Organizational coping with institutional upheaval in transition economies

Journal of World Business 38 (2003) 314–330

Organizational coping with institutional upheaval in transition economies Kendall Roth*, Tatiana Kostova1 International Business Department, Moore School of Business, University of South Carolina, Columbia, SC 29208, USA

Abstract The radical change in corporate governance systems is fundamental to the period of institutional upheaval characterizing transition economies. Using an institutional theory framework, this paper develops a model of responses to this change. The model is tested with data from 1,723 firms in 22 countries in Central and Eastern Europe and the Newly Independent States. The results suggest that a firm’s adaptation to the new governance order will be facilitated or hampered depending on the characteristics of the institutional and organizational contexts it faces. A major implication of the study is the need to consider cultural and contextual embeddedness in explaining how governance systems transform. # 2003 Elsevier Inc. All rights reserved.

1. Introduction Organizational responses during periods of extreme institutional change are not well understood (Newman, 2000). In discussing extreme change, Greenwood and Hinings observe that neo-institutional theory is ‘‘silent on why some organizations adopt radical change whereas others do not, despite experiencing the same institutional pressures’’ (1996: 1023). They further observe that institutional theory provides insights that, if developed, may help explain organizational interpretations and responses to extreme change. Accordingly, the purpose of this study is to develop a model of organizational responses to radical change in the institutional environment. Referred to as institutional upheaval, such change requires the *

Corresponding author. Tel.: þ1-803-777-3604; fax: þ1-803-777-3609. E-mail addresses: [email protected] (K. Roth), [email protected] (T. Kostova). 1 Tel.: þ1-803-777-3553; fax: þ1-803-777-3609.

‘‘movement from one ‘template-in-use’ for organizing to another . . .’’ however, the institutional context ‘‘no longer provides organizing templates, models for action and known sources of legitimacy’’ (Newman, 2000: 605). Furthermore, even if proper ways of organizing were forthcoming from the institutional context, the new templates may be so far from the historical normative base that organizations may not have the capabilities to recognize or adopt them. Thus, an important question in this context is ‘‘how do organizations react when there is such wholesale change in their institutional environment?’’ We use institutional theory as a foundation for answering this question and suggest that in this context, the response of organizations will be determined by the nature of their embeddedness within the societal and organizational contexts (Greenwood & Hinings, 1996). We also draw from the literature on corporate governance and more particularly, corporate governance in transition economies (e.g., McCarthy & Puffer, 2002a, 2002b; Peng, 2003; Puffer & McCarthy, 2003). Corporate governance is central to the transition

1090-9516/$ – see front matter # 2003 Elsevier Inc. All rights reserved. doi:10.1016/j.jwb.2003.08.018

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to a market economy as it captures both the changes in the external institutional/governance system (e.g., courts, regulations) as well as the radical transformation of the corporate governance guiding firms’ activities (e.g., governance bodies, external control, transparency). As suggested by Puffer and McCarthy (2003: 12), ‘‘Initial efforts in the move toward responsible corporate governance included legislative, judicial, and corporate initiatives to provide investors with more disclosure, transparent information, and voice, as well as redress within the legal system.’’ The institutional framework that we apply can improve further our understanding of the corporate governance transformation in transition economies by providing theory-based explanations of important questions and phenomena that have been recognized in the governance literature. These include, for example, the different rate of change in corporate governance across countries and across firms, as well as the pervasiveness of some informal and sometimes illegitimate behaviors (e.g., bribes) in transition countries. We examine our model with 1,723 firms from 22 countries in Central and Eastern Europe (CEE) and Newly Independent States from the former Soviet Union (NIS).2 This is a particularly insightful setting as the fall of communism is well documented as institutional upheaval, with an unprecedented shock to the full set of institutional structures and organizational sectors (see Newman, 2000; Peng & Heath, 1996; Peng & Luo, 2000; Ramamurti, 2000). Not only were existing institutional entities destroyed, but fundamental values, beliefs and assumptions held by society were radically challenged. Furthermore, this change is instructive in that it occurs independent of, and exogenous to, organizations within the environment. Thus, our model and study isolates organizational activities in reaction to upheaval, where the organizations themselves do not induce the change.

2. Theoretical foundation—institutional upheaval Institutional upheaval is defined as ‘‘a rapid and pervasive change in the norms and values that underlie 2 For clarity of the presentation, throughout the paper, we will refer to these countries as ‘‘transition economies.’’

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and legitimate economic activity, which results in fundamental change in a society’s political system, its legal and regulatory frameworks, its economic system, and its financial infrastructure’’ (Newman, 2000: 603). Institutional upheaval is a wholesale change of major aspects of an institutional environment and governance systems, accompanied by extreme uncertainty, and ambiguity. Using Greenwood and Hining’s terminology, upheaval is a radical and revolutionary change (1996: 1024). Transition economies in the countries in Central and Eastern European and the Newly Independent States have been recognized as experiencing institutional upheaval as a result of the fall of communism. As noted by Newman, not only the political systems, laws, regulations, and financial markets, but also ‘‘the underlying assumptions about the purpose of economic activity were destroyed or significantly changed within a short time’’ (2000: 602). Similarly, Peng and Heath (1996) discuss the wide range of institutional changes taking place in these countries, changes that are at the very foundation of the governance systems such as the dismantling of the central planning regime, the need for a new property-rightsbased legal framework, and the transition from ‘‘statepoliced firms’’ to market-based mechanisms restricting opportunistic behavior of firms. Thus, it is not only that institutions and social structures are non-existent or in disarray, but also that the existing ones are largely inconsistent with the desired market-based economic activity. As noted by Johnson, Smith, and Codling, ‘‘cognitive processes must be put in place that are the reverse of those that led to institutionalization in the first place’’ (2000: 576). Building on ideas from institutional theory, we propose two mechanisms that can explain firms’ responses to the upheaval: institutional imperfection and institutional baggage. Institutional imperfection is the gap between the existing and the desired institutional arrangements and governance systems. It is the degree to which institutions (e.g., structures, practices, legitimating actors) are not well defined and established as well as the inconsistency between these institutions. As imperfection increases, organizational members may lack the understanding of what the desired structures and values should be, as well as the expertise about how to change the organization. Times of upheaval are characterized by significant

