Corporate Governance of

State Owned Enterprises

Dr. Shamshad AkhtarKarachi

June 21, 2012

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State Owned Enterprise sector--Global trends

• Over the years it became clear that State’s capacity to manage and run companies were inadequate given their weak capacities to run businesses and also tendencies to strip assets or

• Late 1970’s to 1990s saw waves of privatization which gained momentum as after the break up the Soviet Union states privatized state assets and empirical evidence showed clearly the benefits of the efficient management

• Excesses of family managed and run conglomerates, insider/connected lending and flouting of transparency and accounting standards for family interests resulted in massive losses to East Asian, Latin American and Russian Governments as evident from the financial crisis in late 1990s.

• European crisis has again brought to forefront issues surrounding governance of sovereigns and companies and off course weaknesses of the framework of Union which operate as a currency union without supportive unified fiscal and banking resolution compact

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Global Trends

• Subsequently, there has been a round of banking sector events: – starting with the housing and mortgage loans crisis – reckless packaging and spin off of these and other low rated instruments off balance

sheets– These transaction were essentially unregulated result in massive hit to banking systems in

different jurisdiction and resulted in closure of Lehman and seizing of control and bail out of a number of financial institutions

• In the last few decades driven by a variety of considerations, we saw– businesses profitability soaring, – Closure of some strategic of companies – Lehman being a case in point– state loosing or bailing out private and state companies and – there has been accompanying swings in moods and sentiments relating to State owned

sector versus private sector.

• Gaining from the experience, globally we have learnt a lot of why businesses do not work well, be it in state or private sector, unless accompanied by strong governance framework, regulation and its enforcement.

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Globally: State Owned Sector Significance

• Despite privatization and growing size of private sector everywhere, state owned sector has grown in size and breadth as large companies have expanded their capital both from within local and international markets and expanded domestic and cross border operations and remained significant in a number of countries for a variety of reason

• According to the 2011 OECD survey, combined value of SOEs companies was close to $2 trillion and their economic weight in listed market cap and country’s output is quite significant

• Predominance of state sector remains because world’s largest oil and gas companies remain in state hand, and there are cases of world’s largest port operators, airlines, mining and insurance companies being in state hands

• There has been a trend to corporatize the SOEs and a number of large companies have managed to raise capital overseas and adopt good corporate governance principles and practices and are investing overseas

• SOEs make up for 80% of value of stock exchanges in China, 62% in Russia and 48% in Brazil etc.

• SOEs accounted for one-third of foreign direct investments during 2000’s

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State Owned Sector: Special Considerations and Concerns

• Globally, the State ownership of strategic assets brings with it responsibility as state has to serve as a custodian of public assets and safeguard the nation’s sovereign wealth as such a number of countries have set up special purpose vehicles and companies to manage state assets

• State ownership was driven by public welfare considerations where state was perceived and expected to provide services efficiently and on competitive prices

• State companies were as such offered special privileges' and treatment by way of special enactments or by way of exclusively defined exemptions or rights– Awarded privileged access to land, networks and distribution rights– Exemptions from regulations and laws (such as competition and bankruptcy laws) – Exemptions from licensing – Access to capital through development budgets, sovereign guarantees, export credit and

preferential trading arrangements– Explicit and implicit Subsidies

• These privileges‘ nurtured management complacency and inefficiencies, Create distortions and hurt and hamper private companies operations free-riders both within and outside companies exploit the company

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Pakistan State Owned Sector: Profile and IssuesPrivatization scaled down the size of SOE sector and improve the performance of companies under private ownership• Case in point is banking sector & telecom• Privatization is a preferred option and

solution as SOEs governance in Pakistan will remain a challenge

• In any case about 40 odd federal SOEs operate in the manufacturing sector

Size and significance of sector: over 140 companies are involved in commercial activities and about 50 or so companies operate in strategic sectors such as power, transport and financial sector• Pakistan SOEs contribution to output is

roughly 10% but it shoulders burden of employment generation.

