Part 2: Overview of Governance Issues

Local Authority Governance of Subsidiary Entities.

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In this part we discuss general themes and issues that emerged from our case studies, and recommend best practice. Many of our findings reinforce the views expressed in our 1994 report. Other findings relate to the varied governance arrangements that have developed since, as local government has continued to explore a range of structural options to achieve its goals.

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Three main themes emerged from our examination of governance arrangements for subsidiary entities:

  • roles and responsibilities;
  • governance structures; and
  • monitoring and accountability arrangements.

Roles and Responsibilities

Council Representatives on Boards of Local Authority-owned Companies

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The Local Government Act 1974 (the Act) requires at least two directors on the board of a LATE to be persons who are neither members nor employees of any local authority.4 Direct local authority representation is further limited in the case of port companies and passenger transport companies.

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In our 1994 report we commented that:

  • appointing councillors to boards of local authority-owned companies may create a conflict between their obligations as elected members and their duties as directors;
  • councillor directors were seldom selected through a competitive process against the same criteria as other members of the board; and
  • councillor directors were not an appropriate means by which to monitor the activities of the board.

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Our findings in this study confirm these views. However, the local authorities we reviewed had a better understanding of the need for councillor directors to have regard to potential conflicts of interest.

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The local authorities we visited were generally aware of the need for councillor directors to have the necessary knowledge and skills to perform the duties of a company director. Using skill-based criteria to appoint directors (including councillor representatives) provides some assurance that all board members will be able to contribute to the board’s work.

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Although councillor directors face potential conflicts of interest, they may also provide a useful service by:

  • being a council voice;
  • providing a local community perspective; and
  • ensuring that the objectives of the board are aligned with those of the local authority.

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The presence of councillor directors also enables the board to explore the likely response of the shareholding local authority to board proposals.

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We observe that local authorities often appoint councillors as directors from a lack of confidence that non-councillor directors will be sufficiently responsive to the expectations of a local authority owner. Given the potential conflict of interest faced by councillor directors, we recommend that councils consider other ways to obtain the necessary assurance, such as:

  • selection and appointment processes which require non-councillor directors to have a sound understanding and acceptance of the wishes, needs and priorities of the public shareholder, and the needs of the community;
  • a clear statement outlining the council’s expectations of the board, including a commitment by the board to “no surprises” on matters likely to cause community concern or have political implications;
  • periodic forums for discussion between the company and councillors on strategic business issues and shareholder objectives; and
  • ongoing communication between the council and board chairperson, and between company executives and local authority officers, on matters of common interest.

Council Representatives on Non-profit Entities5

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Special-purpose non-profit entities (such as trusts) are commonly formed to operate at arms-length from, but in close association with, a local authority. They undertake activities that contribute to the achievement of a local authority’s desired core social outcomes. Because of the close association, the considerations for appointing directors to commercial trading enterprises are not necessarily relevant to the circumstances of non-profit entities.

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Of the local authorities visited, we selected four in which to review the trusts or other non-profit entities they had set up. Three had appointed no councillor representatives to the governing bodies, while one had a policy of appointing elected members in addition to people from the local business community. The benefits of the latter approach were seen to be:

  • to promote alignment between the objectives of the non-profit entity and the local authority;
  • to provide a community voice on the governing body; and
  • to give the council a means to oversee performance of the non-profit entity.

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Council representatives on the governing body of a non-profit entity are personally liable for the decisions of that body. In their role as trustees or governing body members, councillors owe a primary fiduciary duty to the interests of the entity – creating potential conflict with their duty as councillors.

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Nor is council representation a transparent and effective means to hold the governing body to account and provide assurance to the council and the community about its performance. Performance monitoring should be undertaken by the local authority at arm’s length and with reference to a clear and agreed set of expectations about performance.

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Local authorities should consider the role of councillors as trustees or representatives on non-profit entity governing bodies in the context of our other comments in this report about:

  • appointment processes; and
  • the need for a service agreement framework within which to make the entities transparently accountable for the use of ratepayer funds or assets.

Appointing Members of Governing Bodies

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A governing body – whether of a commercial trading enterprise or a nonprofit entity – should have members with a mix of skills and experience appropriate to the entity’s activities.

