Investors were warned off Czech steelmaker Trinecke Zelezarny following its takeover by a domestic investment vehicle known as Moravia Steel. A Prague-based analyst advised selling the stock because of fears about where profits generated by Trinecke Zelezarny might end up. What worried Patria Finance analyst Charles Kulp was the prospect of profits being transfer-priced out of Trinecke Zelezarny - an increasingly common practice in the Czech Republic - and used by Moravia Steel to pay debt taken on to fund the acquisition.
"Due to the ... uncertainty of the contract conditions between Moravia Steel and Trinecke Zelezarny, we choose to be cautious with this stock and recommend that investors sell their shares," said Kulp's report, which described how Moravia Steel would handle financing and management of between 60% and 70% of all major raw material purchases such as iron ore, scrap iron and coal; supervise sales of about 90% of final products; and make arrangements for most services. "This arrangement will probably generate improved Trinecke Zelezarny sales. However, because Moravia Steel will set prices for sale of raw materials (purchased by Moravia Steel and sold to Trinecke Zelezarny) and final products (produced by Trinecke Zelezarny and sold to Moravia Steel), it is not clear that Trinecke Zelezarny will gain an appropriate share of profit."
Transfer pricing is just one of a number of methods used by domestic strategic shareholders in the Czech Republic to deny rights and rewards to minority shareholders. Over the past nine months, and with an unprecedented takeover frenzy in progress, these shareholders have watched helplessly as ownership of companies has switched, with premiums being paid for control, but without equivalent offers being made to minorities. Similarly, investors in closed-end funds have suffered as some funds have converted to holding companies, so destroying confidence in their intent to deliver returns, and opening up discounts between share prices and net asset values of between 30% and 70%. On top of this there have been examples of insider trading, greenmail, overcharging by brokers, price manipulation, minimal disclosure, investment funds amassing large stakes in their parent companies to maintain control, and fund managers siphoning out money by charging funds for advertising, consultancy services and public relations.
Up until now few of these practices have been illegal. In the Czech Republic the free market concept has been interpreted literally as allowing individuals to do more or less as they please. The most aggressive members of the country's new entrepreneurial class have seized upon this opportunity to gain control of assets at below-market values and to make speculative profits. Foreign institutional investors, some of them the victims of such intrigues, have been moving very cautiously in the Prague Stock Exchange (PSE), and in this year's eastern European stock market boom, the pse has lagged rival bourses in Poland and Hungary.
Regulatory framework
But on July 1 sweeping changes to existing capital markets legislation in the Czech Republic came into effect. By establishing a takeover code as well as rules on a whole range of fund management and corporate governance issues, Czech legislators are hoping the amendments to the Commercial Code, Securities Act and Stock Exchange Act will usher in a new enlightened era in the country's short history of contemporary capitalism.
Some analysts complain, however, that the legislation is not keeping pace with the questionable practices of some of the country's sharpest movers and shakers. They say that by tackling specific issues, rather than establishing a complete regulatory framework, the amendments are likely to solve difficulties in one area only for them to reappear in another. In particular, they note that the kind of transfer pricing possibilities raised by Moravia Steel's acquisition of Trinecke Zelezarny are unlikely to be plugged by the new laws. (In a further twist, the company is now the subject of rumours of a takeover by Slovakian steelmaker VSZ.)
"These rules [the takeover code] are coming a bit late. Over the last nine months there has been a huge consolidation of holdings," says Jiri Huebner, director of the Czech and Slovak country team at the European Bank for Reconstruction and Development (EBRD). "Now the problem is what you do for the poor [minority] shareholder whose stock is languishing and how you stop profits being taken out [of the company]. The new bogey is transfer pricing."
Jan Vlachy, vice-chairman of the foreign-Czech joint-venture investment bank Patria Finance, comments: "The main weakness is that changes have not been made as part of a strategic plan to restructure the Czech corporate sector. Someone should have asked what the Czech capital markets ought to look like and then made the appropriate changes. What has happened is the opposite. Certain issues have been addressed, but that still doesn't make the markets operate in a proper way. There is no comprehensive package."
