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Journal of Comparative Policy Analysis: Research and Practice 4: 143–163, 2002 c 2002 Kluwer Academic Publishers. Printed in The Netherlands. Establishing Legitimacy in Emerging Markets: An Empirical Comparison of the Warsaw, Budapest, and Prague Stock Exchanges STEPHEN S. STANDIFIRD stephen.standifi[email protected] College of Business and Economics, Western Washington University, Bellingham, WA 98225-9077 MARC WEINSTEIN [email protected] Management Department, Charles H. Lundquist College of Business, 1208 University of Oregon, Eugene, OR 97403-1208 Key words: Warsaw, Budapest, Prague, market, regulation, legitimacy Abstract The purpose of this analysis is to investigate the influence of economic and sociological institutional constraints in determining the legitimacy of firms. This study specifically looks at the importance of regulatory and transnational institutional constraints for firms traded on the Warsaw, Budapest, and Prague stock exchanges. The results indicate that a well-regulated securities environment has a direct impact on the ability of firms to establish organizational legitimacy. We also find that, lacking local regulation, firms can increase their legitimacy by adopting international accounting standards. Thus, we find support for the assertion that both economic and sociological “solutions” to the problem of legitimacy are appropriate for firms operating in an emerging market. Introduction Firms in transition economies confront difficult challenges when attempting to establish legitimacy in financial markets. These companies operate in an environment characterized by economic uncertainty (Papaioannou and Duke, 1997) and immature institutional structures (Mobius, 1995; Papaioannou and Tsetsekos, 1997). Actions of both local governments and individual firms are needed to compensate for the general lack of confidence concerning organi- zations in emerging markets. This article empirically investigates this issue by examining the impact of state regulation and the adoption of international ac- counting standards on the ability of firms traded on the Warsaw, Budapest, and Prague stock exchanges to establish organizational legitimacy. We choose to focus on organizational legitimacy because of its importance for publicly traded firms. Increased legitimacy enhances the ability of firms to attract (Selznick, 1949; Tolbert and Zucker, 1983) and retain (Hirsch, 1975) resources and has been found to have a direct effect on organizational

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Page 1: Establishing Legitimacy in Emerging Markets: An Empirical Comparison of the Warsaw, Budapest, and Prague Stock Exchanges

Journal of Comparative Policy Analysis: Research and Practice 4: 143–163, 2002c© 2002 Kluwer Academic Publishers. Printed in The Netherlands.

Establishing Legitimacy in Emerging Markets:An Empirical Comparison of the Warsaw,Budapest, and Prague Stock Exchanges

STEPHEN S. STANDIFIRD [email protected] of Business and Economics, Western Washington University, Bellingham, WA 98225-9077

MARC WEINSTEIN [email protected] Department, Charles H. Lundquist College of Business, 1208 University of Oregon,Eugene, OR 97403-1208

Key words: Warsaw, Budapest, Prague, market, regulation, legitimacy

Abstract

The purpose of this analysis is to investigate the influence of economic and sociological institutionalconstraints in determining the legitimacy of firms. This study specifically looks at the importanceof regulatory and transnational institutional constraints for firms traded on the Warsaw, Budapest,and Prague stock exchanges. The results indicate that a well-regulated securities environmenthas a direct impact on the ability of firms to establish organizational legitimacy. We also find that,lacking local regulation, firms can increase their legitimacy by adopting international accountingstandards. Thus, we find support for the assertion that both economic and sociological “solutions”to the problem of legitimacy are appropriate for firms operating in an emerging market.

Introduction

Firms in transition economies confront difficult challenges when attemptingto establish legitimacy in financial markets. These companies operate in anenvironment characterized by economic uncertainty (Papaioannou and Duke,1997) and immature institutional structures (Mobius, 1995; Papaioannou andTsetsekos, 1997). Actions of both local governments and individual firms areneeded to compensate for the general lack of confidence concerning organi-zations in emerging markets. This article empirically investigates this issue byexamining the impact of state regulation and the adoption of international ac-counting standards on the ability of firms traded on the Warsaw, Budapest, andPrague stock exchanges to establish organizational legitimacy.

We choose to focus on organizational legitimacy because of its importancefor publicly traded firms. Increased legitimacy enhances the ability of firmsto attract (Selznick, 1949; Tolbert and Zucker, 1983) and retain (Hirsch, 1975)resources and has been found to have a direct effect on organizational

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survivability (Baum and Oliver, 1991, 1992; Rao, 1994). Thus, for the firms tradedon these nascent exchanges, the ability to establish legitimacy may be criticalfor future growth and survivability.

The comparison of the Warsaw, Prague, and Budapest exchanges providesan excellent opportunity to study organizational legitimacy. The evolution ofthese exchanges produces an unusual natural experiment to study this par-ticular issue. Each exchange was founded at about the same time. Each wasfounded in a comparable economic environment and encountered the samechallenge of facilitating the transition from state-controlled to free market econ-omy. Finally, each exchange has been subject to a distinct regulatory regime,which has differentially impacted the ability of the firms traded on theseexchanges to establish organizational legitimacy.

We begin by discussing the basic aspects of organizational legitimacyfollowed by a discussion of how firms establish legitimacy where regulatoryconstraints are lacking. This leads us to a discussion of the distinction betweeneconomic and sociological solutions to the problem of legitimacy. We then out-line the basic aspects of the Warsaw, Budapest, and Prague Stock Exchangesfollowed by specific hypotheses concerning how firms traded on these ex-changes establish themselves as legitimate. We follow this with a discussion ofthe methods and results of an analysis designed to investigate the hypotheses.We conclude with a discussion of the implications of the research.

