Owner’s Expectations Manual for Crown Research Institutes

6. FINANCIAL GOVERNANCE

The public funding component of CRI revenue is becoming increasingly devolved.  Examples of this devolution include the CRI Capability Fund and recent moves toward the negotiation of some FRST funding contracts.

This places greater responsibility on CRI boards to set strategies and to ensure adequate management of their CRI’s financial affairs and to make decisions about the allocation of funding where these decisions were once essentially dependent on the outcome of FRST funding rounds. 

Financial targets

All CRIs are expected to add to shareholder value in their operations over the longer term and to meet the short-term financial targets specified in their SCI.

The expected target for each CRI is to make a net (post-tax) return equivalent to its cost of equity capital on average over time.  Shareholding Ministers have adopted 9.0% as the cost of equity target. 

The setting of appropriate financial targets aims to ensure that CRIs operate in a financially viable manner (in line with section 5(2) of the CRI Act and as discussed further in the Operating Framework).

This does not mean that the target needs to be achieved consistently every year as long as an appropriate average return is achieved over time.

Performance against targets

If a CRI anticipates that it will not meet its stated performance targets, shareholding Ministers expect advice from the board, including detail of the reasons for the expected shortfall.  In general, this can be achieved through the quarterly reporting process.  Where performance shortfalls are significant, however, shareholding Ministers expect more direct notification, including any remedial action proposed and to be kept aware of progress.  In this instance, advisors may interact more frequently with the board, with the extent and nature of this closer monitoring depending on the circumstances at the time.  Companies may be placed on ‘monthly watch’.  This would require the board to submit monthly reports and for the chair and/or senior managers to meet with officials to outline monthly progress against target and to explain any significant variances.

In cases of serious under-performance or financial distress by a CRI, shareholding Ministers have a number of options including:

• seeking more detailed information from the CRI,
• working with the board with a view to improving its performance,
• reviewing the membership of the board, and
• liquidating or re-capitalising the CRI.

Such measures, particularly the latter, would only be reverted to in extreme circumstances and shareholding Ministers would consult the board before taking such steps.  Boards should not, in the absence of an express agreement to this effect from shareholding Ministers, assume that additional financial support will be provided by the Crown to a CRI.

Managing risks

Boards are responsible for managing risks and should, therefore, establish processes and practices within the CRI to manage all risks associated with its operations.

Boards should also keep shareholding Ministers informed of risk management strategies through their business plans and other reports when necessary.

Foreign exchange risk management

CRIs with exposure to foreign exchange risks should have policies and procedures for managing these risks and, if requested, report against these policies and procedures to shareholding Ministers.

Capital structure

Each CRI should have a target optimal capital structure (ie the combination of debt and equity used to fund its assets) in line with its business opportunities and risk/return profile.  The onus is on boards to develop and propose an appropriate target capital structure.  In the absence of an agreed capital structure, a 30% net gearing ratio with a three-times interest cover requirement will continue to operate as the default target. 

Shareholding Ministers would expect the setting of a CRI’s capital structure target to have undergone external review to ensure that it conforms to current best practice.  In such a case, the board is expected to undertake an externally assessed capital structure review and present to shareholding Ministers the result of that review.   The decision on what additional supporting information is provided is one for each board; it could be a copy of the capital structure review itself or a separate detailed summary of the review’s key assumptions.

CRIs should not just set the target but actively manage to it within an acceptable margin should they exceed the target.  CRIs are expected to re-evaluate their capital structure target whenever circumstances suggest it is necessary, such as following any major change to the CRI’s risk profile.  A CRI’s capital structure should be reviewed by the CRI if its investment decisions and/or dividend policy have not led to, or are unlikely to lead to, an optimal capital structure within the timeframe forecast in the business plan.

Dividends and reinvestment

The level and timing of estimated dividends is agreed annually between the board and shareholding Ministers through the annual SCI.  Proposed dividends should be identified for each of the three years covered by the SCI.  The level and timing of estimated dividends is driven by the desired capital structure, the company’s profitability and the level of reinvestment.

With regard to reinvestment, this should add value on an aggregate basis, ie the CRIs are not restrained from reinvesting into activities with low financial returns to them, provided that other reinvestment initiatives provide a compensating return that allows them to continue to meet company return targets on average and over time. 

For the payment of dividends, the Treasury requires at least one week’s notice of the actual date and amount before payment, which should be accompanied by a shareholder dividend payment statement.

CRI borrowing

CRIs are exempt from the restriction on borrowing contained in section 162 of the CE Act.

Explicit disclaimer of Crown guarantees and loan covenants

For all CRI financing not provided by the Crown, there must be a disclaimer associated with the contract that the Crown does not guarantee or financially support any CRI borrowings.  The disclaimer aims to give a clear signal to third parties of the nature of the relationship between the Crown and a CRI.

Ownership review clauses

Some loan documents link the loan terms to the shareholder’s identity, so that, if the control of the company changes, the lender reserves for itself the right to call up the loan.  For CRIs, this would connect the terms of borrowing with the Crown, and could incorrectly give the appearance of an implicit Crown guarantee. 
Notwithstanding the Crown’s current ownership policy, the policy on such clauses is as follows.

• It is acceptable to have loan provisions that require lenders to be informed whenever a CRI becomes aware that its ownership will change.
• Shareholding Ministers prefer CRIs not to enter loan agreements that provide for a review of the loan at the lender’s discretion, in the event of an ownership change.
• It is not acceptable to have loan provisions that involve a technical default at the lender’s discretion in the event of an ownership change.

There are alternative mechanisms that can provide lenders with the comfort they desire without the drawbacks typically inherent in ownership change clauses.  These range from covenants concerning the debt/equity ratio and interest coverage to lenders taking security over specific company assets.  However, these mechanisms can place constraints on the company and must be designed to minimise the extent to which they frustrate any future restructuring of a CRI. Boards should bear this in mind when considering such mechanisms.

Tax planning

CRIs are expected to conduct their businesses on the same basis as comparable businesses not owned by the Crown, including normal prudent planning of their tax affairs.  At the same time, CRIs are also required to act as good corporate citizens by exhibiting a sense of social responsibility where able to do so.

These objectives are not served by tax planning that is outside the spirit of the law.  While shareholding Ministers are comfortable with CRIs engaging in normal tax planning in accordance with tax law, they are not comfortable with companies leading or seeking to lead the market in developing aggressive tax planning strategies.

When assessing performance, the government views dividend payments as if it were a domestic resident taxpayer.  This means imputation credits are treated as if they have value in the hands of shareholders, and should be reserved for attachment to dividends.

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