Public Disclosure Authorized WORLD TECHNICAL NUMBER BANK PAPER 306 c Iq es3 Improving State Enterprise Performance The Role of Internal and External Incentives Public Disclosure Authorized Russell Muir and Joseph P. Saba Public Disclosure Authorized RNIi Public Disclosure Authorized N_ _ USN R FORESTH ONMLANDNTENURE LMNG STX RECENT WORLD BANK TECHNICAL PAPERS No. 216 Carr, ImprovingCash Cropsin Africa:FactorsInfluencingthe Productivityof Cotton,Coffee,and TeaGrownby Smallholders Century:Technical No. 217 Antholt, GettingReadyfor the Twenty-First and in Change InstitutionalModernization Agriculture of Technical No. 218 Mohan, editor, Bibliography Publications: 1992 Department,AfricaRegion,July 1987to December Problems an Obstacle the Development Human Capital: No. 219 Cercone, Alcohol-Related as to of Issuesand PolicyOptions Quality in Asia No. 220 Kingsley, Ferguson, Bower, and Dice, ManagingUrbanEnvironmental Soil and in Dry No. 221 Srivastava,Tamboli,English,Lal,and Stewart,Conserving Moisture Fertility the WarmSeasonally Tropics No. 222 Selvaratnam, Innovationsin HigherEducation: at Singapore the CompetitiveEdge No. 223 Piotrow, Treiman, Rimon, Yun, and Lozare, StrategiesforFamily PlanningPromotion in No. 224 Midgley, UrbanTransport Asia: An Operational Agendafor the 1990s Approachto Civil ServiceReformin Sub-Saharan No. 225 Dia, A Governance Africa No. 226 Bindlish, Evenson, and Gbetibouo, Evaluationof T&V-Based Extensionin BurkinaFaso No. 227 Cook, editor, Involuntary Resettlementin Africa:Selected on Papersfroma Conference Environmentand Settlement Issues in Africa of A No. 228 Webster and Charap, The Emergence PrivateSectorManufacturingin St. Petersburg: Survey of Firms of No. 229 Webster, The Emergence Private SectorManufacturingin Hungary:A Survey of Firms of No. 230 Webster and Swanson, The Emergence Private SectorManufacturingin the FormerCzechand SlovakFederal Republic:A Survey of Firms for to No. 231 Eisa, Barghouti, Gillham, and Al-Saffy,CottonProductionProspects the Decade 2005:A GlobalOverview and A No. 232 Creightney, Transport EconomicPerformance: Survey of DevelopingCountries and Issues No. 233 Frederiksen, Berkoff,and Barber,Principles PracticesforDealingwith WaterResources No. 234 Archondo-Callao and Faiz, Estimating VehicleOperatingCosts No. 235 Claessens, Risk Managementin DevelopingCountries and of No. 236 Bennett and Goldberg, ProvidingEnterpriseDevelopment FinancialServicesto Women:A Decade Bank Experiencein Asia of A No. 237 Webster, The Emergence Private SectorManufacturingin Poland: Survey of Firms Survey and Prospectsfor No. 238 Heath, Land Rights in C6ted'Ivoire: ProjectIntervention No. 239 Kirmani and Rangeley, InternationalInland Waters:Conceptsfora More Active World BankRole A No. 240 Ahmed, RenewableEnergyTechnologies: Reviewof the Status and Costs of SelectedTechnologies No. 241 Webster, Newly PrivatizedRussian Enterprises No. 242 Barnes, Openshaw, Smith, and van der Plas, WhatMakesPeopleCookwith ImprovedBiomassStoves? A ComparativeInternationalReviewof Stove Programs Issuesand Recommendations No. 243 Menke and Fazzari, Improving ElectricPowerUtility Efficiency: No. 244 Liebenthal, Mathur, and Wade, Solar Energy:Lessonsfromthe PacificIslandExperience An No. 245 Klein, External Debt Management: Introduction Concepts,Issues,and Applications No. 246 Plusquellec, Burt, and Wolter, Modern WaterControlin Irrigation: No. 247 Ameur, Agricultural Extension: A Step beyondthe Next Step No. 248 Malhotra, Koenig, and Sinsukprasert, A Survey of Asia's EnergyPrices No. 249 Le Moigne, Easter, Ochs, and Giltner, WaterPolicyand WaterMarkets:SelectedPapersand Proceedingsfromthe WorldBank's Annual Irrigationand Drainage Seminar,Annapolis,Maryland,December 8-20,1992 in No. 250 Rangeley, Thiam, Andersen, and Lyle, InternationalRiver BasinOrganizations Sub-SaharanAfrica No. 251 Sharma, Rietbergen, Heimo, and Patel, A Strategyfor the ForestSectorin Sub-Saharan Africa No. 252 The World Bank/FAO/UNIDO/Industry Fertilizer Working Group, Worldand RegionalSupply and Demand for and Balances Nitrogen,Phosphate, Potash,1992/93-1998/99 Agriculture:A GlobalReview No. 253 Jensen and Malter, Protected (List continues on the inside back cover) PAPERNUMBER306 WORLDBANKTECHNICAL Improving State Enterprise Performance The Role of Internal and External Incentives Russell Muir and Joseph P. Saba The World Bank Washington, D.C. Copyright © 1995 The International Bank for Reconstruction and Development/THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing October 1995 Technical Papers are published to communicate the results of the Bank's work to the development com- munity with the least possible delay The typescript of this paper therefore has not been prepared in accor- dance with the procedures appropriate to formal printed texts, and the World Bank accepts no responsibili- ty for errors. Some sources cited in this paper may be informal documents that are not readily available. The findings, interpretations, and conclusions expressed in this paper are entirely those of the author(s) and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent. 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T1hecomplete backlist of publications from the World Bank is shown in the annual Index of Publications, which contains an alphabetical title list (with full ordering information) and indexes of sub- jects, authors, and countries and regions. The latest edition is available free of charge from the Distribution Unit, Office of the Publisher, The World Bank, 1818 H Street, N.W., Washington, D.C. 20433, U.S.A., or from Publications, The World Bank, 66, avenue d'Iena, 75116 Paris, France. ISSN: 0253-7494 Both authors work in the Private Sector Development Department of the World Bank. Russell Muir is senior industrial economist; Joseph P. Saba is principal private sector development specialist. Library of Congress Cataloging-in-Publication Data Muir, Russell, 1948- Improving state enterprise performance: the role of internal and external incentives / Russell Muir and Joseph P. Saba. p. cm. - (World Bank technical paper; no. 306) ISBN 0-8213-3470-0 1. Government business enterprises-Management. 2. Industrial efficiency. 3. Incentives in industry. I. Saba, Joseph P., 1947- II. Series. HD62.35.M85 1995 350.009'2-dc20 95-42147 CIP TABLE OF CONTENTS FOREWORD .................................................................. vii ABSTRACT .................................................................. ix ACKNOWLEDGMENTS .................................................................. xi EXECUTIVE SUMMARY .................................................................. 1I I. THE WORLDWIDE EVOLUTION OF THE SOE ................................................................. 11 A. The Growth of SOEs.................................................................. 1I B. The Impact of SOEs on Economic Performance .............................................................. 12 C. Governments' Policy Responses to Poor SOE Performance ............................................ 15 II. THE CORPORATION AS AN OWNERSHIP AND MANAGEMENT STRUCTURE ....... 17 A. The Incentive Framework .................................................................. 17 B. Internal Organization and Corporate Governance System ................................................ 19 C. External Discipline .................................................................. 22 D. Use of the Corporate Form when the State is the Owner ................................................. 25 III. THE INTERNATIONAL EXPERIENCE WITH SOE REFORMS ...................................... 29 A. Internal Incentives: Key Lessons of Experience ............................................................... 30 B. External Incentives: Key Lessons of Experience .............................................................. 40 C. Summary: International Lessons of Experience ................................................................ 47 APPENDIXES Appendix A Summary of International Divestiture Experience .49 Appendix B Anglo-American Model of Corporate Governance .59 Appendix C German Model of Corporate Governance .75 Appendix D Japanese Model of Corporate Governance .83 Appendix E Summary of the Case Study Samples .93 Appendix F Semen Gresik (Indonesia) Case Study in Corporate Governance .99 Appendix G Usinor Sacilor (France) Case Study in Corporate Governance .107 Appendix H Statoil (Norway) Case Study in Corporate Governance .119 Appendix I CoalCorp (New Zealand) Case Study in Enterprise Reform .129 Appendix J IRI (Italy) Case Study in Corporate Governance .141 Appendix K Sumer Holding (Turkey) Case Study in Corporate Governance .157 Appendix L Hindustan Machine Tool (India) Case Study in Corporate Governance. 163 Appendix M Ksiaz Porcelain Factory (Poland) Case Study in Corporate Governance ........... 173 - Iv - LIST OF FIGURES Figure 1. Internal and ExternalIncentives:Key Lessonsof Experience ....................................7 Figure I-1. Countrieshave moved along a reform spectrum...................................................... 15 Figure 2-1. The Modern CorporateSystem............................................................. 19 Figure 2-2. ModernCorporationhas CommonStructure........................................................... 21 Figure 2-3. ModernCorporationis Disciplinedby Internal and ExternalIncentives ...................25 Figure 2-4. TypicalState-OwnedEnterprise (SOE)............................................................. 26 Figure 2-5. How to Reform SOEs:Change Internaland ExternalIncentives.............................28 Figure 3-1. Framework for Analysisof SOE Performance 30 ......................................................... Figure B- 1. Anglo-AmericanModel of CorporateGovernance 62 ................................................... Figure B-2. Shareholders ............................................................. 63 Figure B-3. Board of Directors ............................................................. 67 Figure B-4. Officers............................................................. 71 Figure B-5. CorporateFinance: "Anglo-AmericanModel" 73 ........................................................... Figure C-I. GermanModel of CorporateGovernance(Share Company)...................................77 Figure D- 1. JapaneseModel of CorporateGovernance .............................................................85 Figure D-2. FinancialFlows............................................................. 88 Figure D-3. Compositionof Board of Directors............................................................. 89 Figure G-1. Usinor Sacilor............................................................. 113 Figure H- 1. Employment ............................................................. 122 Figure H-2. Overall Market Share............................................................. 123 Figure H-3. End DecemberExchange Rate............................................................. 124 Figure H-4. Returnon CapitalEmployed............................................................. 125 Figure H-5. Shareholder'sEquity............................................................. 125 Figure H-6. Statoil CorporateGovernanceStructure ............................................................. 128 Figure I-I. Tonnes sold/employee ............................................................. 133 Figure 1-2. Return on ShareholdersFunds............................................................. 133 Figure I-3. Sales............................................................. 133 Figure 1-4. Profit before tax and extraordinaries ............................................................. 133 Figure 1-5. Exports............................................................. 134 Figure 1-6. Net Profit after tax and extraordinaries ............................................................. 134 Figure 1-7. CoalCorp ............................................................. 139 Figure J-I. Structureof IRI and its Subholdings,December 1992........................................... 145 Figure J-2. Structureof IRI and its Subholdings,May 1995 146 .................................................... Figure J-3. IRI: Ownershipand VerticalStructure ............................................................. 149 Figure J-4. IRI's Board and ManagementStructure............................................................. 151 Figure J-5. IRI's FinancialStructure............................................................. 155 Figure K-I. Sumer Holding CorporateGovernance ............................................................. 161 Figure L- 1. Hindustan MachineTools............................................................. 168 Figure L-2. ManagementRelationships ............................................................. 170 Figure M-1. Ksiaz Porcelain FactoryLtd............................................................. 181 - v - LIST OF BOXES Box 3-1. Social Assets: How Russia is facing up to the Burdens of SOE Housing .................. 32 Box 3-2. IRI: Changing Policies on Employment .................................................... 34 Box 3-3. Private Sector Leadership on Coalcorp's Board Structure ........................................ 38 Box 3-4. Semen Gresik: The Impact of the Initial Public Share Offering ................................. 43 Box H-1. Features of Statoil conducive to its efficiency.................................................... 125 Box I-I. Factors Encouraging Positive Commercial Performance at Coalcorp ...................... 138 Box J-1. Rationale for IRI's existence in Italy .................................................... 143 Box J-2. IRI Facts in 1991.................................................... 145 Box M- 1. Restructuring Benefits .184 LIST OF TABLES Table 3-1. International Experience with SOE Reform .47 Table A-1. SOEs: Divestiture Options .54 Table A-2. Revenues from divestiture of SOEs .56 Table A-3. Foreign exchange flows in divestiture transactions .57 Table C-I. Composition of Supervisory Board .79 Table F- I. Semen Gresik: Selected Operational Indicators .102 Table F-2. Semen Gresik: Selected Financial Indicators .103 Table G-1. Ownership in 1993.109 Table G-2. No. of Employees at Sacilor in 1993.110 Table G-3. Key Financial Data .11 Table H- 1. Statoil-Consolidated Financial Results .124 Table J- 1. Consolidated Financial Highlights of IRI Group .147 Table J-2. Government Assistance to IRI Group .154 Table M-l. Return on Sales.177 - vii - FOREWORD DisappointingState-OwnedEnterprise (SOE)performancepresents one of the major challengesfor many governmentsover the next few years. InefficientSOEs can have a significant impacton the macroeconomic frameworkby underminingthe efficientoperation of the financial system,fueling inflationand increasingpublic debt. In addition, they increasethe cost of doing business for all firms in the economy. Internationalexperienceindicatesthat poor SOE performance can account for direct and indirectlosses equal to 5 to 8 percent of GDP. For countries that have a large public sector, the losses could be 8 to 12 percent of GDP-about 2-3 times the amount spent on educationand health. As such, seekingways to redress these problems has become a major challengein developedand developingeconomiesalike. This paper summarizesthe internationalexperiencewith SOEs and exploresthe options for, and limits to, reform. The paper outlines how the corporateform has been developedinternationallyto become the most efficient institutionthrough which commercialactivity-in essencethe transformationof inputs into outputs-can be carried out. Its success is due to the dynamic interplay of internal and external incentives which, in large measure,determinethe performanceof all corporations, whether private or state owned. Virtuallyall SOE reforms have aspiredto transforminefficient SOEs into efficient moderncorporations. The focus of the paper is on how SOEs might be structured,governed,operated and financed as modern corporations. Based on the broad internationalempiricalresearch of SOE reform combined with the analysisprovidedby eight case studies, a number of specific lessons are presented for policy makers and SOE managers. In addition,the paper explores whether there may be systemic limits to SOE reforms which do not address the role of increasedprivate participationin terms of financing,managementand ownership. The World Bank's Private Sector DevelopmentDepartmentprovides specializedservices in the fields of enterprisereform,privatization,the private provision of infrastructureand small and medium enterprisedevelopment.Both authors have extensiveexperiencewith issues of enterprise reform and corporategovernancebased on their work in the WorldBank and in the private sector. This paper is designedto provideoperationaladvice based on internationalbest practices to enterprise reformpractitionersand policy makers. Magdi R. Iskander Director Private Sector DevelopmentDepartment - ix - ABSTRACT The central objectiveof the research summarizedin this report was to explore the ways and means of reforming State-OwnedEnterprises (SOEs) to achieveefficiency, profitability and accountability. Specifically,this project sought to: (i) survey internationalexperience in SOE reform; (ii) develop models and identify key factors for successfulreform; and (iii) formulate recommendations. The research was two-pronged. First, eight case studies of large, industrial SOEs in the tradeables sector in OECD and non-OECDcountries were developed. Second, since a key defining characteristicof internationalSOE reforms has been the reorganizationof SOEs into the corporate form, considerableattention is given to analysisof the corporate form, in particular its fundamentalattributes and the dynamic interplayof its internalorganizationand critical external market factors. In this analysis,the three most common internationalmodels of corporate organizationare considered. Taking into account the case studies and the corporate analysis, the report focuses on how SOEs might be reformed as moderncorporations; what incentivesare needed to achieve the reform goals and the systemiclimits to reform. Finally, recommendations for specific actions to enhance, sustain and lock-in reform gains are offered. Chapter I details the worldwideevolution of the SOE. Chapter 1I sets forth an analysis of the modern corporation, various models and contraststhese to the SOE. Chapter III presents the internationalexperience with reform and conclusionsand lessons. - xi - ACKNOWLEDGMENTS The authors are grateful for the valuablecomments and insightprovided by AndrewEwing, John Nellis, S. Ramachandran,Richard Newfarmer and Harry Broadman. In addition, the authors would also like to thank Enna Karlova,John Franchiniand LindseyStevenson for their research, commentaryand continued assistance. EXECUTIVESUMMARY Introduction Despitethe wave of privatizations that have occurredover the past fifteen years, State Owned Enterprises (SOEs) continue to occupy a centralrole in many economies in terms of value added relative to GDP, employmentand investment. Yet the performance of SOEs has been largely disappointingand the negativeimpact on macroeconomicstabilitysevere. Inefficientpublic enterprises have underminedthe operation of financial systems, fueled inflation, increasedpublic debt while acting as an obstacle to private business. Seeking ways to redress these problems has become a major challengein developed and developing economies alike. This paper reviews the internationalexperience with SOEs and exploresthe options for, and limits to, reform. In advanced economies worldwide-and in virtually all economiesin transition-the corporation is the defining characteristicof the modernindustrial enterprise. The modern corporate form has evolved over four centuries to become the most efficient institutionthrough which large scale commercialactivity-in essencethe transformationof inputs into outputs- can be carried out. The focus of the analysisis on how SOEs might be reformed, i.e., structured, governed, operated and financed as modern corporations;what incentivesare needed to achieve the goals of the reform program; and, why there may be systemic limits to SOE reforms which do not address the role of competition, factor markets and increased private participation in corporate finance, managementand ownership. The Worldwide Evolution of the State OwnedEnterprise(SOE) Chapter I details the rise of the SOE and the challengeit came to present to its owner, the State. Many countries established SOEs after 1945 to promote profitable and efficient economic growth by undertakingcommercialactivities that the private sector could not or would not perform. Over time, governments assignedto SOEs non-commercialobjectivessuch as regional developmentand employmentmaximization. Many SOEs increasinglyresembled governmental, not commercial,structuresin their organization,governanceand funding. Large holdings emerged with many of the negativefeatures of inefficient bureaucracies(e.g., Italy, United Kingdom, Turkey, Egypt, Austria). After a period of growth in the immediatepost-WorldWar II period, SOE performance declined in the 1970sand 1980sas global markets fueled competitivepressures. In response, governmentsoften protected their SOEs from competition and provideddirect and indirect subsidies. Although the residual risk bearer for SOE losses, the state had little effective means to monitor economicperformance and often failed to develop mechanismsto discipline management. The combinationof non-commercialobjectivesand related burdens, the difficulties of holding SOE management accountableand the continued blurringof governmental functions with SOE ownership and management,led to declining performancein most countries. -2- The result was increasing budget deficits, externaldebt, inefficientresource managementand a "crowding out" of the private sector from many areas of businessor finance. In response, by the 1980s,governmentsbegan to search for meansto reform their SOEs through different modes of organization, governance and operation. The preferred option was to seek to "mimic the market" by organizing SOEs along the lines of enterprisesin the private sector in the hope of achieving similar levels of efficiency and profitability. Almost universally,the corporation becamethe preferred organizationalform for reform. In many cases, however, too much reliance was place