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Contextual Embeddedness

Firms Responses

Initial Condition

Informal Substitutes Institutional Imperfection

Current Condition Ownership Type

Deinstitutionalization Institutional Baggage

Perceptions

Effecting Mechanisms Fig. 1. Model of firm responses to upheaval.

institutional imperfection, which is likely to diminish over time as a result of the transformation of the society. Institutional baggage is determined by the strength, ingrainment, and pervasiveness of the institutional arrangements that existed prior to the radical change. Zucker observes that ‘‘every institutionalized system tends to carry ‘baggage’ of related structures and activities that become institutionalized over time . . .’’ (1991: 105). High institutional baggage implies that the establishment of a new institutional arrangement will be very difficult. As North states, ‘‘although formal rules may change overnight as the result of political and judicial decisions, informal constraints embodied in customs, traditions, and codes of conduct are much more impervious to deliberate policies’’ (1990: 6). The more ingrained and pervasive behaviors, routines, and cognitive scripts are, the more difficult it will be to destroy them and replace them with a radically different new set of scripts and behaviors. As observed by Oliver, ‘‘institutionalized values and activities will exhibit inevitable resistance to erosion or change’’ (1992: 580). She states that even if organization members recognize the need for change, or transition to a new set of values and activities, they may be immobilized by the previously institutionalized arrangements. We argue that institutional upheaval is characterized by both high institutional imperfection and significant institutional baggage. These are important to consider when analyzing firms’ behaviors during such periods of time.

3. A model of organizational responses to institutional upheaval3 In this section, we develop a model of firms’ responses to institutional upheaval using institutional imperfection and institutional baggage as explanatory mechanisms. We consider two types of behaviors that firms use to deal with these conditions—informal substitutes and deinstitutionalization. In addition, we examine firms’ perceptions (i.e., cognitive and affective responses) about the context. We propose that these organizational responses are determined by the embeddedness of the firm in the past institutional system, the current institutional system, and its ownership structure. These are referred to as initial condition, current condition, and ownership type. Fig. 1 presents the overall model. 3.1. Responses to upheaval Informal substitutes are initiatives taken by a firm to reduce or circumvent the barriers created by the underdeveloped formal institutional context (e.g., codified governance system, political, judicial, and economic rules). As summarized by Peng, transitional contexts are characterized by: (1) the lack of sufficient number of rules to govern all transactions 3

For clarity of the presentation and the subsequent empirical examination of the model, we will refer to transition economies to represent environments undergoing institutional upheaval.

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(North, 1990); (2) the lack of credible enforcement of the rules that do exist (Stiglitz, 1999); and (3) the tremendous inertia, resistance, and lack of adaptation on the part of some organizations (Newman, 2000; Oliver, 1992) (2003: 281–282). Khanna and Palepu (1997) refer to such conditions as ‘institutional voids,’ where it is likely that ‘‘managers and firms often have to perform basic functions by themselves . . .’’ (Peng & Luo, 2000: 487). Given that the formal governance systems are unable to support effective business activities, managers may have to use informal substitutes during the transition period (Xin & Pearce, 1996). Furthermore, since governments in transition economies retain considerable power, informal substitutes will often be directed towards government officials in an attempt to secure favorable treatment or ‘‘buy’’ market functions. For example, if property rights are underdeveloped and ill protected, a firm cannot rely on the formal infrastructure. It may, therefore, seek alternative ways of securing those rights, possibly through ‘‘private payments’’ to public officials and politicians (Hellman, Jones, & Kaufmann, 2000). Preliminary evidence suggests that these informal activities may be quite important, as Peng and Luo (2000) found that firm performance in transition economies is positively related to a firm’s personal ties with government officials. Deinstitutionalization generally refers to ‘‘the erosion or discontinuity of an institutionalized organizational practice’’ (Peng, 2003: 277). In this study, we use the term to describe the actions which firms take to facilitate the transformation from the old to the new institutional model or governance system. An established or accepted organizational practice loses its legitimacy such that what was once taken for granted is discontinued or abandoned (Oliver, 1992: 564). In essence, deinstitutionalization attempts to rid the firm of institutional baggage (i.e., dismantling of the old, deeply ingrained, and widely shared structures and templates). While institutional theory has recognized deinstitutionalization as part of the institutional process (e.g., Oliver, 1992; Scott, 2001), much more attention has been given to the adoption of new institutionalized structures than to the destruction of the old ones. As Zucker notes, ‘‘there has been little work on the processes by which institutions disappear’’ (1991: 105). Even when researchers have

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discussed deinstitutionalization, they have typically taken a more incremental view. Under conditions of upheaval, the need for deinstitutionalization is much more radical in nature and becomes critical and central to the transition to a new institutional arrangement. Within transition economies, the fundamental need is a change in governance systems to a market-based model.4 However, adopting new market-based practices may not be possible if little or no knowledge of these practices exists. And even if some level of knowledge exists creating a catalyst by which change is accepted throughout the organization may be quite difficult. Therefore, to effect deinstitutionalization within this context, firms will use as change agents outside entities which carry and convey the new market-based practices. Deinstitutionalization efforts will include inviting equity ownership by foreign enterprises, engaging in outside alliances, and participating in foreign markets through activities such as exporting. As previously argued, such activities will facilitate the process of change by allowing firms to experience directly the governance arrangements associated with the capitalistic model (e.g., Filatotchev, Dyomina, Wright, & Buck, 2001; McMillan & Woodruff, 2002; Peng, 2003). As asserted by Oliver, firms that ‘‘diversify their operations into other sectors or markets, particularly in different countries, are likely to be exposed to alternative organizational customs . . .’’ (1992: 577). Similarly, Newman notes the need to import organizing templates from other cultures, suggesting that ‘‘. . . for firms trying to change without a foreign partner, the use of foreign templates is not as effective, because the template might not be relevant to the culture’’ (2000: 609). The behavioral responses reflected in informal substitutes and deinstitutionalization will also be accompanied by managers’ perceptions about the changing governance system. The underdevelopment, ambiguity, and inconsistency within the environment that reflect imperfection will result in firms questioning, to various degrees, the effectiveness of the new institutional arrangements and cause firms to 4 While we recognize that the market-based models used in different economies will vary due to cultural and historic influences, we can expect that all of them will incorporate some common fundamental principles of market governance, such as transparency of business transactions expected by the World Trade Organization.