Vlachy says the issues tackled are, politically, the most visible ones, such as the investment funds. In some cases the funds which grew out of voucher privatization have been manipulated by their managers and owners. For many ordinary Czech citizens, who swapped their vouchers for shares in the funds, this has made their first taste of capitalism a bitter one.
The architect of both voucher privatization and the amendments, parliamentary member Tomas Jezek, who was appointed chairman of the PSE in April, says that it is important to understand that "not all the problems of the Czech capital markets can be solved through legislation".
Jezek claims the legal changes will control transfer pricing. But he agrees with many market observers that the difficulty now is enforcement and that there is a need for some kind of securities and exchange commission (SEC). "The most visible problem of Czech capital markets is the non-existence of an sec. Within one minute of debate about the markets' future, this issue is on the table."
Jezek is pushing to have an sec set up by next year. However, he will have to battle with the ministry of finance which has current responsibility for surveillance and doesn't want to give up its powers. Indeed, the ministry opposed some of the new changes because, claims Jezek, its civil servants hold dear the idea that capitalism is synonymous with absence of regulation.
Beating the deadline
Whatever the shortcomings of the changes, analysts agree that they mark an important step forward in curbing excesses on the PSE, which with nearly 1,800 stocks and a market capitalization of $22.4 billion - 47% of GDP - is the largest of the stock markets in the Visegrad countries. The strongest evidence of this is that in the run-up to the amendments going into force, market players have been behaving more wildly than usual, knowing that their days of complete freedom will soon be coming to an end.
For the past nine months, anyway, a grand consolidation has been under way in the Czech Republic. According to one estimate, majority control in 60% of listed companies has changed. The takeover frenzy has been dubbed the third wave of Czech privatization: the first and second waves were when corporate equity was distributed to Czech citizens via vouchers. This scheme has been criticized for spreading ownership so thinly as to prevent shareholder pressure for restructuring. In this sense, consolidation can be viewed as positive, even though it has been conducted in an unorthodox way with blocks of shares being traded off the PSE at privately agreed prices. (About half the stock dealing in the Czech Republic takes place over the counter and, while prices have to be registered at the Centre for Securities, they may not bear any resemblance to market prices.)
"It has been takeover mania in a freebooting style that frightens the living daylights out of the average conservative institutional investor: this is why many of them have thrown up their hands and walked away," says James Oates, director of eastern and central European equities with UBS in London. "Even so, it may be possible to argue in five years' time that they did things in a better way than Poland [where the stock exchange is tightly regulated and otc deals are banned] where privatization has been so slow."
Under the Czech Republic's new takeover code, investors will have to make a public bid for the remaining stock if they pass the 50%, 66% and 75% thresholds. Bidding must start within 60 days of the purchase and the offer must be valid for at least 60 days. One problem is that prices on the stock market are generally 15% below those on the OTC market. This is because, outside the top counters, stocks are highly illiquid and trading is thin. To get hold of sufficient stock to make a takeover would require paying a premium and this could push takeovers to be executed outside public markets. A second problem is that the threshold is quite high and investors holding say, 30%, could have a large influence on a company without having to make a public bid.
The new rules also require investors to notify the Centre of Securities of any acquisitions of more than 10% in a company and any further increases over 5%. The penalty for not doing so is loss of voting rights in the shares for one year. Some brokers are concerned that the amendments might not be robust enough to prevent groups acquiring multiple stakes of less than 5% - which they do not even have to declare - and gaining control by stealth.
Frances Cloud, an east European specialist with Nomura Research Institute Europe, says: "I don't think the new regulations will make any difference [to the difficulties of investing in the Czech Republic]. There is no system to enforce them and no effort has been made to define groups or related companies." But a report by Prague-based brokerage Wood & Company, whose analyst Jan Muller was part of the drafting committee for the new laws, says: "Group interest is now much more clearly defined. This principle is very important, both for reporting requirements and public bid commitment."
Many critics, however, do complain that the regulations lack the necessary details and definitions to transform the PSE. "The devil is in the details - or rather the lack of them," says the EBRD's Huebner.