on formalistic approaches. The characteristicsinherent in the corporate form and the factors causing it to be successful in the private sector were often misunderstoodor ignored. Many came to see the role of whole or partial divestitureas contributingto reform goals. Over the past fifteen years, the two most importantreforms in the productionof goods and services by the State are through policies aimed at the corporatizationof SOEs and whole or partial divestiture. In a number of the more successful cases these policies have been viewed as points on a continuum with corporatizationof SOEs leading over time to divestitureprograms. The Corporationas an Ownershipand ManagementStructure Drawing from internationalbest practices, ChapterII establishesthe analytical frameworkfor the paper. Focusing first on the essential characteristicsof the corporation and the ways and means corporations in the private sector are organized, governedand operated, it sets out models for reform. Essential Attributes. The moderncorporate form is characterizedby four essential or fundamental attributes: (a) Separate identity. The corporationis a legal person distinct from the shareholders,with clearly defined propertyrights and a separate accountingfor its own assets and liabilities; (b) Limited liability for shareholders. Shareholder's risk of loss is limited to their contributionto the corporation's capital; (c) Centralizedmanagement. The day-to-dayaffairs of the corporation are conducted by one or more persons chosen by the shareholders;and (d) Transferabilityof shares. The shareholders' ownership interests are transferable and a transfer by a shareholderof its ownershipinterest in the corporation does not, in itself, change the rights of the corporationwith respect to its own assets and liabilities These attributes combine to enable the corporationto mobilizeresources and to undertakeeconomic activity on a large scale with a clarity and singleness of purpose. The absence of one or more of the attributeswould significantlyimpair the corporation as an effective vehiclefor reform. In each of the eight case studies, achievementof reform objectives - 3- was blocked or constrained when the reforms omitted one or more of these attributes in reorganization. The Incentive Framework. There are specific key variables whose dynamic interplay determine and discipline the performance of all corporations, whether private or state owned. Although the variables are relatively few, many reforming states have had difficulty in recognizing their complex relationships and the importance of including each and every one as part of the reform. These key variables can be presented in two categories and summarized as follows: (a) Internal Organizational and Governance Incentives. These include the internal structures and arrangements between the owner (the principal) and the corporate managers (the agents) by which the owner directs and monitors the managers' actions taken for the goals set by the owner; and (b) External Incentives. These are variables relating primarily to market factors which, while not under the direct control of owners, discipline mangers and owners in performance. Internal Organization and Corporate Governance. Throughout the world, as corporations grew in size, complexity and numbers of shareholders, corporate owners have faced the challenge of how to structure the corporate organization and regulate its operations in a manner which assures the attainment of the owner's corporate goals of efficiency and profitability as well as accountability for assets and performance. The key issue is how the shareholders-the "principal"-can achieve efficiency, profitability and accountability while also permitting the managers-the "agents"-the necessary degree of autonomy to operate the corporation in a competitive market environment. This principal-agent problem has been a major focus of corporate development over the last 50 years. While the evolution of the corporate form has been eclectic over the past 15 years, there has been a significant degree of international convergence in the laws and forms for corporate organization and governance. These elements are relatively few. Organizationally, the primary participants in the modern corporation are: (a) the shareholders; (b) a supervisory board; and (c) the executive, sometimes referred to as officers, management or managing directors. The shareholders provide risk capital for which they have certain governance rights: (a) to elect and remove the board; (b) to approve or disapprove fundamental or extraordinary changes (e.g., changes in the corporate charter, mergers, increase/decrease in capital); and -4 - (c) to determine and receive dividends. Boards manage the corporation on behalf of the shareholders through appointment and supervision of the executive, and by reviewing and ratifying all major decisions not reserved to the shareholders. The executive is usually a set of persons elected by the board, who undertake the day-to-day affairs of the corporation. Three examples of different Board structures are summarized below as follows: (a) German model. This system relies on a two-tier board model with strong labor representation-a legacy of post-WWII reconstruction. The two-tiered board is less in favor now. The model is more an "insider" model since a relatively few shareholders, banks (holding powers of attorney from shareholders) and labor appoint the main monitors of management; (b) Japanese model. More an "insiders" model, the board normally includes representatives of management and, through extensive cross-holdings, informal influence is imposed by "insiders" such as suppliers, customers and the corporation's "main" bank; and (c) Anglo-American model. This is often referred to as an "outside" control model. Shareholders either tend to be numerous and rely on exit to protect their investments or are often passive institutional investors such as pension funds which increasingly rely on directors drawn from outside corporate management. Banks play no direct role on boards but are very influential as an "external" factor in their role as creditors. Because shareholders are so often at a distance from management, the legal duties of board members to the shareholders ("fiduciary" duties) are now extensively delineated and clarified by law. Internal Incentives. Shareholders, usually on Board advice, have adopted many varying plans to provide incentives and discipline to management to assure attainment of shareholders' goals. These include share option plans, indexing of salaries to corporate performance and various other benefits/schemes. External Disciplines. While internal incentives are necessary to achieve efficiency, they are insufficient. Far too many SOE reforms have begun and ended with formalistic, organizational changes-rearrangements of boards and bureaucratic structures. These changes, while often needed, do not in themselves yield significant returns. What is also required is the application of external incentives and disciplines-that is, influences outside the direct control of the corporation but which promote management efficiency and accountability to the shareholders. These must be allowed to play a central role in disciplining the performance of the firm. These external factors include: (a) Product market competition. This forces the management to adopt the most efficient methods to maximize profits through market share and general -5- competitiveness. Failure to maximize profits in a competitive market exposes the firm to the prospect of bankruptcy and failure; (b) Competitive capital markets. Both debt and equity impose substantial constraints on management. When the management must turn to equity markets, those markets quickly and continuously monitor and place an objective value on the company and, by reference, on the management. Debt markets impose additional and often more stringent constraints since the management must often agree with creditors on a plan which requires the maintenance of debt/equity ratios and a certain levels of cash flow; (c) Labor Markets. These discipline corporations since managers not only compete with each other to attain the top positions within the modern corporation, but there also is an active market outside companies for managers to improve corporate performance. In addition, where labor markets function well, corporations must compete for the best trained, most efficient workers. In countries where labor has a management position on the Board, labor organizations in and outside the company also exert influence and thus constrain management; (d) The Corporation's Legal Obligations. In most market economies, laws directly affecting corporate governance such as Company and Securities Laws set minimum norms and standards for management, aimed at protecting shareholder rights. These laws are enforced vigorously in most market economies; and (e) Bankruptcy. The threat of surrender of day-to-day control to a trustee in bankruptcy or to a liquidator is a powerful incentive for managers to achieve the owners' commercial goals of profitability through financial discipline. Use of the Corporate Form When the State is the Owner. Typically, many unreformed SOEs (even those nominally organized as corporations) lack one or more fundamental attributes and one or more of the organization and incentive structures of the modern corporation. Most lack a clear separate commercial identity, suffering from government interference in the day-to- day management of the enterprise and a lack of clarity between owner/manger functions. Many states have sought to impose accountability and achieve efficiency through the creation of large holding companies. Almost universally, these have failed to achieve their goals as a result of cross-subsidization, monopolistic behavior and insufficient, inadequate or erroneous information flows to the owner. The very complexity of the structures almost ensures that a distant and non- specific owner cannot hope to master and use, in a timely manner, available information to monitor and discipline the structure. In addition, the financial sector often provides debt on terms softer than commercial basis, particularly for the larger enterprises, relying on the state to bear losses. Thus the state as owner of the enterprise does not benefit from limited liability but bears all risks. Most significantly, external incentives such as product and labor markets are prevented from or are unable to function effectively, while economic legality is absent since there is no effective provision for the implementation of bankruptcy or liquidation. -6 - Reforms. Faced with these challenges, a number of countries such as New Zealand, the UK, Chile, Sweden and Korea have tried, with some success, to reform SOEs through introductionof both internal and external incentives. SOE reform has had its most significant and lasting impact on the macroeconomicframeworkwhere priority was focused on tackling the large loss-makingenterprises. The common elements of all these reform programs include simultaneous action aimed at: (a) Introducing into SOE reorganizations,all four basic attributes of the modern corporation, for the purpose of achievingcommercialobjectives; (b) Introducing competitionfrom the private sector internationalsources, and between SOEs in product and labor markets; (c) Cutting direct and indirectfinancial subsidiesfrom government to SOEs; (d) Reformingthe financial sector, including upgradingprudential regulations and banking supervisionsystems so that the financial sector can provide the necessary external incentives and discipline; (e) Separating the role of owners (i.e., government)from the day-to-daymanagement of the SOEs while also minimizing the number of bureaucratic layers between the company and the government,e.g., in a large state, allowing provincialbodies to represent their owner interestswithout interferencefrom the central government; (f) Unbundling non-core businessesfrom the SOEs; (g) Transferring many of the social functionsfrom the enterprise to municipalor central government authorities; (h) Introductionof necessarysocial safetynet, including pension system and unemploymentservices;and (i) Revision of state functionsthrough the creation of an ownership neutral policy/regulatoryframeworkfor commercialenterprises,removingdistortions (price controls) and correcting disincentives(tax policy and administration)for greater equity and efficiency. If these conditionsfor effective reform can be met and sustained,the internal and external incentives will improve the performanceof the SOE and it will begin to resemble more closely the form of the modern corporation. - 7- The International Experiencewith SOE Reforms Based on the broad internationalempiricalresearch of SOE reform combined with the analysisprovided by the eight case studies presentedin the Appendixes,a number of specific lessonsare presented for policy makers and SOE managers. These are summarizedin Figure I below. Figure 1. Internal and ExternalIncentives:Key Lessons of Experience INTERNALINCENTIVES EXTERNALINCENTIVES * Incentives Clarify Principal/Agent * EncourageCompetitionin Product * Separate Commercialfrom Social Markets Objectives * Improve FinancialDiscipline:Role - Provisionof SocialSafety Net of Debt - MeetingEmploymentObjectives * Sell Sharesof SOEs:Role of Equity - Promotionof Regional Development EncourageOperation of LaborMarkets - DirectedInvestment * Impose Policy Regime - Competiors in Domesticand Export - LegalFactor Markets - Bankruptcy * Non-Governmental SectorRepresentation - Independent AuditingStandard on Board of Directors * Avoid Large Holding Companies \\_// | IMPROVED i Separate Commercialfrom Social Objectives. Many SOEs are faced with a complex agenda-that of pursuing a range of social and political targets that often conflict with sales or profit maximizationobjectives. The noncommercialroles of SOEs and their economic impact can be categorized under the followingheadings: (a) provision of a social safety net; (b) meeting employmentobjectives; (c) promotionof regional development;and (d) directed investment. Effective SOE reform requires assignmentof clear and unambiguousobjectivesin which commercialprofitability features prominently. In other words, SOEs should pursue commercial objectives and be given incentivesto succeed similar to those that apply to private firms. Clarify Principal/Agent Relationships. Clarifying the relationship between SOE managersand the firm's owner is one of the most fundamentalissues for the State as owner of the corporation to address. How should the state interact with SOE managementin such a way that the firm best achieves its commercialgoals? What owner/managerframeworkfor SOE control has worked? Internationalexperienceto date offers several lessons based on the principal of recognitionand applicationof the four basic attributesof the modern corporation. - 8- First, the most effective SOE owner/managerregimes have been those where there has been a separate legal identity of the corporationfrom its owners with strict application of the principalof limited liability for the owners. Second, centralized,commerciallymotivated managementis critical. However, internationalexperiencein countriesas diverse as France, Italy, Norway, New Zealand,Korea and Indonesia,suggeststhat effective internalgovernance for corporatizedSOEs has been achievedwhen the state has provided adequateincentives to boards, managersand employees to meet commercialobjectives. Third, internationalexperience also indicatesthat share transferabilityis a fundamentalattribute of successfullyreformed SOEs. This finding stems from the concept of residual risk-i.e., the risk accepted by the owners of the enterprise who take the ultimate risk of loss and also benefit from the ultimate gains. In private sector firms, the residual risk bearersmust have effective control over managementdecision- making and/or be able to sell their ownershiprights to new purchasers. In the case of SOEs however, the residual risk is borne by the population as a whole which in turn has no ready vehicle for either controlling the enterprise or for divesting its ownershiprights. In these circumstances,the incentivesto perform efficiently are weakened since residual gains or losses are not borne in full by the local, municipalor nationalauthority which owns the enterprise but by the population at large. Therefore, while a corporatizedSOE may be structuredto look like a privately owned enterprise, if it lacks one significantattribute,such as transferabilityof shares, this deficiency will underminethe effect of other reforms. Many countries have confrontedthis problem by diversifyingSOE ownership; in some cases, to secure the gains from ownership diversification, SOE divestiture has beenpursued. Appoint Non-Governmental Representatives to Boards. One of the key factors which has continued to frustrate the efficient operation of SOEs after corporatization,has been the failure to attain a clear separationof overt political influences from the commercialand business objectivesof the enterprise. While it is importantto establisha strong Board structure to develop the overall strategy for the SOE and to monitor the performance of management,the creation of a Board which facilitatesundue political interferencein the day-to-dayoperation of the business will achieve little by way of improvedcorporate governance. A more effective way of ensuring that Boards are able to performtheir strategicand monitoring role is through the introductionof private sector representativesonto the Boards. This has proven to be a useful method of improving the performance of SOEs in a numberof countries such as Korea and New Zealand. However, even in New Zealand the remainingSOEs that have not yet been privatized have begun to suffer from the re-emergenceof escalating interferencefrom politicians, prompting authorities to turn to divestitureas a way of "locking in" efficiencygains. Avoid the Creation of Large Holding Company Structures. International experience suggests that the significantdisadvantagesof large holdingcompanies outweighany limited advantages:many of the aims of these structurescan best be achievedby improvingstructures at the level of the enterprise and by ensuring that the external factorsoutlined in the section below are in place and free to impact SOEs. The countryexamples of Italy (IRI), France (Usinor Sacilor), Turkey (Sumer Holdings) and India (HMT)as well as the poor experience with these corporate forms in Algeria, Egypt and Kazakhstanamply demonstratemany of the drawbacks of these systems. The main disadvantagesof holding structurescan be summarizedas: -9- (a) the creationof additionallayers of bureaucracywith few benefits, in terms of increasedefficiency, to the operating companies; (b) a failure to shield the operating companiesfrom undue political intervention; (c) the propensity for cross-subsidizationbetween operating companies in the Group and the concomitant distortionof signals and incentivesto managementthat this practice promotes; and (d) the difficultyin controllingthe growth and longevity of these corporate forms once established. ExternalIncentives: Key Lessonsof Experience Encourage Competition. Perhaps the most importantexogenous factor impactingthe efficient operation of any firm-including SOEs-is the overall degree of competition in the enterprise sector. Economictheory and practice amply demonstratesthat companies in a "contestable"market facing the full rigors of competition with freedomof entry and exit, are likely to react to these pressures in a manner which will foster and maintain high levels of efficiency at the level of the firm. Yet, even when there are numerous SOEs operating in the same sector, governments have been known to prohibit competition between SOEs and/or restrict entry or competition from private sector firms in an effort to provide protectionto potentiallyinefficient SOEs. Internationalcountry experience varies from fierce competitionin contestablemarkets with negligible interferencefrom government-the UK and New Zealand-to overt protection by the State for heavily subsidizedoperations-Turkey and India. In all cases, the impact or absence of these external competitiveforces on governance, and hence performance of the enterprises, has been marked and direct. Improve Financial Discipline: the Role of Debt. When markets for debt finance operate according to commercialprinciples they induce corporationsto demonstratethey can employ the debt profitably, by servicingit or coveringthe creditor's losses if it cannot be repaid. Thus, creditors exert a discipline on corporationsakin to the disciplineimposed by shareholders. However, where the state as owner protects its corporationfrom that discipline-usually by guaranteeingits debts-it removes a strong incentivefor managementto be efficient and to seek profit and introduces issues of "moral hazard." All too often in countriesas varied as Italy, Japan, Turkey and Pakistan there is evidence that governmentsare unwillingor unable to impose debt market disciplineon SOEs through the banking system. Diversify Ownership of SOE Shares: The Role of Equity. In the private sector, the transferabilityof shares is a basic attribute of a successfulcorporation. Coupled with an active equity capital market, internationalexperience shows that diversified sales of SOE shares or the dilution of government ownershipthrough rights issues can have a major impact on improving a - 10- company's performance. In the case of most SOEs, it is difficultto develop appropriate surrogates for these private sector capital market forces. However,experience has shown that it is possible to create some of the external pressureswhich can motivate improvedgovernance by selling even a minority portion of the government's shares to the private sector. This is a trend which has accelerated internationallyin recent years. Avoid Complex External Performance Monitoring Schemes. In a number of countries such as Korea, Pakistan, France, Indonesia,New Zealand and Mexico a great deal of effort has gone into designingsystems to measureand monitorthese targets, drawing both on the internal performance of the firm as well as applying internationalcomparisonsof sectoral performance. However,there is little hard evidencethat these systemshave been able to develop and, equally important,maintain objective performance benchmarksin such a way that the measures reflect