Theoretical background

Organizational legitimacy

Suchman (1995, p. 574) defines legitimacy as “a generalized perception orassumption that the actions of an entity are desirable, proper, or appropri-ate within some socially constructed system of norms, values, beliefs, anddefinitions. . . . Legitimacy is socially constructed in that it reflects a congru-ence between the behaviors of the legitimated entity and the shared (or theassumedly shared) beliefs of some social group.” The source of socially con-structed norms, values, beliefs, and definitions can be found in the institu-tional environment of firms. We adopt here a definition of institutions similarto that proposed by Berger and Luckmann (1966) and consistent with thedefinition provided by North (1991). Specifically, institutions are socially con-structed realities that provide a basis for sense making (Weick, 1979) by in-stitutional participants. “Institutions are the humanly devised constraints thatstructure political, economic and social interaction” (North, 1991, p. 97). Insti-tutions establish norms and values by providing postconscious scripts (Tolbertand Zucker, 1996) that guide behavior. In addition, institutions shape beliefs byproviding preconscious scripts (Tolbert and Zucker, 1996) that shape the cog-nition (Powell and DiMaggio, 1991; Zucker, 1977) of institutional participants.Institutions establish definitions that increase comprehensibility (Kieser, 1989).

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In short, institutions provide socially constructed order in an otherwise complexenvironment.

The mere existence of certain institutional structures can increase the legit-imacy of compliant firms. According to Berger and Luckmann (1966, p. 55),institutions “by the very fact of their existence, control human conduct by set-ting up predefined patterns of conduct.” Institutional influences result in in-creased organizational isomorphism (DiMaggio and Powell, 1983). Increasedorganizational isomorphism decreases organizational variation and, in doing so,precludes the possibility of certain efficient organizational forms. However, iso-morphism also increases the ability to predict the actions of others (Berger andLuckmann, 1966; North 1990) and, in doing so, increases perceived legitimacy.

Institutions establish formal constraints, thereby reducing complexity and in-creasing the predictability of all affected organizations (Commons, 1950; North,1990). The very fact that a firm lists on the New York Stock Exchange (NYSE),for example, suggests that it conforms to some clearly defined and widely ac-cepted set of standards. The expected compliance to these standards assuresa certain level of “appropriate” behavior by the individual firm, which enhancesorganizational legitimacy. The existence of a well-regulated exchange such asthe NYSE is sufficient to engender increased confidence in all firms listed onthis stock exchange.

The ability of a regulatory institution such as the NYSE to engender confi-dence depends somewhat on the legitimacy of the institution itself. Institutionsthat “formally” exist but that are incapable of influencing the actions of in-stitutional participants do little to assure standard operating procedures and,therefore, have little ability to enhance the legitimacy of affiliated organizations.Conversely, regulatory institutions that have a history of forcing compliance toinstitutional norms and regulations, such as the NYSE, are capable of enhanc-ing the legitimacy of all affiliated organizations. Thus, the ability of a regulatoryinstitution to influence common operating procedures constitutes the essenceof constraints associated with economic institutions (North, 1990).1

In summary, individual firms establish legitimacy by conforming to a sociallyconstructed system of norms, values, beliefs, and definitions. The standardby which individual firms are evaluated is embedded in the institutions thatdominate the environment. The mere existence of certain regulatory institutionscan increase individual firm legitimacy provided that the dominant institutionsthemselves are deemed legitimate and are capable of influencing the actionsof affiliated organizations.

Legitimacy in the absence of institutional stability

Institutions provide the foundation for organizational legitimacy. What happenswhen the institutional infrastructure is itself disrupted? How do individual firmsestablish legitimacy in such a chaotic environment? For example, how do firms inemerging economies establish legitimacy as macro-institutional forces are

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continually redefined? Different variants of institutional theory provide differentinsights into these questions.

Economic institutionalists (e.g., Commons, 1950; North, 1990; and to a lesserextent Williamson, 1985) would argue that new institutional constraints mustemerge to replace the outgoing infrastructure. Such an argument (an argu-ment embraced by organizations such as the IMF) suggests that individualfirms will be incapable of appearing legitimate until a new regulatory regime isestablished. Therefore, governments must intervene by establishing appropri-ate macro-economic policy and erecting the appropriate regulatory structures.Only when such constraints are in place can the individual firm hope to emergeas internationally legitimate. The demands placed on troubled economies by theIMF as a condition for aid is an excellent example of institutional economics inaction.

Some would argue that regulatory institutional constraints can have adetrimental impact, since regulators can be unduly influenced by competi-tor firms (Easterbrook and Fischel, 1991), which have incentives to reducecompetition by limiting entry of new firms (Stigler, 1971). Advocates of marketregulation, on the other hand, note that many countries have uncertain prop-erty rights and limited judicial enforcement. In these instances, strong marketregulation would reduce information asymmetry and lead to more transpar-ent firm valuation (Simon and Shleifer, 1999; Coffee, 1999). Thus, consistentwith the perspective of institutional economists, advocates of market regula-tion would argue that regulatory institutional constraints are necessary if firmsfrom emerging markets are to establish themselves as legitimate.

Sociological institutionalists (e.g., Meyer, 1994a, 1994b; Powell, 1991; Powelland DiMaggio, 1991; and, to a lesser extent, Hirsch, 1985; Scott, 1994, 1995)present an alternative solution. Institutional forces, according to theseresearchers, transcend international boundaries. According to Meyer (1994a),even national institutions are subjugated to a rationality that is now worldwide.In an increasingly global economy, national institutions are being displaced bynew forms of institutional regulation. Mere affiliation with national institutionsthat require compliance to national regulations may be insufficient for firmsto gain legitimacy. Rather, organizations can attain legitimacy by conformingto wider, transnational norms and expectations. Meyer (1994a, p. 53) is mostexplicit in this position when he suggests that “The effect (of a modern rational-ized environment) is that organizational structure tends to be less predictable insectoral and national environmental factors and more predictable in worldwidetrends.”