However, in one instance, at least, the details contained in the new regulations may cause market players to change their operating methods rather quicker than they had expected. A number of prominent investors increased their stakes in listed companies during June. These include one of the Czech Republic's largest banks, Ivesticni a Postovni Banka (IPB) which, through its investment fund Prvni Ivesticni, raised its stake in the country's largest brewery Plzensky Pravdroj from 18.9% to 53% and its stake in paper company Biocel Paskov from 27% to 51%. Harvard Capital and Consulting, and its partner Stratton Investments, increased their stake in shipping company Ceska Namorni Plavba from 52% to 88%. But, according to a report in the Prague Business Journal, lawyers have pointed out that the new public bid rules went into effect on May 30, unlike the rest of the changes, which did not become law until July 1. In what may prove to be the first test case of whether the rules will be properly enforced, these investors could be obliged to make public bids.
"If the authorities don't act upon what appear to be early violations of the code, it will be difficult to persuade others to follow them," says a Prague-based broker. Daniel Arbess, principal and chief executive of the Stratton Group, comments: "Concerning the new legislative amendments, we will of course comply with any obligations."
The reforms which market observers are most enthusiastic about are those concerning investment funds. More than 70% of the free float on the Czech equity markets is controlled by the funds. The changes specify what costs can be charged to a fund, require regular reporting of holdings and net asset values (NAV), and allow management contracts to be terminated with six months' notice. In the case of funds, transfer pricing has been dealt with and no longer will it be possible for managers to take out capital gains by selling and buying assets to a related party at non-market prices. But, arguably, the most significant change is the requirement that a fund cannot convert into an industrial holding company without the approval of 66% of all shareholders and that dissenting shareholders have the option to be bought out at NAV.
Holding companies
Conversion into a holding company removes funds from restrictions placed on them by the ministry of finance, such as the maximum of 20% a fund can hold in a company and the maximum of 10% of a fund's assets that can be invested in one company - guidelines that have been retained under the new rules. Mindful that tougher rules were on the way and that conversion itself would be more difficult, a number of high-profile funds have transformed themselves into holding companies this year. This has sent share prices of funds tumbling as investors have become suspicious of their motives. But brokers expect that in the relatively more transparent environment following the reforms, prices of remaining blue-chip funds will improve. Consequently, they are starting to recommend their stock again.
"The legislation has forced funds to show their face. Those which do not wish to be transparent and give investors information have converted, thus allowing investors a clearer view of the genuine funds," says Vladimir Jaros, research director at Wood & Company. "The industry is safer than before."
The event that sent shockwaves through the sector was the conversion in March of Harvard Capital and Consulting's dividend investment fund (see graph). A small advertisement placed in the daily business paper Hospodarske Noviny, on a Thursday, announced that the following Tuesday there would be an extraordinary meeting in Velke Bilovice, a small town near the Austrian border about four hours' drive from Prague. Unsurprisingly, the meeting was attended by fewer than 30 shareholders, questions could be put in writing only and the decision to convert was passed with only a few shareholders voting against.
The Harvard conversion was the latest in a series of bold moves made by the Prague-based company and its founder Viktor Kozeny who resides in Nassau in the Bahamas. Back in 1991 Kozeny was the first to realize that voucher funds would do better investing in about 50 stakes of around 15% to 20% rather than holding smaller amounts in hundreds of firms. He promised and delivered a 10-fold return to the hundreds of thousands of Czechs and Slovaks who invested their privatization vouchers in Harvard. The next step was to invite in foreign capital; and Sir John Templeton, the doyen of global fund management and one of Kozeny's neighbours in Nassau, is said to have bought $5 million worth of Harvard stock. Then, last year, another Nassau neighbour, Michael Dingman, the former boss of American engineering firm Allied Signal, bought stakes in leading Czech companies from Harvard, to be held through privately owned Stratton Investments (see the table for latest portfolio). According to Stratton's Arbess, Harvard and Stratton have a voting agreement under which Harvard agrees to use its vote in the companies jointly owned by Stratton, in accordance with Stratton's wishes.
At the end of June, Harvard merged six converted investment funds into a single industrial holding, the Harvard Industrial Holding Group, which was in turn merged with the major Stratton holding, Sklo Union, thus making Stratton a Harvard shareholder after the merger.
