Part 7: Commercial Trading Enterprises

Local Authority Governance of Subsidiary Entities.

In our 1994 report we discussed the governance relationships between a selection of local authorities and their commercial trading enterprises. Since then, although the LATE model has evolved, many issues fundamental to effective governance remain subjects of debate across the sector. In this part, we:

  • re-state briefly the principles of good governance against which all local authorities should assess their practices;
  • record and evaluate governance practices across a further selection of local authorities;
  • identify and comment on issues relevant to the governance of commercial trading enterprises in local government; and
  • promote best governance practice.

We examined the relationships between five local authorities and their commercial trading enterprises – four LATEs, one energy company and three port companies. Our more general findings are covered in Part Two, “Overview of Governance Issues”. In this part, we address issues concerned with the relationships between shareholding local authorities and their commercial trading enterprises; specifically:

  • the role of holding companies;
  • monitoring company performance; and
  • disclosure of corporate governance practices.

The Role of a Holding Company

Some local authorities have transferred their shareholdings in operating subsidiaries, and thus their legal rights and responsibilities of ownership, to a holding company. In our 1994 report, we noted the implications of the holding company structure for the governance of LATEs. In particular, the local authority needs to keep close control over its holding company.

As part of this study, we examined the roles of three holding companies, and three governance issues in particular:

  • monitoring the performance of operating subsidiaries;
  • relationships with the parent local authority; and
  • composition of the holding company board.

Monitoring the Performance of Operating Subsidiaries

A holding company can be effective for monitoring the performance of operating subsidiaries. The three holding companies we reviewed performed a monitoring function, each in a different manner. In our view, essential elements of an active and informed monitoring function are:

  • consideration of draft SCIs submitted by the boards of operating subsidiaries;
  • detailed analysis of quarterly, six-monthly and annual reports from operating subsidiaries; and
  • regular strategic reviews of individual investments and of the local authority’s trading portfolio as a whole.

Regular reviews are essential for proper management of a local authority’s investments in commercial trading enterprises. Holding companies are well placed to perform these reviews on behalf of the local authority parent.

The value of the holding company role was well illustrated in the case of one local authority we visited. The local authority had made a commitment in its Borrowing Management and Investment Policy to periodically review the rationale and status of its equity investments against strategic and financial parameters. The holding company was:

  • acting as the investment vehicle, responsible for managing the local authority’s investments in a professional and commercial manner; and
  • commissioning regular valuations of its three subsidiary companies, measuring movements in value over time.

Estimates of market value provided the local authority shareholder with a valuable benchmark against which to assess the ongoing costs and benefits of each investment, including alternative investments or opportunities for expenditure in the community.

Effective monitoring and liaison requires analysis and support. The holding company may have this expertise or may employ a contractor. Each holding company we reviewed had access to resources to perform these tasks. Two of the three holding companies used parent local authority staff for advice and support, reflecting the local authority’s close working relationship with its holding company. This arrangement can also provide a useful means of integrating the financial strategies of the holding company and the parent local authority.

Relationships with the Parent Local Authority

The three holding companies we examined had different relationships with their parent local authority, and were performing a number of important functions, such as:

  • preserving the operating autonomy of the local authority’s commercial trading enterprises;
  • applying business disciplines to the professional management of the local authority’s commercial investments;
  • acting as a channel of communication between the local authority and its operating companies;
  • promoting best practice in corporate governance; and
  • providing a source of information and analysis for local authority review of investment options.

One holding company had been set up as a tax-efficient means of funding the establishment of its sole subsidiary LATE. The holding company structure enabled the LATE to operate independently of the local authority while retaining formal reporting structures.

The second holding company had a closer relationship with its parent local authority, supplying it with advice and information for the management of its commercial investments. Lines of communication between the local authority and the operating companies were an important source of information about the direction and activities of its various businesses.

The boards of the holding company and the operating companies gave periodic briefings and presentations to councillors. These covered issues generating strong community concern (such as power prices), and played an important part in providing information to all councillors. These briefings also provided a valuable opportunity for the council to:

  • put questions to the boards;
  • articulate their strategic objectives for the businesses; and
  • outline their expectations as a public owner.

