"
If board machinations helped torpedo investor confidence in Fotex, they also hold the key to the further development of Hungarian corporate culture, analysts say. "To find somebody who is really good and is not sitting on any board, and fulfils all the requirements is a hell of a job," says Andras Simor, head of Creditanstalt Securities Budapest. Executives at banks and brokerage houses are forbidden by law from participating in the boards of companies traded on the exchange. Beyond, the pool of potential board candidates is considerably smaller than it might be in the west. Because of the recent transition, "in Hungary there are few people who have a long, successful track record in this environment", says Simor.
The pool is further drained by the realities of Hungarian education which funnels most bright young people through just a few universities. By the time they reach 30, most Hungarians feel like they know, all too well, everyone in their respective sphere of interest.
"Hungary is a small country with few experts in every field and so there is no competition for these [board] positions," says Peter Mihalyi, formerly the chief economist at the State Privatization and Holding Company (APVRt) and now chief economist at Bank Austria-GiroCredit Budapest. "So how can you get someone on the board who is independent? People who are qualified technically, have the management experience, [and] have the financial experience they are deeply entrenched in the lobbies and industry structures."
Putting a good board in place is not the end of investors' worries. Who teaches a board what its job is? Simor says board members must, like everyone else in Hungary in the new economy, "learn by doing".
"Everything we learnt in the last six years was by making mistakes and hopefully doing better the next time," he says. Some boards, unfortunately, have erred on the side of doing nothing. "It happens all over the world. The board member says, 'I've got a nice relationship with the management, I get my board fees, I get my cigars every three months at the board meeting.'"
Simor notes that the board of Ibusz, the first company floated on the BSE in June of 1990, didn't lift a finger as the travel company's management steered the company from disaster to disaster in subsequent years and the company's price fell from its initial offering price of Ft4,500 to Ft950. "For me it was an obvious case for the responsibility of the board to stand up and say, 'We either need a serious change in strategy or we need a new management'," he explains. "But it lasted six years before something happened and it wasn't the board that did it." The board and management were finally turned out only after Ibusz was taken over by another Hungarian company.
Last hurdle
Few experiences are so bad, but Simor notes that "boards in Hungary in public companies and companies without controlling shareholders really haven't started to function in earnest.... I think a lot more time will have to pass before boards function more effectively."
In theory, board members of Hungarian companies are liable up to the full extent of their personal wealth. In practice, no one interviewed for this article had ever heard of that happening. "It is too strict and because it is so strict it's unrealistic," says Mihalyi.
There's a final hurdle in the transformation of Hungary's corporate culture. Even as the number of private and foreign companies in Hungary swells, a core of companies ranging from media to utilities, to key manufacturers, to agriculture remain in state hands.
That leads to a problem. Board memberships at state-owned companies are a key perk for mid-and low-level government officials. While the top three tiers of ministry officials are forbidden from serving on company boards, the salaries of more junior staffers are often almost doubled by pay from board memberships handed out by their minister, Mihalyi says. A head of a ministry department may make Ft90,000 ($600) monthly, with several board memberships each adding an additional Ft30,000 to Ft40,000 to that base. Or the person might serve on the board of one large company, earning Ft100,000 monthly, Mihalyi says. Such board membership may carry other perks like a car, a portable phone or a secretary.
The practice creates incompetent boards, since board memberships are often distributed willy-nilly among ministry staffers, says Mihalyi. "It doesn't really matter [what your area of expertise is], they put you where there is a place. So, that of course creates all sorts of confusion. A guy lands in a totally different industry that he doesn't know anything about. He is not even interested, so he just goes to the meetings and gets the money."
But the situation has a flip side. Board members from a given ministry may become too interested in their company, says Mihalyi. "After two or three months, these people start to love the company and they become the lobbyist of the company with the government. So a Mol board member [for example], who is a ministry official, will do everything he can to lobby the government for Mol, rather than lobbying for the government in Mol."
But Gabor Baranyai, who has attended two board meetings since he was elected to serve as one of two board representatives of foreign shareholders on Mol's 11-person board, says he's been pleasantly surprised by his experience so far. "The biggest surprise is that those 11 people are really committed," he says. "After two months, I found that people are competent. Everybody has a special field that makes a contribution to the board."
Baranyai, a systems engineer, worked for Mol, attended business school in the US and then worked for the International Finance Corporation (IFC), before taking his current job at a telecom investment fund created by IFC. With all that preparation, however, the 40-year-old still says he's nearly overwhelmed by the challenges of serving on Mol's board.
"Right now, I spend half my time preparing [for meetings]," he says. "The board meetings are like a university exam. You make notes, you study. Sometimes [afterwards] you feel like you did well. Other times you feel like you should have focussed more on something else in your studying." There is at least one difference between university tests and board meetings, says Baranyai. "In university, you get a grade quickly. But in a company, you have to wait years to see if you made the right decisions." Hungary, too, will have to wait several years to receive its grade in Corporate Governance 101. *
Flawed but functional laws
Hungary suffers from being ahead of its time. Like a manufacturer which adopts a new technology early on, only to watch its competitors install newer, better versions soon after, Hungary once a regional leader in legal innovation now finds itself making do with antiquated laws.