decisionsthat can be controlledby management. In a numberof instances, the systems are fraught with poor design parameters,distortionaryincentivesand lack the facility for enforcement. Summary:InternationalLessons of Experience The broader internationalexperience, the cross-sectionaldata and the case studies examiningSOE reform suggest a number of broad conclusions. The main lessons are: (a) SOE performance can be improved measurablythrough reforms such that the enterprise, government and consumers all benefit from efficiencygains, even in the absenceof divestiture; (b) Improvementin internal corporategovernance are a necessarybut not sufficient condition for enhanced SOE performance. Equally, the external environmentand policy frameworkmust be allowedto operate effectively and to impact, in full, the performance of the SOE sector;but (c) International experienceshows that these reforms may be politically and technicallydifficult for governmentsto implement; (d) The whole package of reforms must be implemented-partial reforms are seldom sufficient-and they must be sustainedover time; (e) This is a challengingagenda for most governmentsand there are few examples of real success stories;and (f) Even where there are successes with SOE reform, governmentshave increasingly recognizedthat to sustain these reforms, there is a compellingcase for increasing the role of the private sector in terms of financing, managementand, most importantly,as equity shareholders. I. THE WORLDWIDE EVOLUTION OF THE SOE A. THE GROWTH OF SOEs The rationale for the increase in State involvementin the production of goods and services stemmed from an amalgam of political and economicforces and philosophies which were prevalent in the immediatepost-WorldWar II period. Namely: (a) a belief that the scale and range of investmentrequired for sustainableeconomic regenerationwas beyond pure market forces; (b) a political commitmentto multiple non-commercialobjectivesfor enterprises such as employmentgeneration,income redistributionand economic welfare which, it was argued, only the State could provideor direct through enterprises; (c) the continued growth and subsequentelectoral success of political parties founded on socialist principlesemphasizingthe State's control of the "commanding heights" of the economy; (d) a convictionthat widespreadState ownershipcouldprotect their fragile economies from external shocks; (e) the near collapse of banking systemsand stock exchanges and the inability of these moribund institutionsto provide medium and long-termfinance for capital intensive projects; and (f) the reluctance or inability of the equally devastatedbusinesscommunities to commit resources to capital-intensivesectors with long pay-back periods in the years immediatelyfollowingWW II. Against this background,a numberof policies were implementedin the post-WorldWar II period which shaped the economicprofile of developed and developing economies alike. In Western Europe, socialist governmentsin the UK, France,Italy and elsewhere embarked on nationalizationprograms focusing primarily on energy,transport and other utilities but also extending into some of the tradable,heavy industry sectors. In a period when conventional wisdomemphasized the importanceof economiesof scale, these governmentsfocused on the consolidationof a numberof previouslyprivatelyowned companies in sectors such as steel and chemicals under the control of large State-ownedoperations.' In some instances, these I In some countriessuch as the UK, the nationalizationprocess beganshortly after World War I when the State intervenedas part of a bail-outoperationto take-overmines and railwaysin situationswhere the existingprivate ownerswere facing financialruin. - 12 - nationalizedcompanies were transformedinto entities which becamepart of Government Departments. In other cases, the nationalizedcompanybecame a State OwnedEnterprise retaining the broad corporate form of the formerlyprivate firm, but taking on the attributes of an administrativebureau. In addition, many companies were created as new net investments by the State, either to fill a gap left by the private sector or to competewith existing private producers. In numerous countries,economic planning was predicatedon the assumptionthat only the State had the political commitmentand financial resources to promote the growth of mixed economies, economies where the balanceof power would be shifted from the private to the public sector. Some of the immediatepost-Warfactors which obtained in Western Europe were felt with equal force in developing economies-particularly in these countries under colonial control. Private companies reluctant to invest in capital intensiveprojects in Europe were-with the exceptionof trade in raw materials-incapable of, or disinclinedto, extend their exposure in these developing markets. Faced with rebuilding their home economies, colonial powers had little appetite and limited resources available for investmentoutside those minimal expenditures deemed essential to maintain the continuityof supply of traditional trade patterns. During the past twenty five years, governmentsin developingcountries have added significantlyto the stock of SOEs, marketingboards,utilities and other enterprises which they inherited at independence. With the challengingobjectivesof fostering infant industries, promoting indigenization,creating employmentand controllingstrategicresources, many developing country governmentsresponded by acceleratingthe role of the State from the late 1960suntil the early 1980s. For instance, it is estimated2that between 1967 and 1980,more than half of Africa's extensive SOE sector was established by governmentsseeking a variety of these often conflictingeconomic and political objectives. During this same period, the number of SOEs continued to grow rapidly in most other parts of the world in countries as diverse as the Philippines,Mexico, Brazil, India, Bangladesh,Costa Rica, Portugal and Egypt. The most recent systematicestimates of public ownershipin the 1980sindicate that, on a worldwide basis, SOEs accountedfor an average of 10 percent of GDP while their average share of gross capital formation was much higher at 35 percent. In these circumstances,it is clear that SOEs have achievedsuch a degree of visibilityin the economic landscapethat their collective financial performance has had a decisive impact on the overall economic welfareof their respective economies. B. THE IMPACT OF SOES ON ECONOMIC PERFORMANCE In the 1950s,higher overall growth rates in a large numberof developed and developing countries masked some of the inefficienciesin SOE performance. Nonetheless,during the 1950s and the 1960s,many SOEs did performrelatively efficiently and served to support and complementthe growth of the private sector. In this growth mode, the achievementof certain social objectives at high economiccosts was tolerated. However,with the curtailmentof growth 2 See World Bank, WorldDevelopmentReport 1988 (WashingtonD.C., 1989). - 13- and the emergence of severe resource constraintsthat began to bite in the late 1970sand 1980s, many governmentsbegan to recognizethat poor SOE performance was introducing rigidities into the labor market as well as contributing,in large measure, to their fiscal, foreign debt and inflationaryproblems. This resulted in disastrous spill-overeffects on the banking systems rather than providingthe solutionsto economicdevelopmentas originallyintended. In both product and factor markets, SOEs were increasinglycrowdingout the private sector and raising the cost of doing business across the board. At the same time, the business environmentin which SOEs operated has changed markedly between the 1950s and the present. First, the l 960s began to see the emergence of consumer-drivenmarkets where issues of consistent and increasingquality of goods and services became paramount. Second, technologicalchange had the impact of fueling competitive pressures,forcing private sector finns to adopt new processes or upgrade existingproduct lines if they were to maintain sales and market shares. In contrast, many SOEs remainedinsulated from the objective market forces which were impacting the behavior of an increasing number of private firms, relying instead on direct or indirectprotectionfrom competition. In addition, in the absence of protection or subsidies, many of these SOEs were increasinglyunable to compete with private enterprisesin internationalmarkets. Over time, SOEs became unfocussed in their objectivesand undisciplinedin their operationswith many firms lacking a clear owner and an advocatefor capital. Governanceand ownership issuescentral to the achievementof efficiency at the level of the firm became buried beneath other priorities in the rush to expand the scale and range of the State sector. Based on the findings of an increasingbody of literatureand research, underlying trends of SOE performancehave been largely disappointing;indeed, in many cases the negative impact 3 on overall economicperformance has been accelerating. To illustrate: - In the UK, the profitability of SOEs over the period 1970-85was substantiallylower than returns for comparableprivate sectorfirms--4.1 percent over the period for SOEs as against 17.6 percent in the private sector. * In China, although annual total factor productivityfor SOEs is rising, this growth is only about one third to one half the correspondingrate for non-state enterprises. SOE financial losses currently stand somewherebetween 2.4 percent and 5.3 percent of GDP. It is acknowledgedthat over a third and perhaps up to two thirds of SOEs are loss-makingdespite absorbing at least 70 percent of all bank credit. These losses have required substantialfiscal and quasi-fiscalpublic subsidieswhich have impacted negatively on macroeconomicsperformance,resourceallocation and social stability. 3 See World Bank, Developing the Private Sector: The World Bank's Experience and Approach, 1991; 0. Bouin and C.A. Michalet, Rebalancing the Public and Private Sectors: Developing Country Experience, OECD, 1991; A. Galal, Public Enterprise Reform, World Bank, 1991; M. Shirley and J. Nellis, Public Enterprise Reform: The Lessons of Experience, EDI Development Studies, 1991. - 14 - * In Egypt during the 1970sand 1980s,the SOE sector was characterizedby a large and growing overall deficit,mounting externaldebt and low rates of savings. Financial rates of return fell from a modest 7.8 percent rate of return on total net assets in 1975 to a meager 3.6 percent return by 1990. The overall deficit of the non- financial SOEs rose from about I percent of GDP in the early 1970sto around 4 percent of GDP in 1990-accounting for between 20 and 25 percent of the overall deficit of the centralgovernment. * In Turkey, the borrowing requirementsof the SOEs soared to 7.4 percent of GNP in 1991-more than 50 percent of the entire public sector's borrowingrequirements. The increasing financing needs of the SOE sector not only crowded out the private sector from the domestic financial markets but also increased the burden on the rest of the public sector. The rise in the SOE sector's deficits was accompaniedby a deteriorationin financialperformance with return on capital employed falling from an average of 17.2 percent in 1985to 5.3 percent in 1991. Significantly,over the period 1985-91,SOEs on average earned only half as much as the private sector firms in the largest 500 industrial enterprisesin Turkey. * In India, an estimated40 percent of the SOEs are currently loss-making;since independencein 1948 it is estimated that the governmenthas spent (in nominal terms) $40 billion on SOEs while returns on capital employed have barely covered depreciation costs over the last two decades. * In Vietnam, it is estimated that a sixth of the estimated 12,000 SOEs were loss- making despite receiving"soft budget" subsidiesin the form of loans at rates up to I percentagepoint lower than private firms. Since 1990,the government has closed approximately2,000 of these loss-makingfirms and merged another 3,000 SOEs. * In New Zealand, prior to the major corporatizationand divestitureprogram that began in 1987, many of the SOEs and firms operated as GovernmentDepartments were poor performers. In 1984,the public sector accountedfor 22 percent of all economic activity and consumed28 percent of all investmentwhile the level of services providedto consumers in sectors such as telecommunicationswas well below comparableOECD standards. The aggregatefigures of profit after tax/shareholdersfunds for four of the largest companies-Coalcorp, Electricorp, New Zealand Post and Telecom-stood at a disappointing5.7 percent in 1988,a figure which improved to 11.9 percent in 1991 after the radical corporatizationplans were implemented. * In Kazakhstan,gross SOE lossesrose from 14.1 percent of GDP in 1992to 23.7 percent of GDP by 1993. SOEs experiencedsevere liquidityproblems despite large transfers through credit subsidiesand the non-paymentof dividends to the State. Net inter-enterprisearrears increased twenty-foldover the first nine months of 1993with - 15 - the new credit to the SOE sectorrunning as high as 46 percent of GDP in the same period. * In Mexico,the poor financial performanceof the SOEs precipitateda wide-ranging divestitureprogram in that country. The Minister of Finance announcedin 1991 that a fraction of the $10 billion in losses incurred by the steel sector that year-prior to the divestitureof the company-would have been sufficientto bring potable water, educational facilities, sewerage and hospitalsto an entire region of the country. * In Argentina, SOE losses reached an unacceptablelevel of 9 percent of GDP in 1989 with the SOEs' share of the total public debt standingat 50 percent. These alarming figures contributedto the decision to implementthe subsequentdivestitureprogram in Argentina. C. GOVERNMENTS' POLICY RESPONSES TO POORSOE PERFORMANCE in Over the past fifteen years, the two most importantreformns the production of goods and services by the State are through policies aimed at the corporatizationof SOEs or through divestiture. In a number of the more successfulcases these policies have been viewedas points on a continuum with corporatizationof SOEs leading over time to divestitureprograms in many cases. Figure 1-1. Countrieshave moved along a reformspectrum .~e~a~ization CorPo~aflzation' Non-m - X * Efficiency Gvernment a Comercial State-owned]Dves -jectives rtment[ c n Corpoo Profitability P-. " - riistiirtng = * Agility fp# Corporatization. In an attempt to improve the performance of SOEs, some governments have sought reforms through initiatives which followedand copied private sector models of corporate governance-the process known as "corporatization." The UK and New Zealand were among the first countries to embark on widespreadprogramsof this nature by tacklingthe fundamental issue of clarifyingthe respectiveroles of the owner (the Principal) and the management(the Agent). These corporatizationprograms were aimed at achievingmajor improvementsin efficiency by: (a) Allowing bureaucraticcivil service administrationto be replaced by commercial management; (b) Facilitating the introductionof transparent,unambiguousfinancialand operationalperformance targets and introducingcommercialaccounting procedures; - 16 - (c) Distancing the enterprises as much as possible from undue political interference; and (d) Permitting centralized production-orientated decisions to be replaced by consumer and market-driven ones. However, a fundamental question posed by the corporatization process is whether state enterprises can be made to achieve the same degree of efficiency and profitability as bona fide private firms by taking on certain, but not all attributes of a private corporate structure while retaining public ownership. Equally importantly, is it possible for SOEs to sustain efficiency gains without "slippage" occurring through renewed government interference in the running of these enterprises? The next section examines different international models of corporations and governance and explores how best these approaches can be applied to SOE reform. The broader international experience with these SOE reforms is discussed in Section III of the paper. Divestiture. Since the late 1970s there have been attempts to reduce the role of the public sector either through privatization or other forms of private participation, such as concession agreements and leases-a trend which has continued into the 1990s with the divestiture of large numbers of enterprises in Eastern Germany, Russia and other parts of Eastern Europe. In parallel, a number of the larger SOEs in Latin America and East Asia have been sold to foreign and domestic private buyers; many OECD countries such as the UK, France, Italy, Germany, Spain, Greece and Sweden have accelerated their respective divestiture programs in an attempt to seek efficiency gains from private ownership and, at the same time, reduced the swollen fiscal deficits that poor performing SOEs have generated as a burden for the State. It is estimated that, internationally, the sums raised from divestiture reached approximately $328 billion since 1985; in recent years the value of divestiture transaction has grown rapidly-$60 billion worth of sales in both 1993 and 1994-with many analysts forecasting further growth in transaction values over the next five years. A growing body of evidence supports the net economic benefits to be obtained from privatization of public enterprises4 but only when the process is well planned and implemented in the context of competition, an appropriate regulatory framework and a comprehensive safety net. See Appendix A "Summary of International Divestiture Experience." 4 See Bureaucrats in Business: Economics and Politics of Government Ownership, World Bank Research Report, forthcoming, October 1995; Galal et al, Welfare Consequences of Selling Public Enterprises 1992; Kikeri et al, Privatization: The Lessons of Experience, 1992; Ravi Ramamurti and Raymond Vernon eds., Privatization and Control of State-Owned Enterprises, EDI Development Studies, 1991; Pierre Guislain, Divestiture of State Assets: An Overview of the Legal framework, World Bank Technical Paper No. 186, 1992; Reason Foundation, Privatization 1994: The 8th Annual Report on Privatization; Frank Sader, Privatization and Foreign Investment in the Developing World, World Bank Working Paper, October 1993; W. Megginson, R. Nash and M. van Randenborgh, "The Financial and Operating Performance of Newly Privatized Firms: An International Empirical Analysis," The Journal of Finance, Vol XLIX, No. 2, June 1994; Ian Duncan and Alan Bollard, Corporatization and Privatization: Lessons from New Zealand, OUP, 1992. - 17 - II. THE CORPORATIONAS AN OWNERSHIPAND MANAGEMENT STRUCTURE A. THE INCENTIVE FRAMEWORK Virtually all recent internationalSOE restructuringhas employed the corporate form as a vehicle for seeking gains in efficiency,profitability,agility and accountability. While the corporate form is the most successful and universalform of organizationfor the large scale mobilizationof resources for its productionof commercialgoods and services,it also presents particular problems for its owners chiefly concerning control and accountabilityfor managers. Both the potential and the problems of the corporate form present challengesto the state reforming its SOEs through use of the corporation. Therefore to establish a standardand provide a basis to compare internationalSOE restructuringexperienceand to suggest how these experiencesmight best be applied to both transition and market economycircumstance,it is useful to analyze the attributes,structuresand dynamicsof the corporate form in the private sector. This analysis involvesthe review of models drawn from internationalbest practice, models which focus on the ways and means corporationsare organized,governed, and operated to achieve the owners' goals of efficiency and profitability. These models in turn, when considered against internationalexperience,suggest practical means for achievinga modern enterprise system. The Four Structural Attributesof the Modern Corporate Form As a general principle,modern CompaniesLaw in most countriesrequires that a large business corporation have at least the followingfour basic structural attributes: (a) Separate identity. The corporationis a legal person distinct from the shareholders,with clearly definedproperty rights and a separate accountingfor its own assets and liabilities; (b) Limited liabilityfor shareholders. Shareholder's risk of loss is limited to their contributionto the corporation's capital; (c) Centralized management. The day-to-dayaffairs of the corporation are conducted by one or more persons chosen by the shareholders;and (d) Transferabilityof shares. The shareholders'ownership interests are transferable and a transfer by a shareholderof its ownershipinterest in the corporation does - 18 - not, in itself, change the rights and of the corporationwith respect to its own 5 assets and liabilities. These attributescombine to enable the corporationto mobilize resources and to undertake economicactivity on a large scale with a clarity and singlenessof purpose. The absence of one or more of the attributes would significantly impair the corporation as an effective vehicle for efficiency. The separate identity of a corporationpermits specificity,clarity and accountabilityfor property rights. The corporation has its own assets and liabilities,clearly defined and expressed in a balance sheet. If the balance sheet is preparedin accordancewith internationalaccounting rules, then the corporation's property,at any time, can be valued,compared and controlledin relation to all other property. This clear definitionof property rights affords owners a control mechanism. It also gives the corporationthe possibilityof significantgrowth, through independentaccess to capital markets,through reliance on its own, not its owners, assets and commercialpotential. The attribute of limited liability encourageswidespreadparticipationand mobilizationof capital, while at the same time limiting losses to a specific sum, averting unquantifiablefinancial disaster for the owners. Limited liability also facilitatesexit of non-viable corporations. Once a specific amount is lost, the corporation is withoutcapital, and without a transfusion, can be left to liquidate without further loss to its owners. Since the owners' liability is known to be limited, creditors cannot expect