The holding company was also a leader in promoting best practice in corporate governance. For example, the company had adopted a policy for evaluating the performance of its own directors. It had also drawn up a code of conduct, and guidelines on directors’ responsibilities, for directors in local authority-owned companies.

The third holding company operated with the greatest independence from the parent local authority. The company:

  • had responsibility for maximising the performance of the local authority’s equity investment portfolio; and
  • engaged its own professional investment advice.

On occasions, the parent local authority drew on contestable advice from its own staff. The local authority had also engaged the holding company to assess the commercial viability of new investment opportunities against financial investment criteria and the scope of the company’s activities as defined in its SCI.

Composition of the Holding Company Board

Should holding and subsidiary company boards have common membership?

One of the three holding companies we reviewed had no directors on the boards of its commercial trading subsidiaries; the second had at most one director on each company board. Two of the five board members of the third holding company were also board members of its sole operating subsidiary. We were told that this governance structure facilitated holding company scrutiny of subsidiary performance and was efficient for managing the local authority’s relationship with its single trading enterprise. Common directorships can also enhance the flow of information from the subsidiary to the parent company, and the local authority.

However, common directorships may weaken the holding company’s performance of its monitoring role. Ownership monitoring on behalf of the parent local authority needs to be carried out in a rigorous and detached manner. Holding company directors who also sit on the subsidiary board face weak incentives to criticise the latter’s performance (in effect, their own performance).

This arrangement may also increase the risk that the subsidiary will withhold information necessary for a fully informed assessment of its performance. A free flow of information will be better supported by:

  • systematic analysis of subsidiary performance;
  • a close accountability relationship between the local authority and its holding company; and
  • a clear set of expectations for the holding company to oversee and report to the local authority on the subsidiary’s performance.

What was the mix of councillor and non-councillor directors?

As shown in Figure 6 below, councillor representation on holding company boards differed across local authorities. There was no consistency as to whether councillor directors were in a majority or a minority, or constituted half the membership.

Figure 6
Councillor and Local Authority Officer Directors in the Holding Companies We Reviewed

Total membership of the board of directors Number of directors who were councillors Number of directors who were local authority officers
Holding Company A 9 6
Holding Company B 4 2
Holding Company C 5 1 1

Elected members can be an important link with the parent local authority and allow it, if necessary, to influence the holding company directly in discharging its ownership obligations in the community interest. We believe that a strong councillor presence is justified on holding company boards.

When accountability relationships between the holding company and the local authority are well established, we suggest that local authorities review the balance of councillor and external directors. Strengthening the holding company board’s commercial skills can enhance its capability to advise the local authority on strategic options for diverse business portfolios.

We recommend that holding companies develop a process for evaluating the performance of subsidiary board members and the board as a whole. Effective evaluation processes should reveal:

  • to the board, whether it is working effectively; and
  • to the shareholding local authority, the quality of stewardship across its portfolio of trading enterprises.

Monitoring Company Performance

The free flow of information between companies and their shareholding local authorities:

  • provides ongoing assurance that the company is meeting the performance targets specified in planning documents such as the SCI;
  • alerts the owner to issues of interest or concern in the community; and
  • enables the owner to review its investment.

We identified the following as issues affecting the flow of information to shareholding local authorities:

  • business planning and the SCI;
  • the nature and frequency of reporting;
  • reporting on the activities of subsidiary companies or ventures;
  • the disclosure of commercially sensitive information;
  • listing on the New Zealand Stock Exchange;
  • responsiveness to the expectations of the local authority owner; and
  • selecting and appointing councillor directors.

Business Planning and the SCI

We examined what consultation took place on the development of SCIs. We expected that consultation would take place in the context of strategic business planning discussions between the company board and the shareholding local authority. We did not analyse the content or format of SCIs as part of this study.15

In most instances the content and format of the SCI was discussed. However, boards did not always consult the parent local authority about company direction, prospects, risks and opportunities; nor was such consultation sought. Shareholding local authorities had not always reviewed their interests in the entity, which would have provided a framework in which to consider strategic initiatives proposed by the board.