It is still not clear how much the Harvard-Stratton alliance intends to use its controlling stakes to give Czech industry a much-needed shake-up (the saying goes that the Czech Republic has privatized without restructuring, while Poland has restructured without privatizing), or whether it prefers speculative trading of stakes. Either way, the conversions and a Harvard annual general meeting - also held in sleepy Velke Bilovice - which decided against distributing dividends from the dividend fund, have convinced some foreign institutional investors that Harvard has turned its back on their interests.
Wood & Company's sales and trading director, Alexander Angell, recalls that he and the brokerage's founder, Richard Wood, took three investors out to the Bahamas for a pre-arranged meeting with Kozeny earlier this year. When they arrived, though, Kozeny refused to see them.
"Kozeny has a lack of regard for large institutional shareholders in his fund," Angell says. "For a time the argument was that the reason the funds were lagging was because of the consolidation going on ... but now I have lost hope that any premiums achieved through these block corporate finance transactions will accrue to shareholders."
Among the foreign investors which have backed Harvard is the London-listed Central European Growth Fund, managed by Credit Suisse Investment Management. The fund's annual report for 1995 lists Harvard Dividend and Growth Funds among its significant new holdings for that year. As of May 31 1996 the fund's net assets stood at just less than $230 million, of which 30% was invested in the Czech Republic, almost all in equities.
Credit Suisse Investment Management's associate director, James Juracka, is keen to play down fears about the Harvard funds. "Harvard has been maligned more than it should be on the evidence so far. I haven't seen any concrete evidence that minority shareholders will suffer from the Harvard conversions. At the same time, the majority of shareholders in the Czech Republic are afraid that there will be a period of underperformance."
Positive case for conversion
The Harvard dividend fund in the Czech Republic has fallen from a price of Kr611 ($22) at the end of December to Kr321 in mid-June, and the growth fund from Kr670 to Kr354 over the same period and prior to the merger of the Harvard funds. Neither Kozeny nor other senior executives with Harvard Group in Prague were available to be interviewed for this article.
The positive case for conversion is made by Jan Valdinger, chief executive of PPF Investicni Spolecnost, whose Prvni Cesky Investicni Fond has converted into PPF Investment Holdings. Its net asset value in mid-June was Kr3.6 billion and its share price Kr399, giving a discount of 60%. ppf Investment Holdings was delisted from the main board of the pse following conversion and has subsequently relisted on the less-regulated free market.
But Valdinger says the main reason for conversion was to protect its investors as minority shareholders in other companies. Prior to the new regulations, he says, it was possible for PPF to hold 20% of a company through the fund and another 20% through a closed-end unit trust (the main differences between this and an investment fund is that only the fund is a separate legal entity and its shares have voting rights).
"Our house could invest 40% in a single company and we believe that, at this stage of Czech capital market development, it is right for an investment group to have more than 20%," he says. "We want to be active in helping managers to improve their stewardship of their companies. We want to be sure there are financial controls and management accountability, and that activities such as siphoning off profits are prevented. We don't want to be in a minority risk position and if we are limited to 20%, we could be."
Valdinger says the policy of PPF is to sell holdings when it can no longer add value to them. This is the case with its controlling stake in Slezan Textiles, which is being marketed by hsbc following general management improvements and its merger with a Czech textile printing company.
Of the remaining funds, the ones being recommended to foreign investors are the blue-chip ones managed by large domestic banks such as Komercni Banka, Ceska Sporitelna and Zivnostenska Banka. "They have quality underlying portfolios, yet are trading at huge discounts because of general uncertainty over funds," says Dan Wilson, head of research at Creditanstalt Securities in Prague. "Now the threat of conversion has subsided there is no reason why they should be trading at such large discounts and we expect to see them close up over the coming months." Wilson adds that tight liquidity in the PSE means investing in funds is the best way to get exposure to mid-size stocks such as Vertex and ZPS Zlin.
But one fund that Creditanstalt Securities will feel unable to recommend is the one still trading under the Creditanstalt name, although this is set to change shortly. This fund was the subject of a greenmail attack last year by an aggressive Czech company called Motoinvest which acquired a substantial stake and then offered to sell the shares to the managers. Two other funds to which Motoinvest had meted out the same treatment, including that of Komercni Banka, paid up; but Creditanstalt and its partners decided to sell out. "We only wanted to be fund managers, not owners," says Wilson.