the owners to clear arrears or otherwisesuffer losses beyond their capital contribution. Centralizedmanagementfacilitatesmobilizationof the most specialized and efficient management. The separation of ownershipand control permits hiringmanagers who are most skilled in the intended activity, and directingthem to achieve the intended gains. Centralized managementalso permits owners to establishincentivesand monitoringmechanismsfor managementlinked to the attainmentof the owners' goals. Finally, transferabilityof ownershipaffords owners significantflexibility in allocating their capital and, in so doing, encouragescorporate managementto respond flexibly and rapidly to variables in the market which affect performance. Owners can lock in gains or express dissatisfactionby selling shares, thus creating incentivesfor keeping the corporation focused in achievingthe shareholders' objectives. When an owner can transfer the risk of gain or loss that is part of share ownership("residual risk"), managershave a powerful incentive to cause the corporationto achieveits goals efficiently. Unhappy ownersmay transfer the residual risk of shareholdingto new owners who may appoint new management. Transferabilitycreates a 5 In many countries,particularly those following the French corporate model, there are different forms of corporations, some of which limit the number and transferabilityof shares in small corporations to facilitate business forms more similar to individualpartnerships. - 19 - market for corporate control which in turn also disciplines corporate managementto satisfy their owners' goals. B. INTERNAL ORGANIZATIONAND CORPORATE GOVERNANCESYSTEM There are specific key variables whose dynamicinterplaydetermine the performanceof all corporations,whether private or state owned. These key variablescan be presented in two categoriesand summarized as follows: (a) Internal Organizational and Governance Incentives. These include internal organization and corporate governance-the internalstructuresand arrangements between the owner (the principal) and the corporate managers (the agents) by which the owner causes the managersto act for the goals set by the owner; and (b) External Incentives:These are variablesrelatingprimarily to market factors, which, while not under the direct control of owners, discipline mangersand owners in performance. These two categoriesare describedbelow. Models drawn from increasinglyconverging internationalpractice are detailed in the Appendixes. Figure 2-1. The Modern CorporateSystem INTERNAL , EXTERNAL INCENTIVES \// INCENTIVES THE MODERN CORPORATION |EFFICIENCY|l PROFITABILITY| | AGILITY l Internal Organization and Corporate Governance. Throughout the world, as corporationsgrew in size, complexity and numbersof shareholders,corporate owners have faced the challenge of how to structurethe corporate organizationand regulate its operationsin a manner which assures the attainmentof the owner's corporate goals of efficiency and profitability as well as accountabilityto the owner for assets and for the enterprise's - 20 - performance. The key issue is how the shareholders-the "principal"-can achieve efficiency, profitability and accountability while also permitting the managers-the "agents"-the necessary degree of autonomy to operate the corporation in a competitive market environment. Models of Governance The effective use of the corporation then poses a dilemma: how to achieve a balance between strong managerial direction and accountability.6 The difficulty is that many of the measures that foster one discourage the other. The dilemma is commonly referred to as the "principal-agent question." There is no single or "correct" solution to the principal-agent dilemma and solutions will vary according to many factors. The section that follows, based on international experience, highlights how different countries have addressed the challenges in reforming their SOEs. While the evolution of the corporate form has been eclectic, there has been a significant degree of international convergence in the laws and forms for corporate organization. Consequently, a number of generic models-the Anglo-American, German and Japanese-can be considered as representative of the universe of arrangements for internal governance. These models and brief description are presented in the Appendixes. All the models follow the classic scheme for allocation of powers among the major participants in the corporation. Each model represents the reaction in each society to concerns about efficient organization and the principal/agent problem-that is, how shareholders manage the managers. Figure 2-2 below outlines a simple variation of the relationship between owners, the Board of directors and management of an enterprise. 6 Initially, concern focused on shareholders' financial interests and the agency problem in particular, the power of management to dilute shareholders equity through various means and the management's broad discretion over accounting rules and dividend policy. (See Berle & G. Means, The Modern Corporation and Private Property, 1932.) Berle & Means demonstrated how the separation of ownership and control brought with it an apparently inevitable divergence of interests, with shareholders seeking their benefit and managers seeking to entrench themselves and further their own interests: "It is therefore evident that we are dealing not only with distinct but often opposing groups, ownership on one side and ultimately to lie in the hands of the management itself, a management capable of perpetuating its own position. The concentration of economic power separate from ownership has, in fact, created economic empires, and has delivered these empires into the hands of a new form of absolutism, relegating "owners" to the position of those who supply the means whereby the new princes may exercise their power." (Id. at 124) - 21 - Figure 2-2. Modern Corporationhas Common Structure Owners Incentives Internal |L abor Reot App.t . Shareholdersl~~~~~~~ Supervisor Managemen Board Cor The primary participants in the modern corporation are: (a) the shareholders; (b) a supervisory board; and (c) the executive, sometimes referred to as officers, management or managing directors. The shareholders provide risk capital for which they have certain rights: (i) to elect and remove the board; (ii) to approve or disapprove fundamental or extraordinary changes (e.g., changes in the corporate charter, mergers, increase/decrease in capital); and (iii) to determine and receive dividends. Boards manage the corporation on behalf of the shareholders through appointment and supervision of the executive, and by reviewing and ratifying all major decisions not reserved to the shareholders. The executive is usually a set of persons elected by the board, who undertake the day-to-day affairs of the corporation. Boards of Directors. Generally, shareholders exercise their interests in a large corporation through a Board of Directors. The functions of the board are threefold: representation, direction and oversight.7 Concerning representation, most systems provide for the right of shareholders to elect board members and for certain minimum protection and representation for minority shareholders. Concerning non-owner representation, there has been significant debate and experimentation concerning the role of non-owners on the corporate boards. In some societies there is representation of labor, banks, creditors, suppliers and customers in corporate decision making even if they are not owners. In Japan, the board is the least representative of shareholders in composition and is generally an extension of management. However, through extensive cross-shareholdings, informal influence is imposed on the boards and management through stakeholders or "insiders" such as suppliers, customers and the "main" bank. Germany has the most inclusive representation with its two-tiered board system; this includes strong labor representation (a legacy of its post-war reconstruction). The Anglo-American board is often referred to as a model based on "outside" control since shareholders are numerous or passive institutional 7 An extensive discussion of the functions of the board is in "Board Directors and Corporate Governance," Oxford Analytica, 1992. - 22 - investors such as pension funds with little day-to-day interest in the corporation. Increasingly, the board representatives of these passive investors tend to be "outsiders." Banks play no direct role in the Anglo-American model, but are very influential as an "external" factor in their role as creditors. In many jurisdictions, accountability to labor is mandated by law requiring labor presence in the body which monitors the performance of management.8 In almost every nation, creditors can obtain the right to representation on the board or outright control of a corporation if it is unable to pay its debts. The board function, that of providing direction over management, also varies somewhat from country to country but is generally focused on three major factors: strategic planning, including mergers and acquisitions; the appointment or dismissal of executives; and setting appropriate incentives for management. The oversight or monitoring functions of the board are taking on increasing importance as shareholders demand greater information and accountability. Board oversight is considered weakest in Japan, moderately rigorous in France and Italy and strongest in the US. However, more informed shareholder interests are resulting in changes and improvements to the oversight mechanisms. In the US and UK, the legal duties of board members to the shareholders ("fiduciary" duties) are now delineated and clarified by law, and are enforceable against both the company and the individual board members by the shareholders. Other trends are toward greater use of independent outsiders on boards coupled with the use of committees to deal with executive remuneration and audits. The effectiveness of these outside directors and committees is necessarily limited by management's control of information and insider conflicts of interest (e.g., the presence on the board of stakeholders, particularly customers, suppliers and banks raises serious conflict of interest issues and can diminish the oversight function). Over time, corporate governance problems have been addressed in several ways in different countries but several of the most common solutions are sought through diverse board composition, management compensation, board committees and improved accounting rules, practice and enforcement. C. EXTERNAL DISCIPLINE While internal incentives are necessary to achieve efficiency, experience demonstrates they are insufficient. Rather, external incentives-influences that are outside the direct control of the corporation but which promote management accountability to the shareholders-also must play as role. These external factors are: 8 In the Anglo-American model, accountability to the community is enforced not through participation in internal corporate governance but through external legal constraints imposed on management through a well developed legal and regulatory system. These constraints vary over time and are subject to constant and intense public debate--see discussion on external constraints. - 23 - (a) Product Market Competition. Product market competition forces the management to adopt the most efficient methods to maximize profits through market share and general competitiveness. Failure to maximize profits in a competitive market exposes the firm to the prospect of bankruptcy and failure. Where ownership is dispersed or where the owner does not have the capacity to monitor the management closely, the company's market power is a clear indicator of its performance. Managers have a strong incentive to protect their positions, their own source of wealth (particularly if compensation includes stock or stock options) by maintaining market power. Failure to maintain that power will result in below-average return on investment and also will be reflected in the dividends and price of shares. (b) Competitive Capital Markets. Both equity and debt markets impose substantial constraints on management. An all-equity structure gives substantial discretion to managers to use the corporate assets for their own benefit, subject only to the internal governance controls. However, when the management must turn to equity markets, those markets quickly and continuously monitor and place an objective value on the company and, by reference, on the management. This value permits shareholders to make quick and rational decisions as to management performance; constrains management in its ability to dilute existing shareholders equity; and also provides an incentive to managers to minimize the costs of equity since failure to do so will make them vulnerable to takeover in large markets. Debt markets impose additional and often more stringent constraints. In order to raise debt capital, the management must often agree with creditors on a plan, (usually embodied in an agreement with creditors in the form of positive and negative covenants) which requires the maintenance of debt/equity ratios and a certain levels of cash flow. (c) The Market for Corporate Control. The public stock markets provide effective discipline mechanisms for management. This discipline is dependent on the corporate attribute of share transferability-manifest in tender offers, takeovers or other actions triggered by management failure to maximize the shareholders' value in their stock as signaled by the share price.9 This effective constraint on management presupposes freely transferable shares and a market through which existing shareholders can exit and new ones enter-purchasing shares at a perceived discount when management fails to maximize shareholder value. This creates the possibility of acquiring shares at a discount, replacing management with more efficient management and taking other necessary steps to maximize value. In the US this is often characterized as "hostile takeovers." However, in Europe and East Asia, the failure of management to keep up the share value has resulted in a growing market for corporate control engineered among friendly, 9 See Manne, "Mergers and the Market for Corporate Control," 73 J. Pol. Econ. 110 (1965). - 24 - related shareholderswho accomplishtheir goals through management replacement. (d) Well-DevelopedLabor Markets. Not only do managerscompete with each other to attain the top positions within the modem corporation, but there also is an active market outside companiesfor managers to improvecorporate performance. In addition, middle and lower level managementcan and often do leave a company when they perceivethat it is poorly managed. Thus management is disciplinedfrom inside and outsidethe company by well-developedlabor markets. In countries where labor has a managementposition on the Board, labor organizationsin and outside the company also exert influenceand thus constrain management. (e) The Corporation's Legal Obligations. In most market economies, laws directly affectingcorporate governance such as Companyand Securities Laws set minimum norms and standardsfor management,aimed at protectingshareholder rights. These laws are enforced vigorouslyin most market economies. Such legislationnormally details shareholdersrights and mandates a high degree of disclosure of corporate affairs, permittingeasier shareholdermonitoring. Other laws on anti-monopoly,fair trade, and competition impactmanagementin varying degrees in different countries. The net effect of these laws is to force managementto adhere to competitivenorms. In the Anglo-Americancase, there is heavy reliance on the legal system, an approach which is gaining currency in Europe as well. In East Asia and Japan, long established social constraints which might be expressed in law in America operate to reduce agency costs (f) Bankruptcy. The threat of surrender of day-to-day control to a trustee in bankruptcyor to a liquidatoris a powerfulincentive for managers to achieve the owners' commercialgoals of profitabilitythrough financial discipline. Bankruptcy,and perhaps more relevant,the threat of bankruptcyimposes a strict disciplineon corporate management,monitored by creditors,generally to the benefit of owners. Conversely,the lack of crediblebankruptcyfacilitates asset strippingand rent seekingsince there is no credibleend or exit for the poor performingenterprise. Figure 2-3 below illustrates how the moderncorporation is disciplinedby both internal and external incentives. - 25 - Figure 2-3. Modern Corporationis Disciplined by Internal and ExternalIncentives Owners InternalIncentives ExternalIncentives Sharehold ~~~~~~~~~~~~~~~Legal Regulation Shareoldr Supervisor Bankruptcy Labor | RepoartsAppoints &Financial Sector to mnitors * Debt Management | Equity Board | _ Markets * Product Ope,txe. -* Labor * "CorporateControl" D. FORMWHEN USE OFTHE CORPORATE THE STATEIS THEOWNER Typically, many unreformed SOEs display the following features: (a) Government interferes in the day-to-day management of the enterprise-lack of clarity between owner/manger functions; (b) The financial sector provides debt on terms softer than commercial basis, particularly for the larger enterprises-state does not benefit from limited liability but bears all risks; (c) There are often too many unrelated non-core businesses; (d) Social responsibilities are a major feature of the SOE's objectives, taking up management time; (e) External incentives such as product and labor market are not able to function effectively; (f) Economic legality is absent and there is no provision for the implementation of bankruptcy or liquidation. These features are illustrated in Figure 2-4 below. - 26- Figure 2-4, Typical State-Owned Enterprise (SOE) Owners Internal Incentives External Incentives -~ .----------------,,, , , , : :I Managementr - - Hq Legal Regulation Bankruptcy I !I .Rnaneial Sector Govemment -- . It------------'I · Debt I I · Equity --- - <: I ~(~ --C;;;~- . . . ~- . -.. Markets ofi-----~, __!?ivi.iOnt __ <:-~ 1!.~,.---~~~ t-'S= · Product · labor · 'Co"",,_t. Control' I Social Functions I o As a result there is no level playing field-Le., competition in the market or for the market is limited and there is widespread "crowding out" of the private sector. The subsidies to SOEs from the financial sector and the absence of hard budget constraints dampen the impact of other external incentives. These influences come most sharply into focus in the case of large loss-making SOBs, given their negative impact on the financial system. However in the past decade, many governments have transformed public enterprises into modem corporations and, to varying degrees, exposed them to external market forces with the objective of increasing enterprises' efficiency. The question posed now is whether the state, as owner, can reform SOEs and capture both the key corporate attributes and create the environment for maximum impact of best practice in corporate governance and the discipline of the variable external factors. 1O The success of the modem corporation rests on the four attributes described above. Remove one and the result is instability, a loss of effectiveness. The attempted use of the corporate form to restructure SOEs in several reforming states has often failed due to an absence of one or more of these attributes in their corporations. For example, in some cases there is an absence of transferability of shares. In many, the separate identity of the corporation and its property rights from the government and its constituent parts is not clear due to a lack of strong 10 In the case studies discussed in Section III below and in Appendix B, corporatization has been a major vehicle for reform in a number of the companies reviewed. See also "Corporatization: the Solution for State Owned Enterprises?" Peter McKinley, Institute of Policy Studies, Victoria University Press, 1987. - 27 - accounting rules and practice. In others, the identity of the corporation and its owners is blurred administratively with resulting unclear objectives, incentives and accountability. Still in others, management or board supervision may be disbursed among different agencies or distant holding company levels with the result that no one in particular can be held responsible for assets and performance. Finally, there have been cases where the limited liability of the owner is in fact non-existent because the state explicitly or implicitly guarantees all creditors of the corporation. The evidence from international experience in transforming SOEs into corporations suggests that certain preconditions must exist if reform is to be successful. These include: (a) Separation of Ownership and Government Functions. A private shareholder has clear, commercial objectives. Reforming the role of the state as shareholder of a modern corporation requires the state also to separate its various functions in respect of the corporation it owns, including its functions as: (i) owner; (ii) contractor for (potentially unprofitable) public services; and (iii) regulator and protector of public safety, environment, competition and fair trade. (b) Designation of an Ownership Agency. One of the first tasks in the corporatization process is to define which state agency should represent the state as owner/shareholder. Best practices based on international experience suggest the separation of powers of the line ministry from the government supervisory body of the corporation. This is done to limit the leverage the Minister and his/her staff have on the corporation's management. Ministers are often politically rather than commercially motivated and thus ministerial interventions can often result in adverse effects on profitability. (c) Clarify and Finance Social Objectives. Early reform decisions must be made as to responsibility, means of payment and accountability for the corporation's social objectives as assigned by the state. Best practices suggest that this be accomplished by contract. However, many of the functions such as education and health should be transferred to municipal or national authorities. (d) Clarification of Regulation and Ownership Roles. The state's motives as regulator and shareholder are quite different. If these functions are performed by the same actor (e.g., a ministry) then mixed signals or even conflicts of interest are likely to occur resulting in the SOE's financial loss or lack of