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form opinions about the different components of the governance system (e.g., courts, government, infrastructure). The institutional baggage that comes from the previous institutional regime will also impact these perceptual reactions, such that firms with a different degree of entrenchment in the previous system will form different views of the new governance arrangements. In the following sections, we develop hypotheses on the effects of the three types of embeddedness (initial condition, current condition, and ownership type) on the three sets of outcome variables (informal substitutes, deinstitutionalization, and perceptual responses). 3.2. Initial condition Initial condition characterizes the state of the institutional environment at the time of the upheaval relative to the desired end-state. As noted by Spicer, McDermott, and Kogut in reference to North (1990), there is a path-dependence in country development, such that ‘‘countries differ in their institutional conditions, and these differences have powerful effects on the subsequent evolution’’ (2000: 643). Initial conditions reflect the starting point of a transition and is essential to understanding the path dependence. In the context of transition economies, initial condition is relative to the market economy model. The European Bank for Reconstruction and Development (EBRD) views initial condition in transition economies as comprised of the level of development, trade dependence on the Council for Mutual Economic Assistance (CMEA), macroeconomic disequilibria, distance to the European Union, natural resource endowments, market memory, and state capacity (Transition Report, 2000: 21). Thus, initial condition captures both how far away from the market model the starting point is, as well as how ingrained and pervasive the old institutional and governance arrangements are. Based on their initial condition, some countries will be in a more favorable position than others. For example, a country from Central and Eastern Europe that has previously allowed for some type of private property to co-exist with the predominant state property (e.g., Poland) will have a more favorable starting position than a country that has never had alternative ownership forms (e.g., Uzbekistan).

We argue that the initial condition of a country will affect firm responses to upheaval. A favorable initial condition would mean a relatively smaller amount of radical change in the institutional environment and governance system in its movement towards the end state compared to the change needed in countries with an unfavorable initial condition. Thus, it is likely that at any given point in time during the transition period, countries with a favorable initial condition will have less institutional imperfection as it will be easier for them to build the new regulatory, economic, and legal institutional elements and become closer to the desired end state. As a result, firms operating in such environments will find less need to deal with institutional imperfections and will use less informal substitutes. In contrast, firms in countries with unfavorable initial conditions will face more institutional imperfection and are likely to use, as a result, more informal substitutes. Furthermore, an unfavorable initial condition implies a significant amount of institutional baggage due to the strong entrenchment of the previous system in cognitive and behavioral scripts (Barley & Tolbert, 1997). Johnson et al. define scripts as ‘‘the cognitive schema informing behavior and routines appropriate in particular contexts’’ (2000: 573) and refer to them as institutional templates. Institutional upheaval requires a dramatic change in the institutional templates that are operative in an environment. Deinstitutionalization implies getting rid of the old templates and creating and adopting new ones. Depending on the initial condition, firms in different counties will find it more or less difficult to initiate and move through these processes. Favorable initial conditions are characterized by less entrenched templates and a tolerance for alternative templates to co-exist or be created (Johnson et al., 2000: 576). In contrast, unfavorable initial conditions imply substantial institutional baggage, and therefore, a higher need for change and deinstitutionalization. At the same time, in the short run, firms in such environments may not be able to recognize the need for new institutional templates or be able to create them due to the high levels of ‘‘takenfor-grantedness.’’ For example, firms from the former Soviet countries, where there was no social memory of market-based templates, will find a greater need to destroy the communist-era templates in an effort to move to the new ones, compared to countries where

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some institutional memory of market structures remain. Finally, the initial condition will affect firms’ perceptions about the effectiveness of the changing governance system. Favorable initial conditions will lead to better views of the current arrangements because the current arrangements would be closer to the desired end state. Firms from unfavorable initial conditions may have a more negative attitude about the changing arrangements due to their lack of understanding of the new ‘‘rules of the game’’ and their lack of psychological readiness to mentally accommodate the new template for business activity. Therefore, we propose: H1: The initial condition of an institutional environment will influence firms’ responses to institutional upheaval. Specifically: H1a: Firms from environments characterized by unfavorable initial conditions will use more informal substitutes compared to those with favorable initial conditions. H1b: Firms from environments characterized by unfavorable initial conditions will engage in more deinstitutionalization initiatives compared to those with favorable initial conditions. H1c: Firms from environments characterized by unfavorable initial conditions will have worse perceptions about the institutional environment compared to those with favorable initial conditions. 3.3. Current condition Current condition characterizes the position of a country’s institutional and governance systems at a particular point in time after an institutional upheaval. It reflects both the nature of their trajectory towards the desired end-state5 as well as the gap that still exists between the current state and the end state of the transition (i.e., where economic transactions are governed through formal market arrangements). As 5 In this study, current condition is measured 9–10 years after the initial point of upheaval.

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North states, rule-based impersonal exchanges have been regarded as ‘‘the critical underpinning of successful modern economies involved in the complex contracting necessary for modern economic growth’’ (1990: 35). The ‘‘end-state’’ of the transition is difficult to achieve and takes substantial time. In their study of the evolution of corporate governance in Russia, Puffer and McCarthy (2003) observe different stages of transformation—commercialization, privatization, nomenclature, and statization. These authors suggest that although progressing along the trajectory towards the market governance system, Russia is still challenged by a number of problems related to the underdeveloped and incompletely enforced legal system, abuse of power, denial of minority shareholders rights, and others. Peng (2003) also takes a temporal view, proposing two stages in the transformation of the governance system, and suggesting that this process is extremely complex and lengthy and may take a generation to fully accomplish. Countries vary in the degree to which they have successfully adopted rule-based market governance systems. Some are further along the transition trajectory and can be said to have favorable current conditions (e.g., Hungary, Poland, Czech Republic). Others have a less favorable current condition as they lag behind the adoption of market-based governance arrangements. We argue that current condition affects firm responses to upheaval because of its implications for institutional imperfection. Where current condition is less favorable, there is an insufficient level of development and/or enforcement of formal arrangements capable of guiding economic transactions. The absence of a reliable formal governance system allows for, or may even necessitate, the use of alternative informal substitutes for securing support for economic activity (Peng & Heath, 1996). Such support may range from facilitating day-to-day operational business transactions (e.g., customs, court system) to shaping laws and regulations in the interest of private business entities. These may be achieved through both legitimate and illegitimate means. Firms may find it expedient or even necessary to use ‘‘private payments’’ to influence the content of laws, decrees, or regulations, such as parliamentary votes and presidential decrees to private interests, court decisions in commercial cases, Central Bank handling of funds, etc. Thus, corruption becomes a more pervasive