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The majority of local authorities we reviewed had documented processes for selecting directors for company boards. This provided a means of assurance that appointees had the skills and experience to meet their obligations as directors and contribute fully to the work of the board. The board appointment processes established by legislation for Infrastructure Auckland and Watercare Services Limited are a useful example for the appointment of directors to the boards of local authority companies.

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The processes followed to appoint the governing bodies of non-profit entities were not as clearly documented. We recommend that, for nonprofit entities, local authorities follow processes similar to those used for appointments to the boards of their commercial trading enterprises.

The Role of the Local Authority Chief Executive Officer

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A key role of the chief executive officer (CEO) of any local authority is to act as its chief adviser. This includes advising the local authority on its relationship with the various organisations in which it has an interest.

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In all local authorities we reviewed, the CEO had links (either directly or through senior managers) with the organisations in which the local authority had an interest. However, we found that not all CEOs were in a position to provide informed or independent advice to their council. Reasons for this included the absence of a framework for reviewing the council’s strategic interests, and the CEO’s involvement in the internal governance of the organisations.

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To ensure that the CEO is fully able to discharge his or her advisory responsibilities, we recommend that:

  • The CEO be kept fully informed – either directly by entity staff or through local authority management – of all material matters about the local authority’s subsidiary entities.
  • The CEO take no part in the internal governance of subsidiary entities. This ensures that the CEO is independent when assessing entity performance against expectations and providing independent strategic advice to the council. In many local authorities this advisory role will be delegated to local authority managers. For similar reasons, local authority employees should not, as a rule, sit on the governing bodies of such organisations.
  • The CEO be assigned formal responsibility for reviewing, or commissioning regular reviews of, the local authority’s interests in subsidiary entities, and for putting policy options to the council based on those reviews.

Governance Structures

The Role of a Holding Company

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Three of the local authorities we reviewed had holding companies charged with monitoring the performance of the local authority’s commercial trading companies. We examined the benefits and risks of this arrangement.

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We found that a holding company had the potential to perform a number of useful roles on behalf of their parent local authority – including developing and promoting best practice in corporate governance processes for:

  • evaluating board and director performance;
  • appointing boards of subsidiary companies; and
  • succession planning across the boards of subsidiaries.

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A holding company may also bring specialist commercial skills, experience and business disciplines to the monitoring of the local authority’s trading activities, including:

  • scrutiny of Statements of Corporate Intent (SCIs) and consultation over business plans and strategic outlooks;
  • creation of an environment where informed commercial decisions can be made quickly; and
  • provision of a vehicle for managing and reviewing the commercial performance of the local authority’s trading portfolio in an integrated manner.

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Local authorities that have established holding companies to oversee the performance of operating subsidiaries need to preserve their ability to exercise their rights as the ultimate owners on behalf of their communities. We recommend that local authorities retain the capability to:

  • monitor the performance of their holding companies in managing their investments;
  • obtain, and where necessary respond to, information about activities or intentions of the subsidiary companies which may have political implications or raise community concerns; and
  • review their investment strategies at regular intervals, having regard to the objectives specified in their investment policies and balancing strategic, community, and commercial considerations.

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Two of the holding companies we looked at had reserved the following key ownership control mechanisms to their parent local authority:

  • approval of appointments to the boards of subsidiary companies; and
  • ratification of the SCIs for those subsidiaries.

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In our view, those reservations were appropriate, given the local authorities’ responsibilities as ultimate owners to discharge governance responsibilities on behalf of their communities.

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We recommend that local authorities define clearly – through the SCI – the role and reporting requirements for their holding companies. These reporting requirements need to ensure that elected members are appropriately informed about matters of community or political interest. In the SCIs we reviewed, we were not satisfied that such accountability requirements were sufficiently well defined. This lack of definition carries the risk that local authorities will not receive necessary information about the performance and prospects for their commercial investment companies.

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At the time of our visit, one holding company had recently expanded the performance objectives in its SCI by incorporating a range of non-financial requirements in addition to existing financial targets. These non-financial requirements should strengthen the company’s relationship with the local authority through explicit commitments to:

  • maintain awareness of strategic and business issues in its subsidiaries, and advise the local authority where required;
  • monitor the quality of the SCIs submitted by subsidiary company boards, and review their compatibility with the local authority’s strategic aims; and
  • keep the local authority informed of all significant matters with two-monthly progress reports and twice-yearly seminars for councillors.

