State Owned Enterprises

This post explains the state-owned enterprise (SOE) governance and accountability framework in some more detail than my posts on state sector board governance (which noted that SOEs operate under a different legal framework from Crown entities in New Zealand) and on Crown companies (which noted that SOEs are just one category of company owned by the Crown).  It emphasises the features of SOEs that distinguish them from privately-owned companies.

There are 10 active SOEs:

Among them, SOEs generate annual revenues of around $5 billion and they own assets totalling around $36 billion, mostly in NZ Post, Transpower, KiwiRail and Landcorp.  [Link to details]

As limited liability companies under the Companies Act 1993, these SOEs are subject to the same legal and accountability framework as other privately-owned commercial businesses in New Zealand.  This is overlaid with the requirements of the State Owned Enterprises Act 1986 and some other public law, such as the Public Audit Act 2001 and the Official Information Act 1982.  Other practical elements of the framework are set out in the Owner’s Expectations Manual.

The SOE Act (s 4) reinforces the applicability of the private sector framework by providing that:

The principal objective of every State enterprise shall be to operate as a successful business and, to this end, to be—

(a)  as profitable and efficient as comparable businesses that are not owned by the Crown; and

(b)  a good employer; and

(c)  an organisation that exhibits a sense of social responsibility by having regard to the interests of the community in which it operates and by endeavouring to accommodate or encourage these when able to do so.

Adoption of the private sector legal and accountability framework has had a number of advantages:

  • It draws on the existing and well-established framework for the management, governance, accountability and ongoing ownership of the commercial businesses.
  • It provides a reasonably clear and explicit separation between the role of ministers as shareholders of the companies on behalf of the Crown, and the board and management of the companies.
  • The limited liability nature of the companies limits the commercial risks to the Crown and imposes greater financial discipline by reducing the likelihood of lenders to assume any implicit Crown guarantee.
  • It provides access to a pool of directors and executives who are familiar with a common commercial framework and so their expertise is more easily transferable between SOEs and privately-owned commercial businesses.

The private sector legal and accountability framework has also been adopted for a range of other businesses owned by the Crown that are not SOEs, including the Crown Research Institutes, the Schedule 4A companies, and the mixed ownership model companies.

This reliance on the private sector framework as the basis for the governance and accountability of SOEs means that much of the best practice approach to the governance of privately-owned businesses can be applied readily to the governance of SOEs (see my post on state sector board governance).

However, there are some important distinctions to consider:

  • Ownership constraints:  The SOE Act (s 11) requires all of the voting shares in SOEs to be held only by Ministers, on behalf of the Crown. This has a few implications for SOE governance:
    • First, it potentially limits the company’s options for raising new capital either to debt capital from private lenders, or to seeking equity investment from the Crown in competition with the Crown’s other Budget priorities.
    • Second, as a result, there could be a temptation for management to hoard currently surplus capital to provide options for future investment, rather than disbursing free cash flow in dividends to the shareholder.  This is one reason why the SOE Act (s 13(1)(b)) provides for the shareholders, rather than just the directors, to determine the amount of dividends to be paid.
    • Third, inability to sell its shares in the company means that the Crown is obliged to continue its equity holding regardless of whether the company’s strategic direction continues to meet with the Crown’s investment priorities.  This creates the potential for a mismatch between the direction of the company and the Crown’s commercial interests that, in the private sector, could be resolved by the shareholder selling its interest to a new owner who is more aligned with the direction of the company and values it accordingly.
    • Fourth, this lack of the “market for corporate control” also potentially weakens the incentives on management to maximize value for shareholders.
    • Fifth, the lack of a market for equity investment in the companies means that there is no sustained analyst following of the companies and no share price signal.  This reduced scrutiny reduces the pressure on management to perform.
    • Sixth, there is no opportunity for managerial share ownership. However, while share ownership can help to align managers’ incentives to maximize value for shareholders, it can also lead to some other agency conflicts.

Operation of these ownership constraints is illustrated by the fact that the SOEs in the mixed ownership programme significantly increased their dividend payout ratios once they were partially privatised and listed on the stock exchange:  The Crown now receives higher dividends as a 51% owner than it did owning 100% of these businesses (see detail here).

  • Auditor-General:  The SOE Act (s 19) requires the Auditor-General to be the auditor of SOEs.  She typically appoints a private sector auditor to undertake SOE financial statement audits on her behalf.  However, the Auditor-General also has wider powers to undertake more general performance audits and inquiries.
  • Public accountability:  In addition to the public accountability requirements on companies, each SOE is subject to an Annual Review of its performance and operations by a parliamentary select committee under the Standing Orders of Parliament (cl 345(3)).  SOEs are also subject to the Official Information Act 1982, which requires official information to be released on request.
  • Political sensitivity:  One motivation for adopting the private sector framework is that its separation of ownership and management reduces the potential for non-commercial political intervention in management of the business.  This sensitivity to political influence has led to the shareholding ministers having much less engagement and influence with the direction of the SOEs than a private sector controlling owner might expect to have.  The SOE Act (s 7) does provide for the SOE to agree with the Crown to undertake non-commercial activities for a fee but this provision is not in general use.
    Reflecting this political sensitivity, the SOE Act (s 14) provides a formal process in which each SOE consults with its shareholding ministers on a Statement of Corporate Intent produced ahead of the start of each financial year and the directors are required to act in accordance with it (SOE Act s 5).  However, this routine annual process does not necessarily easily accommodate the critical situations when strategic alignment between the company and its controlling owners is particularly important, such as new strategic directions, and financial distress.
  • Director appointment:  As for other companies, the directors of SOEs are elected by the shareholders.  In widely held companies, and also in many less widely held companies, the process for the selection and succession management of directors is led by the board, and would usually not follow a publicly advertised recruitment and selection process.  Treasury manages SOE board appointments on behalf of shareholding ministers, consistent with the requirements of the Cabinet Office, usually through a public process (see  Implications of this difference are that:
    • While SOE chairs are invariably involved in the SOE director selection process, SOE board members are not as much in control of who sits alongside them at the board table.  This has advantages and disadvantages.
    • SOE directors would generally regard themselves as being “independent directors”.  This contrasts with other wholly-owned companies, where it would be quite usual for parent company executives or board members to be on subsidiary boards, or for there to be executive directors.
    • Another difference from other wholly-owned companies is that cross-appointments (that is, a director being on multiple SOE boards simultaneously) are rare.
    • SOE directors are appointed for a three-year term and are usually reappointed for a second term, but usually not more. This raises issues of director tenure and board reappointments.
  • Best interests of the company:  The Companies Act (s 131(1)) requires that each director “… must act in good faith and in what the director believes to be the best interests of the company.” This can at times present some difficult issues for SOE directors:
    • Aside from the requirement to be able to satisfy obligations to creditors ahead of return to shareholders, in what way can the interests of “the company” be different from those of its wholly owning shareholder who is prohibited from selling their shares (SOE Act s 11)?  For a privately owned company, this ambiguity can be resolved, at least partly, by a provision in its constitution (following Companies Act s 131(2)) but, for various reasons, SOE constitutions have not included this explicit provision.
    • What does it mean for a company to have a principal objective of being a “successful business” (SOE Act s 4) in the context of a wholly-owning and stranded shareholder?
    • Is it acting in good faith and in the best interests of the company for directors of a distressed company to request their stranded shareholder to provide further capital or other support when there is little prospect of a commercial return on that capital commensurate with the risk?

In summary, while these SOEs are limited liability companies and thus take advantage of the legal framework that applies to privately owned businesses, they have some distinctive features to their governance and accountability environment that need to be taken into account by directors, policy makers and commentators.