Accounting is one area where the transnational convergence to a particularstandard is well established. The International Accounting Standards Commit-tee (IASC), founded in 1973, is supported by 122 accounting organizations and91 countries worldwide. The International Accounting Standards (IAS) intro-duced by the IASC are endorsed by the International Federation of Accoun-tants and are increasingly seen as a world standard for accounting. Through the

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development of IAS, the accounting standards deemed most desirable, proper,or appropriate are increasingly internationally defined. As Meyer (1994b, p. 122)notes, “Environments that create organizational elements, such as accounting,and accountants, make it easy and necessary for organizations to use them,and treat organizations that have them as by definition more legitimate thanothers.”

The use of international accounting standards is deemed desirable, proper,and appropriate regardless the motivation for adopting the standard. The deci-sion to adopt international accounting standards can be pre- or postconsciouslyinfluenced. That is, the firm may decide to adopt the standard due to subcon-scious institutional influences (Tolbert and Zucker, 1996). Alternatively, the firmmay consciously decide to adopt international accounting standard predomi-nantly for strategic reasons (Tolbert, 1985). The impact on the legitimacy of thefirm is the same regardless. The use of the internationally defined IAS shouldincrease a firm’s legitimacy independent of local institutional forces and themotivation behind the adoption of such standards, according to Meyer.

We argue that both economic and sociological “solutions” to the problemof legitimacy are appropriate for firms operating in an emerging market underdiffering conditions. Where national regulations are well developed and enforce-able, they will enhance the legitimacy of affiliated organizations. Factors inde-pendent of regulatory institutions diminish in importance as these institutionsgain credibility and establish the criteria for appropriate firm behavior. Firmstraded on the NYSE, for example, establish legitimacy by conforming to NYSEexpectations and maximizing on the organizational attributes made salient bythe institutional environment. Thus, in the case of the well-regulated NYSE,financial performance is the strongest factor contributing to organizational le-gitimacy. Where institutional regulation is weak or absent, as is the case in manytransition economies, an alternative template is needed to assess an organi-zation’s legitimacy. In this instance, international institutional forces emergeas important. Thus, firms from developing nations lacking regulatory institu-tions can establish legitimacy by emulating internationally recognized norms ofbehavior (e.g., by adopting IAS).

National regulatory regimes and the establishmentof organizational legitimacy

East Central Europe

During 1989, East Central Europe (ECE) witnessed one of the most remarkabletransformations in sociopolitical history. Entire political systems were trans-formed from socialism to democracy virtually overnight. The economic transfor-mation that followed represents one the most remarkable economic transitionsin modern history. Fixed prices, protective trade, and governmental subsidieshave all but vanished in most ECE countries. Mass privatization, individual sale,

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or liquidation have thrust all but the largest and most strategic organizationsinto the rapidly expanding private sector. By 1997, individual firms throughoutECE found themselves directly exposed to international competition with littleor no protection being offered by national governments.

Many of the firms throughout ECE required significant improvement to suc-cessfully compete with their newly defined international rivals. The youthfulnessand limited cash flows associated with most ECE firms virtually demanded thatany improvements be funded through the influx of new capital. The ability toattract investment capital was critical to the survivability of the individual firm.This, in turn, depended largely on the ability of the firm to appear legitimate tothose responsible for distributing capital (i.e., investors). Therefore, we specifi-cally examine the factors that lead to increased legitimacy among investors forfirms traded on the Warsaw, Budapest, and Prague stock exchanges at the endof the year 1996.2

The Warsaw Stock Exchange

The reopening of the Warsaw Stock Exchange (WSE) began with Polishpolicymakers reviewing various international models. After considering a va-riety of options, WSE founders ultimately decided to adopt a French modeland began developing the appropriate mechanisms with the aid of Societede Bourses and the French depository SICOVAM. In March 1991, the PolishParliament passed the Act on Trading in Securities and Trust Fund. The actestablished the groundwork for core capital market components: brokeragehouses, the stock exchange itself, trust funds, and most importantly, the PolishSecurities Commission. On April 12, 1991, the act formally establishing the WSEwas signed into law. Initial trading on the WSE began four days later.

To many, the WSE was considered a model exchange. In October 1994, theWSE was the first exchange in ECE to become a full member of the InternationalFederation of Stock Exchanges (FIBV). Described as professional and well reg-ulated, “the Warsaw Stock Exchange is the darling of the region, an integral partof the country’s financial sector” (Smith, 1997). The most critical component ofthe WSE’s success seemed to be the aggressive nature of the Polish Securi-ties Commission (PSC). In 1995 alone, the PSC initiated 20 proceedings andlevied 10 fines in cases where firms were found not to have made appropriatedisclosure under the law—this in a year when less than 60 firms were listedon the exchange. According to William Philbrick, editor of “Taking Stock” andformer securities lawyer for the U.S. Securities and Exchange Commission, “Adiligent enforcement system is vital to the transparency and legitimacy of anystock market. . . . The successes of the Polish stock market are due to the ex-emplary oversight of the Polish Securities Commission and the Warsaw StockExchange” (Philbrick, 1996, p. 6).

The WSE had distinguished itself as an important regulatory institution intwo important ways. First, internationally recognized securities and exchange

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regulations clearly defined behavior that was deemed desirable, proper, orappropriate. More importantly, the exchange (with the aid of the PSC) had shownitself to be both willing and capable of exercising its influence in shaping theactivities of subjugated firms. Having established itself as a credible regulatoryinstitution, the WSE ensured a modicum of financial transparency. Thus, a firm’sfinancial performance, the cornerstone of all well-regarded securities markets,will have dominated organizational legitimacy for firms traded on the WSE atthe time of this study, while international influences such as the adoption of IASwill have proved less important.

Hypothesis 1a. Firm financial performance will be positively related to thelegitimacy of firms traded on the Warsaw Stock Exchange.

Hypothesis 1b. The firm’s adoption of International Accounting Standards willnot be positively related to the legitimacy of firms traded on the Warsaw StockExchange.