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practice in firms’ behavior. In summary, consistent with Peng (2003), we expect that in environments where the transition remains in its early stages, firms will use more informal substitutes of this nature. In addition to its effects on firms’ informal behaviors, current condition will also influence firms’ perceptions about the environment and the current governance system. Unfavorable current conditions will likely result in negative views about the integrity of the governance system as a whole. Specifically, firms will view governments as not sufficiently supportive of economic activity, they will not expect courts to be fair and honest, and will question the protection of property rights. Thus, we propose: H2: Current condition will influence firms’ responses to institutional upheaval. Specifically: H2a: Firms facing unfavorable current conditions will use more informal substitutes compared to firms in favorable current conditions. H2b: Firms facing unfavorable current conditions will have worse perceptions about the institutional environment and governance system compared to firms in favorable current conditions. 3.4. Ownership type Ownership type is defined by the party (e.g., the state or private individuals) that holds the property rights of a firm. Introducing new forms of ownership and changing the ownership structure of existing firms is central to the change in the governance systems in transition economies. As noted by Zahra, Ireland, Gutierrez, and Hitt (2000), the implications of changes in the ownership type or form, for example through privatization, ‘‘are so radical that a new organizational mindset is needed to comprehend and capitalize on the opportunities that become available to the firm (Smith, Golden, & Pitcher, 1999)’’ (2000: 516). Similarly, Johnson et al. assert that privatization constitutes a change in ‘‘institutional templates—change that is challenging and problematic’’ (2000: 572). We argue that ownership type has an effect on firms’ responses to the institutional context because each type has

specific constraints and is confronted with particular institutional pressures (Peng, 2003). We suggest that both previous and new ownership forms must be considered in examining firms’ responses to institutional upheaval. In the context of transition economies, the preupheaval governance system was based on state ownership. As a result of the upheaval, ownership types emerge that are generally consistent with the market economy model, in particular, private and publicly held firms. However, an important distinction regarding these new forms should be considered. Some private and pubic firms will result from privatization processes and, therefore, will have a stateaffiliated history. New private and public firms with no such former state affiliation will also emerge. Finally, some state-based firms will continue to exist after the upheaval. In the context of our study, the distinction between these three types becomes very important. This is because, while institutional imperfection and institutional baggage are general characteristics of transition environments that affect all firms, imperfection and baggage vary by these ownership types. State firms are experiencing relatively lower imperfection than both formerly state and emergent private and publicly held firms because it is the latter two that are directly confronting the market-based institutional arrangement, while the state firms are somewhat buffered from it. Furthermore, state firms likely have better support from the institutional environment, as they can leverage their relationships with influential actors in the environment. Peng and Luo note that while state firms may have lost a lot of privileges during the upheaval, they still have preferential access to government officials (2000: 489). This access or connectedness is based on both the stake of the state as an owner of the firm and the firm’s historical contacts prior to the upheaval. Some of these contacts will carry forward after the upheaval and, as a consequence, these firms will be able to correct for institutional imperfections without having to buy services or support through alternative mechanisms (e.g., offer payments to officials). In contrast, formerly state and emergent firms will use more informal substitutes because they have less ability to utilize state-based networks and, as argued by Peng, ‘‘. . . they have to rapidly build ties to establish legitimacy, thus necessitating an intense networking strategy’’ (2003: 285).

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Ownership type will also have an important influence on the institutional baggage carried by a firm and, therefore, on its deinstitutionalization initiatives. State organizations will have substantial amounts of institutional baggage. Furthermore, those private and publicly held firms that were state-owned prior to the upheaval will have more institutional baggage compared to those emerging after the upheaval, as they previously operated according to the old institutional template for economic activity grounded in the centrally-planned model. Hence, the higher need for deinstitutionalization for state-owned and previously state-owned. In contrast, organizations founded after the upheaval, will have relatively lower institutional baggage and need for deinstitutionalization. Although some elements of the old template will enter these newly founded organizations through the cognitive scripts carried by their members, there will be less residual from the old system to deal with. Thus, we expect that they will engage in less deinstitutionalization initiatives. Finally, the different ownership types will be associated with different attitudes and perceptions about the institutional environment. As argued above, state organizations will face less institutional imperfection and thus are likely to form more favorable views than others. The formerly state and emergent firms will view the environment more negatively. Both formerly state and emergent firms confront directly the new market economy and governance system and thus, are likely to report general dissatisfaction with the current context. Therefore: H3: The ownership type of a firm affects its responses to institutional upheaval. Specifically: H3a: State firms will use less informal substitutes compared to formerly state-affiliated and emergent firms. H3b: State and formerly state-affiliated firms will engage in more deinstitutionalization initiatives compared to emergent firms. H3c: State firms will have more positive perceptions about the institutional environment compared to formerly state-affiliated and emergent firms.

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4. Methods 4.1. Data and sample To examine the relationships posited in our model we used secondary data (Business Environment and Enterprise Performance Survey) collected by the World Bank, in conjunction with the European Bank for Reconstruction and Development (EBRD), Inter-American Development Bank, and the Harvard Institute for International Development.6 The data were collected in June–August 1999 in the following countries: Albania, Armenia, Azerbaijan, Belarus, Bulgaria, Croatia, the Czech Republic, Estonia, Georgia, Hungary, Kazakhstan, Kyrgyzstan, Latvia, Lithuania, Moldova, Poland, Romania, the Russian Federation, the Slovak Republic, Slovenia, the Ukraine and Uzbekistan. It consists of responses from 3,438 firms, with the range of firms by country varying from 112 to 150, with the exception of three countries with larger samples—Poland (246), Ukraine (247), and Russia (552). For the purpose of examining our model, where the interest is in organizational and not individual responses to upheaval, we removed single-owner proprietary-type operations. This resulted in a data set for our study consisting of 1,723 firms. 4.2. Measures We selected measurement items from the Business Environment and Enterprise Performance Survey database to reflect the constructs of interest. In this section, we describe the measurement item(s) for each construct. We first describe the three variables measuring organizational responses, followed by the three variables measuring the contextual embeddedness. 4.2.1. Informal substitutes Four measurement items were used to reflect informal substitutes that firms use. In the first item, respondents were asked to indicate the percentage of senior management time per year spent on dealing with 6

For a detailed description of the survey and survey methodology, visit the World Bank website http://worldbank.org/wbi/ governance/data.html.