Without a clear understanding of the board’s thinking, or a considered and informed view on its own interests, a shareholding local authority is poorly placed to make informed comment on the board’s draft SCI.

The Nature and Frequency of Reporting

The Act requires annual and six-monthly reporting to shareholders. As we noted in our 1994 report, reporting to local authority shareholders needs to be both more frequent and more comprehensive than the legislation requires.

In our 1994 report, we recommended as a minimum that the shareholding local authority should receive quarterly reports. These should supply information about:

  • trading levels;
  • revenue and expenditure;
  • financial position;
  • investments and divestments; and
  • key non-financial performance indicators.

We assessed the quality and quantity of reporting to local authority owners (or to their holding companies as agents) against that benchmark.

In two of the five local authorities we reviewed, the quality and quantity of reporting met our expectations. The holding companies for those local authorities were receiving comprehensive quarterly reports from all their operating subsidiaries. This regular reporting was supplemented by periodic reporting on current issues – for example, one energy company was reporting on the possible impact of changes in its regulatory environment. The two holding companies then provided summarised financial results to their parent local authorities.

In a third instance, the holding company received quarterly reports from all operating subsidiaries. However, we were not satisfied that reporting from the holding company to the council was sufficient to meet councillors’ information needs.

The remaining two of the five local authorities we reviewed received reports that, in our view, were neither frequent nor comprehensive enough to provide them with the necessary ongoing information about subsidiary performance and activities. In these two cases, communication between the local authority owner and the subsidiary relied largely on informal discussions between the board chairperson and the mayor or local authority managers.

Informal communications are important in building trust and goodwill. But formal reporting of key financial and non-financial performance information is needed for the local authority to effectively monitor board performance and systematically assess investment value.

The company board should keep the shareholding local authority fully informed about its activities. Effective communication did not always occur.

One company was providing quarterly operating reports to the holding company. The role of raising any issues of concern with the operating company fell to the local authority’s chief executive, who was a member of the holding company board. The council itself had access to only limited information about the performance of the company.

The Act requires every local authority to adopt an investment policy outlining how it will manage its investments, and a report on the management to be made to the council. Periodic reviews of investments are a key component of any investment policy. The responsibility for reviews rests with the chief executive. In the five local authorities we reviewed, the chief executive had the necessary independence from dayto- day governance of the trading enterprises to undertake such reviews in an impartial manner.

However, such reviews were not always taking place and the objectives of the legislation were not always met. Three authorities had neither gathered the information nor carried out the analysis necessary to undertake such reviews.

Reporting on the Activities of Subsidiary Companies or Ventures

A company wholly or partly owned by a local authority may in turn invest in joint ventures or subsidiary companies. Investment may be by merging with or taking over existing businesses or investing in new ventures. Investments may change the nature of a business and may lead to the restructuring of the investing company.

Reasons to invest may include:

  • expanding market share;
  • seeking economies of scale;
  • acquiring further processing capability;
  • undertaking research and development; or
  • diversifying business activities.

Investments create new opportunities and risks, including:

  • moving away from core business;
  • adding uncertainty to projected financial results; and
  • involving the company in experimental operations.

We expected to find reporting processes which kept the shareholding local authority informed about new business ventures – in particular, the impact of such changes on the value of the business and shareholder returns. This reporting may need to be more frequent and detailed than usual, particularly on potential financial impacts.

In some cases, the shareholding local authority was kept well informed about the financial impact of investments, including particular strategic or financial risks for the subsidiary. For example, one contracting company had purchased a neighbouring business in July 1998, raising a loan for the purpose. The board had briefed the holding company on the financial benefits and estimated returns from the purchase. Quarterly meetings between the operating company and the holding company provided a means of monitoring the impact of the purchase. The annual report for the 1998-99 financial year recorded that the newly purchased company’s sales and net profits both exceeded budget.

In other instances, we were not satisfied that reporting regimes provided adequate information to shareholding local authorities about the risks and opportunities associated with such investments, and the subsequent changes to business structure. In these cases, the local authorities were less able to oversee subsidiary company activities and, if necessary, influence company direction.