competitiveness. Consequently, without separation of the state's ownership and regulatory roles, distortions are likely to appear at the outset of the reformed SOE's corporate life. If these pre-conditions for effective reform can be met and sustained-as they have been in countries such as New Zealand, Austria, Chile, Sweden and Korea-the internal and external incentives will improve the performance of the SOE and it will begin to resemble more closely the form of the modern corporation. Figure 2-5 below illustrates these relationships. - 28 - Figure 2-5. How to Reform SOEs: Change Internal and External Incentives Owners InternalIncentives Incentives External ---------------- ~~Legal Regulation Management Financial Sector Govemment r------- ebt -' Core Function Markets SocialLabor S ' 7 t j~2 f *o- . ~~~~~~~~~~Corporate Control" son o)c;^ on or al Fucions 8e°c. . , F~~~~~~~~~~~~~~~~~~~~~~d//X - 29 - III. THE INTERNATIONAL EXPERIENCE WITH SOE REFORMS The analyticalframeworkoutlined in Chapter 2 argues that enhancing the efficiency of SOE performance is determinedby establishing a corporation with four key attributes and applying a set of internal and externalincentives. All of these actions are necessary. Establishing commerciallyoriented governance systemsand related internal incentives-i.e., corporatization-is a necessarybut not sufficient condition for achievingefficiencygains in SOE performance. Externalincentives must also be in place if improved SOE performance is to be realized. Internationalexperience teaches that the financial and economicperformance of SOEs are not uniform; they vary between and within countriesas well as across sectors. The differences in broad country experienceare mirrored in eight case studies, as detailed in Appendix E." Such variationis to be expectedgiven the diversity in sector coverage, size of operations and the country context and legal frameworks in which SOEs operate. Nonetheless, there are a number of broadly consistent lessonsfrom internationalexperience. These lessons are examinedbelow in detail and summarizedin Figure 3-1. ll The case studies include the followingSOEs: SemenGresik, Cement (Indonesia); Usinor Sacilor, Steel (France); Statoil, Oil & Gas (Norway);Coalcorp,Coal (New Zealand); IRI, Holding Company (Italy); Sumer Holdings,Holding Company (Turkey);Hindustan Machine Tools (India); and Ksiaz Porcelain Factory(Poland). - 30 - Figure 3-1. Frameworkfor Analysis of SOE Performance INTERNALINCENTIVES EXTERNALINCENTIVES * Clarify Prncipal/Agent Incentives EncourageCompetitionin Product * SeparateCommercialfrom Social Markets Objectives Improve FinancialDiscipline:Role - Provision of Social Safety Net of Debt - Meeting Employment Objectives Sell Sharesof SOEs: Role of Equity - Promotionof Regional Development EncourageOperationof LaborMarkets - Directed Investment * Impose Policy Regime - Competitorsin Domesticand Export - LegalFactor Markets - Bankruptcy * Non-Govemmental Sector Representation - IndependentAuditingStandard on Board of Directors * Avoid Large HoldingCompanies \\_// TE STAEWD | IMPROVED PERFORMANCE A. INTERNAL INCENTIVES: KEY LESSONS OF EXPERIENCE Separate Commercialfrom Social Objectives Many SOEs are faced with a complex agenda-that of pursuing a range of social and political targets that often conflictwith sales or profit maximizationobjectives. Whenever possible, the temptationto mix social with commercialobjectives should be avoided. SOEs should be reformed in such a way that they are be assignedclear and unambiguousobjectives in which commercialprofitability features prominently. In other words, SOEs should pursue commercialobjectives and be given incentivesto succeed similar to those that apply to private firms. The noncommercialroles of SOEs and their economic impactcan be categorizedunder the followingheadings: (a) provision of a social safety net; (b) meeting employmentobjectives; (c) promotion of regional development;and (d) directedinvestment. Provision of a Social Safety Net. In many formerly socialist export economies, SOEs were expected to provide employees and their dependentswith a broad range of social services, services normally provided in most market economies at the nationalor local level by the State. These services ranged from free or subsidizedhousing to childcare facilities, schooling, occupational healthcare,hospitals, recreationfacilities and company pension plans. Although - 31 - less prevalent in market economies, there are also some examples of SOEs in Europe and developing countries which also shoulder the burden of social assets such as housing- particularly in regions where the SOE is the main employer. However, for many SOEs in Central and EasternEurope (CEE) or the Former Soviet Union (FSU), social assets representedvery significantlevels of capital investmentand maintenancecosts which had to be funded from the company's operating budget. In addition to the financial burden which the provision of these servicesplaced on the individualenterprise, the operation of these facilities representsa significantdrain on the scarce managerial resources within the enterprise. In a number of countries,there has been some progress on tacklingthese enterprise-levelconstraintswith reforms focusing on two main solutions:(a) the transfer of assets such as schools, hospitals and housing to municipalor nationallevel civil authorities; and (b) the sale and privatization of services such as transport,hotels, holiday resorts and housing directly to employees or to other bidders from the private sector. See also Box 3-1 "Social Assets: How Russia is facing up to the Burdens of SOE Housing." In the case of pension schemes in Central and Eastern Europe (CEE), most countrieshave now transferred and consolidatedenterprise level funds into nationallevel programs normally administeredby the State. Increasingly these schemesare being supplementedby private pension funds offered by newly privatized companies. - 32 - Box 3-1. Social Assets: How Russia is facing up to the Burdens of SOE Housing The former Soviet government relied heavily on larger SOEs, particularly those located in single- industry towns, to finance and manage substantial housing programs. In some cases, SOEs were even responsible for generating electricity, water and heat. It is estimated that by mid-1992, enterprise (sometimes referred to as "departmental") housing comprised some 40 percent of all housing in Russia; municipal authorities owned 38 percent of the total stock with cooperative and private housing accounting for the remainder. As enterprise reformsbegan to acceleratein 1992 and SOEs were required to adapt increasinglyto the demands of a market economy, it was recognized that their responsibility for housing-and other social assets-was impedingenterprises' attemptsto restructuretheir core business activities. A typical enterprise in Russia might have up to 10 percent of its labor force involved in maintaininghousing stock. Although there is broad agreement in principle that housing should be removed from the responsibility of recently privatized enterprises either through privatization to incumbenttenants or through transfer of ownership and management to municipal authorities,the implementationof this policy is still fraught with obstacles. On the divestiture front, only an estimated 25-30 percent of enterprises housing has been privatized to date. Similarly,despite the passing of the Presidential Decree requiring SOEs to divest their responsibilities for housing to municipal authorities, these authorities are generally reluctant to accept the housing for the same reasons that SOEs and recently privatized companies want to divest themselves of it. Under the current practices, most cities would face rapidly escalating costs of maintainingthese houses and, as importantly,cities would simply be unable to manage the additional stock adequately. To address these problems, initiatives are underway in a variety of areas including: * Acceleration of Privatization. Since many tenants fear that as private owners they would have to pay higher maintenance charges and property taxes, the pace of divestiture could be increased by: introducing a rent payment for non-owners equivalent to the property tax for owners; clarifying owners' rights to receive the same (albeit declining) level of subsidization for maintenance and utilities as non-owners;and, setting a clear time limiton privatization of housing. * Improving the Management of Housing. A number of cities in Russia have begun to establish condominium associations and to delegate to them the authority to contract for their own maintenance. However,progress has been hampered by the absence of a national level legal enabling framework. Where this solution is not feasible in the short run, other municipal authorities are contracting out the management of former enterprises housing to newly privatized maintenance organizationswhich have demonstrateda facility to improvestandards without an increase in costs. * Reforms in Financing and Taxation. One way of financingthe municipalauthorities' responsibilities for housing maintenance will be to utilize the provisions of the current tax regime as a means of raising revenues for city governments. These provisions require enterprises to pay taxes equivalent to the decrease in their direct expenditureson housing following divestiture. A central principle of the proposed reforms is that additional revenues be realized from increasedcost recoveryfrom tenants in both municipal and enterprise housing. However, the ability of enterprises to increase wages will determine, in large measure,the pace at which this cost recovery can be increased. This in turn will require further reform of the pattern and level of taxation. Finally, successfullyraising cost recovery from the bulk of the population will require implementation of the federally mandated housing allowance scheme, a process which is already underway in many cities. * Reducing Housing MaintenanceCosts. Since it is estimatedthat the Russian housing stock is four to five times more energy-intensive that in Western Europe, there are considerable incentives and opportunitiesfor decreasingthe cost of maintaininghousing. It is anticipatedthat modestinvestments in insulation, weatherproofing,thermostatic controls, meters and related measures will assist tenants in sharply reducing their energyusage. Russian authoritiesare also exploring other small investments in the physical housing stock that may yield substantialreturns in terms of lower routine maintenance costs. Meeting EmploymentObjectives. In additionto meeting financial targets, many SOEs face implicit, but nonethelessreal, pressures to generate significantlevels of employment or, at - 33 - least, to protect existing jobs. On the one hand, SOEs do have an opportunity to act as model employers by honoring labor legislationsuch as equal pay requirementsand providing comprehensivebenefits to employees. While in theory SOEs may set an example for labor practices in the private sector, actual experienceis less encouraging. In fact, typically, SOEs are often overstaffed to such a degree that the financial objectivesset by the governmentfor the firm are unattainablein the face of excess labor costs. Internationalexamples abound in developed and developing countries of SOEs with unacceptablylow levels of productivity,absenteeism rates well above the average for comparablefirms in the private sector and unbridled growth of non-monetarybenefits. Notable examples from the case studies are Hindustan Machine Tools, Sumer Holdings and Ksiaz Porcelain Factory. Yet despite these inefficiencies,governmentsare often unwilling to liquidate or even downsize SOEs precisely because of the impact on employmentlevels. Incumbentpoliticians view the short-termcosts of downsizing or closure as exceedingthe medium-termeconomic benefits-benefits that may be diffuse and that may often accrue only after their tenure in office is complete. This dynamic has created systemicmarket rigidities which, in turn, have impacted adverselyon the performance of SOEs. Where governmentshave been willing to address downsizingof SOEs-such as the restructuring of British Steel in 1981or the reforms in IRI (See Box 3-2 below) in the mid- 1980s-they have been successfullargely becausethey have put in place social safety nets which have explicitly addressed the twin issues of redundancypaymentsand retraining. In the British Steel case, the UK governmentand the European Coal and Steel Communitydeveloped substantial retraining grants and redundancypackages (an average of 26 weeks pay) with further financial and technical assistancefrom the companyitself through a speciallycreated subsidiary known as BSC (Industry) Ltd. BSC (Industry)was able to offer subsidizedloans, training and 2 leasing facilities to retrenchedemployees.' The success story of Corby New Town in the heart of the traditional steel industry in the British Midlands and the thriving private sector that developed on the back of newly established small businessesopened by former steel workers, is testimony to the potential of well planned, adequatelyfunded and imaginativelyimplemented regenerationschemes. 12 See ChristopherBeauman, "The Turnaroundof the British Steel Corporation,"EBRD, unpublishedmanuscript, October 1994; and, Susan Housemen,Industrial Restructuringwith Job Security, Harvard UniversityPress, 1991. - 34 - Box 3-2. IRI: Changing Policies on Employment Over the period 1974-80nearly 70 percent of the losses of the IRI Group came from the declining industfies in the steel and engineeringsubsectors. These losses peaked at US$2.4 billion in 1980, equivalent to 9 percent of its consolidated sales. During the same period, employmentat IRI reached 530,000-this has been reduced to 385,000 by 1992-or one percent of the Italian population. Yet despite mounting financial losses and poor industrial relations,the maintenanceof employmentwas a critical govemment objective over this period and labor shedding was difficult. However, by the mid-1980sIRI embarkedon a major restructuringof loss-makingfirms and, where necessary, a concomitant redeploymentor downsizingof the labor force. In some instances,the Holding Company was able to transfer blue collar workers in the industrialnorth out of the production facilities of one IRI subsidiary company to another. But where redundancieswere inevitable,IRI did not operate a special fund to assist laid-off workers but instead relied on the government's CIG (Cassa IntegrazioneGuadagni)scheme. Establishedoriginally in 1947-48as a vehicle to assist with temporaryproblems,the fund-financed largely from employercontributions- was extendedin 1977from temporary stoppage to reconversion and then to closure. Withoutthe benefitof the GIG, it is unlikelythat IRI could have achieved the extensive labor- shedding that took place from 1985-1990. Promotion of Regional Development. A sub-set of these employment objectives is the role given to SOEs as vehicles for regional employment. In situations where governments (or groups of governments such as the European Union) view the promotion of underdeveloped regions as a core element of their economic strategy, there has often been a predilection for direct intervention by government in regional employment through the creation of SOEs. In some instances, such as Hindustan Machine Tools and Sumer Holdings, these firms have been able to make a contribution to employment generation. However, unless there is an explicit subsidy from the government to the SOE to cover the full financial costs of operating in development areas, there will be significant constraints in the firms' ability to meet financial targets. In the case of Statoil, the development plans of the company had to be approved by the Ministry of Industry and Energy in the early days of the company's operation. These procedures led to the establishment of plants at sub-optimal economic locations throughout the Norwegian territory with the explicit intention of creating employment opportunities in less developed regions. However, after the second major dip in international oil prices in the mid-1980s, government's proclivity for utilizing Statoil as a compliant vehicle for the implementation of regional development objectives was replaced by harsh financial pressures on the company and a move towards internal Statoil Board decisions driven primarily by commercial objectives. Regional development programs in southern Italy (the mezzogiorus) were imposed by the government of Italy on IRI Group, which adversely affected the financial performance and commercial objectives of its sub-holdings and operating companies. The law passed in Italy in 1959 required all SOEs to ensure that at least 40 percent of total and 60 percent of incremental investment directed towards new projects is located in Mezzogiorus. Directed Investment. In several countries, governments direct SOEs to invest in sectors that are viewed as essential to national security, or in economic activities that the private sector might neglect, such as the provision of essential foodstuffs or infrastructure. In these latter cases, the investment is often accompanied by pricing decisions designed to provide subsidized goods and services to consumers or targeted groups of consumers. Unfortunately, uneconomic prices or tariffs will result in financial losses for the companies operating in these sectors, and without a resolution of this conflict through full and transparent financial compensation for these - 35 - subsidized goods and services, the result will be widespread underinvestment and misallocation of resources. Lessons on Separation of Social and Commercial Objectives. A critical element contributing to the poor performance of many SOEs has been the diverse, ill articulated and often conflicting roles set by the owners for the management of the enterprises. It has, as a result, been difficult for many SOEs to achieve and to sustain the productive, allocative and dynamic efficiencies required for maximizing economic benefits Where governments are nonetheless determined to utilize SOEs to achieve non- commercial objectives, two principles should be applied with rigor and with consistency. First, it is essential that the non-commercial objectives be clearly and explicitly identified and agreement reached between the shareholders and its agents on the nature and the timing of the measures. Second, the costs-in financial and human resource terms-of achieving these objectives should be delineated in full and timely and transparent arrangements should be made to compensate the enterprises for the provision of these non-commercial objectives. Such an attempt was made in IRI, where close attention was paid to calculations of costs of non- economic investments at the beginning of the 1980s. These calculations were taken into account when payments from the government endowment (equity) funds were made. Whenever possible, the temptation to mix social with commercial objectives should be avoided. It is strongly recommended that SOEs be assigned clear and unambiguous objectives, in which commercial profitability features prominently. Specifically, SOEs should be set commercial objectives and given incentives to succeed similar to those which obtain in the private sector. Clarify Principal/AgentRelationships Clarifying the relationship between SOE managers and the firm's owner is one of the most fundamental issues for the State as owner of the corporation to address. How should the state interact with SOE management in such a way that the firm best achieves its commercial goals? What owner/manager framework for SOE control has worked? International experience to date offers several lessons. First, the most effective SOE owner/manager regimes have been those where there has been a separate legal identity of the corporation from its owners. Nonetheless, too often the state tends to blur its function as owner and manager. One of the most common features associated with inefficiently run SOEs has been the predilection for the state's designated representative as owner to intervene repeatedly in day-to-day management (to achieve noncommercial goals) to the detriment of the enterprise's profitability. International examples abound throughout the developed and developing world of undue political influence by governments in the running of SOEs. This is a dominant theme in countries as varied as India (e.g., Hindustan Machine Tools), Turkey (e.g., Sumer Holdings), and Italy (e.g., IRI). In many such cases, the property rights of the corporation were not clarified and accounting systems were weak. In Turkey for instance, accountancy followed state agency rules, not the principles applicable to commercial enterprises. - 36 - Audited accounts were sent to a government agency, but were not used to evaluate management's commercial performance. This blurring of the functions of owner, shareholder and manager has contributed in large measure to the poor performance of SOEs. Second, international experience in countries as diverse as France, Italy, Norway, New Zealand, Korea, Indonesia, India and Turkey suggests that effective internal governance for corporatized SOEs has been achieved when the state has provided adequate incentives to boards, managers and employees to meet commercial objectives. In countries where this has not been the case and actions have been taken to redress the problem-such as New Zealand, Norway and Korea-SOE performance has improved. However, underpayment for outstanding performance and failure to discipline non-performers are common errors. All too often, state-owned corporations have not made the rewards commensurate with the risks in reformed SOEs. Incentives to managers for profit and efficiency gains are notably missing. In many socialist systems, rewards were given for quantitative production achievements, but usually without regard to quality, cost, efficiency or return to the owner. In many cases, managers are civil servants, and performance evaluation, dismissal, compensation and benefits are all tied to the government's noncommercial standards. One of the features which has most consistently distinguished efficient from inefficient SOEs has been the introduction of salary and benefit incentives for managers which reflect market conditions. Most SOEs were originally established with human resource models based on the terms and conditions offered to civil servants. On the one hand, SOE managers and workers enjoyed implicit