The Budapest Stock Exchange

The Budapest Stock Exchange (BSE) reopened its doors on June 21, 1990. TheBSE was the first stock exchange in ECE to be commissioned after 1989. The le-gal framework for the exchange was established in the Securities and ExchangeAct of 1990. The BSE had been innovative and aggressive in many ways. Forexample, the BSE was the first exchange in ECE to introduce futures tradingand was the originator of the regional index known as the Central EuropeanStock Index (CESI). In March 1995, the BSE became the first exchange in theregion to launch a derivatives market.

One area where the exchange had not been overly aggressive, however, is inthe area of enforcement. Notes Smith (1997), “A major problem with Hungaryis a lack of legal recourse for investors who lose money buying into compa-nies that put out overly ambitious corporate projections.” In the early years ofthe Budapest Stock Exchange, the State Securities and Exchange Supervision(SSES) supervised the exchange. By end of the year 1996, securities regulationfell under the jurisdiction of the State Banking and Capital Markets Supervision.The establishment of the State Banking and Capital Market Supervision orga-nization was supposedly an attempt to increase regulatory oversight. However,according to Taking Stock Central Europe, a joint publication of the Budapest,Warsaw, and Prague Business Journals,

As a regulator of capital markets, the new agency is quite frankly, a joke. . . .Time after time, circumstances have proven that a stock market cannot sus-tain healthy positive returns over the long-term without an effective regulatorymechanism. The party at the BSE is bound to end unless serious efforts aremade to provide the regulatory body with sufficient resources and support tocarry out its legislative mandate (Taking Stock Central Europe, 1997, p. 4).

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The BSE had made significant progress in establishing itself as a viableregulatory institution. Sound regulations combined with innovative mechanismsmade the BSE one of the more interesting exchanges in ECE. Nonetheless, theinability of the BSE to consistently demonstrate a willingness or capacity toexercise its influence impaired the ability of the BSE to serve as a legitimatinginstitution.

Lax enforcement of exchange regulations and the lack of transparency infinancial reporting and other management activities meant that traditional met-rics of financial performance, such as profitability, would be insufficient in al-lowing firms traded on the BSE to establish legitimacy. In the absence of reliableand transparent financial indicators, other autonomous actions taken by the firmfacilitated the establishment of organizational legitimacy. The adoption of inter-national standards such as the IAS demonstrates conformance to internation-ally defined norms of appropriate behavior and thus should emerge as importantin determining organizational legitimacy for firms traded on the BSE in 1996.

Hypothesis 2a. Firm financial performance will not be related to the legitimacyof firms traded on the Budapest Stock Exchange.

Hypothesis 2b. The firm’s adoption of International Accounting will be posi-tively related to the legitimacy of firms traded on the Budapest StockExchange.

The Prague Stock Exchange

The Prague Stock Exchange (PSE) started trading on April 6, 1993, makingthe PSE the youngest of the three exchanges. Despite its youthfulness, thePSE boasted the largest number of listings at over 900 firms and the largestmarket capitalization in the region at 29% of the country’s GDP at the time ofthe analysis.

The PSE performed quite well during the mid-1990s. The number of tradesconducted on the PSE in 1996 more than doubled compared with 1995. Still,the vast majority of PSE firms remained inactive. Taking Stock Central Europe(1997), for example, focused only on the 45 most liquid firms, ignoring the vastmajority of firms traded in 1996. Investors also appeared to ignore the vastmajority of firms traded on the PSE. Indeed, most firms on the exchange re-mained completely inactive. Moreover, investors became increasingly weary ofthe exchange in general, given the complete lack of effective regulation andenforcement. As noted in Taking Stock Central Europe,

The Czech Republic lacks effective governance, which translates into a lackof transparency. There has been outright and widespread fraud in the mar-ketplace...Much to the astonishment of international financial participants,there are still people in the Czech government who spew rhetoric trivializingthe need for an independent regulatory body (Taking Stock Central Europe,1997, p. 5).

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The PSE had made significant progress in the area of introducing firms into themarket place. However, unlike both the BSE and WSE, the PSE lacked effectiveregulation, let alone enforcement. This lack of regulation meant that firms tradedon the PSE could not establish legitimacy merely by being affiliated with thisexchange. Moreover, information concerning the accounting standard used byfirms traded on the PSE was not readily available to investors. Therefore, in-vestors were forced to rely on the information provided by the individual firmas a signal of legitimacy. This information was inherently suspect in 1996 giventhe lack of regulation and enforcement. Thus,

Hypothesis 3. Firm financial performance will not be positively related to thelegitimacy of firms traded on the Prague Stock Exchange.

Comparisons and contrasts

The WSE, BSE, and PSE each provided a tremendous boost to the transitionfrom command-and-control to market-based economies. Still, there existed aninstitutional coherence associated with the WSE that was not found in eitherthe BSE or the PSE. The respect and prestige of the WSE afforded firms tradedon the exchange an increased legitimacy. This situation was in direct con-trast to both the BSE and PSE. As observed by the U.S. International TradeAdministration,

Poland’s security laws are commonly lauded by Hungarian observers for theirstrictness and transparency, while Prague gets criticized for lack thereof.Hungary’s market also gets criticized for a lack of transparency, a problemthe GOH (Government of Hungary) hopes to change with its new security law(USITA, 1996).

Lacking appropriate enforcement mechanisms, firms traded on the BSE wereforced to look elsewhere for legitimacy. Both basic regulation and enforcementwere needed before the firms traded on the PSE could gain legitimacy from theiraffiliation with this exchange. Since the legitimacy afforded by the exchangeitself has a direct influence on individual firms,

Hypothesis 4a. The individual legitimacy of firms traded on the WSE will behigher on average than for firms traded on the BSE or PSE.

Hypothesis 4b. The individual legitimacy of firms traded on the PSE will belower on average than for firms traded on the WSE or BSE.