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We recommend, as in our 1994 report, that the boards of holding companies include councillor directors. We consider that councillor directors are better placed on holding company, rather than subsidiary company, boards. A holding company (itself a LATE) is required to operate independently of the parent local authority. While the holding company is the legal owner of operating subsidiaries, the local authority is ultimately accountable to the community for the performance of the subsidiaries. Councillor directors on the holding company are a means of ensuring that commercial decisions have appropriate regard to the wider interests of the local authority shareholder.

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In determining the balance of councillor and external directors on the board of the holding company, the local authority should consider:

  • the desired mix of skills and experience for the holding company’s role as the local authority’s professional investment manager;
  • the nature of the local authority’s investment portfolio; and
  • the relationship between the holding company and the local authority.

Collectively Managing Regional Investments

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The framework for the Canterbury landfill joint venture project, and the governance arrangements for the operations of Watercare Services Limited and Infrastructure Auckland, provide useful guidance as to the factors essential to the success of a regional venture. Key factors are:

  • A governance framework that creates a forum for effective collective decision-making, preserves the autonomy of individual local authorities, and maintains a balance of power and influence among the participants.
  • Delegations, authorities, and lines of communication that underpin the relationship between the joint venture partners collectively and each individual partner. These should reflect the commitments of the authorities to the partners collectively, on the one hand, and the ultimate accountability of each local authority to its community, on the other.
  • Agreed regional policies and strategies that ensure that a venture is based on common objectives at political and operational levels.
  • Provisions to promote the commercial viability of the venture and the proper control of current and future costs.

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The Canterbury landfill joint venture project is a particularly useful reference for other local authorities that are considering similar regional ventures. Participating local authorities and the private sector joint venture partner undertook lengthy consultation on a range of governance issues in reaching agreement on the ways in which they would work together.

Trusts and Other Non-profit Entities

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A number of local authorities have set up stand-alone organisations as vehicles to undertake non-profit activities in an effective and efficient manner. Local authorities have used a number of different forms (including incorporated societies and trusts) for a variety of activities designed to provide community benefits (such as regional marketing, economic development and employment promotion).

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Establishing stand-alone entities to undertake community activities on behalf of the local authority has the potential to remove such activities from public scrutiny. Local government legislation provides little guidance as to how such entities should account to the local authority (and the community) for the use of ratepayer funds, for stewardship of community assets, or for the delivery of services on behalf of the local authority.

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We examined governance arrangements for a selection of stand-alone entities, with the objectives of establishing (for each authority concerned) whether the local authority:

  • had clearly defined its roles and responsibilities in relation to the outcomes sought;
  • had adequate means to influence the direction of the entity, consistent with the relationship between the parties;
  • was monitoring the performance of the entity against clearly stated measures and indicators; and
  • had a regime for reviewing the roles and function of the entity.

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Our examination highlighted the risks associated with setting up entities independently of local authority influence and control, without an established statutory framework for public accountability. The local authorities we reviewed had, by and large, successfully addressed these risks through a variety of mechanisms. We found that:

  • the roles of the entities were clearly defined, and their functions were clearly related to outcomes sought by the local authorities concerned;
  • a range of instruments was in place as a means for the local authorities to influence the direction and strategies of such entities; and
  • the funding of stand-alone entities was subject to public consultation and community input though the local authority’s annual planning process.

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There is potential, however, to strengthen some aspects of the accountability arrangements in order that:

  • service agreements would be in place to ensure that entities meet the performance criteria required of them in delivering services on behalf of, or sought by, the local authority;
  • all such entities would recognise the need to consult with the community, having regard to their relationships with the local authority and the impact of their programmes or activities; and
  • all appointments of trustees and other governing bodies would be drawn from candidates across the community, and be based on identified skills and competencies (by using, for example, procedures similar to those for making appointments to the boards of their commercial trading enterprises).

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Our findings highlighted the need for local authorities to specify key accountability arrangements when setting up trusts and other stand-alone entities. In the absence of effective arrangements, governance by the authority and accountability to the community is likely to be dictated largely by the goodwill of the governing body, its willingness to work with the authority, and informal personal relationships. While informal relationships contribute to effective governance, they do not provide a robust accountability framework over time.