assurances that they would receive the security of tenure offered to employees in the civil service. On the other hand, they were constrained in their performance by the lack of incentives manifest in pay scales and benefits designed for government administrative employees. In these circumstances, it is difficult to reward or to sanction the performance of managers and that the ability of the State, as owner, to provide incentives for their "agents", i.e., management, is severely circumscribed. Since one of the central tenets of sound internal governance is the creative tension necessary between the principal and agent, efforts to seek efficiency gains through increased managerial autonomy in the day-to-day operation of the SOE will inevitably fail if there are insufficient financial rewards available to management. International experience, including the case studies in the Appendixes, shows that some of the most efficient reformed SOEs-Statoil, Semen Gresik, Usinor Sacilor and Coalcorp-have all recognized that, in order to attract and retain top level management which is willing to assume the full responsibilities of their positions of authority, the link with civil service pay and conditions must be severed. In its place, these companies have offered terms and conditions more akin to the risks and rewards available in the private sector and have sought to compete with private firms in the market for experienced and competent management. Incentives for employees can also be devised and, in this regard, profit sharing and some equity distribution have proved effective. Employee positions on boards may serve some social ends, but rarely, if ever, constitute the necessary incentives to increase productivity. - 36 - Audited accounts were sent to a government agency,but were not used to evaluate management's commercialperformance. This blurring of the functionsof owner, shareholder and manager has contributedin large measure to the poor performance of SOEs. Second, internationalexperiencein countriesas diverse as France, Italy, Norway, New Zealand, Korea, Indonesia,India and Turkey suggeststhat effective internalgovernance for corporatizedSOEs has been achievedwhen the state has provided adequateincentives to boards, managers and employees to meet commercialobjectives. In countries where this has not been the case and actions have been taken to redress the problem-such as New Zealand, Norway and Korea-SOE performance has improved. However, underpaymentfor outstandingperformance and failure to discipline non-performersare common errors. All too often, state-owned corporations have not made the rewardscommensuratewith the risks in reformed SOEs. Incentives to managers for profit and efficiencygains are notably missing. In many socialist systems, rewards were given for quantitativeproduction achievements,but usually without regard to quality, cost, efficiencyor return to the owner. In many cases, managers are civil servants, and performanceevaluation, dismissal,compensationand benefitsare all tied to the government's noncommercialstandards. One of the features which has most consistentlydistinguishedefficient from inefficient SOEs has been the introductionof salary and benefit incentivesfor managerswhich reflect market conditions. Most SOEs were originallyestablished with human resource modelsbased on the terms and conditions offered to civil servants. On the one hand, SOE managersand workers enjoyed implicit assurancesthat they would receivethe securityof tenure offered to employees in the civil service. On the other hand, they were constrained in their performance by the lack of incentivesmanifest in pay scales and benefitsdesigned for government administrative employees. In these circumstances,it is difficult to reward or to sanction the performanceof managers and that the ability of the State, as owner, to provide incentivesfor their "agents", i.e., management,is severely circumscribed. Since one of the central tenets of sound internal governance is the creative tension necessarybetween the principaland agent, efforts to seek efficiency gains through increased managerialautonomyin the day-to-dayoperation of the SOE will inevitably fail if there are insufficientfinancialrewards available to management. International experience, including the case studies in the Appendixes,shows that some of the most efficient reformed SOEs-Statoil, SemenGresik, Usinor Sacilor and Coalcorp-have all recognizedthat, in order to attract and retain top level management which is willing to assume the full responsibilitiesof their positions of authority, the link with civil service pay and conditions must be severed. In its place, these companieshave offered terms and conditions more akin to the risks and rewards available in the private sector and have sought to compete with private firms in the market for experiencedand competentmanagement. Incentives for employees can also be devised and, in this regard, profit sharing and some equity distribution have proved effective. Employeepositions on boards may serve some social ends, but rarely, if ever, constitutethe necessaryincentivesto increase productivity. - 37 - The board of directors' role vis-a-vis management's decisions also lies at the heart of clarifying owner/manager relations in SOEs. International experience and research demonstrate that the most effective SOEs are those where the board's compensation is tied to managerial performance. The board must thus receive incentives to monitor and control the corporation's executives, including the right to hire, fire and monitor their decisions and set their compensation. In turn, the board's success is monitored by the shareholders, and disciplined or rewarded by shareholders' actions. International experience also suggests that share transferability is a fundamental attribute of successfully reformed SOEs. This finding stems from the concept of residual risk-i.e., the risk accepted by the owners of the enterprise who take the ultimate risk of loss and also benefit from the ultimate gains. In private sector firms, the residual risk bearers must have effective control over management decision-making and/or be able to sell their ownership rights to new purchasers (e.g., through the sale of shares or to a strategic investor). In these circumstances the private owners of the enterprise have powerful incentives to be efficient since they bear the full consequences of their own decisions. In the case of SOEs however, the residual risk is borne by the population as a whole which in turn has no ready vehicle for either controlling the enterprise or for divesting its ownership rights. In these circumstances, the incentives to perform efficiently are weakened since residual gains or losses are not borne in full by the local, municipal or national authority which owns the enterprise but by the population at large. Therefore, while a corporatized SOE may look like a privately owned enterprise it lacks one significant factor and this deficiency will undermine the effect of other reforms. The efforts to incentivize management and Boards within the State structure will ultimately be undermined since the monitoring government institution does not bear the residual risk-the population as a whole does. Many countries have confronted this problem by diversifying SOE ownership; in some cases, to secure the gains from ownership diversification, SOE divestiture has been pursued. The case of the UK provides an instructive example. Despite the clear intention that, through ownership diversification, SOEs in the UK should operate at arms-length from government as commercial organizations, this did not occur. Poor SOE performance was due primarily to the lack of incentives for greater efficiency; over 1970-85, there were few rewards or penalties for management or employees if profits of SOEs were unsatisfactory. After several years of disappointing reform efforts, the UK government concluded that sustained improvement of SOE performance would be brought about by divestiture. As a result, the government embarked on a program to divest most of the larger SOEs. Appoint Non-GovernmentalRepresentativesto Boards One of the key factors which has continued to frustrate the efficient operation of SOEs after corporatization, has been the failure to attain a clear separation of overt political influences from the commercial and business objectives of the enterprise. While it is important to establish a strong Board structure to develop the overall strategy for the SOE and to monitor the performance of management, the creation of a Board which facilitates undue political - 38 - interference in the day-to-day operation of the business will achieve little by way of improved corporate governance. International evidence suggests that a more effective way of ensuring that Boards are able to perform their strategic and monitoring role is through the introduction of private sector representatives onto the Boards. (See also discussion in Section II.) Experienced and civic- minded representatives with strong private sector and technical backgrounds can provide the substantive and motivational underpinnings necessary for improved corporate governance. In Norway, Statoil has had representatives from the private sector on its Board for some time as has the French steel firm Usinor Sacilor, all of the large Korean SOEs (known as Government Invested Enterprises) and, more recently, Semen Gresik in Indonesia. However, even the most private sector oriented SOE Board such as Coalcorp in New Zealand has struggled with the ability to "lock in" the positive impact of good governance that comes from these appointments. Significantly, the remaining New Zealand SOEs that have not yet been privatized have begun to suffer from the re-emergence of escalating interference from politicians seeking objectives that are often at variance with the agreed strategy of the SOEs. Indeed, the New Zealand government has explicitly recognized that the most effective way to deal with these relapses in governance is to consolidate the gains by permitting market forces to operate with minimal interference through the divestiture of many of its corporatized SOEs. Box 3-3. Private Sector Leadershipon Coalcorp'sBoard Structure In New Zealand,the govemment transferred commercialoperationsfrom conventional Govemment Agencies to nineteen SOEs as part of a wide-rangingcorporatizationprogram which began in 1984. The shares of Coalcorp, transformed into an SOE in 1987,are held by two Ministries-the Ministry of Finance and the Ministry of State OwnedEnterprises. The duties of the shareholdersare primarilyto monitor and to control the commercial performanceof the SOE through the Board of Directors. Other Ministries of the governmentare responsible for ensuring the achievementof social objectives and the SOEs are not responsible for broader social objectives that impact profitabilityunless compensatedby a payment from the State. The Coalcorp shareholders,in turn, have appointed a Board of Directorscomprised of five to seven directors from the private sector which normallymeet monthlyand operate on a part-timebasis. It is the New Zealand government's view that the appointmentof private business men and women will ensure that there is sufficient commercialand business experience to determine broad strategy and to monitor the performanceof the SOE managers. The Board members are appointed and removed by the shareholdingministries,often after recommendationby the State-OwnedEnterprisesUnit and the Treasury. Avoid the Creation of Large Holding Company Structures The debate over the efficacy of holding company structures as an efficient vehicle for enhancing corporate governance in groups of companies has been the subject of heated 1 deliberations for some time.' 3 This issue is of particular interest to economies in transition 13 For discussions of holding companies in Italy (IRI), Egypt, and Algeria see Anjali Kumar, State Holding Companies and Public Enterprises in Transition, St. Martin's Press Inc, 1993; Andreja Bohm, The State Holding Corporation: An Incomplete Divisional Form of Organization, Public Enterprise, Vol 10, No.]. - 39 - where economic forces have dictated the need to seek radical forms to deal with the governance of SOEs in the interregnumleading to private ownership. However, internationalexperience suggeststhat the significantdisadvantagesof large holding companiesoutweigh any limited advantages:many of the aims of these structurescan best be achievedby improvingstructuresat the level of the enterprise and by ensuring that the external factors outlined in the section below are in place and free to impact SOEs. The country examples of Italy (IRI), France (Usinor Sacilor),Turkey (Sumer Holdings) and India (HMT) as well as the poor experience with these corporate forms in Algeria, Egypt and Kazakhstanamply demonstratemany of the drawbacks of these systems. The main disadvantagesof holding structurescan be summarizedas: (a) the creation of additionallayers of bureaucracy with few benefits, in terms of increasedefficiency, to the operating companies; (b) a failure to shield the operating companies from undue political intervention; (c) the propensityfor cross-subsidizationbetween operatingcompanies in the Group and the concomitantdistortion of signals and incentivesto managementthat this practice promotes; and (d) the difficultyin controllingthe growth and longevity of these corporate forms once established. Various countryexperiences illustrateeach of these points In the cases of both IRI (Italy) and HMT (India),the "apex" institution has been unable to provide many of the efficiencies and economies of scale that the structure was purported to deliver in terms of strategicplanning and improvingcentralizedfunctions. Indeed, in IRI the structureof vertical links involves cumbersome,multiple layers of decision making comprising the apex holding company with sub-holdingcompanies and affiliated companies below this. The HMT structure is similar. This top heavy decision making and reporting structure has created additional and expensive layers of bureaucracywhich elongates the chain of decision makers representing the State's often multiple and conflictingobjectives. The IRI structure has also palpably failed in one of its prime objectives-to shield the Sub-HoldingCompaniesand the operating companies from interferencefrom politicians and political parties. Instead, the recent political problems in Italy have pointed to widespreadand deep-seatedinvolvement by political parties in many financialand operational aspectsof IRI's operations. On the other hand, in Sumer and HMT, the centralizedmanagementhas shielded the operating companies from external market factors, which otherwise would provide the incentives for competitiveness. The centralizationof profit allocation, revenue and expendituredecisions at Holding Companylevels have distorted the messages and incentivesto management on the need for - 40 - emphasizingresourcefulness,flexibility and efficiency at the operating level. For instance, in Usinor Sacilor, the managementand Board of the profitablestainless steel division, Ugine, have long complained that the decision to use profits from their operation to cross-subsidizethe loss making long-productscompany-Unimetal-has the effect of sending the wrong signals and incentives to the managementof both companies. This arbitrary reallocationof surplus funds by the Apex institution is a dangerouspractice which has the very real effect of minimizing the incentivesfor Ugine managementto improveprofitabilitywhile reaffirmingUnimetal's belief that their financial shortfallswill be met from externalsources. Equally, any legitimate transfers from the Italian governmentgo directly and only to the IRI apex holding company which has the power to decide how these funds are to be disseminatedto Sub-Holdinggroups. Experiencein countries as varied as Austria, Zambia,Germany and Sweden indicates that holding companies have a propensityto grow in size and influence, and that, once established, become the enemies of reforms that involve any reduction in their longevity or influence. In socialist countries,the holdingcompanies have tended to replicate the vertical monopolies of the old system, locking in inefficienciesand resistingchange mandatedby external market factors. In Kazakhstan,the governmenthas taken the unusual step of annulling the 1993 decree which establishedthe Holding Companiesin light of the negative influencethat these structures imposedon the government's reformprogram. Finally, even in the private sector where many holding companieswere established in the 1970sand 1980s,a large number of the larger companies such as ITT, Kodak and Volvo have announcedthat they are "unbundling" their conglomeratesto allow for a greater focus at the operating level on individual lines of business. B. INCENTIVES: EXTERNAL KEY LESSONS EXPERIENCE OF There are powerful factors,external to the corporationand not within the normal control of shareholders,which encourage corporate managers to act in ways which are consistent with the shareholders' interest of efficiency and profitability. In order to create the conditions where SOE performance can be optimized, these externalforces must also be allowed to operate as a complement to the package of internal governanceforces discussed above. This section reviews the nature of these external factors and their significancein impacting SOE reform. Encourage Competition Perhaps the most importantexogenous factor impactingthe efficient operation of any firm-including SOEs-is the overall degree of competitionin the enterprise sector. Economic theory and practice amply demonstratesthat companiesin a "contestable"market facing the full rigors of competition with freedom of entry and exit, are likely to react to these pressures in a manner which will foster and maintain high levels of efficiency at the level of the firm. Conversely,companies in a monopolisticor oligopolisticmarket protectedby barriersto competitiveentry and exit will be in a position to extracteconomic "rents" from their position, with few incentivesto seek cost reductions;indeed, the more likely outcome is higher prices, losses in consumer welfare and restrictions in output. - 41 - Even when there are numerous SOEs operating in the same sector, governments have been known to prohibit competitionbetween SOEs and/or restrict entry or competition from private sector firms in an effort to provide protectionto potentially inefficient SOEs. Equally importantly, governmentshave seldom displayeda willingnessto liquidatepersistentlypoor performing enterprises. Instead they have sought to provide direct financial subsidiesor indirect subsidies such as concessionarycredits from the bankingsector, debt for equity swaps and exemptions from the payments of customs duties,dividends,taxes and suppliercredits. International country experiencevaries from fierce competitionin contestablemarkets with negligible interference from government-the UK and New Zealand-to overt protectionby the State for heavily subsidizedoperations-Turkey and India. In all cases, the impact or absence of these external competitiveforces on governance,and hence performance of the enterprises, has been marked and direct. Statoil, the fully integratedNorwegianoil company,is a firm which has had to compete vigorously in the production and sale of a homogeneousproduct in internationaloil markets with large multinationalcompanies. As a consequence,both the owner-the State-and its agents in Statoil have been united in their resolve to match the efficiencylevels of their larger competitors from the private sector in order to survive commercially,particularlyin the absence of large subsidiesfrom the State. Similarly,Coalcorp in New Zealand has maintainedacceptable levels of financial performance despite the imposition of hard budget constraintsin line with the recent policies of the government of New Zealand and competition from other energy sources. In large measure, this has been due to the very real pressures that Coalcorp faces withinthe domestic market from forty to fifty privately owned coal mining companies;in the internationalmarket, the company is a small player in a highly competitiveenvironment. The increasesin export sales in 1993 and 1994 are testimony to Coalcorp's relentless emphasison commercialpractices and productive operations. In the case of the French steel producer, Usinor Sacilor, the company competes freely for the French and Europeanmarket against other European SOEs and private steel producers although the European Union does monitor steel prices. However, competition is constrained to the extent that, in recent years, the European Union has invoked restrictions on imports from Central and Eastern European steel producers operating at low levels of capacity utilizationand willing to undercutprevailingmarket prices. Where these competitiveforces are kept in abeyance by direct government actions, the result has led to a stifling of the incentivesand rewards for efficient operationswith negative impacts on consumers. The exampleof SemenGresik and the Indonesiancement industry is a case in point. The Indonesiancement industry is comprisedof nine companies,of which five- including Semen Gresik-are in the public sector. The Indonesiangovernmentintervenes in the domestic market by setting regional benchmarkprices and by allocating regional markets based on proximity ("defined regional markets"),installedcapacity and projectedcement demand. Export of cement must also be authorizedand is only done so when domestic cementdemands have been met. This market control system which has presented Semen Gresik and the other producers with, in effect, captive regional markets, is realized by the Ministriesof Industry and Trade in consultationwith the Associationof Cement Producers. However,this reliance on cumbersome administrativecontrols and minimal competitionhas led to supply bottlenecksfrom - 42 - time to time and shortages in the market for consumers. Significantly,the governmentis actively consideringthe deregulationof cementpricing and marketingboth to improve the efficiency of existing producers and to provide incentivesfor investmentpromotion in the sector. Improve Financial Discipline:the Role of Debt When markets for debt finance operate according to commercialprinciples they induce corporationsto demonstratethey can employ the debt profitably,by servicingit or covering the creditor's