Methods

Data collection and analysis

Data for our analysis come from end of the year 1996 reports for firms tradingon the Warsaw, Budapest, and Prague Stock Exchanges and is taken directly

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from the annual publication Taking Stock Central Europe (1997). The companiescovered include all firms traded on the WSE’s main and parallel markets, allcategory A and B companies traded on the BSE, and the 45 most liquid firmstraded on the PSE.

A potential bias is introduced by focusing on only 45 PSE firms. However,the bias is toward stronger performing firms, firms that tend to be more legiti-mate than the market average. To the extent that a bias exists, the bias shouldmake it more difficult to distinguish between the legitimacy of firms traded onthe PSE and firms traded on the WSE and BSE. Any finding that suggests differ-ences in legitimacy between the three exchanges (Hypothesis 4) remains valid.Therefore, the 45 most liquid PSE firms are used for this analysis.

Variable operationalization

Measures of legitimacy. Legitimacy has proved a difficult construct tooperationalize (Suchman, 1995). However, reputation (Fombrun, 1996) serves asan appropriate proxy measure and has been widely used in empirical research.Organizational reputation is defined as an assessment of an organization’s de-sirability in a given environment by a specific entity external to the organization(Standifird, 2001; Fombrun, 1996; Rao, 1994; Weigelt and Camerer, 1988). Rao(1994) provides the most concrete argument linking organizational reputationand legitimacy. As suggested by Rao (1994, p. 31),

[I]f models of reputation emphasize a tight coupling between endowmentsand evaluations, then models of legitimacy direct attention to the collectiveprocesses by which reputation is created and sustained. . . . More concretely,legitimation consists of creating an account of an organization, embeddingthat account in a symbolic universe, and thereby endowing the account withsocial facticity.

Legitimating activities become the determinants of organizational reputationas symbolic activities are translated into the social facts that define a firm asreputable. Thus, reputation serves as an appropriate measure of legitimacy inthat reputation represents the outgrowth of a firm engaging in activities that aredeemed as legitimate.

Reputational capital, specifically, is used as the measure of reputation withinvestors for this analysis. Reputational capital, according to Fombrun (1996),can be measured by taking the market value of the firm minus its replacement(asset) value (M − B). The stock price of a firm represents investors’ collectiveassessment of a firm’s future worth (Milgom and Roberts, 1992). Therefore, itwould seem logical to use market value (number of shares multiplied by stockprice per share) as the measure of reputation with investors. However, stockprice is not an accurate reflection of reputation with investors in that stock pricetakes into account the value of firm assets. Reputation with investors is better

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assessed as the market value of a firm minus asset value (Fombrun, 1996). Theresidual (“reputational capital,” according to Fombrun) represents the collectiveconfidence of investors in the ability of an organization to perform above andbeyond the capabilities embedded in the organization’s assets.

A similar measure, often found in the financial reports issued by individualfirms, is Market/Book Value (M/B). In essence, M/B measures percent excessvalue, while M − B measures absolute excess value. As a percentage, M/Bis a more conservative estimate of reputation. Fombrun (1996) prefers M − Bfor this very reason. However, M/B measures are readily available for com-parative analysis while M − B measures are not. Moreover, Fama and French(1995) find that U.S. firms with high M/B values are, on average, more profitablethan low M/B valued firms four years prior to the observed M/B values. Thefinding that more profitable U.S. firms consistently rate higher in terms of M/Bvalues provides strong empirical support for M/B as a measure of reputation.Therefore, M/B is used as the surrogate measure of legitimacy in this analysis.

Firm financial performance. Firm financial performance is included toinvestigate Hypotheses 1a, 2a and 3 and to serve as a control variable wheninvestigating the remaining hypotheses. Performance is measured as net prof-its (loss) of the individual firm for one year prior to the measure of M/B and isreported in million USD to allow for comparative analysis. The profits variablemeasurement of one year is a rather short time frame when discussing firmprofitability in general. However, this rather short time frame is appropriate forthis particular analysis, given that this was the information generally availableto investors in these markets at the time of the study.3

Use of International Accounting Standards. The variable of IAS usage isincluded to investigate Hypotheses 1b and 2b. Firms traded on both the WSEand BSE are required to use either Polish or Hungarian accounting standards,respectively. In addition, some firms chose to adopt International AccountingStandards (IAS). Firms that report the use of IAS are coded as one. Firms thatdo not report the use of IAS are coded as zero.

Exchange. The exchange where a firm is listed is identified in order toinvestigate Hypotheses 4a and 4b. A dummy variable (WSE) was created forfirms traded on the WSE. Firms traded on the WSE are coded as one and aszero otherwise. An additional dummy variable (PSE) was created for firms tradedon the PSE. For this variable, firms traded on the PSE are coded as one and aszero otherwise.

Predictions concerning the effect of size are uncertain but potentiallysignificant and thus must be controlled for. Size, however, is implicitly con-trolled for by using the ratio of M/B values versus the absolute measure ofM − B. Therefore, no additional variable is included to control for size.

Means, standard deviations and the correlation matrix for firms traded on theWSE, BSE, and PSE, respectively, are provided in Tables 1, 2, and 3. Means,

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Table 1. Means, standard deviations, and correlations for the WSEa.

Variable Mean s.d. Y1 Y2

Y1. Profits 7.82 18.03(mil $)

Y2. Standard .16 — .4021b

(1 = IAS, 0 = Polish)

X1. M/B 2.18 2.01 .0132 −.0550(%)

a N = 83b p < .01

Table 2. Means, standard deviations, and correlations for the BSEa.

Variable Mean s.d. Y1 Y2 Y3

Y1. Profits 7.11 20.01(mil $)

Y2. Standard .58 — .2956b

(1 = IAS, 0 = Hungarian)

Y3. Book Value 100.88 335.332 .9296c .1855(mil $)

X1. M/B 1.5 1.38 .0703 .4389c −.0776(%)

a N = 40.b p < .10.c p < .01.