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Accountability requirements will vary according to the degree of influence that the local authority is able to exercise in each set of circumstances. These requirements include:

  • a formal service agreement which documents the scope and purpose of the association between the organisation and the local authority, defines the services to be provided, and specifies how the organisation will be held to account for delivery of those services;
  • an objective process for appointing the governing body, based on a documented set of competencies relevant to the functions and activities of the organisation;
  • a means (conceivably in the context of its own annual planning process) for the local authority to approve or endorse the organisation’s philosophy, direction and strategies, planned programmes and activities, financial and non-financial targets, and outcome measures; and
  • an agreed framework for regular reporting against stated measures of performance, in order to provide the local authority with information as to how the organisation is meeting the terms of its service agreement and contributing to the achievement of agreed outcomes.

Group Structures

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Stand-alone organisations may themselves set up subsidiaries or invest in other entities. This has the potential to:

  • weaken accountability relationships with the local parent authority; and
  • change the nature of the risks faced by the local authority.

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The parent local authority should establish the means to ensure that it is kept fully informed about the status and outcome of new business ventures. This can be achieved through specific reporting, or tailoring existing reporting, to provide necessary information about the plans and activities of such entities.

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While some reporting to the parent local authority referred to such investments, the impacts on risk were not explicitly addressed. The absence of adequate reporting may mean that the local authority is not properly informed about the consequences for its own short-term or long-term interests.

Monitoring and Accountability Arrangements

Information Flows

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A systematic flow of relevant information between a local authority and its subsidiary entities is crucial to good governance, by:

  • building goodwill, trust and confidence; and
  • providing assurance that accountability requirements and performance expectations are being met consistent with the outcomes sought by the authority.

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Significant changes within a subsidiary entity itself (such as rationalisation or restructuring), or in the environment within which it operates (such as the regulatory framework), may expose the local authority to additional risk but also offer new opportunities. Information needs should be reviewed periodically to reflect such changes. We assessed whether information flows were adequate in these circumstances, having regard to the local authority’s interests.

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Where a single entity was owned by one or more local authorities (such as jointly owned companies or collaborative arrangements) we compared the nature and extent of information available to investors or joint venture participants with differing levels of influence or control. In these circumstances we found governance arrangements were such that even participants with small investments had access to information which allowed them to manage their interests in an effective manner.

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However, we did identify the following two ongoing issues to be addressed by local authorities:

  • reviewing local authorities’ interests in external entities; and
  • facilitating the flow of commercially sensitive information to local authorities or their agents.

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To address these issues, we recommend that local authorities regularly assess their interests in such entities and seek strategic information, as necessary, to:

  • account to the community for management of their investments;
  • review the costs and benefits of holding those investments; and
  • discharge their obligations as diligent and informed investors.

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Where necessary, local authorities should negotiate arrangements for the supply and handling of commercially sensitive information. These arrangements must meet their own information needs while maintaining confidentiality.

Business Planning and the SCI

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Consultation on the SCI gives local authorities an opportunity to review the objectives and strategies of their companies and other LATEs against their own interests as shareholders. Most local authorities were making positive use of this opportunity to give careful attention both to the content of the SCI and to the review process itself.

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In some instances, consultation on the SCI content had revealed significant differences in objectives and strategies between the local authority owner and the boards of companies and other LATEs. Consultation and negotiation on the SCI allowed such differences to be discussed and resolved.

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The SCI should be the product of the board’s annual strategic business planning. An understanding of the board’s thinking and priorities is critical for effective consultation with the shareholding local authority. Effective consultation also requires the board to have a good understanding of the shareholder’s goals and objectives, as they are an important focus for the board to plan its strategy for the business.

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Most local authorities were responding actively to the issues raised in draft SCIs received from their company boards. However, we were not satisfied that consultation on the key features of their strategic business plans was always taking place between boards and shareholding local authorities prior to preparation of the draft SCI. In the absence of prior consultation on the assumptions underlying business plans, and on the risks and prospects for their companies, shareholding local authorities will be poorly placed to provide informed comment on the content of the SCI.