We found that reports to the local authority contained limited reference to:

  • the operations of subsidiary entities or ventures; and
  • their impact on the capital structure, asset base, income stream or other aspects of financial performance.

Disclosing Commercially Sensitive Information

Shareholding local authorities must decide what information they will make public. If company boards are concerned about how their public owners will handle commercially sensitive information, this may seriously impede the flow of information between the board and the local authority.

Concerns about the handling of commercially sensitive information were raised in both interviews and documentation. Such concerns, and their underlying lack of confidence in the other party, may affect the relationship between the board and the shareholding local authority and the effectiveness of governance arrangements.

The Local Government Official Information and Meetings Act 1987 provides for local authorities (as public bodies) to make information available to the public wherever possible, and to promote the open and transparent transaction of business at their meetings. However, that Act also provides for withholding official information and specifies grounds on which a local authority may do so. As an example, a local authority may withhold information where necessary to carry out commercial activities without prejudice or disadvantage, subject to an overriding public interest test.

The Local Government Act allows LATEs not to disclose in public documents any information which could be properly withheld under the Local Government Official Information and Meetings Act.

Local authorities need strategic commercial information to act as diligent shareholders, including:

  • details of the board’s forward strategy;
  • business cases for major investments;
  • the financial outlook for the business;
  • operational and investment projections; and
  • expected turnover.

We recommend that shareholding local authorities consider establishing with their boards:

  • protocols for handling sensitive information;
  • a common understanding of respective interests; and
  • a clear set of expectations about how such information will be handled.

Listing on the New Zealand Stock Exchange

If a subsidiary company obtains a listing on the New Zealand Stock Exchange (NZSE), the shareholding local authority’s access to information held by the company board will be affected.

Some entities, including port companies, may seek an exemption from the requirement to prepare an SCI. All three port companies we reviewed were listed on the NZSE, and two had taken advantage of this exemption. This removes one source of key information for the shareholding local authority about board strategy and the outlook for the business.

In our 1998 report Statements of Corporate Intent: Are they Working? (see footnote 15 on page 101) we recommended that the SCI model be applied consistently to all entities in a sector. We recommended that exemptions be permitted only where public sector control ceases to exist.

The NZSE Listing Rules also constrain information flows. The Rules aim to create a fair and informed market for the trading of securities in which all shareholders have equal access to information likely to influence the traded price of the securities. The Rules govern the relationship between shareholding local authorities and listed companies and also set standards for the behaviour of listed entities.

Listed companies that pass information to one party without public disclosure to all shareholders expose their boards to allegations of insider trading. But without relevant information, shareholding local authorities may be constrained in monitoring the performance of their investments and in reviewing short and long-term options for ownership.

We recommend that local authorities explore arrangements with their company boards for the supply of strategic information, ensuring that any such agreements comply fully with the requirements of the NZSE. Preserving the confidentiality of the information and taking action to limit access only to authorised persons are measures that need to be included in such arrangements.

Responsiveness to the Expectations of the Local Authority Owner

In a local government environment, commercial decisions can be politically sensitive. One factor which has led local authorities to appoint their own representatives to boards has been the desire to bring a community perspective to the boards’ deliberations, and thereby make the companies more responsive to the expectations of their public owners.

In our 1994 report we noted that local authority owners can expect that they should be informed about matters which are likely to arouse public interest or political controversy. Local authority shareholders should ensure that they select directors who are likely to be responsive to their particular interests as public bodies.

In general, we observed that boards had kept their public owners informed of matters likely to generate significant public interest. For example, one port company had informed its shareholding local authority of its intention to make changes to its waterfront land, recognising that the board’s decision would generate public comment. Another company briefed its shareholder before issuing media statements likely to generate public controversy.

Nonetheless, local authorities must rely heavily on the judgement of boards to be sure that they are alerted to any such issues in a timely way. It is not feasible to define each set of circumstances under which such communication should take place.

