Owner’s Expectations Manual for State-Owned Enterprises

6. FINANCIAL GOVERNANCE

Financial targets

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

The setting of appropriate financial targets aims to ensure that SOEs:

• are focussed on earning appropriate risk-adjusted rates of return over the business planning period,
• replicate the disciplines exerted over private sector companies that result from share market trading and the threat of takeover, and
• operate in an environment that is competitively neutral with the private sector.

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

Performance against targets

If an SOE anticipates that it will not achieve 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 nature and extent depending on the circumstances at the time.

In cases of serious underperformance or financial distress by a SOE, shareholding Ministers have a number of options, including:

• seeking more detailed information from the SOE (eg monthly accounts and cash flow forecasts),
• working with the board with a view to improving its performance,
• reviewing the membership of the board,
• appointing a special advisor to the board, and
• liquidating or re-capitalising the SOE.

Such measures, particularly the latter, would only be taken in extreme circumstances and shareholding Ministers would consult with 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 an SOE.

Managing for value – value-based reporting (VBR)

A core expectation for SOE boards is that there is a continual focus on managing for value. As outlined in this document under the heading ‘Estimate of current commercial value’, boards should understand the company’s value drivers and monitor enterprise value constantly.

To support this, in addition to reporting under the requirements of generally accepted accounting practice (GAAP), Ministers also encourage the use of VBR. VBR represents a useful tool to assist both Ministers and boards to advance the objectives of SOEs. The most widely used form of VBR is Economic Value Added (EVA) performance measurement. (EVA is a registered trademark of Stern Steward.)

EVA is a useful additional measure of performance for any long-term owner of businesses, and it can be calculated from publicly available information. Using economic methodologies, EVA focuses on the changes in a company’s economic value from a shareholder perspective. In light of the government’s current long-term hold policy for SOEs, EVA can help measure the economic performance of those businesses over time. It is internationally recognised as a measure of performance and provides another dimension for boards and agencies like CCMAU, in assessing the performance of SOEs.

Put most simply, EVA is net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise. The resulting EVA is therefore the profit (or loss) in excess of (or below) an investor’s required return. A key benefit of EVA is that the system encourages a mindset in which managers recognise that all capital has a cost and therefore they should allocate capital to its most effective use.

While each SOE is required to be as profitable and efficient as comparable companies not owned by the Crown, a number of SOEs have no companies with which to compare their performance. EVA is a useful benchmarking tool in such cases. Some SOEs already use EVA for internal purposes and/or publish their EVA results, eg Airways Corporation, New Zealand Post and Transpower. Shareholding Ministers support and encourage this approach.

By providing decision-makers with additional information focusing on shareholder value, EVA should be able to contribute to improving overall performance over time.

Managing risks

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

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

Foreign exchange risk management

SOEs 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 management

Shareholders expect SOEs to minimise the level of surplus capital on their balance sheets, without adversely affecting their ability to meet objectives under the SOE Act. SOEs are expected to return surplus capital to the Crown so that it may be used for other government priorities.

Optimal capital structure

Each SOE should have a target optimal capital structure (ie the combination of financial liabilities and equity used to fund its assets). An optimal capital structure is one that, in light of economic, industry and company-specific factors, would provide for an appropriate credit rating, while at the same time imposing a discipline on the SOE to optimise efficiency.

To this end, the government has a credit rating benchmark policy whereby SOEs are expected to have a capital structure consistent with a BBB(flat) credit rating (unless the SOE can demonstrate good reasons for an alternative benchmark). This is to ensure that all SOEs have appropriate financial disciplines to manage capital efficiently at similar risk levels.

The application of this credit rating benchmark may involve moving to a higher gearing ratio. While there may be a number of ways to achieve this, shareholding Ministers have a general preference for SOEs to reach higher gearing through debt financed distributions (ie, special dividends) to shareholders. Shareholding Ministers recognise that for some SOEs, the timing of any repayment of a special dividend will depend on existing banking restrictions and future capital expenditure plans. Ministers expect Boards to use their best endeavours to negotiate prudent levels of borrowing to closer reflect shareholder preferences, and if necessary explore alternative banking arrangements. Shareholding Ministers additionally expect Boards to report on the likely timing for a change in gearing levels, to better align with the BBB(flat) benchmark.

Dividend policy

The level of estimated dividends (and forecast payout ratio) is set by the board after considering shareholding Ministers’ comments through the SCI and business plan consultation process. It should aim to maintain, or progress toward, the company’s optimal capital structure within defined and agreed timeframes.

The level of estimated dividends is driven by each SOE’s desired capital structure, profitability, and the level of future capital expenditure as outlined in the business plan and SCI.

The proposed dividend payout ratio and estimated dividend payment should be included in the business plan for each year covered by the plan.

Ordinary dividends, if any, may be paid in two instalments: an interim dividend and a final dividend. Special dividends may be paid as seen fit.

Interim dividends, if any, are paid as soon as possible after the half-yearly report and final dividends, if any, as soon as possible after the annual accounts are finalised. The Treasury requests at least a week’s notice of the actual date and amount before payment, which should be accompanied by a shareholder dividend payment statement. Shareholding Ministers may agree on variations to those dates, after consultation with the board.

SOE borrowing

Explicit disclaimer of Crown guarantees and loan covenants

For all SOE 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 SOE borrowings. The disclaimer aims to give a clear signal to third parties of the nature of the relationship between the Crown and SOEs.

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 SOEs, 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 long-term hold policy, the position on such clauses is as follows.

• It is acceptable to have loan provisions that require lenders to be informed whenever a SOE becomes aware that its ownership will change.
• Shareholding Ministers prefer SOEs 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 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 an SOE. Boards should bear this in mind when considering such mechanisms.

Tax planning

SOEs 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. SOEs 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 SOEs engaging in normal tax planning in accordance with tax law, they are not comfortable with companies leading the market in developing aggressive tax planning strategies.

Shareholding Ministers recognise that what might be considered aggressive may change over time and that there will always be an element of judgement involved. This is a judgment for SOEs, not shareholding Ministers, to make.

The principles that shareholding Ministers expect boards to adopt when considering tax planning are as follows.

• Final decisions regarding whether to proceed with any single, or series of related transactions are for individual SOE boards to consider, subject to the usual shareholder consultation requirements set out in each SOE’s SCI, and thresholds specified in the Companies Act regarding major transactions.
• All transactions should be legal in all jurisdictions in which they have effect, and with respect to unusual or non-trivial tax issues have sign-off from professional tax advisors and appropriate tax authorities where possible (eg receiving a binding ruling on the transaction from IRD where appropriate). Moreover, the tax-planning component of transactions should not be aggressive from a New Zealand or international corporate perspective, which should be confirmed in professional tax advice received by an SOE.
• Ownership risks arising from the transactions should be remote.
• The normal expectations regarding the ‘no surprises’ policy and disclaimers on company financing still apply.
• Boards are fully accountable for their tax planning activities, and so need to be able to explain their decisions to all stakeholders, recognising the obligations imposed on SOE directors through the SOE Act and other legislation, and shareholder expectations.

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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