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government officials about the application and interpretation of laws and regulations. The scale was 1: ‘‘up to 1%,’’ 2: ‘‘1–5%,’’ 3: ‘‘6–10%,’’ 4: ‘‘11–25%,’’ 5: ‘‘26–50%,’’ and 6: ‘‘more than 50%.’’ For the second item, respondents reported, on a 6-point Likert-type scale, how common it is for ‘‘firms in my line of business to have to pay some irregular additional payments to get things done.’’ The scale varied from 1: ‘‘always’’ to 6: ‘‘never.’’ The third item asked respondents, ‘‘If a government agent acts against the rules I can usually go to another official or his superior and get the correct treatment without recourse to unofficial payments.’’ The scale ranged from 1: ‘‘always’’ to 6: ‘‘never.’’ For the fourth item, respondents were asked, ‘‘When a new law, rule, regulation, or decree is being discussed that could have a substantial impact on your business, how much influence does your firm typically have at the national level of government to try to influence the content of that law, rule, regulation or decree?’’ This question was asked for the executive, legislature, and regulatory agencies. Respondents used a 6-point scale ranging from 1: ‘‘never influential’’ to 6: ‘‘very influential.’’ 4.2.2. Deinstitutionalization We measured deinstitutionalization through external affiliations or activities, by which the firm attempts to replace the old templates with new ones. We use three items that measure external affiliations through equity, export activities, and external control: (1) percentage of the organization’s capital held by a foreign company; (2) percentage of the firm’s sales represented by exports; and (3) use of external agents in the control structure of the organization (1 ¼ owner, family, manager or worker-based control; 2 ¼ bank, domestic company group, or external board of directors-based control). 4.2.3. Perceptions These measures reflect the perceptions about both the effectiveness of the new institutional and governance arrangements as well as their components. We used five indices. The first index is comprised of three items, using a 6-point scale (1: ‘‘very good,’’ 6: ‘‘very bad’’), measuring the overall quality and efficiency of services provided by the Government, Parliament, and Central Bank. The second index is comprised of four

items (1: ‘‘very good,’’ 6: ‘‘very bad’’) measuring the overall quality and efficiency of services provided by public health care, education/schools, police, and military. The third index asked respondents to indicate how often (1: ‘‘always,’’ 6: ‘‘never’’) they associate the following descriptions with the court system in resolving business disputes: fair and impartial, honest/ uncorrupted, quick, affordable, consistent/reliable, and able to enforce its decisions. The fourth index asked respondents to indicate the extent to which they agree (1: ‘‘fully agree’’ and 6: ‘‘strongly disagree’’) that ‘‘the legal system will uphold their contract and property rights in business disputes.’’ The final index comprised five items indicating how problematic (1: ‘‘no obstacle,’’ 4: ‘‘major obstacle’’) each of the ‘‘following are for the operation and growth of your business’’: customs/foreign trade regulations in your country, labor regulations, foreign currency/exchange regulations, environmental regulations, and tax regulations/administration. 4.2.4. Initial condition The initial condition measure was taken from the EBRD Transition Report (2000). This report provides an initial condition index for 1990, the start of the upheaval period. The index is based on each country’s level of development, trade dependence on CMEA, macroeconomic disequilibria, distance to the European Union, natural resource endowments, market memory, and state capacity. Examining the measure for the countries in our sample indicated that it did not meet normal distribution assumptions. The distribution was basically bimodal. Thus, consistent with EBRD, we classified countries into two groups—with favorable or unfavorable initial condition prior to the upheaval (see Table 2 for the lists of countries). 4.2.5. Current condition As an indicator of the progress that countries have made on their transition paths towards a market economy, World Bank analysts have developed a measure referred to as ‘‘state capture’’ (Hellman et al., 2000). In capture economies, where state capture is high, ‘‘public officials appear to have created a private market for the provision of normally public goods (e.g., the security of property and contract rights) and rent-seeking opportunities which a relatively

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4.2.6. Ownership type Respondents indicated if their firms were originally private from the time of start-up, or if they were a result of the privatization of a state-owned firm. They also reported if they were a state-owned firm and, if not, whether the legal ownership of the firm was privately- or publicly-held (listed on a stock exchange). Using the responses to these two questions, we categorized ownership type as: (1) state, (2) private/publicly-held, but formerly state-owned, (3) emergent private/publiclyheld.

small share of firms can obtain’’ (Hellman, Jones, Kaufmann, & Schankerman, 2000: 3). In high state capture environments, private firms have the ability to shape and affect the formation of ‘‘the rules of the game’’ (e.g., laws, regulations) or to avoid them. This is mostly done through private payments. Thus, high state capture reflects a deviation from the transition towards a market economy. State capture is measured as the extent to which the following activities have a direct impact on business activities in a given country: sale of parliamentary votes on laws to private interests, sale of presidential decrees to private interests, Central Bank mishandling of funds, sale of court decisions in criminal cases, sale of court decisions in commercial cases, and illicit contributions paid by private interests to political parties and election campaigns. An analysis of this measure also indicated that the distribution was not normal. Therefore, the measure was transformed and, consistent with the EBRD Transition Report (2000), we classified countries into two groups—with favorable or unfavorable current condition (see Table 3 for the lists of countries).