Table 3. Means, standard deviations, and correlations for the PSEa.

Variable Mean s.d. Y1

Y1. Profits 21.07 57.06(mil $)

X1. M/B 0.99 0.80 −.1043(%)

a N = 45.

standard deviations, and the correlation matrix for the combined data set of allfirms traded on the WSE, BSE, and PSE are reported in Table 4.

Analysis and results

OLS regressions were performed for firms from the WSE and BSE, respec-tively, to investigate Hypotheses 1a, 1b, 2a, and 2b (Table 5). An additional

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Table 4. Means, standard deviations, and correlations for the combined data from theWarsaw, Budapest, and Prague Stock Exchangesa.

Variable Mean s.d. Y1 Y2 Y3

Y1. Profits 9.44 25.16(mil $)

Y2. PSE .24 — .1314b

(1 = PSE, 0 = Other)

Y3. WSE .51 — −.0664 −.5772c

(1 = WSE, 0 = Other)

X1. M/B 1.74 1.68 −.0150 −.2231c .2638c

(%)

a N = 162b p < .10.c p < .01.

Table 5. Results of OLS regression for the Warsaw andBudapest Stock Exchanges (M/B as the dependent variable)a.

Warsaw Budapest

Profits (in mil $) .04 −.06

Standard (1 = IAS, 0 = other) −.07 .46b

Adjusted R2 −.020 .153

F .181 4.52c

aStandardized regression coefficients are shown.b p < .01.c p < .05.

regression was performed for the data set comprising firms from all threeexchanges to investigate Hypotheses 4a and 4b (Table 6). In each of the re-gression analysis, M/B was treated as the dependent variable. When look-ing at firms from the individual exchanges, both profits and the use of IASwere included as independent variables. When we examined the data setcomposed of firms from all three exchanges, the independent variables usedwere profitability and whether or not the firm was listed on the WSE orPSE.

The results of OLS regression for firms traded on the WSE in 1996 (seeTable 5) show a lack of support for the importance of profitability (contraryto Hypothesis 1a) and a lack of support for the importance of the adoptionof IAS (in support of Hypothesis 1b). Neither profits (p = .731, β = .04) nor IAS(p = .557, β = −.07) proved significant, while the overall model proved insignifi-cant (F = .181, p = .835). Thus, we find support for the assertion that the firm’sadoption of International Accounting Standards will not be statistically signifi-cant in determining the legitimacy of firms traded on the WSE in 1996

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Table 6. Results of backwards stepwise regressiona comparing the Warsaw,Budapest and Prague Stock Exchanges (M/B as the dependent variable)b.

Model 1 Model 2 Model 3

Profits (in mil $) .01

PSE (1 = PSE, 0 = other) −.11 −.11WSE (1 = WSE, 0 = other) .20c .20c .26d

Adjusted R2 .060 .065 .064

F 4.41d 6.64d 11.96d

aProbability of F entry = .05, removal = .1.bStandardized regression coefficients are shown.c p < .05.d p < .01.

(Hypothesis 1b) and a lack of support for the assertion that firm financialperformance will be statistically significant and positive in determining the le-gitimacy of firms traded on the WSE in 1996 (Hypothesis 1a).

The results of OLS regression for firms traded on the BSE in 1996 (see Table 5)show a lack of support for the lack of importance of profitability (in support ofHypothesis 2a) and support for the importance of the adoption of IAS (in sup-port of Hypothesis 2b). The influence of profits proves insignificant (p = .675,

β = −.06), while the influence of IAS proves significant (p = .005, β = .46). More-over, the overall model proves significant (F = 4.52, p = .017). Thus, we find sup-port for Hypothesis 2a, which postulates a relationship between firm financialperformance and legitimacy. We also find support for Hypothesis 2a, whichsuggests that the firm’s adoption of International Accounting Standards willbe statistically significant in determining the legitimacy of firms traded on theBSE.

The possibility exists that book value is calculated differently using differ-ent accounting procedures, thereby explaining the results supportingHypothesis 2b. This potential complication was checked by calculating bookvalue for firms traded on the BSE in 1996 and comparing the results with the useof IAS. Book value was calculated as Total Assets – Liabilities (long and shortterm). If accounting procedures explain the statistical relevance of the posi-tive influence of adopting IAS, then book value should be negatively correlatedwith the use of IAS (thus resulting in increased M/B, since price is independentof accounting standards). In fact, to the extent that a correlation does exist, itsuggests the exact opposite (see Table 2). The statistically insignificant (p = .31)positive correlation of .1855 between book value and IAS increases the salienceof any findings concerning the positive effect of BSE firms adopting IAS.

The lack of a statistically significant correlation (−.1043, p = .511) betweenprofits and M/B for firms traded on the PSE in 1996 suggests that profits donot influence the legitimacy for PSE as predicted in Hypothesis 3. Thus, firmfinancial performance proves insignificant in influencing legitimacy for firms

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traded on each of the three exchanges (in support of Hypotheses 2a and 3 andin contradiction of Hypothesis 1a).

The regression analysis comparing the three exchanges supportsHypothesis 4a but not Hypothesis 4b (see Table 6). There does not appear to bea statistically significant negative effect associated with being listed on the PSEin 1996 (p = .253, β = −.11), nor do profits prove significant (p = .870, β = .01).However, the advantage of being listed on the WSE in 1996 is significant(p = .032, β = .20), while the overall model is statistically significant (F = 4.41,

p = .005). The results of the backwards stepwise regression provide even greatersupport for Hypothesis 4a. Here, the advantage of being listed on the WSE in1996 (the only variable remaining in the model) is quite pronounced (p = .0007,

β = .26), further lending support to the assertion that the existence ofstrong regulatory institutions increases legitimacy for all subjugatedfirms.