losses if it cannot be repaid. Thus, creditors exert a disciplineon corporationsakin to the discipline imposedby shareholders. However,where the state as owner protects its corporationfrom that discipline(usually by guaranteeingits debts), it removes a strong incentive for management to be efficient and to seek profit and introducesissues of "moral hazard." To guarantee a state owned corporation's debt is to acknowledgethat the external and internal governance of that corporation is insufficientto cause its managementto achieve the goals of efficiency and profit. The existenceof such guarantees has undermineddiscipline,and in some cases, contributedto serious financial difficultiesfor the State. Turkey's Sumer Holdings is a case in point. Most of the borrowingby Turkey's SOEs has been backed by a governmentguaranteeof some form or another. This debt has had a major adverse impact on the government's finances. Other examples of the negativeimpact of the absence of debt market disciplineis IRI in Italy. Here loss-makingenterprises were permittedto continue with debt financing, backed by government guarantees. The lessons learned from these reformingenterprises are that undisciplinedborrowing-that is at no risk to the corporation's assets, managementor labor- leads not only to poor SOE efficiency but also to a rapid rise in public debt. In addition to abuses of the debt markets, many SOEs have also been able to by-pass governmentsattempts to imposehard budget constraints. For instance, where direct subsidies to SOEs are stopped, these enterpriseshave still been able to turn to non-bank financial institutions for credit or continue their operationsby running up large inter-enterprisearrears. Equally, companies such as HMT and Sumer Holdingswent unpunished when they failed to pay taxes, customs duties or dividends. Even in cases such as Japan (JapaneseNational Railway), New Zealand (the NZ Post Office) and Pakistan (many of the industrial SOEs), there has been recent evidence of backsliding in the application of hard budget constraintsover time as politicians buckle to the demands of the inevitable short-termpolitical crises. Diversify Ownershipof SOE Shares:The Role of Equity In the private sector, the transferabilityof shares is a basic attribute of a successful corporation. Coupled with an activeequity capital market, internationalexperience shows that diversified sales of SOE shares or the dilution of governmentownership through rights issues can have a major impacton improvinga company's performance. When a company's shares are listed on a stock exchange, the day-to-dayperformanceof these shares is a transparent reminder to the managers and owners of the perceivedviabilityof the company. Threats of takeovers, - 43 - fluctuationsin stock prices-particularly for managers with share options-and the influenceof non-state shareholdersare pressures that effectively concentrate the minds of managementon the need for corporate efficiency and commercialsuccess. The internationalexperience with divestiturehas yielded a numberof lessons about the different methods to implementthese initiatives. However,there is little doubt that-well planned and properly executed-the positive economicbenefits of divestitureprograms in terms of consumer welfare and economic productivityoutweighany of the costs. See Appendix A for a Summaryof International DivestitureExperience. In the case of most SOEs, it is difficult to develop appropriatesurrogates for these private sector capital market forces. However,experience has shown that it is possible to create some of the external pressures which can motivate improved governanceby selling even a minority portion of the government's shares to the private sector. This is a trend which has accelerated internationallyin recent years. IRI for instance, has embarked on a flexible ownershipinterface with the private sector; there are many companiesin the Group which have some measure of private shareholdingand acquisitions and sales of smaller companies have occurredfrequently. However, until 1990 full divestiture was not an option althoughownership dilution did occur mostly through share issues and issues of convertiblebonds and warrants up to 49 percent of the companies' value. Similarly,both Statoil and Usinor Sacilorhave a numberof joint ventures and strategic alliances with private sector investors which have proved to be significantand positive external pressureson enterprise behavior. Overall, the trend of non-state minority ownership of SOEs has accelerated in recent years. Box 3-4. Semen Gresik: The Impact of the Initial Public Share Offering In recent years, the Indonesiangovernmenthas become increasinglyreluctantto increaseits capital participation in SOEs and has encouragedcompaniesto seek long-term investmentfinancingfrom the capital market. As a consequence, in July 1991Semen Gresik became the first IndonesianSOE to issue shares on the Jakarta Stock Exchange in order to finance a major capital investmentproject. This Initial Public Offering (IPO) comprised 27 percent of total share capital and generated about Rp.280 billion ($140 million equivalent). Of the new shares sold, about 85 percent of the total are held by foreigners,mostly institutionalinvestors. Following the successful listing of the company, the managementand oversight of the enterprise have been affected in significantways. First, as a result of IndonesiangovemmentRegulation 55/1990,the company is exempt from cumbersome regulationson governmentsupervisionand monitoring as well as onerous governmentprocurement rules, while enjoying greater flexibility in sourcing of funds. Second, a very significant impact of the IPO has been the much greaterscrutiny of company performanceby the (minority) private shareholders. Public reporting now takes place every three months while company finances are audited in line withinternational accountingstandardsby a reputedinternationalaudit firm. Company performanceis also scrutinizedby external financial analysts who publish periodicrecommendationson the attractivenessof Semen Gresik's shares for current and potentialinvestors. Managementand governmentofficials agree that the much closer scrutiny and the external pressures which accompanythe listingof shares, have led to greater transparency of the company's performance and have created a greater sense of accountabilityby company managementfor efficiency improvements. While Semen Gresik's performancein 1994 remainedsatisfactory, further efficiency improvementsleading to improved financial performanceis anticipatedas a result of the new capital investments coming on stream. - 44 - Encourage the Efficient Operationof Labor Markets For an SOE to operate efficiently, it must be free to use, and be disciplinedby, the availability of all its inputs, including labor. This implies the right of the corporation to hire and fire the labor it needs, freedom to optimize the labor factor of production as well as the right and freedom to change managersand skilled technicians. A key advantageof the corporate form is its ability to mobilize the labor skills needed to achievethe corporate goals. This fact also provides incentivesto both labor and managementto increase productivityto maintain or improve their positions. Efficiency gains have been severely limited in a number of enterpriseswhere state interference has separated SOEs from labor markets and denied them freedom to optimize this factor. In Sumer Holdings,for example, the managementand most staff have civil service or equivalent status. Dismissal is almost impossible,while at the same time, offering monetary or other incentivesfor extraordinaryperformanceis illegal. In HMT, rigid rules applicable to SOEs similarly freeze the labor patterns,resulting in overmanningand an inability to attract the most promisingtechnicallyskilled labor. Avoid Complex External PerformanceMonitoringSchemes To a greater or lesser degree, SOEs operate at the formal level within recognized parameters such as target rates of return on assets, return on sales as well as acceptable financial performance measuredby standardkey operating ratios. In a numberof countries such as Korea, Pakistan, France, Indonesia,New Zealand and Mexico a great deal of effort has gone into designingsystems to measureand monitorthese targets, drawing both on the internal performance of the firm as well as applying internationalcomparisonsof sectoral performance. However, there is little hard evidencethat these systemshave been able to develop and, equally importantly,maintain objective performancebenchmarksin such a way that the measuresreflect decisions that can be controlledby management. In a number of instances,the systemsare fraught with poor design parameters,distortionaryincentivesand lack the facility for enforcement. In the Indonesianperformance monitoring systems,there have been several reforms aimed at reflecting technical differences amongsub-sectors and a number of non-financial indicators were addedto the long list of financial indicators in 1993. Financialperformance indicators now account for 70 percent of enterprise evaluation and technical indicators tailored to each sub-sector or enterprise make up the balance. However, once Semen Gresik's shares were listed on the Stock Exchange, the companywas exemptedfrom this cumbersomescheme-an explicit recognitionby governmentthat a strong Board and capital market pressures are a more effective method for monitoring the company's performance. In Pakistan,the once innovative annual monitoringprogram with rewards and sanctionsfor managementhas deterioratedfrom its influential role in the 1980sto a point in 1993where officials now indicate that the system was no longer being energeticallyapplied. - 45 - One of the key lessons from internationalexperienceappears to be that such external performance monitoring systems are successfulonly when the monitoringunits-as in Mexico and Korea-are directly linked to bodies with real policy-makingand political influence. However, even in these cases, the solutions involve significantcosts in terms of the bureaucracy required to perform the externalmonitoring functions. Improvingthe Policy Regime Legal Factors. Companiesand securities laws, laws setting out the scope of fiduciary duties, and general business legislationcovering the creation, incorporation,management and liquidationof companiesdetermine the rules by which corporationslive. Importantly,they also constrain managerial opportunismand protect each of the participantsin the corporation. If these laws are absent or deficient, or if these laws, in whole or part do not apply to the SOE, then the SOE is deprived of importantelementsof governance which provide incentivesto managers for the state shareholdercommercialgoals. In many states, SOEs are exempt from various legal or regulatoryprovisions otherwise applicable to corporations,such as tax, customs, competitionlaws or labor laws; in other cases, special privileges such as tariff protectionor governmentprocurementpreferences are granted. These exemptions and privileges are intended to confer competitiveadvantages on the SOEs aimed at their improved performance. In each of the case studies reviewed, such exemptions and privileges were conferred to some extent. While these favors to SOEs may constrain competitors,there is no evidence that such measuresimproved SOE performance. On the contrary, there is some evidence (Sumer Holdings,IRI, New ZealandCoal, HMT), that the grant of legal protections or exemptionsdeprives the enterprisesof incentivesto improve efficiency, technology and profitability-outside the laws applicableto private enterprise. SOEs will tend to grow complacent. HMT receives numerous legal benefits including high tariff protection and governmentprocurementpreferences. Yet, it continuesto lose market share, its technology level is precariously low, and its cost of productionnow exceeds world market prices for many of its core products. Permit Bankruptcy. In the tradable sector, there is no sound economicreason why a state owned corporation should not be subject to bankruptcy. Protection from creditors removes from corporation managers one of the strongest incentivesfor efficiency and profitability. The absence of a threat of bankruptcyhas kept alive most of the failing SOEs in reform. The Polish case study of Ksiaz Porcelain Factory, however,demonstratesthat bankruptcydoes not always result in a complete loss. There, the process resulted in a liquidationand restructuringexercise which in turn led to a rejuvenation of the firm and an opportunityfor regeneration. Thus a significant,but often overlooked,advantageof bringing bankruptcyto bear on SOEs is that part of the reconstructionof a firm after its bankruptcyoften involvesconstructing arrangementsfor motivatingnew and surviving managersand employees. Develop and Enforce Independent Auditing Standards. One of the features that has frustrated attempts to improve the efficiencyof SOEs is an absence of reliable financial informationon the performance of the company. This type of informationis important from a - 46 - number of perspectives. First, accounts that are audited by an independent,professionalfirm up to internationallyaccepted standards will provide the owners and the Board of Directorswith a reliable data base to supplementmanagement accountsand on which the strategy for the enterprise can be developed and monitored. Second, this independentdata will be a necessary pre-conditionfor entering into significantjoint venturepartners-particularly with non- nationals-or for preparing the companyfor partial divestiture. Countriesas varied as France, New Zealand, Norway and, more recently, Indonesiahave recognizedthat this type of informationis necessaryfor increasing the performance of their respectiveenterprises in both domestic and internationalmarkets. Finally, governmentsare better able to design and to implement taxationand customs regimes which both satisfy revenue generatingrequirements and, at the same time, broaden the tax base in such a way that principlesof equity are more efficiently achieve. - 47 - Table 3-1. InternationalExperiencewith SOE Reform WHAT HAS WORKED: WHAT HAS NOT WORKED: 1. Governance 1. Governance Separate commercialfrom social objectives Create multiple and conflicting objectives Clarify principal/agentrelationships Permit ad hoc political interferencein running of the company Pay private sector level salaries and provide similar Link SOE managerial salaries to civil service pay scales labor incentive packages to managers Appoint private sector and union representativeson Staff Boards with politicians and civil servants Boards Appoint strong, independentprivate sector oriented AppointCEOs responsiveprimarily to political agendas CEOs Minimizebureaucracy in the organizationof the firm(s) Create large HoldingCompanyStructures WHAT HAS WORKED: WHAT HAS NOT WORKED: II. External Incentives II. External Incentives Encouragecompetitionbetween SOEs and with the Prohibitcompetitionin product markets; create a private sector, foreign and domestic and open trade and monopoly investmentchannels Apply hard budget constraints Allow SOEs to accrue arrears with banks unchallenged or avoid taxes, customsduties Allow shares of SOEs to be sold to the private sector Prohibitthe sale of shares to the private sector Allow labor markets in the public and privatesector to Restrictthe operation of labor markets operate freely Encouragethe development of external,independent Rely on internal auditors auditors Avoid complex external performance monitoring Establishcomplex, ambiguousperformance contracts schemes Establish internationallyacceptedCompany and Rely on ad hoc rulings on legal issues impactingSOE Security Laws performance C. SUMMARY: INTERNATIONAL LESSONS OF EXPERIENCE The broader international experience, the cross-sectional data and the case studies examining SOE reform suggest a number of broad conclusions. These are summarized in the table above. The main lessons are: (a) SOE performance can be improved measurably through reforms such that the enterprise, government and consumers all benefit from efficiency gains, even in the absence of divestiture; - 48 - (b) Improvementsin internal corporate governanceare a necessarybut not sufficient condition for enhanced SOE performance. Equally, the external environmentand policy frameworkmust be allowed to operate effectively and to impact, in full, the performance of the SOE sector;but (c) International experienceshows that these reforms may be politically and technicallydifficult for governmentsto implement; (d) The whole package of reforms must be implemented-partial reforms are seldom sufficient-and they must be sustainedover time; (e) This is a challengingagenda for most governmentsand there are few examples of real success stories;and (f) Even where there are successeswith SOE reform, governmentshave increasingly recognizedthat to sustain these reforms, there is a compellingcase for increasing the role of the private sector in terms of financing, managementand, most importantly,as equity shareholders. - 49 - APPENDIX A SUMMARY OF INTERNATIONAL DIVESTITURE EXPERIENCE - 51 - APPENDIX A SUMMARY OF INTERNATIONAL DIVESTITURE EXPERIENCE Global Trends in Divestiture The divestiture process began in Chile, the UK and a limited number of other countries in the 1970s and early 1980s but it was not until the mid-1980s that SOE equity sales began to accelerate internationally. More than 8,500 SOEs in over 80 countries have been sold over the past fifteen years. The former socialist countries of Eastern Europe and the FSU-most notably the Czech Republic, Russia, Kazakhstan, Poland and Hungary-have all embarked on ambitious divestiture programs. But this activity has not been confined to economies in transition- developed, middle-income and, to a lesser extent, poorer countries have also sought economic and social benefits through divestiture initiatives. To illustrate: * In France-historically a country with the strongest SOE sectors in the EU-the Government decided in late 1993 to sell all or part of 21 public sector groups. These recent equity sales in 1993 and 1994 have included very large enterprises such as the giant oil group Elf Aquitaine, Rhone-Poulenc the chemicals conglomerate, a large Bank, BNP, and the insurance group, UAP. The remaining 17 firms slated for divestiture range from loss makers such as Air France and Aerospatiale to currently profitable firms such as Usinor Sacilor and the tobacco firm, Selta. * In Italy, a number of the IRI subsidiaries and companies such as Alitalia, Agip and the telephone company. STET, are being offered for full or partial sale. The Government hopes to raise as much as $15 billion from these sales. * In Germany, a decision was recently taken by the Government to divest shares in two of its largest companies-Lufthansa and Deutsche Telecoms. It will take some time to prepare the telecoms company for divestiture given the regulatory and competition issues involved but it is anticipated that the sale will take place in 1996. * In Indonesia, the Government-initially wary of divestiture-has already floated shares of the cement company Semen Gresik and Indosat, the telecom satellite enterprise. It has recently announced plans to float shares of the telecoms and electricity companies on the Jakarta and international stock exchanges as well as divesting shares of a major toll road company. * In Pakistan, the Government has sold 22 companies since October 1993 when Benhazir Bhutto took power, adding to the sixty companies previously divested APPENDIX A - 52 - during the period 1991-93. In 1994, shares of Pakistan Telecoms were sold along with power plants and gas companies. In Argentina, as recently as January 1995, the Government announced its intention to embark on another round of divestitures aimed at selling several hydroelectric plants, three nuclear power stations and a large petrochemical plant. The Government intends to consolidate Argentina's public debt and to build up a budget surplus. * In the Philippines, a series of Governments have implemented a comprehensive divestiture program which began in 1985 and which has generated over US$4.5 billion in sales revenues. During the course of 1995 major companies targeted for divestiture include the National Steel Corporation, the Manila Electric Company and the National Power Corporation. * In Kenya, the Government has recently signed a Letter of Intent with the IMF in which it has agreed to sell-or, as appropriate, liquidate-all of the non-strategic parastatals over the next three years. In addition, the Government is committed to contracting out the services of parts of the Ports Authority and preparing the Telecoms company for divestiture. * In Ghana, divestiture has already begun with the sale of a number of the larger SOEs. For example, Ashanti Gold Mines shares were floated on the Ghana and London Stock Exchanges in 1994 coupled with the earlier involvement of strategic private sector investors. By the end of 1996, the Government plans to divest a further 50 SOEs including the telecoms company and Ghana Airways. Pre-Conditions for Effective Divestiture Programs One of the main international lessons of experience that can be gleaned from divestiture programs has been the importance of planning and structuring the implementation process carefully. The main messages are highlighted below as follows: * The more market-friendly a country's policy framework, including the capacity to regulate, the less difficulty it will have in privatizing and the higher the likelihood that the sale will yield positive results. Countries in this category include Chile, the UK, New Zealand and France; * An appropriate regulatory framework must be in place before privatizing monopolies (e.g., British Telecoms, Chile Telecom). Failure to regulate private monopolies or oligopolies properly can not only impact consumer welfare and efficiency levels adversely but also reduce popular support for privatization; - 53 - APPENDIX A * Low income countries with a limited regulatory and institutional capacity, should consider increasing the role of the private sector through management contracts, contracting out, leases or concessions (e.g., C6te d'Ivoire Water) as a first step towards ownership change; * Some restructuring of SOEs may be necessary before divestiture but these should be restricted to legal changes, managerial reorganization (British Airways), labor shedding (steel and