INTOSAI Working Group on the Audit of Privatisation

OBLIGATIONS WITHOUT REPRESENTATION: THE STATE AS A MINORITY STAKEHOLDER

PAPER FOR THE SIXTH MEETING
WARSAW, 5 and 6 OCTOBER 1999

Dr Akiva Ilan, Economic Consultant to the State Comptroller, Israel

It was during, or before, the famous Boston Tea Party (1773) that the slogan "No taxation without representation" was coined. It reflected the resentment of ordinary citizens, the taxpayers, against taxes imposed by a distant ruler.

I suggest that taxpayers, through their elected governments, are facing similar situations. Their governments are subject to financial obligations imposed upon them by decisions and actions of certain groups and organizations, acting on their own. Therefore I suggest that one may paraphrase the famous slogan to "No obligations without representation".

The official topic of this paper is "The State as a Minority Shareholder". A minority shareholder, in any corporation, is in a position where the economic value and future income from his assets depends upon actions and decisions by managers and directors appointed by people who own a controlling interest.

The paper will also claim that in some circumstances the very fact that the State owns a corporation, or even a minority share, may create obligations in addition to the initial investments, which contradicts the notion of "limited liability". Also, that that minority share holding by the State is only a special case of situations in which the actions and decisions of organizations, not controlled by the State, may create financial obligations of the State.

Thus it is essential that the relevant State Agencies establish effective safeguards against the misuse of State assets and of explicit, and implicit, commitments by the State. It is also the duty of SAIs to audit the actions of such Agencies in this area.

The disadvantages of being a minority shareholder are obvious. The assets, and a potential source of income, are controlled by someone else, someone whose considerations may differ from those of the minority shareholder. The way he conducts the firm may affect the value of its assets. The fortunes of the firm depends upon the business acumen, the motivation, the tendency to assume risks and many other factors.

One has also to consider the possibility of conflicts of interests in managing sales, purchases, investments or business alliances. To that one may add dividend policy, which may be important in many cases, or dilution of equity.

The most simple and straight forward test of the advantages of control is the premium paid, in most financial markets, for blocks of shares which provide control.

A public shareowner may also have an interest in the style of management and the behavior of the corporation as a "citizen". Are its decisions affected by the desire to make a contribution to social goals, But notwithstanding the advantages of being in control most investors, and most of the money invested in shares, are, and belong to, minority shareholders. The reasons are very simple. For most small, and many big, investors the "dependence" upon the business acumen of others, talented managers, is the main reasons for becoming passive investors, They want to share in their success, even though most of them are aware that the fruits of the success are not going to be shared equally.

Also, in the large capital markets there is effective protection against abuses of power by management. The most effective of which is the ability to sell the shares if unsatisfied. Such a sale may realize a loss, but limit it. The very existence of such an option provides a strong motivation to management to abide by the rules.

This motivation has increased during the last decades by the use of hostile takeovers as a means to remove from office inefficient management. This is a tool used by business people who spot an opportunity to make profits. But by doing so they also protect the interests of the share owners and may contribute to more efficient use of assets.

There are also some laws protecting minority share owners, against the abuse of control to oppress the minority. Such legal defence is effective because it makes possible to harness the self interest of lawyers who have a motivation to represent large groups of investors in class actions.

The State has different motives to invest in corporations. It is not in the business of seeking a high rate of return by looking for the most promising shares. It's investment policy is guided by the need to promote some specific public goals. SOEs are not known by their drive to maximize return on capital. This is a major reason why, in most cases, the State is not a partial owner of a corporation.

But there are many exception to that statement, otherwise there would be no point in preparing this paper. I shall point out some of the possible exceptions.

a. When the privatization process is conducted in stages;

b. In some cases the SOE was established by several public organizations and the State is just on of them. Sometimes some of the partners in such an enterprise sell their share to private investors;

c. In some cases the State buys a partial ownership in an enterprise as a means to save it from bankruptcy or decline; this is usually done if it is deemed to be in the public interest, or sufficient pressure is exerted upon the government to behave as if it so believes.

d. In some countries the State supports certain industries by Investment Grants, or special assistance for R&D by soft loans. This may serve the same purpose as seed capital which is very important for start ups in the high tech industry.