An alternative explanation to the “exchange influence” argument presentedhere is that other macro economic variables (e.g., the “country effect”) accountfor the increased legitimacy of firms traded on the WSE in 1996. However,support for the “country effect” seems weak in the face of macro economicdata. By virtually all macro-economic measures, both Hungary and the CzechRepublic were outperforming Poland during the time period of this analysis. In1996, GDP per capita in Hungary and the Czech Republic were approximately6827 USD and 11,122 USD, respectively, compared to Poland’s 5939 USD.In 1996, unemployment in Poland was 13.2% compared to Hungary’s 10.7%and the Czech Republic’s 3.5%. Inflation was slightly higher in Hungary (23%)but significantly lower in the Czech Republic (8.8%) compared with Poland(19.9%) (Vienna Institute for Comparative Economic Studies, www.wiiw.ac.at).In 1996, Foreign Direct Investment (FDI) per capita in Hungary was over threetimes larger than in Poland, while FDI per capita in the Czech Republic out-paced Poland at a rate of 2 to 1 (Styczek, 1998). The only area where Polandconsistently outperformed both Hungary and the Czech Republic was GDPgrowth, with 1996 GDP growth rates of 6%, 4.8%, and 1.3% for Poland, theCzech Republic, and Hungary, respectively (Eurostat, 2001).4 To the extentthat a country effect does exist, it would seem to suggest increased legit-imacy for Czech and Hungarian firms in 1996. Therefore, any findings sug-gesting increased legitimacy for firms traded on the WSE in 1996 are betterattributed to the effect of the exchange itself and not to general economicconditions.

Discussion and conclusion

Our aim in this article has been to empirically investigate the effectiveness ofactions taken by both local governments and individual firms in an attempt toestablish firms traded on the Warsaw, Budapest, and Prague Stock Exchangesas legitimate. The basic premise of this analysis is that both economic and

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sociological “solutions” to the problem of legitimacy are appropriate underdiffering conditions.

The support for Hypothesis 2b (the importance of IAS for firms traded onthe BSE in 1996) suggests that, in the absence of effective regulation, individ-ual firms can increase legitimacy by linking to international institutional forces.Thus, consistent with the position of sociological institutionalists, individualfirms increase legitimacy by conforming to wider, transnational norms and ex-pectations. The support for Hypothesis 4a (the importance of the WSE in de-termining firms traded on the WSE in 1996 as legitimate) suggests that theintentional construction of regulatory institutional constraints can have a sig-nificant effect on the legitimacy of compliant firms. This finding, combined withthe lack of IAS influence for firms traded on the WSE in 1996, suggests that,consistent with the position of economic institutionalists, local government canhave a significant effect on the legitimacy of individual firms by erecting theappropriate regulatory institutions.

More interestingly, the finding of support for the importance of IAS whenlooking at BSE firms and the increased legitimacy afforded firms traded onthe WSE in 1996 suggests that both economic and sociological “solutions” tothe problem of legitimacy are appropriate under differing conditions. Whereregulatory institutions are well developed and capable of exercising influence(as was the case of the WSE), the existence of strong regulatory influencesincreases legitimacy for all compliant firms. Where regulatory influences arenot as well developed (as was the case of the BSE), worldwide institutionalforces emerge as important.

The support of Hypothesis 4a (positive influence of being listed on the WSEin 1996) suggests an important role for regulatory enforcement. Neither thePSE nor the BSE had done an effective job at enforcing regulations. The WSEwas distinctive given its aggressive stance in the area of enforcement. Boththe BSE and the WSE had fairly sound securities regulation. The PSE wasunique among the three exchanges for its lack of sound regulation. However,only WSE firms were distinguished as statistically significantly different (interms of legitimacy) from the total population of WSE, BSE, and PSEfirms.

The lack of regulation associated with PSE firms did not appear significantenough to distinguish PSE firms as less legitimate. Thus, the existence of reg-ulatory institutions lacking effective enforcement is only marginally differentthan the lack of regulatory institutions altogether. However, the aggressive en-forcement associated with the WSE did appear significant enough to distinguishWSE firms as more legitimate. Therefore, the existence of regulatory institutionseffectively enforced is significantly different than the existence of regulatory in-stitutions lacking in the area of enforcement (North, 1990). In short, the ability ofa regulatory institution to enforcement norms of behavior appears to be a crit-ical factor in the ability of the institution to effectively influence the legitimacyof subjugated firms.

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The support for Hypothesis 2a and 3 (the lack of importance of profitability forBSE and PSE firms) and the lack of support for Hypothesis 1a (the importance ofprofitability for WSE firms) is itself quite interesting, especially given the stronglink between profitability and M/B values found by Fama and French (1995)when investigating U.S. firms. This peculiar finding seems to suggests that,while traditional performance variables may be important in some environments(e.g., in the U.S.), institutional forces dominated the determination of legitimacyin the hyperturbulent environment of ECE. Thus, individual organizations copedwith the ongoing uncertainty in ECE by linking to wider society values (Emeryand Trist, 1965), defined either internationally by organizations such as the IASCor locally through the establishment of regulatory institutions such as the WSE.

While this study sheds significant light on the importance of institutional con-straints, there are a variety of limitations associated with the analysis that shouldbe noted. In this particular analysis, we use reputation as a surrogate measure oflegitimacy. We do so due to the inherent complexities associated with measur-ing legitimacy directly (Suchman, 1995). Still, the inability to measure legitimacydirectly does suggest a potential weakness of the analysis. In our analysis, weuse Market/Book to measure reputation. Ideally, we would have used Marketminus Book (Fombrun, 1996). Unfortunately, we were unable to do so due todata constraints. Finally, we provide a somewhat limiting measure of firm fi-nancial performance in that we are only able to measure financial performancefor one year prior to the analysis. While these data are consistent with infor-mation available to investors, the lack of more complete financial data doesconfound the discussion of firm financial performance in general. Despite thelimitations, this particular analysis does provide an initial step in understandingthe influence of institutional constraints in general.