4.3. Analysis To test our hypotheses, we conducted a series of multivariate analysis of variance (MANOVA) procedures. We first verified that a significant main effect existed for the full model. However, to avoid loss of information due to missing observations, each set of hypotheses (H1, H2, H3) was examined with a separate MANOVA procedure for each main effect. As appropriate, post hoc analyses (using Duncan’s multiple range test, with significant group differences

Table 1 Means, standard deviations, and correlations Variable

Mean SD

Informal substitutes 1. Time with 2.72 1.42 government officials 2. Bribery 4.48 1.55 3. Negotiated 3.71 1.69 enforcement 4. Influencing 2.22 0.99 government Deinstitutionalization 5. Foreign 4.21 17.07 ownership 6. Exporting 10.82 23.51 7. External control 1.49 0.50* Perceptions 8. Government services 9. Public services 10. Legal system 11. Property rights 12. Institutional obstacles *

p < 0:05;

**

1

2

0.11*** 0.02

0.24***

0.11***

3

4

0.03

0.12***

0.06*

0.003

0.002

0.08 0.02

0.03 0.18***

0.03 0.06

5

6

7

0.04 0.13**

0.10***

0.22***

0.23***

0.11

0.06*

0.04

0.08*

3.47 3.93 3.90 2.09

0.95 1.05 1.90 0.65

0.13*** 0.08** 0.09*** 0.11***

0.31*** 0.19*** 0.16*** 0.22***

0.14*** 0.28*** 0.18*** 0.09***

0.01 0.08 0.03 0.06

0.05 0.06* 0.02 0.03

0.06 0.06 0.02 0.05

0.04 0.08* 0.09* 0.004

p < 0:001.

10

11

0.62*** 0.42*** 0.27*** 0.28***

0.42*** 0.29*** 0.26***

0.28*** 0.23***

0.14***

0.15*** 0.14*** 0.06

1.19

***

9

0.01

3.62

p < 0:01;

8

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set at the p < 0:05 level) were conducted to examine differences between groups.

5. Results The descriptive statistics and correlations for the variables are reported in Table 1. The results of the MANOVA procedures are reported in Tables 2 through 4. 5.1. Initial condition The first hypothesis concerns the influence of initial condition and is reported in Table 2. For H1a, there was a significant main effect (F ¼ 26:88, p < 0:001). Firms from environments characterized by unfavorable initial conditions reported spending more senior management time dealing with government officials, Table 2 MANOVA results—initial condition Variable

Initial conditiona Favorable

Informal substitutes Time with government officials Briberyb Negotiated enforcement Influence government Deinstitutionalization Foreign ownership Exports External controlc Perceptionsd Government servicesy Public servicesy Legal systemy Property rights Institutional obstacles y

F

Unfavorable

2.26

3.03

86.04***

4.65 3.73 2.09

4.27 3.70 2.38

15.77*** 0.21 21.92***

7.81 19.37 1.44

3.45 7.56 1.52

18.30*** 80.76*** 8.14**

3.29 3.12 3.75 3.07 2.16

3.73 3.68 3.91 3.53 2.08

24.29*** 67.81*** 4.16* 20.67*** 0.14

p < 0:10; * p < 0:05; ** p < 0:01; *** p < 0:001. a Favorable initial condition: Albania, Bulgaria, Croatia, Czech Republic, Hungary, Poland, Romania, Slovak Republic, Slovenia. Unfavorable initial condition: Armenia, Azerbaijan, Belarus, Estonia, Georgia, Kazakhstan, Kyrgyzstan, Latvia, Lithuania, Moldova, Russian Federation, Ukraine, Uzbekistan. b Lower values indicate more bribery. c 1: internal; 2: external. d Higher values indicate more negative perceptions.

using higher levels of payments, and having greater influence on business-related governmental activities compared to firms from favorable environments. There was no difference in the negotiated enforcement variable between the two groups. Based on these results, support exists for H1a, as firms from unfavorable environments were found to use more informal substitutes compared to firms from favorable environments. An overall main effect was found concerning deinstitutionalization activities (F ¼ 34:08, p < 0:001). Firms from unfavorable conditions reported lower levels of foreign ownership, lower levels of exports and higher use of external control, compared to firms from favorable initial condition environments. With the exception of the use of external control these results are in the opposite direction than posited in our hypotheses. Therefore, our results generally do not support H1b. Compared to firms from favorable initial conditions, firms from unfavorable conditions were also expected to have worse perceptions about the institutional and governance environment (H1c). The main effect was significant (F ¼ 18:27, p < 0:001) and for four of the five variables (institutional obstacles was not significant), firms from unfavorable initial conditions reported higher dissatisfaction with the components of the new institutional system compared to firms with favorable initial conditions. This finding provides strong support for H1c. In summary, our overall conclusion is that the initial condition of an institutional environment does influence firms’ responses to institutional upheaval. 5.2. Current condition Our second hypothesis examines the influence of current condition. The analysis of this hypothesis is reported in Table 3. For H2a, there was a significant main effect (F ¼ 5:51, p < 0:001). Firms from environments characterized by high state capture reported spending more senior management time dealing with government officials and using higher levels of bribery and negotiated enforcement compared to firms from low capture environments. There was no difference in the use of influence on businessrelated governmental regulation activities. Based on these results, support exists for H2a as firms from unfavorable current conditions generally used more

K. Roth, T. Kostova / Journal of World Business 38 (2003) 314–330 Table 3 MANOVA results—current condition Variable

State capturea

F

Favorable Unfavorable Informal substitutes Time with government officials Briberyb Negotiated enforcement Influence government

2.64

2.90

10.12**

4.57 3.57 2.35

4.28 3.79 2.26

11.45*** 5.30* 2.56

Perceptionsc Government servicesy Public servicesy Legal systemy Property rights Institutional obstacles

3.19 3.21 3.63 3.01 2.11

3.77 3.59 3.98 3.55 2.12

41.95*** 28.98*** 21.11*** 27.54*** 0.02

y

p < 0:10; * p < 0:05; ** p < 0:01; *** p < 0:001. a Favorable current condition (low state capture): Albania, Armenia, Belarus, the Czech Republic, Estonia, Hungary, Kazakhstan, Lithuania, Poland, Slovenia, Uzbekistan. Unfavorable current condition (high state capture): Azerbaijan, Bulgaria, Croatia, Georgia, Kyrgyzstan, Latvia, Moldova, Romania, Russian Federation, Slovak Republic, Ukraine. b Lower values indicate more bribery. c Higher values indicate more negative perceptions.