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Nor were local authority owners always considering draft SCIs in the light of their own assessment as shareholders of strategic, financial and management risks for their interest in the entity. Without its own strategic framework, the shareholding local authority will be less able to respond to board proposals in a considered and consistent manner.

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We recommend that:

  • local authority owners seek consultation on the key features of boards’ business plans, including briefings on the strategic outlook for the company;
  • local authorities and boards reach a clear understanding of each other’s interests and priorities;
  • drawing on the strategic outlook and business plan, shareholding local authorities review, or engage advisors to review, their interests in the light of issues facing the entity; and
  • local authorities use this information as a framework against which to consider the draft SCI and their own future options as an investor.

Capability to Monitor Performance

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Specific responsibility for monitoring performance had been assigned by each local authority. In some instances oversight and scrutiny were regular and well directed, and incorporated in-depth exploration of issues affecting the risks for the authority. For two authorities, the holding company model was a valuable vehicle through which to monitor operating subsidiaries’ performance, drawing on informed and specialist advice in-house and externally.

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However, this task was not receiving the same attention in each local authority. In some cases infrequent reporting, little analysis of performance, and no formal provision for review, provided limited assurance that the authority’s interests were being addressed.

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Structures for the monitoring of non-profit entities were sometimes weak. In the absence of contractual agreements directly reflecting their interests, local authorities sometimes depended on other mechanisms for information on performance. These included the co-operation of stand-alone entities, informal communication channels, and councillor representatives on the governing body. None of these mechanisms constitute a reliable means of holding the governing body accountable for the use of ratepayer funds or for the delivery of programmes in the interests of the local authority.

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In some instances, local authorities had limited capacity to analyse reports received from informal sources, and so little such analysis was undertaken.

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To strengthen accountability relationships and provide ongoing assurance that their interests are being met, we recommend that local authorities:

  • establish a framework for monitoring performance, which should include reporting to the local authority, undertaking analysis, and conducting a periodic strategic review; and
  • identify and draw on the necessary skills and experience to perform an ongoing performance-monitoring role on their behalf.

Summary of Recommendations

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We make a number of recommendations on three subjects:

  • roles and responsibilities;
  • governance structures; and
  • monitoring and accountability arrangements.

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Our recommendations are intended primarily for local authorities. However, effective governance relies on constructive, well-understood relationships among a number of different parties. In particular, governing bodies and individual board members play an important part in making governance arrangements work. We encourage all parties to consider how our recommendations could usefully be applied to their own circumstances.

Roles and Responsibilities

Responsiveness to the Expectations of the Public Owner

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A local authority should ensure that a subsidiary entity’s board is responsive to its expectations as a public owner, without compromising the board’s responsibility as the governing body to direct and control the conduct of the entity’s business. In consultation with the board, the local authority should establish:

  • director selection and appointment processes which require non-councillor directors to have a sound understanding and acceptance of the wishes, needs, and priorities of the public owner, and the needs of the community;
  • a clear statement outlining the council’s expectations of the board, including a commitment by the board to “no surprises” on matters likely to cause community concern or have political implications;
  • periodic forums for discussion between the board and councillors on strategic business issues and ownership objectives; and
  • ongoing communication between the council and the board chairperson, and between entity executives and local authority officers, on matters of common interest.

The Accountability of a Non-profit Entity

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A local authority with an interest in a trust or other non-profit entity should ensure that:

  • a service agreement framework is drawn up within which the entity can be held transparently accountable for the use of ratepayer funds or assets; and
  • performance monitoring is undertaken at arms-length and with reference to a clear and agreed set of expectations.

Appointing the Governing Board of a Non-profit Entity

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A local authority should:

  • document clearly its processes for appointing the governing body of a trust or other non-profit entity; and
  • consider following processes similar to those used for board appointments to commercial trading enterprises.

The Role of the Local Authority Chief Executive Officer

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A local authority chief executive officer (CEO) has important advisory responsibilities to the council. To exercise these responsibilities in an independent and informed manner in relation to subsidiary entities, the CEO should:

  • Be kept fully informed of all material matters about the local authority’s subsidiary entities.
  • Take no part in the internal governance of subsidiary entities. In many local authorities this advisory role will be delegated to local authority managers – who also should not, as a rule, sit on the governing bodies of subsidiary entities.
  • Be assigned formal responsibility for reviewing, or commissioning regular reviews of, the local authority’s interests in subsidiary entities and for putting policy options to the council based on those reviews.