As with many studies, the current study creates a host of additional researchquestions. For example, what explains the lack of significance for any of theactivities of firms traded on the WSE in 1996? The finding that neither perfor-mance nor international institutional forces seem to influence legitimacy forfirms traded on the WSE suggests a far more complicated and potentially in-teresting story. Perhaps Poland has reached a phase in the transition wherethe link to international influences is no longer critical, yet performance aloneis not sufficient in determining a firm as legitimate. The question remains asto what fills the void in the absence of international or performance effects.Clearly, more research on the determinants of legitimacy in Poland is warranted.Indeed, a follow-up study that looks at how firms establish themselves as legit-imate in each of these markets seems warranted now that the stock exchangesthemselves have matured.

What influence, if any, does international economic turmoil such as the crashof the Hong Kong market in 1997 have on the ability of firms in ECE to es-tablish legitimacy? It is difficult to predict with certainty the response of in-dividual investors. It seems reasonable to suggest, however, that regulatoryinstitutions will increase in importance in the wake of international instability.

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According to Wilbur L. Ross, Jr., of Rothschild Inc., investors will be “more risk-averse, reversing their recent mad rush into obscure foreign markets” (BusinessWeek, December 29, 1997, p. 120). Only those markets capable of engenderingconfidence through sound regulatory mechanisms will be capable of sustain-ing foreign investment as investors look to decrease uncertainty in the face ofincreased international turmoil.

The results presented here are based on the comparison of three of the moredeveloped capital markets in ECE. How do firms in less developed capital mar-kets establish themselves as legitimate? Increased insight might be gained byinvestigating less developed exchanges such as the Bucharest and MoscowInternational Stock Exchanges, where the importance of international institu-tional influences are expected to be more pronounced. The primary challengeof such an analysis is in finding comparable data. With a less developed ex-change, information is either lacking or highly suspect. Still, the results of thisanalysis suggest that the effort necessary to find or create comparable data forless developed exchanges seems warranted.

At what point do the advantages of collective behavior supersede the ad-vantages of individualistic competition? The results of this analysis suggestan opportunity for individual ECE firms to exploit ongoing market uncertaintyby adopting certain internationally prescribed practices (e.g., by adopting IAS).Such an individualistic approach appears most advantageous where regulatorystructures are less developed. However, the results presented here also sug-gest an important role for collective behavior in establishing the appropriateregulatory structures. The legitimacy afforded firms that are traded on a highlyregulated exchange seems to supersede the benefit associated with the individ-ualistic behavior. Thus, it may be to the advantage of the individual organizationto put aside competitive behavior and, instead, focus on the development ofregulatory constraints. The exact point at which the benefits of collective ac-tion supersede the advantages of individualistic behavior is a question open tofuture research.

When asked what, in addition to firm performance, might influence his eval-uation of an individual firm, a senior equity analyst in Warsaw was quick torespond, “Well, nothing else should influence my evaluation, now should it”(personal interview, Nov. 5, 1997). The adoption of internationally prescribedpractices or the effects of listing on a specific exchange may not affect hisanalysis. However, they do seem to affect his clients, who appear to give anedge, albeit weak, to firms that trade on a specific exchange or to firms thatadopt IAS even when such activities do not seem to have a direct influence onfirm performance. To suggest that financial performance alone determines thelegitimacy of an individual firm would be as naive as to suggest that financialperformance itself is unimportant. Clearly, nonperformance variables are impor-tant to the survival of the individual firm. What remains to be discovered is whenand how performance significantly influences the determination of legitimacyin emerging capital markets.

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Acknowledgments

We wish to thank Dan Moshavi, Rick Mowday and the three anonymousreviewers for their insightful comments on earlier drafts of this article. We alsowish to thank Paul Hirsh and Alan Meyer for many conversations that help shapethe ideas that lay the foundation for this particular analysis.

Notes

1. We do not discussion in this particular analysis the legal formation of institutional constraintssince our focus is more on the effect of institutional constraints currently in operation, regardlessof the source. For those interested in the legal foundation of institutional constraints, an excellentexample of this literature can be found in La Porta et al. (1998).

2. Our intent was to go collect data as close to the formation of the stock exchanges as possible soas to capture exchanges in their formative years. However, reliable data for a sufficient numberof firms for the three stock exchanges were not available until the end of the year 1996. As such,we use the year 1996 as the focus of our analysis.

3. It was possible to get additional information concerning profitability for some firms traded onthe Warsaw, Budapest, and Prague Stock Exchanges. However, for many of the firms tradedon these exchanges, accurate information concerning firm profitability was particularly difficultto find in 1996. Indeed, the data source used for this particular analysis was considered oneof the more accurate sources of information, according to broker analysts interviewed by oneof the authors during an extended visit to Warsaw, Poland, in Fall 1997. Correspondingly, thismeasurement of firm financial performance is an accurate reflection of the information shapingthe perception of investors in 1996.

4. Conditions had changed dramatically by 1998 (Eurostats, 2000). In 1998, GDP growth rates forPoland, Hungary, and the Czech Republic were 4.8%, 4.9%, and –2.2%, respectively. However,at the time of this analysis, GDP growth rates for the Czech Republic were in line with those ofPoland and Hungary.

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Stephen Standifird is Assistant Professor of Business Policy at Western Washington University.Dr. Standifird has a Ph.D. from the University of Oregon, an MBA from Northwestern University, anda B.S. in chemical engineering from Purdue University. His research focuses on the determinantsof organizational reputation, the importance of reputation as related to electronic commerce, andthe role of institutional characteristics in shaping organizational activity.

Marc Weinstein is Assistant Professor of Management at the Lundquist College of Business,University of Oregon. A graduate of MIT’s Sloan School of Management, Prof. Weinstein examinesin his work the role of national institutions in structuring firm-level activities. Much of his researchexplores this question in the transition economies of central Europe.