Not all advisers are convinced that bank funds are the best solution to the Czech investment dilemma. One view is that some banks enjoy a lending relationship with the companies held in their funds. This deters the funds from restructuring the companies, because it could involve writing off loans held by their parent banks. Indeed, there is an argument that Czech privatization has been somewhat artificial, since great chunks of equity are held by bank funds and yet the banks themselves are still largely owned by the state.
However, whether or not the government decides to dispose quickly of its stakes (held through the National Property Fund), on at least one front, there are signs of equity being freed up for private investors. The new rules prevent funds from buying shares in companies which have more than a 25% stake in the management company. A report by Wood & Co, Landmark Legislative Changes, comments: "This forces the funds of Komercni Banka, Ceska Sporitelna and IPB to sell their stakes in parent companies. This should not be a problem for Komercni and Sporitelna as they have a relatively small portion of parent bank shares in their funds, and may place these shares out in global depositary receipts (GDRs) or sell them to the parent bank. This is not the case for IPB as the bank has an estimated 30% of its shares in the portfolios of its funds, subsidiaries and friendly related companies. This may result in selling pressure on IPB."
It may also result in a poor reception for IPB's forthcoming gdr issue, the first primary one out of the Czech Republic, and a method of investment that could increasingly appeal to foreigners as a way round the domestic difficulties.
Otherwise, if investors baulk at the funds, they will have come full circle back to investing directly in listed Czech stocks. Then they would have to tackle head-on the problems of deciphering Czech accounts. Oates of ubs quotes the example of Skoda Plzen, by most standards one of the better Czech companies, which has unconsolidated accounts consisting of 36 balance sheets and which has taken a ubs researcher three months to analyze - two months longer than usual.
Rationalizing listed stocks
On the exchange, continuous trading has been introduced for a handful of stocks and is expected to be extended eventually to all frequently traded stocks. Most investors, and the PSE itself, agree that nearly 1,800 is far too many stocks, a situation that has come about through the privatization programme which stipulated that everything had to be listed. Small family companies which rarely trade - known as black chips - are being approached by the pse and asked to delist. Pruning back to a few hundred stocks would make it easier for foreign investors to get a clear perspective on the market. To further improve conditions, there are plans to introduce derivatives.
But the real headache, even after the rules changes, is still the position of the minority shareholder in a joint stock company. Czech courts are unused to dealing with commercial cases of this type, even where the laws are in place. So far there has been only one well-known case of a minority shareholder bringing a successful court action and this was not of the type that would give foreign investors much comfort. In May the Prague regional court ruled that an extraordinary general meeting approving the sale of a 27% government stake in SPT Telecom to TelSource (the foreign arm of the Dutch and Swiss telecom companies) was invalid. The action was brought by a group of minority shareholders who were unhappy about last year's sale of the shares to a foreigner. Their sentiments may be questionable, but their legal case appeared solid as it was based on a number of technicalities, including the fact that a letter from the National Property Fund, giving the then economy minister Karel Dyba power of attorney, was dated August 24 1993. This was before the decision to privatize SPT had been taken, so, in effect, Dyba did not have the legal authority to sell the shares. The government is appealing against the ruling.
The case proves that rule of law as a way of resolving disputes rather than government fiat is the way the Czech Republic is moving. But until the method is more tried and tested investors must conclude that caveat emptor will be the way of the Czech markets for some time to come.