Andras Simor, head of Creditanstalt Securities Budapest, confronts this daily in dealing within his country's securities laws. He laments that short-selling, securities lending and nominee trading are all still forbidden by Hungary's securities law, which was passed in early 1990.
"In 1989 and 1990, Hungary was a pioneer in establishing and reforming its legal system, preceding events of the market. That helped the market grow very fast. In terms of the securities legislation, the market has now overtaken the system and the system is hindering further development."
That law was part of a long crescendo of legislation that constituted Hungary's transition to free market democracy. In 1984, the government issued a decree giving greater autonomy to its companies; in 1988, it introduced the corporate act and an act permitting foreign investment; in 1990, laws on securities trading and privatization; and in 1991, laws codifying bankruptcy and accounting.
Left to bureaucrats
But the legal innovations slowed soon after 1991. Having helped launch capitalism, the aggressive young men and women who had pushed the government along from the inside gravitated to the private sector's big money and excitement, leaving the law-writing to bureaucrats. Simor left the National Bank to run Creditanstalt. Zsigmond Jarai who, as deputy minister of finance, helped draft the act which permitted a stock exchange, went to work as an investment banker for James Capel. Today Jarai is chairman of the Budapest Stock Exchange.
With many flawed but functional laws on the books, the temptation has been to stretch and fiddle, rather than rebuild. Why fool with de jure when de facto works? Such sub rosa innovation comes naturally to Hungarians. In the most tolerant regime of the Soviet bloc, the rule was very often simply, "don't get caught". During the 1970s and 1980s, the authorities increasingly turned a blind eye to capitalist innovations in the hope that such flexibility might save their system. (The state's often schizophrenic approach to law enforcement persists. Even today, the state radio station regularly broadcasts the location of police speed traps.)
Corporate law is still, in the large part, governed by the 1988 Act on Corporations. For its time, the act was revolutionary. In a country that was still nominally communist, the act laid down western-style rules for everything from takeovers to the election of corporate boards. Now, however, corporate lawyers in Budapest are churning out a growing body of practice that either stretches or contradicts the law. Companies at least those who understand the problem are holding their breath to see when and how the courts will rule.
For example, the company law of 1988, in theory, obligates one Rt (the Hungarian equivalent of Ltd) buying a majority of another Rt's shares to offer the same price and terms to all minority shareholders. In the last 18 months, the big question has been, should this be taken literally and applied only to Hungarian companies, or should Rt be translatable and thus apply to all Ltds. If so, the law would apply to foreign companies which purchased more than $1 billion of privatized companies last year, obligating the foreigners to buy out minority shareholders. Although the purchases took place nine months ago, a final court ruling may not come for yet another year.
"The law is clearly deficient," says Simor. "If an Rt takes over another Rt, you have this obligation. But if a private person buys a company, then there is no duty. So it would be very easy to avoid the problem. Even a 10-year-old could find the solution to this problem."
With the exception of a few clauses, Hungary lacks a full takeover code. A comprehensive code was included in early drafts of a new securities law, but as the number of drafts now approaches 20, takeover provisions have dropped out, much to the brokerage community's dismay.
Last winter, Creditanstalt advised Bristol-Myers on its purchase of Pharmavit, a Hungarian drug company. Side-stepping any apparent ambiguities in the law, Bristol-Myers simply applied UK takeover rules, which are far more stringent than those now in place in Hungary, and bid for the whole company.
Even as corporate law remains stuck in 1988, practice is creeping forward every day in law offices around Budapest. In many cases, the innovations come in something as basic as a company's articles of association, which determine a company's corporate governance and must be registered at the court of registration. Many articles of association currently in use create new mechanisms which are not necessarily encompassed in the current law, says a Budapest corporate lawyer.
Untested
This creates a hazard. "Even if the court of registration registers special rules, they haven't been tried in normal court," the lawyer says. Given the chance, a conservative judge might well throw the practice out, he says. The attorney spoke on condition of anonymity, saying he did not want to be seen to be discouraging any potential investors in Hungary.
The court of registration only registers a company's articles of association six to 18 months after they are filed. If the court requests a change in the articles, an applicant faces a choice: appeal and wait another two years or simply change its articles of association to make the court happy. Lawyers recommend biting the court-ordered bullet. Asked how long an appeal would take, the lawyer laughs. "I've never tried it. One year for sure, maybe two or three," he says.
With corporate lawyers and the companies they advise taking the path of least resistance judges are not challenged to broaden and interpret the law. A gap is opening between the law as recognized by the courts' practice and as implemented by corporations, the lawyer said. Sooner or later, a new law will be written that validates corporate lawyers' innovations, the lawyer says.
Asked if eight years of innovations might simply be overturned, the lawyer replies, "that's impossible". HC
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