The rate of failure is very high in the high tech industry. Thus, such soft loans are similar to equity capital if the firm fails and to loans if it succeeds. Economists, including some in our office, believe that the State ought to receive a share of the equity in return for its contribution to seed capital. That would be a minority stake in the companies.

The question arises whether the legal and economic safeguards provided, in most capital markets, to private investors - laws against the oppression of the minority and the ability to sell the shares - are sufficient for the State.

They are certainly not sufficient to ensure that the enterprise involved continues to promote the public goals, or to abide by the public constraints, which were the original motive for the investment by the State in the first place.

Generally, it is unlikely that private firms would promote public goals unless such behavior is consistent with business objectives. This is the case even if the State is a partner. It could be achieved by special "incentives". The cost of such incentives may reduce the efficiency of such a method of promoting the goals. It is pursued, in some cases, mostly when the real cost is not explicit, and thus no price tag us attached to such a policy.

But, when SOEs are privatized and the State wants to impose certain constraints upon the actions of the new owners, eg on their ability to move production to foreign countries, it is done by retaining a "golden share". By owning such a share the State retains a veto power upon certain decisions by the new board. The restriction upon the the power of the new owners does, in most cases, affect the price of the shares sold by the State. A rational policy would require that the decision to retain such a golden share would be subject to a cost/benefit analysis.

The analysis would include not only the discounted value of preventing such actions but also the probability of those action being taken if the restrictions imposed by the golden share did not exist.

The laws and regulations destined to protect the interests of shareholders, in general, in cases of conflicting interests between the management and the shareholders, or the oppression of the minority, are as good for the State as for the private shareholders. The State, being a large organization, is even in a better position than most shareholders to exercise its rights. What is required, of course, is the motivation to do so.

But the State may find itself restricted in exercising the oof selling the shares, if unsatisfied with the management. As suggested above the possibility of such sale and the potential effect upon the price of the shares is a strong motive for management to deliver acceptable performance. A management that does not realize the full potential income from the assets entrusted to it face the risk of an attempted takeover. Thus the ability to sell the shares or to respond positively to an offer by a potential raider, is an effective safeguard against poor performance by management.

The State being more sensitive to public opinion and pressure by trade unions may find it difficult to "unload" its share when the company involved may face the need to contract and discharge many employees. Hostile takeovers may contribute to economic efficiency but they still possess a stigma and the State may find that joining such actions is unacceptable to the public. Thus a State as a minority share holder may not be free to use all the options open to private investors.

For a SOE one may envisage situations in which not only that the State is not free to reduce its holdings in it, but it may be be under pressure to increase its involvement. If the SOE is in financial trouble and is unable to honor its obligations, the combined pressure of unions, suppliers and communities to help the SOE will cause the government to make an additional investment in the equity of the SOE. While such a situation is less likely when the State is a minority share holder, it does happen. So the notion of limited liability which is the cornerstone of the corporation does not necessarily apply for a company owned, even partially, by the State.

One may conclude that being owned by the State, even partially, provides the enterprise with an implicit guarantee against financial failure. Such a guarantee, like many forms of insurance, may create a moral hazard. A tendency to engage in actions or assume risks that would not be undertaken without such a guarantee. The safeguards available to most private shareholders are not sufficient for the State.

The issues arising from an implicit guarantee are not limited to SOEs. Other organizations and businesses which provide essential services to the public, mostly monopolies, enjoy a similar position, at least in Israel. These are organizations deemed too important to fail, and thus are more likely than others to get close to the brink and be bailed out by the State.

Two illustrations will suffice.

(1) Public transport in Israel is provided, mostly, by two Bus companies, which are organized as cooperatives. The Ministry of Transport is controlling the fares. The policy of the Government is to subsidize bus fares, as the service is used mostly by working people, children and the elderly.