325

informal substitutes compared to firms from favorable environments. A significant main effect was found concerning the perceptual response (F ¼ 11:30, p < 0:001). Firms in high capture environments reported higher dissatisfaction with the components of the new institutional arrangements compared to low capture environments, with the exception of institutional obstacles, where there was no difference. Overall, this finding provides support for H2b. In summary, based on the results shown in Table 3, we conclude that the current condition of a country has a significant effect on firms’ responses to institutional upheaval. 5.3. Ownership type The third hypothesis suggests that the ownership type of a firm will influence the response of the firm to institutional upheaval. The analysis examining this effect is shown in Table 4. For H3a, there was a statistically significant main effect (F ¼ 12:01, p < 0:001). State firms reported more time spent with government officials compared to emergent firms. Bribery varied between each type, with emergent

Table 4 MANOVA results—ownership type Variable

Ownership type State (n ¼ 541)

Informal substitutes Time with government officials (e) Bribery (c)a Negotiated enforcement (a) Influence government (d) Deinstitutionalization Foreign ownership (a) Exports External control (b)b Perceptionsc Government services (a) Public services (a) Legal system (a) Property rights (a) Institutional obstacles (a)

F Former state (n ¼ 624)

Emergent (n ¼ 558)

2.94 4.78 3.43 2.48

2.78 4.44 3.90 2.25

2.70 3.97 3.75 2.17

2.91* 28.13*** 8.55*** 9.97***

1.54 37.46 1.71

13.36 37.53 1.62

9.90 31.30 1.36

8.59*** 2.09 20.36***

3.19 3.28 3.68 3.02 1.98

3.68 3.45 3.90 3.50 2.22

3.76 3.61 3.96 3.49 2.13

16.05*** 7.06** 5.00** 10.03*** 8.01***

Duncan’s test: (a) state < former state and emergent; (b) emergent < former state and state; (c) state < former state < emergent; (d) emergent and former state < state; (e) state > emergent. * p < 0:05; ** p < 0:01; *** p < 0:001. a Lower values indicate more bribery. b 1: internal, 2: external. c Higher values indicate more negative perceptions.

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firms reporting the highest level of bribery, while state-owned firms reported the lowest level. Former state and emergent firms reported higher use of negotiated enforcement compared to state firms and state firms reported having greater influence on businessrelated governmental activities compared to both formerly state-affiliated and emergent firms. Thus, the results are mixed for H3a, with the bribery and negotiated enforcement variables as expected, the time spent with government officials and the influence government variable significant, but in the opposite direction of what was posited. For the deinstitutionalization hypothesis (H3b), the overall effect was significant (F ¼ 45:57, p < 0:001). The former state and emergent firms reported a significantly higher level of foreign ownership compared to state firms. The emergent firms reported the lowest level of exports. The state firms reported the highest use of external control and the emergent firms reported the lowest use of external control. Thus, our findings provide moderate support for H3b. Consistent with our expectations, state and former state firms engaged in more deinstitutionalization activity in the form of external control and exporting than emergent firms. However, counter to our expectations, state firms had the lowest level of foreign ownership. The final hypothesis (H3c) suggests that state firms will have more positive perceptions about the environment than both former state and emergent firms. This hypothesis is supported, as the main effect is significant (F ¼ 4:80, p < 0:01) and each component of the institutional context is viewed more favorably by state firms than either formerly state-affiliated or emergent firms.

6. Discussion and conclusions We conducted this study to better understand the responses of organizations to institutional upheaval, particularly the fall of communism in transition economies, which led to a radical change of the corporate governance systems in these countries. Our model and findings provide an explanation of why the liberalization and privatization of these economies has not resulted in a fully developed market-based governance arrangement. This study also attempts to explain why firm responses to these changes will vary.

Our theorizing and examination of these issues was guided by institutional theory, which we believe provides a very insightful approach. 6.1. Contribution and future research 6.1.1. Initial condition Generally consistent with our model, the results suggest that firm responses to institutional upheaval are influenced by three types of embeddedness (initial condition, current condition, and ownership type). Initial condition has a strong effect on responses to upheaval, particularly the use of informal substitutes and perceptual responses. Unfavorable initial conditions are associated with actions that circumvent, or attempt to correct, the institutional imperfection and lead to worse/more negative perceptions about the institutional and governance contexts. It is important to reiterate that the initial condition is captured at a point in time that precedes the organizational response measurement by approximately a decade. Despite this time lag, the organizational responses are quite distinguishable. This result suggests that the embeddedness of firms within their institutional context, even after extreme and radical change, has a lasting and pervasive influence. Our study not only confirmed arguments and observations offered in the governance literature on transition economies (e.g., McCarthy & Puffer, 2002a; Peng, 2003), but it also attempted to provide a theoretical explanation of this effect. Although the upheaval dismantled the old institutional arrangements, the ability of firms to embrace new institutional templates appears to be constrained by their initial starting point. This result, the importance of the initial condition, is also a potentially important result for institutional theory and research. While institutional theory clearly recognizes the influence of conditions exogenous to an organization, less attention is given to their initial state. If a similar initial state leads to isomorphism among organizations (in addition to current institutional pressures), then paying more attention, both theoretically and empirically, to this initial state is important to understanding institutional processes and outcomes. Scott observes that ‘‘empirical studies of deinstitutionalization are relatively rare’’ (2001: 183). While we attempted to provide some insight into this activity, our results concerning deinstitutionalization responses

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are mixed. As expected, compared to favorable initial conditions, unfavorable conditions were associated with a higher use of external control. Counter to our expectations, these firms had a lower level of foreign ownership and export activities. The results for ownership type were also mixed. A possible reason for these results may be the limitations due to the use of secondary data to measure deinstitutionalization activities. In addition, foreign investment decisions are not fully determined by the focal firm. In part, investments will flow to firms in attractive markets, firms in progressive transitional environments, and firms that have the potential to produce products appealing to outside markets, even though other firms may need them more to be able to deinstitutionalize. Furthermore, firms may seek outside investors for reasons different from deinstitutionalization, such as raising capital when the local financial markets are underdeveloped (Hitt, Dacin, Levitas, Edhec, & Borza, 2000). Finally, we should note that there might be a disconnect between the need for deinstitutionalization and the actual deinstitutionalization activities. It is possible that firms with the highest need for deinstitutionalization may in fact be in the worst position to take such actions because of inertia and other constraints. We would call for future research to further develop and examine deinstitutionalization in the context of upheaval. 6.1.2. Current condition We also found that current condition influences organizational responses to upheaval, such that firms from unfavorable countries use more informal substitutes and have worse perceptions about the institutional arrangements compared to firms from favorable countries. This result, combined with the findings concerning initial condition, supports the proposition that organizations are indeed attempting to correct for institutional imperfection that results from upheaval. The use of informal substitutes apparently compensates for the underdeveloped institutional and governance systems, as previously suggested by Peng (2003), Peng and Heath (1996), North (1990), Xin and Pearce (1996). However, such informal strategies might be inconsistent with the market model and may actually impede the establishment of the new governance structures, norms, and value. Thus, while understandable, such informal substitutes (e.g., using bribes to