• 23 Pak-SOEs listed on KSE but constitute one third of market capitalization

Public welfare losses phenomenal

Industry is facing hardships because of disruptions and lack of access to electricity, gas and water

Growing financial losses: 2012/2013 reported that almost 1.8% of GDP of fiscal deficit owing to settlement of consolidated liabilities power sector and subsidies on power sector losses is Rs1250 billion over last five years (budget speech) to finance system losses, non realization of dues, low tariffs and fuel charges and management inefficiencies

Not only will some of these items be requiring recurring subsidies, but subsidies to other SOEs are close to Rs560 million

Implicit costs of management inefficiencies and corruption has to also recognized

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The Government’s Plans for SOE sector• Some good initiatives but yet to yield visible results

– Cabinet Committee on Restructuring has developed restructuring plans for few sectors: Power and Railways sectors and PIA/PSM but implementation has been weak

– Policy pronouncements made to professionalize Boards of Directors and induct professional management from the market

– A holding company of GENCOs formed and independent professionals inducted on its Board and policy intentions are to transform other boards

– SECP and industry efforts to work towards introduction of Code of Corporate Governance commendable

These reforms are incomplete and partial and implementation weak

Key Questions: Can Corporate Governance of SOEs really change when the Political and Economic Governance is weak

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Rules of Game for State Owned Sector:• Competitive neutrality in policy and legal framework

– Respect for level playing field in commercial operations so that both private and state companies thrive and compete in a healthy way

• Competitive neutrality in regulatory framework– Work on both internal and external governance of companies – Allow all firms to operate freely under a strong code of corporate governance

framework– Subject SOEs and private companies to rigorous transparency and

accountability standards• Recognize that SOEs need to be handled with “CARE” and have legislature approve

the rules of game and lay out international best practice governance frameworks– Classify and legalize group of SOEs separate commercial versus non

commercial entities– State assets be placed with custodian of public assets– Sector Agencies and Ministries should not be in charge of regulatory oversight – Government should not be involved in the Management, running and possibly

in the Board of the companies– Sector regulators role defined and all companies be subject to the standard

company and securities legislation and competition law

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Pakistan: SOEs Policy Framework• Ownership and oversight of SOEs dispersed and fragmented being with Sector Ministries who

do not have a consistent, transparent policy framework or reporting on SOEs under their domain

• Policy lacks consistency and coherence– Reportedly, the mismanagement of SOEs by inexperienced people, vested interest,

interference and misuse of funds based has grown – While companies reported surplus work force and skill deficiencies companies have been

directed to retroactively absorb past laid off workers who had enjoyed VRS benefits– Patronage and loyalty, rather than performance of company, is being rewarded – No uniform policy of remuneration and wages of SOE sector nor is it linked to productivity

• Develop central management data & information system which could offer a comprehensive perspective on operational and financial performance

• Quality of oversight varies as the Ministries lack capacities and understanding of the principles of governing SOEs and regulators either weak or are being undermined

• Limited recognition of need for safeguarding the public assets and enhancing their market valuation

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Corporate Governance of SOEs• The draft Public Sector Companies (Corporate Governance) Regulations

– a first step and a necessary precondition for setting right the principles of internal governance at firm level.

– The code for SOEs is similar to the Code of Corporate Governance applicable to the listed entities

– 23 SOEs who are publicly listed and are likely to be following most of the Requirements of the Code

– The proposed code offers to SOEs guidance consistent with the OECD Guidelines for Corporate Governance of State Owned Enterprises, 2005

• Add to Code elucidations to offer more deeper guidance on SOEs – SOEs need to be held to higher standards of accountability than private

companies as they are public assets and use tax payer money– State ownership does not automatically guarantee Ministerial or any other

entities misplaced control over the mission and activities of an SOE – Recognition that the goals of SOEs are typically a more complex mixture of

social, political, and commercial objectives. – There has to be simultaneous resolution of a host of external factors that

adversely impact governance

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Adopt SOE Corporate Governance Code

• Within the Code of Corporate Governance, ensure we place high priority on few provision to start off

1. Appointment of CEOs and BOD process and quality

2. Clarify roles and responsibility of the Board and CEOs

3. Separation of the role of Board and CEO

4. Form the technical Committee

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1. Appointment of CEOs, Board and its Composition• Good provision but best to

• Insulate the process of appointment of CEOs and Board member from politics is to set up an independent Commission with high powered professionals to select these professionals on competence and merit

• Appointments to be based on agreed “fit and proper” criteria and a roaster of professional candidate developed to select from

• CEO ought to be appointed by the Board based on defined “fit and proper criteria” based on an open and competitive process

– Scrutiny of conflict of interest provisions – Board should ensure due process for misconduct

• The Board of Directors should include broad based and diverse skills including industry specialist, financial and human resource experts etc.