| Major Czech investment funds |
| Company |
Market cap |
Market cap |
Price |
NAV |
Discount |
| (kr m) |
($ m) |
(kr) |
(kr) |
(%) |
| Komercni banka if |
7,266 |
260.3 |
|
780 |
|
1,264 |
|
38.29 |
|
| IF Zivnobanka |
1,935 |
69.3 |
|
493 |
|
776 |
|
36.47 |
|
| pif |
3,951 |
141.6 |
|
592 |
|
948 |
|
37.66 |
|
| spif Cesky |
6,633 |
237.7 |
|
343 |
|
599 |
|
42.74 |
|
| spif Vynosovy |
2,997 |
107.4 |
|
155 |
|
272 |
|
43.01 |
|
| spif Vseobecny |
2,804 |
100.5 |
|
145 |
|
165 |
|
12.65 |
|
| rif |
8,679 |
311.0 |
|
905 |
|
1,637 |
|
44.72 |
|
| Rentiersky if |
1,420 |
50.9 |
|
855 |
|
1,643 |
|
47.96 |
|
| if Bohatstvi |
1,444 |
51.7 |
|
1,150 |
|
2,205 |
|
47.85 |
|
| Bankovni if |
1,632 |
58.5 |
|
1,225 |
|
2,154 |
|
43.13 |
|
| Note: All figures are calculated at $1 = kr27.911 as of May 31 1996 |
Source: Creditanstalt Investment Bank |
| Joint holdings of Harvard and Stratton |
| June 15, 1996 |
% |
| Sepap |
51 |
| Czech Ocean Shipping |
88 |
| Fatra |
50.3 |
| Sklo Union |
66.4 |
| Biocel |
37.6 |
| Prazska Teplarenska |
43 |
| mnd |
32 |
| Source: Stratton Group |
GDRs offer a solution The latest global depositary receipt (GDR) offering by a Czech company ran into a touch of controversy before it was successfully placed. Ceska Sporitelna, the Czech Republic's largest bank, as measured by total customer deposits, had wanted to use shares owned by the National Property Fund (NPF), the state holding company, as the underlying stock for its GDR issue in June.
But the government objected because it feared back-door privatization, even though the GDRs would carry no voting rights. While the Czech Republic has been one of the keenest privatizers of all the post-communist states, the three main commercial banks still have large state holdings and their disposal remains a sensitive issue. The NPF stake in Ceska Sporitelna is 45%, and release of sufficient stock to sustain the entire GDR issue would have lowered this to 37%.
In the end, the bank acquired the stock from other investors and placed GDRs representing 7.9% of outstanding ordinary shares for a total consideration of $48.5 million. The offer was jointly lead managed by Deutsche Morgan Grenfell and Bankers Trust, and placed with more than 70 investors from 13 countries.
While the issue raised no new capital, Petr Hlavacek, who is director of Ceska Sporitelna's capital investments department, says: "The purpose was to increase the profile of the company and to broaden the shareholder base."
GDRs have been slow to take off in the Czech Republic, but there are signs that they could become more popular in future as Czech corporates seek more overseas investors. For foreign investors they are a good way to get exposure to the market without having to brave the hurly-burly that has characterized the pse's development so far.
The first sponsored GDR in the Czech Republic was done for Komercni Banka a year ago and raised $32 million which was 3.2% of outstanding share capital. The authorities limit GDR issues to 10% of total shares. CSFB, which led the issue, had to work closely with the authorities to get the necessary approvals for foreigners to own shares in a Czech bank. In turn, CSFB had to get an informal agreement that the NPF would not sell any of its shares around the time of the offering. Although the Komercni Banka GDR didn't involve shares owned by NPF, the appearance of their shares "would have created an overhang in the marketplace", says Christopher Sturdy, vice-president with the Bank of New York in London, which issued the GDRs.
One irony of this deal, and a second more recent one for $55.4 million including a green-shoe option (3.6% of outstanding shares), is that since Komercni Banka is Bank of New York's sub-custodian in the Czech Republic, the underlying stock of both issues is held in Komercni Banka's vault in Prague. Secondary purchases of GDRs have taken the total number close to the 10% limit.
Looking ahead, the first capital-raising GDR out of the Czech Republic was due in the middle of this month but has been postponed to September. The issue is for Investicni a Postovni Banka (IPB) and is being lead managed by Nomura. It had to be put off because IPB has been asked by the government to assist with the restructuring of troubled insurer Ceska Pojistovna in which IPB has a stake. The decision was taken after the pre-marketing for the issue had been completed, but was felt necessary because of the questions from investors that will be raised by the restructuring. When placed, the GDR is expected to raise $50 million, about 8% of share capital, and forms part of a $163 million domestic rights issue. |