Governance Structures

The Role of a Holding Company

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A local authority with a holding company should:

  • monitor the performance of its holding company in managing local authority investments against measures of financial and non-financial performance specified in the company’s Statement of Corporate Intent (SCI);
  • obtain, and where necessary respond to, information about activities or intentions of a subsidiary company which may have political implications or raise community concerns;
  • review its investment strategy at regular intervals, having regard to the objectives specified in investment policies and balancing strategic, community, and commercial considerations; and
  • consider whether to reserve the right to approve board appointments and SCIs in order to obtain assurance about governance and strategic direction in operating subsidiaries.

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The board of the holding company should ensure that the company is fully accountable to the parent local authority, by:

  • defining, through the SCI, the role and reporting requirements of the holding company;
  • establishing and reporting against a range of financial and non-financial performance measures;
  • maintaining an awareness, and keeping the local authority informed where required, of strategic and business issues in subsidiary companies
  • monitoring the quality of SCIs of subsidiary companies, reviewing them for compatibility with the local authority’s strategic aims; and
  • keeping the local authority fully informed of all significant matters relating to management of its investment portfolio through regular reporting and briefings to councillors.

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In determining the balance of councillor and external directors, consideration should be given to:

  • the desired mix of skills and experience for the holding company’s role as the local authority’s professional investment manager;
  • the nature of the local authority’s investment portfolio; and
  • the relationship between the holding company and the local authority.

Joint Ventures

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In establishing the governance framework for joint ventures, a local authority should have regard to the following key factors which are likely to be vital to the success of any such venture:

  • A governance framework that creates a forum for effective collective decision-making, preserves the autonomy of the local authority, and maintains a balance of power and influence among the participants.
  • Delegations, authorities, and lines of communication that underpin the relationship between the joint venture partners collectively and each individual partner. These should reflect the commitments of the local authority to the partners collectively, on the one hand, and the ultimate accountability of each local authority to its community, on the other.
  • Agreed policies and strategies that ensure that a venture is based on common objectives at political and operational levels.
  • Provisions to promote the commercial viability of the venture, and the proper control of current and future costs.

Trusts and Other Non-profit Entities

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A local authority should:

  • specify key accountability arrangements when setting up a trust or other non-profit entity;
  • draw up a formal service agreement which documents the scope and purpose of the association between the entity and the local authority, defines the services to be provided, and specifies how the entity will be held to account for delivery of those services;
  • follow an objective process for appointing the governing body, based on a documented set of competencies relevant to the functions and activities of the entity;
  • establish a means (conceivably in the context of its own annual planning process) for the local authority to approve or endorse the entity’s philosophy, direction and strategies, planned programmes and activities, financial and non-financial targets, and outcome measures; and
  • put in place an agreed framework for regular reporting against stated measures of performance, in order to provide the local authority with information as to how the entity is meeting the terms of its service agreement and contributing to the achievement of agreed outcomes.

Group Structures

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A local authority should ensure that it:

  • has the opportunity to consider proposals by subsidiary entities to make significant investments, on the basis of a comprehensive assessment of risk and opportunities; and
  • is kept fully informed about the status and outcome of new business ventures.

Monitoring and Accountability Arrangements

Information Flows

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A local authority should:

  • seek strategic information, as necessary, in order to manage its investments as a diligent and informed investor; and
  • where necessary, negotiate arrangements for the supply and handling of commercially sensitive information.

Business Planning and the SCI

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A company board should consult its shareholding local authority on the key features of the board’s business plan, and brief the authority on the strategic outlook for the company.

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Drawing on the business plan and strategic outlook, a local authority should:

  • review its interests in light of issues facing the company; and
  • use this information as a framework against which to consider the draft SCI and the local authority’s options as an investor.

Disclosing Corporate Governance Practices

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A company board should:

  • include in its SCI a corporate governance statement disclosing how the board proposes to conduct its business and discharge its obligations; and
  • outline in the company’s annual report how those commitments and obligations have been met.

4: Section 594R.

5: In other jurisdictions the equivalent description is “not-for-profit” entities.

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