• If the Government is sole or controlling owner, it is undoubtedly in a unique position to nominate and elect the board but there is often tendency to appoint excessive government representatives.

• If the government opts to nominate BOD it should perform effective due diligence in identifying, nominating and electing board members.

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2. Role and responsibility of Board• Ensure the government and directors understand that the SOE Board is

accountable to shareholder as well as wider stakeholders and is responsible for SOE performance

• Board and shareholders should have a clear understanding of the SOE Board roles and responsibility

• SOE Board, like private companies, have to be involved in the Mission and Vision, strategy and oversight of the company, while delegating management to CEO

• SOE Boards capacities need strengthening and Board has to have an understanding of the public role and functions SOEs

• Directors need to develop a clear understanding of the risks and liabilities company faces and ensure risk mitigation strategies are applied to safeguard public assets and resources.

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3. Separation of the role of Chairman and CEOs

• This is quite common in Europe with German and Dutch regulators requiring this split

• In the United Kingdom, over 80% of large companies have an independent chairman, and

• In US this proportion has steadily grown from a low of 16% to about 40% or so.

• There is also a rise in the share of companies with independent Chairman.

• Cleaving the CEO and chairman role makes senses as CEO is responsible for company management and cannot realistically be expected to self monitor and evaluate own role and performance.

• Chairperson is responsible for driving the strategy and policy and for managing dynamic interaction among the Board and carrying greater compliance and reporting requirements.

• Success depends on how effectively the role of Chairman and CEOs is defined and segregated.

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4. Form Committees to perform critical functions

• The guidelines recommend rightly for SOEs to constitute a range of Board committees:

• audit, • risk, • human resource, • procurement etc.

• These Committees to be assigned clear mandate and ensure their effective accountability

• Ensure Boards chaired by competent Board members

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No one size fit model for state ownership

• A survey of OECD and study of the World Bank suggests a growing trend among its members to move from decentralized to a centralized ownership model.

• Centralization, both in the developed and developing countries, means adopting the holding company structure and transferring the SOE assets and its oversight under “under one roof structure.”

• Rationale for an umbrella framework stems from need for adoption of consistent approach to promote– SOE strategy alignment and synergy creation – allow SOEs of different sectors to operate under a one umbrella to manage strategy,

operational or financial holding. – Achieve economies of scale and scope to pool resources, lower risk, and provide access to

lower cost financing. – a layer that shields the SOEs from politics and government intervention including multiple

conflicting objectives, political intervention, and a lower degree of transparency. – Transparency and accountability by opening access of ownership to the public.

• Re-examination of ownership functions are also critical as a uniform approach has to be adopted to nurture well SOEs for an eventual privatization that is often resisted by the relevant sector ministry whose interference in any case impacts the company performance and dilutes the accountability.

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Holding Company as a Governance Structure inManaging and Monitoring State-Owned Enterprises

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Models of Ownership Differ

• In the UK and Australia, the government’s set up performs monitoring and management functions, although the structure does not hold equity in the companies.

• In Finland, the 2007 State Shareholding and Ownership Act transferred ownership of SOEs to a Unit in the Prime Minister office

• In France, in August 2010 a Commissioner of SOEs who reports to the Ministry of Economics and Finance and the Head of Ownership agency reports to the Treasury

• In Poland, the bulk of SOEs are under the Ministry of the Treasury, which has special units for privatization and SOE governance.

• In Indonesia, the Ministry of State-Owned Enterprises exercises the states ownership rights in SOEs with separate entities for different sectors.

• In Jordan, the ownership function are vested with the Jordan Investment Corporation

• In Turkey, the Treasury and the Privatization Administration, are the legal owners of SOEs.