327

secure economic transactions or purchase favorable treatment) can be detrimental or can change the transition trajectory. Further examination of this complex transition process as well as the possibilities to proactively speed it up would be of great theoretical and practical significance. 6.1.3. Ownership type We found support for the importance of ownership type as well. State firms generally use less informal substitutes than former state and emergent firms. These firms do not engage in more deinstitutionalization activities. Presumably they are being somewhat buffered from the upheaval such that they either confront less imperfection or the imperfection has little direct effect on their activities. As a consequence, these firms may feel less of a need to change old templates. This sustained embeddedness is thereby accompanied with relatively favorable perceptual responses with respect to the institutional and governance systems in the environment. Observing state firms over a longer period of time would be insightful in understanding if this position is effective and sustainable, or if these firms are simply postponing or prolonging deinstitutionalization and change processes. The latter would be consistent with Peng’s (2003) idea that the reforms in a transition economy may advance to a degree (the ‘‘inflection point’’) where the formal arrangements of the new governance system are so well developed that firms using the informal networks (i.e., ‘‘informal substitutes’’ in our terminology) will find themselves no longer efficient and will have to transform accordingly. Perhaps an indirect approach to assessing this issue is through examining performance. We did not develop performance hypotheses because we were primarily interested in firm responses to upheaval and because performance is influenced by a wide set of variables. However, it is interesting to observe that the average sales growth for the three years preceding the survey varied significantly (F ¼ 4:20, p < 0:002), with state firms (8.96%) and former state firms (11.13%) having lower reported sales growth compared to emergent firms (31.33%). This finding is robust even after controlling for organizational size and age. Thus, consistent with Newman’s (2000) basic argument, the embeddedness in the old system seems to hinder firms from deinstitutionalizing and may

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result in an inability or inhibited capability to adapt. As she observes, ‘‘It is difficult to learn from experience during periods of significant institutional change, because past experience is no longer an appropriate guide for future action (Weick, 1979) . . . when institutional-level change is too extreme, when the underlying values, ideologies, and norms in society are in question, and when the economic and political systems are in disarray, it is difficult for managers to coalesce around a new set of value commitments and almost impossible to find the ‘right’ new organizing template’’ (2000: 605). State firms may be exemplifying this description. It is interesting that former state and emergent firms appear to develop similar responses to upheaval (including informal substitutes, deinstitutionalization activities, and perceptions), which we did not anticipate. We expected a difference based on the organizational history, and therefore the larger institutional baggage, of the former state firms. An interesting explanation of this similarity might be that the institutional baggage is determined not only by the organizational history but is mostly ingrained in the cognitive templates carried by the individual members of a society. Thus, individuals who are starting new firms, may bring with themselves essentially the same values and beliefs as individuals moving into privatized firms. The interesting theoretical implication of this observation is that the actual building block for radical change might be the individual. Therefore, the organizational and government initiatives aimed at improving the transition after upheaval should be focused on changing individual values and beliefs. An interesting distinction between the former state and emergent firms is that emergent firms use more bribery and less external control agents. This is probably so because emergent firms lack the external informal networks and thus are more vulnerable in the changing environment. It is also possible that emergent firms are in a way experimenting or devising their own templates, which may require the purchase of additional institutional support through informal (or illegitimate) activities. 6.2. Conclusions and implications Considering institutional theory, this paper suggests the potential use of alternative explanatory mechanisms

for explaining institutional effects. Unlike the mechanisms of coercive, mimetic, and normative pressures that are mostly used in institutional theory-based models, we employed the notions of institutional imperfection and institutional baggage. The corresponding needs to correct imperfections and deinstitutionalize, thereby, provided a means to frame firm responses as they are striving to survive amid the turmoil. We believe these mechanisms hold promise for future research examining firms behaviors during radical change, when the institutional environment is underdeveloped and there is a limited understanding of what is legitimate as well as who are the legitimating actors. Addressing corporate governance, our paper attempts to provide an explanation of ideas that have been previously observed and described in the literature. For example, Johnson et al. (2000) observe that the implicit assumption underlying privatization seems to be that once organizations are subject to new market forces, these forces will naturally initiate desired changes in work processes. Based on our study, we can suggest that much of what firms actually do will be determined by the contexts in which firms are embedded, and that under certain conditions, firms will engage in behaviors counter to the marketbased model. This will be particularly likely when the initial position of the firm is substantially different from the desired end state, when firms are deeply embedded in that initial state, and when there is an inadequate level of understanding of the desired end model. While these inconsistencies may be considered temporary experimental activities, they may also be viewed as new emerging scripts or templates. This may require, in turn, further shocks and deinsititutionalization processes before the desired marketbased templates and arrangements will be established. Newman (2000: 602) asserts that extreme changes in the institutional context may inhibit organizational transformation, as the upheaval hinders organizational learning. Without adequate organizational elites or formulated institutional pressures (e.g., regulation), perhaps such learning is based on expedient economic survival rather than an idealized market model. These ideas are important to consider when studying corporate governance. They are in line with those who emphasize the cultural constraints on corporate

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governance models in general, and the ones developing in transition economies, in particular (e.g., McCarthy & Puffer, 2002a). Apparently, governance is best understood by also understanding the cultural and historical context. This would include not simply end-states of changing governance systems, but also the dynamics and path dependency of moving towards this end-state. Consequently, it may be more important to give additional attention to the specific conditions surrounding the evolution of corporate governance in a particular country. Furthermore, any cross-country comparative discussions should be substantiated with a deeper examination of the contextual factors shaping the national governance systems. Thus, using common and simple indexes to compare the progress that countries and firms have made to transform themselves towards the market model may not adequately reflect the actual national systems of corporate governance. Research based on multiple disciplines and perspectives may be much more adequate to study the complex issues of corporate governance in transition economies.

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