One local authority had adopted two practices that promote responsiveness to the views and perspective of the public owner:

  • promulgation of a statement of shareholder expectations; and
  • an appointment process tailored to the needs of a public owner.

A Statement of Shareholder Expectations (SSE) draws on a model used by the Crown Company Monitoring Advisory Unit of the Treasury. The SSE can help to clarify how the shareholding local authority expects the board to meet its responsibilities, covering:

  • the roles of the board and shareholders;
  • communication flows between the company and the shareholder, including the functions of advisers;
  • the shareholder’s expectations for its involvement in business processes, such as strategic planning; and
  • the shareholder’s expectation to be informed of matters likely to be controversial before they become public.

We recommend that local authorities consider outlining, in consultation with their boards, their expectations as owners and the means by which those expectations will be met. We suggest also that shareholding local authorities should appoint to company boards people who:

  • are responsive to its interests and to the communities in which the company operates;
  • demonstrate a positive attitude to its model of local authority ownership; and
  • demonstrate that they have a good understanding of the needs of a public owner.

Selecting and Appointing Councillor Directors

In our 1994 report we commented on the roles of councillor directors on the boards of commercial enterprises. In this study we heard a variety of arguments for and against such appointments.

The benefits of appointing councillor directors include:

  • providing a local authority voice on the board; and
  • making the company more sensitive and responsive to community views.

Concerns about such appointments include:

  • councillor directors may face difficulties in reconciling their dual roles as councillor and company director; and
  • local authority representatives may be expected to pass information from the company to the shareholding local authority outside established communication channels, which is inappropriate behaviour.

Some local authorities have a policy of appointing councillors to the boards of their commercial trading companies. Of the ten companies we reviewed, only three boards did not include a councillor representative.

Councillor directors need to have the commercial skills, background and experience to make a fully informed contribution to board discussions. A formal process for selecting directors is an effective way to meet this requirement.

One holding company periodically sought expressions of interest from councillors wishing to be appointed to the boards of local authorityowned companies. The skills and experience of those interested can then be assessed against the competencies for appointment to a board. This preserves the transparency of director appointments. It also ensures that all councillor appointees have the necessary competencies to fill director positions and participate fully in governance of the company.

Disclosing Corporate Governance Practices

SCIs and annual reports contain a range of information about the manner in which the governing body:

  • meets its obligations;
  • conducts its business;
  • discharges its stewardship responsibilities; and
  • is accountable to its stakeholders.

Currently, corporate governance information is spread over several documents. Some accountability documents make no mention of important dimensions of good governance such as systems for managing risk, strategies for liaison with stakeholders, and procedures for the appointment and evaluation of the board. The roles and responsibilities of the board as governing body may not be apparent from the information supplied.

Corporate governance statements can bring governance and accountability information together coherently. Such statements also provide stakeholders with information to assess whether governing bodies are meeting desired standards. Of the companies we reviewed, five had included corporate governance statements in their annual reports – one LATE, three port companies, and one energy company.

The NZSE requires every listed company to include in the annual report a statement of the main corporate governance practices in place during the reporting period.16 Similar requirements are set by overseas stock exchanges. The Australian Stock Exchange, for example, has listed those matters that an entity might take into account when making its statement of corporate governance practices.

A corporate governance statement discloses how the governing body will conduct its business and discharge its obligations. This statement can serve as a clear and comprehensive commitment to good corporate governance practice, and has the potential to enhance public accountability and transparency.

We recommend that shareholding local authorities encourage company boards to include a corporate governance statement in their SCI. The annual report should then outline how those commitments and standards have been met.

A corporate governance statement could include:

  • a description of the board’s roles, and structure;
  • an outline of how the board will manage its activities;
  • a summary of the board’s risk management policies; and
  • an outline of the board’s strategy for communicating with shareholders.

Appendix C on page 116 lists in more detail elements that a corporate governance statement could include.

15: We commented on the operation of the SCI model in our Third Report to Parliament for 1998, Statements of Corporate Intent: Are They Working? (parliamentary paper B.29 [98c], pages 99-137).

16: See NZSE Listing Rule 10.5.3(h).

page top