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Singapore Temasek

• Role model being quoted world wide is Singapore established Temasek – an old Malay names “sea town” (or similar bodies with different characteristics in other countries)

• Temasek,, is registered under Company Act and serves as a national holding company for SOEs shares and 100% owned by MOF– the President is custodial of the investments approves THL’s annual budget– Under Singapore’s Constitution and laws, neither the President of Singapore nor the

Government can be involved in THL investment, divestment or other business decisions

• Temasek has substantial authority over its subsidiary companies• is responsible for appointment of Board and CEOs. • Exercise good government internally in THL and • subscribes standards for its subsidiaries or independent statutory corporations• Position of the Chairman and CEO separate and CEOs manage and run companies with

with full flexibility

• Strong and ethically sound civil service and statutory boards legislated by Parliament have full autonomy but accountability is strong and this together contributes to smooth function of Temasek

• To institutionalize its role, Temasek has recently became more transparent and sought credit rating to establish it long term role and be supportive of raising capital

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Conclusion: Fix Policy and Legal Framework

• Develop a clear SOE policy– The Government as a shareholder needs to communicate what the objectives,

role and mandate of SOEs ought to be and what is their expectation regarding operational and financial performance.

– The government to modernize the operating guidelines and rules.– SOEs should be allowed to be run on commercial principles, and held accountable

to ensure judicious use of public resources, while serving the demands of society at an affordable price.

• Convert most SOEs to standard legal structures

– corporatize the departmental undertakings delivering services (such as Pakistan Railways), bodies set up under special Acts/Statues (PIA) and joint ventures (such as Development Financial Institutions).

– Corporatization would contribute to overall transparency by requiring proper compilation of accounts and information, while bring companies under company and other laws and insulating companies from political intrusion. Boards should be empowered with full powers to oversee the companies.

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Conclusion: Competition the driver of performance

• State ownership should not entitle competitive edge to SOE so create a level playing field and nurture contestability in markets. Competition forces firms to minimize costs and to search for new and better ways of doing business and will enhance economic efficiency and innovation.

• Enhance role and capacities of Regulators and Competition Commission to examine the SOEs role in transport, power generation and public utilities which often operate as ‘natural monopolies’ (even if private entry allowed) and examine whether state ownership is ensuring an adequate level of service provision.

• Examine ways of generating competition within the market. For example, through competitive tendering – i.e. competition for the market – as an option: for e.g countries have allocated on a competitive tendering basis the public service obligation such as the domestic transport routes (air and railways), particularly for social and regional access

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Conclusion: Regulators and PSO • Develop the role and capacities of sector regulators– Enhance the regulatory frameworks in accordance with the sector policies– Check the compliance with sector policies, regulation and pricing regime – Involve stakeholders in consultations– Enhance advocacy of corporate governance beyond firm level and – develop awareness of the legislature and executive branch so that these

bodies reinforce corporate governance.

• Develop a policy for public service obligations. – Given its broad based implications for public, SOEs should make full

disclosure of trade offs it faces, costs and quality of delivery etc. – Legislature to approve the PSO policy and its cost implications– The budget should annually provide for financing of the required subsidies

in a transparent manner.

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Conclusion: Transparency and Accountability• The Government and private sector need to reflect on how to institutionalize monitoring

and reporting on compliance of Code in a sustainable manner

• For listed companies, SECP is the main hub that should now extend its ambit to unlisted SOEs too by being more proactive in scrutinizing compliance with the standard covenants of company, securities and other key legislation and regulations.

• Examine the ownership models and see what is suitable recognizing that “old habits die hard” but shielding the SOEs from political and bureaucratic interventions is in its interest and upfront buy in from legislature and Cabinet would be critical

• Establish clear guidelines for subsidies and transfers: it should be rule based rather than dictated by individuals and ensure that separate accounting frames are adopted for commercial versus social service obligation and there is a formulae based approach to compensation for public service obligations

• These guidelines and regulations be approved by legislature so they recognize the implications, while ensuring accountability of finances offered to SOEs

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Conclusion

• Recommend setting up a focal unit – perhaps a public private partnership based on international best practice and sponsored with support of IFC a Commission or body which is empowered and mandated to

– Collate the operational and financial performance and service standards offered vis a vis the corporate strategy and benchmarks

– Develop a score card which both the listed and other SOE undertakings adopt and report their compliance relative to the corporate governance code

– Offer online this information to public and the performance of comparative companies