The recognized costs are based upon an "inputs basket", according to the actual costs in a base year, and updated for inflation every 6 months according to some specific price indices which are external to the cooperatives. Thus the bus operators enjoy the result of any improvement in their productivity, or, are supposed to, bear the consequences of any reduction in efficiency.

But the major cost item is the salaries and fringe benefits of members. The management is elected by the members and is inclined to please them. The salaries and fringe benefits are more important to members than any residual profits.

Now, what happens when costs rise above the "recognized level"? The next stage would be an increase in debts and in interest expenses. These are not recognized because they are not part of the normative costs. Then it becomes difficult to extend the lines of credit. A crisis is imminent.

Now the public cost of such a crisis is much greater than the cost to the cooperatives. Bus transport is essential. Experience tells us that the cures are either a financial bailout, with the cost of interest and amortization of the loan recognized and incorporated into future fare raises, or an immediate raise in fares or in public subsidies.

(2) Higher education in Israel is supported by the State. Universities, like cooperatives, are ruled by the staff. Thus the heads of the institutes of higher learning do not act like presidents of business enterprises but have the interest of the staff, mostly the academic staff in mind.

In this case one has to consider the fact that when universities are growing the current costs are below long term costs. The reason being that during a period of growth the proportion of young and junior staff increases. But young people tend to get older and juniors are advancing in rank as time passes. When the rate of growth declines current costs are rising.

It is unusual for a public institute, even of higher learning, to have a sophisticated financial reporting system. Thus when a University matures, it may be "surprised" to discover that the State support isn't sufficient anymore.

Again, a university may try to economize, in many cases by endangering its future by reducing the hiring of young people. But eventually it comes for more State aid, or else the government will take the blame for a possible decline in the quality of higher education.

A similar scenario could have been drawn for some municipalities.

The common trait of such organization is that the State has a stake in their financial viability, but they are independent in conducting their affairs. Their deficits turns eventually, at least in part, to a State commitment since there is no way to avoid financial assistance. And, also, the need for such assistance is usually discovered when it is too late for a gradual corrective action.

The protection of the State's rights and assets in corporations and other organizations has many facets. But it ought to include, at least, the following:

(1) Accumulating and processing information and a plan for swift reaction when needed.

(2) Reducing the exposure of the State to undue influence. One way of doing so is to maintain a distance between SOEs, and certainly partially owned SOEs, and the State.

(3) Attaining some "representation" in organizations whose actions and decisions may bring about State expenditure. Such representation may be of a "negative" nature, eg the right to veto certain decisions, similar to a golden share.

1. Getting the needed information is a prerequisite for any action. One cannot exercise the rights of a golden share unless he follows closely the developments in the relevant companies and the agendas of their boards meetings. One cannot have the "representation" mentioned above without monitoring developments of the cost structure, the level of obligations and changes in labor contracts and any factor that may affect the financial position of the relevant organization.

The Companies Authority could be a natural office to manage the gathering and processing of information. In some cases the relevant Ministries, eg for Higher Education or Transport could be in charge. The main object being that any enterprise or organization in which the State has, or may have, a stake should be covered.

2. In many cases it is both possible and desirable to separate the State from the enterprises in which it has a stake. This is so since otherwise any involvement, intended to be of a limited scope, may become open ended. It may not be feasible to replace grants to small firms by providing seed capital if the liability is not limited to the initial investment and if the corporate veil could be easily pierced.

A way, out of many, of doing so is to have State owned companies do the investing and be the formal owners of the State's holdings.

3. The State may require organizations which may need its assistance to abide by certain rules and agree to some control of their costs and finances. As suggested above, it may be the equivalent of a golden share. But exercising such rights by the State proved is quite a challenge.

The Ministry of the Interior in Israel requires all municipalities to approve only a balanced budget. But then it has to make sure that the revenue estimateare realistic. It may impose limits on the use of bank loans. But the alternative is delaying of payments to suppliers. It may turn into a war of wits, but one which has to be won or the State loses in its struggle to achieve some "representation".

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