railways in Argentina), financial engineering and organizational changes. The State should avoid large capital investments in new projects prior to divestiture; * Emphasis should be placed on developing comprehensive and sustained public relations campaigns (e.g., Russia and the UK Gas divestiture program) aimed at educating consumers, labor, the general public, civil servants and the politicians on the economic and welfare benefits of divestiture; * Transparency in transactions is essential if the process and the results are to be deemed fair from the perspective of potential investors and the general public. Public offerings, although more complex and time-consuming than trade sales, are normally the most transparent form of transaction; * Governments must consider the establishment of appropriate social safety nets (e.g., UK, Italy, Argentina, Tunisia) in anticipation of the short-term impact of possible down-sizing and the need for re-training of the labor force. Many countries in Eastern Europe and Central Asia are developing social safety nets to address these issues; and * Most successful divestiture programs have benefited from a "champion" of the process from the outset of the program. Margaret Thatcher in the UK, Valcav Klaus in the Czech Republic and President Menen in Argentina are good examples of individuals who have fulfilled this leadership role. Divestiture Process: Implementation Options At the heart of any divestiture program lies the need to weigh the advantages and disadvantages of different divestiture processes. Table A-I below outlines the main divestiture options that have been utilized internationally in the full or partial sale of SOEs. The table provides a broad framework for analyzing trade-offs in divestiture objectives. APPENDIX A - 54 - Table A-1. SOEs: Divestiture Options Pre-Conditions Advantages Disadvantages Initial * track-record of * transparency * takes time Public Offering: profitability * wider share * preparation Domestic * national audit * ownership complex requirements promotes capital needs effective * often minimum size market secondary market development * absorptive capacity may be limited Initial Public * international listing *introduce forex * often difficult to Offering: requirements *management and meet listing International * Minimum Size marketing skills standards Trade Sale * must fit with buyer's * speed * less transparent strategy * management, than IPOs - company marketing and * more performance data technical skills concentrated available * sales revenue ownership maximization Liquidation * poor financial * reduce losses * risk of performance * release some redundancies - future prospects productive assets - poor Employee Shares * financing must be * gain employee * majority available commitment to employee shares privatization can lead to asset * spreads stripping ownership Mass Divestiture * strong political and * speed once * on its own does Programs popular support of system not introduce divestiture established additional capital * infrastructure * promotes broad and/or required to domestic technology disseminate ownership * may provide vouchers and hold * promotes capital inadequate auctions market corporate development governance Combination of * good performing * flexible method * takes time to Methods enterprise to promote share prepare sales * complex negotiations - 55 - APPENDIXA Benefits of divestiture Transferring ownership from state to private hands has a number of immediate consequences. First, the political influence on the management of state enterprises, a major cause of efficiency loss, is reduced. Second, it transfers the residual risk of the company to the private owners thus providing powerful incentives for efficiency gains. Third, under private management and ownership, enterprises are forced to face hard budget constraints because they are unable to borrow "soft money" with implicit or explicit subsidies and guarantees. Finally, privately owned firms are more likely to face closure or liquidation than SOEs and thus have a strong incentive to operate efficiently. While there are a limited, but growing, number of empirical studies examining post- divestiture performance, the evidence available strongly supports the contention that ownership matters in terms of enterprise efficiency gains and positive welfare consequences. Selected examples of post-divestiture changes in enterprise behavior are summarized below. * Enhanced productivity and improved services to customers. During the 1980s, the British government sold a number of SOEs; most notable among the enterprises sold were British Airways, British Telecom, and British Gas. In a short period of time following divestiture, these enterprises were transformned from being loss-makers to high profit-makers. A recent study by the Center for Study of Regulated Industries in the UK' found that since divestiture, the average productivity in British Telecom, for example, increased by 7.2 percent annually between 1989-94. Moreover, this increase in productivity has been delivered at lower prices to consumers largely due to increased competition. In Bangladesh, the sale of a loss-making chemical company led to a 30 percent increase in production and a 50 percent increase in sales. Worker productivity increased five- fold and the cost of production was significantly reduced by lowering procurement costs of raw materials and labor. Although some workers became redundant when the enterprise was sold, the increase in production and sales is expected to result in an expansion of the enterprise and, subsequently, to a growth in employment. A study undertaken by the World Bank and Boston University (see Galal, Jones, Tandon and Vogelsang, 1992) which examined the experience of 12 divestitures in four countries concluded that, in all but one case, divestiture yielded positive gains for the economy as a whole in terms of the efficiency of the enterprise, subsequent investment and consumer welfare. The Chilean telephone company doubled its capacity in four years after sale while the Mexican telephone company reduced its per-unit labor costs sharply. * Rationalizing the labor force. One of the main causes of poor SOE performance has been the rigidities inherent in the labor markets of these state-owned firms. Divestiture will allow market-oriented solutions to facilitate the more efficient use "Privatization and Recession," Centre for the Study of Regulated Industries, March 1995. APPENDIX A - 56 - of both labor and capital inputs. However, fear of immediate redundancies is one of the most common and difficult obstacles faced while implementing divestiture and there is evidence from the Eastern Europe divestiture experience of heavy unemployment costs. However, a recent study of the divestiture of 61 companies in 18 countries has shown that performance of state enterprises can improve significantly with relatively low layoffs (see Megginson, Nash, Randenborgh, 2 1993). Another study found that 41 firms divested through public offerings- including Chile, Jamaica, Mexico and Singapore-also expanded their workforce by small margins while increasing returns on sales. A study of the Chilean privatization programs3 indicated that privatized firms increased employment levels significantly faster than SOEs once the boom of the late 1970s started. The study concludes that while divestiture will tend to increase employment to its optimum level per unit of output, instead of maintaining the excess levels of employment associated with SOEs, this does not imply that divestiture will increase overall unemployment in the economy. Fiscal gains. Although net revenues from divestiture may be limited due to large transactions cost and/or settlement of outstanding debts and taxes, in some countries (especially in Latin America) revenues earned from the sale of enterprise equity has been significant (Table A-2). In some cases, proceeds from divestiture may even be negative, but over the long run, the reduction in transfers of resources from state to enterprise and an increase in tax revenue as the enterprise becomes profitable, is likely to offset the transaction cost for divestiture. In Argentina, the telecommunications company paid US$100 million more in taxes within the first year of its divestiture. Divested public enterprises in the UK now pay close to US$4 billion in taxes to the government. In Mexico, transfers to state enterprises were reduced by US$4 billion between 1982 and 1988 due to an overall stabilization program, the imposition of hard budget constraints on SOEs and divestiture. Table A-2. Revenues from divestiture of SOEs, 1988-93 (US$ billions) EAP ECA LAC MNA SAS SSA Total OECD Total all countries 16.1 17.9 55.2 0.7 3.6 3.4 95.9 174.0 270.0 Source: World Debt Tables 1994, World Bank 2 Attiat F. Ott and Keith Hartley, eds, Privatization and Economic Efficiency: A Comparative Analysis of Developed and Developing Countries, Brookfield, VT: Edward Edgar, 1991. 3 Dominique Hachette and Rolf Luders, Privatization in Chile: An Economic Appraisal, ICS Press, San Francisco, 1993. - 57 - APPENDIX A * Capital market development. Divestitureof SOEs has led to the creationor revival of long-moribundcapital markets. Stock exchangeshave opened or re- opened all over Eastern Europe to facilitatetrading by new shareholders. The ability to exercise ownershiprights through equity marketsimposes disciplineand prudentialmanagementon enterprises. Dailypublishedprices of enterprise shares serve as a public barometerto measure a company's performance,and managers of companiesquickly become alert and sensitiveto this reality. This has been the experiencewith partial minoritysales of equity as well as majoritysales. At the same time, equity prices allowmanagersto see the perceptionof their company's performance,thus enabling them to make well-informeddecisions. In addition to providing corporategovernance,equity markets are a significantsource of much- needed capital for enterprisesand in a number of cases rights issues, leading to a dilution of Government's ownershipshare, have been designedto fund new capital-intensiveprojects (e.g., Semen Gresik in Indonesia). * Foreign investment. Divestitureshave also proved successfulin attracting foreign investment-both long-termflows in the form of direct investmentin enterprises and portfolioflows. Between 1988 and 1993,of the nearly US$100 billion receivedin privatizationrevenuesby developingcountries,roughly one-thirdwas from foreign investors. (Table A-3.) Table A-3. Foreign exchange flows in divestituretransactions,1988-93 (US$ billions) EAP ECA LAC MNA SAS SSA Total 5.0 10.2 16.8 0.03 0.007 0.07 95.9 Source: World Debt Tables 1994, World Bank Dangersof poorly conceived divestitures The potentialbenefits associatedwith divestiturecan only be realizedwhen transactions are carried out under a suitableregulatory frameworkin a transparentmanner and withinthe context of a social safety net program. As indicatedin SectionI above,lack of transparencyand the replacementof a public monopolyby a private one will lead quicklyto disillusionmentamong the general public and may not lead any improvementsin enterpriseperformance,if the incentives it faces remain the same as before. Some of the problemsassociatedwith divestitureprograms are outlinedbelow. Lack of Transparency. Poorly designedand implementeddivestitureshave resulted in allegationsof corruptionand selling state assets to privileged individuals. For example,in Guinea,informationregardingdivestiturewas not distributedwidely amonginvestors and, in some cases, the governmentreceived less than two offers per enterprise. Moreover, the price of enterprise equity was not based on valuationof enterprisesassets but on financialoffers made by APPENDIXA - 58 - investors. There were no sales via public tender and excessive sweeteners (in the form of long payment terms and various tax breaks) were given to new owners resulting in reduced competition and efficiency. The early examples of "spontaneous privatization" in Hungary and Russia also resulted from poorly designed divestiture programs which gave managers and employees an opportunity for asset stripping and less than transparent joint-ventures with foreign investors. * Lack of Political Will to Divest. Lack of commitment to divest by politicians, civil servants in Line Ministries and some SOE managers often leads to disinterest among potential investors and a rapid deterioration of SOEs performance and poor governance as they get caught in the hiatus between the decision to divest and the conclusion of the transaction. In Cameroon, the state-owned sugar company CAMSUCO was offered for divestiture in 1992 after overcoming a four- year long opposition from enterprise managers. The performance of the company, which was to weak to begin with, only worsened during the four-year period. As a result when it was finally offered for public tender, investor interest was low and only one bid was received. The bidder not only offered a heavily discounted price, but demanded additional benefits such as ten-year payment plan, 30 percent increase in the price of sugar, and strict protection from imports. While the government waited to receive more offers, the enterprise's technical and financial situation deteriorated precipitously and in 1994-two years after the company was offered for sale-it ceased production due to mounting losses. Conclusions International experience across the board provides evidence that the sale of equity to outsiders is an effective way of providing governance and improving performance of state enterprises. It is not enough, however, simply to divest. Experience has also shown that without the proper regulatory, institutional, and strategic framework, divestiture may compound the existing problems of SOEs and create perceptions of unfairness. Implementing and managing divestiture should, therefore, be done with well-defined institutional responsibilities and through clear and competitive procedures. - 59 - APPENDIX B ANGLO-AMERICAN MODEL OF CORPORATE GOVERNANCE - 61 - APPENDIX B ANGLO-AMERICAN MODEL OF CORPORATEGOVERNANCE Introduction The modem Anglo-American corporation has evolved from peculiar English forms of doing business which in turn evolved from earlier Church and Roman concepts of juristic personality. The English model of the joint stock company emerged in the seventeenth century to finance trading voyages and engage in commercial activities. By 1700, shares were freely transferable, management of the corporation was seen as distinct from its shareholders, shareholder liability was legally recognized as limited to their capital contribution, and the corporation was recognized as having a distinct and permanent life through the granting of a charter by the state. The American model was inherited from English practice and although the two have many differences in details, primarily concerning share issuance and trading, the two have virtually identical governance structures. The primary participants in the modem Anglo-American model of corporate governance are the shareholders, the board of directors and the officers (see Figure B-1 below). The shareholders own the corporation; the Board of Directors, elected by the shareholders, supervise the affairs of the corporation; and the officers, elected by the Board, manage the day-to-day activities of the corporation. The Anglo-American corporate model seeks to balance the rights and duties of each of these three participants to achieve the most efficient results for the corporation, and ultimately, for its shareholders. Legal System Governmental laws and regulations provide a framework within which corporations must operate. The United Kingdom has a national Companies Law. The United States has no national companies law but rather each of the 50 states has its own corporation law, though the differences are not extreme. The United States has national laws regulating the public trading of shares, the stock market and its participants. In addition, in both the US and the UK, laws in general provide objective boundaries for corporate activities but do not permit the government to proactively interfere with a corporation's affairs. Such governmental laws and regulations include tax laws, labor laws, environmental laws, antitrust laws and fair trade laws. APPENDIX B - 62 - Figure B-1. Anglo-American Model of Corporate Governance OF BOARD DIRECTORS (Supervisors) Corporate Structure Appoint& Supervise Elect OFFICERS (Management) SHAREHOLDERS : / . / ~~~~~~~~~~(Owners) Manage CREDITORS COMPANY , _Lien (Lenders) Discipline \........... .. .... EXTERNAL Structural FACTORS Framework \ ]LEGAL SYSTEM| Incorporating "Articles of Incorporation" and "Bylaws. " The articles of incorporation and the bylaws are the corporation's governing documents. The articles of incorporation, also referred to as the "corporate charter," address important public issues regarding the corporation, evidenced by the requirement that the articles of incorporation be publicly filed with the state. By contrast, the bylaws of the corporation address less important issues primarily concerning the internal governance of the corporation and accordingly are not required to be filed with the state. The articles of incorporation declare: * corporate name; * nature of the corporation's business; * amount of stock authorized for issuance; · the corporation's term of existence (usually perpetual); * limited liability of the shareholders; * express powers of the board of directors; * power to amend the articles of incorporation; * director's and officer's indemnification; * shareholder action by consent and without a meeting; and * super-majority voting on important issues to protect minority shareholders. - 63 - APPENDIX B The bylaws provide: * date, time and place for the General Shareholders Assembly (GSA); * number of directors comprising the board; * whether cumulative voting will be utilized in director elections; * "officer" positions and accompanying duties (e.g., president, vice-president, secretary and treasurer); and * quorum number for a board of directors' meeting. Shareholders The shareholders own the corporation. An investor becomes a shareholder or owner of the corporation by subscribing for or purchasing one or more shares in a corporation. (See Figure B-2 below.) Figure B-2. Shareholders ; L ~~~SHAREtlOLDERS RIGHTS& RESPONSIBILITIES - Receivedividendpayments * or Approve disapprove * Electand removedirectors fundamentalchanges * Amendbylawsand articlesof * Inspectbooks and records CLASSIFIED AS: incorporation * Communicate with * Preferred(ClassA, B etc.) shareholders * Common(ClassA, B, etc.) i Enforceshareholder rights Classification of Shares. Corporations often designate their stock, and therefore their shareholders, into several different classes, such as preferred stock or common stock. Each class of stock differs on issues of voting power per share, the amount of dividends that each share commands, and the preference status to the corporate assets per share in the case of liquidation or dissolution. Shareholder's Rights. Although the shareholders have delegated the use rights of the corporation's property to the directors and the officers, the shareholders retain several important rights including: (a) the right to receive periodic dividend payments per share; (b) the power to elect and remove the board of directors through the voting process; (c) the right to arnend the articles of incorporation and the bylaws of the corporation; (d) the right to approve or disapprove fundamental changes concerning the corporation through the voting process; (e) the right to inspect the corporation's books and records; APPENDIX B - 64 - (f) the right to communicate with other shareholders; and (g) the right to enforce shareholder rights against the corporation. These rights, discussed more fully below, are typically exercised in an General Shareholders Assembly (GSA) as provided in the corporation's articles. Stock ownership and dividends. Most fundamentally, the owner of a share has a right to the residual in the case of liquidation and to profits on a periodic basis. The right to residuals may be altered by the classification of the share. Election and removal of the board of directors. The shareholders elect the members of the board of directors at the AGM. The most common election model is the "annual board" whereby each director, and thus the full board of directors, normally serves a one-year term with the potential to be re-elected the following year. Many corporations have adopted alternative election models referred to as a "staggered board" and a "classified board."'I Amending the articles of incorporation and bylaws. The shareholders are authorized to amend the articles of incorporation through the voting process; for example, increasing the corporation's capital or expanding the nature of the corporation's business. The shareholders also are authorized to amend the bylaws of the corporation; for example, increasing the number of directors comprising the board. Fundamental changes. The shareholders, because they are the owners of the corporation, retain the authority to approve or disapprove fundamental changes regarding the corporation (non-ordinary uses of the corporation's property). Recall that the shareholders are not permitted to manage the day-to-day uses of the corporation's property because they would rarely agree on a single use. Therefore, permitting the shareholders to control fundamental changes, while allowing the directors and officers to control daily affairs, both protects the shareholder's ownership interest and maintains the managerial flexibility required to operate a business successfully. A "fundamental change" includes: * corporate merger; * sale of all or substantially all of the corporation's assets; * incurrence of substantial or collateralized debt; * corporate dissolution; A staggeredboardof directorsis apportioned severalgroups. Eachgroupservesa term greater into than one year and the groupsstaggertheirelectionyears. A staggeredboardincreasescontinuityin the boardof directorsbecauseone or severalgroupsremainon the boardfor the followingyear. A staggered board also removesthe potentialfor a dramaticchangein the composition the board throughonly one of election(such as in the case of a hostiletakeoverwherean "annual"boardcouldpotentiallybe replacedin one electionby a new,controllingshareholder). A classifiedboardof directorsis electedby eachclass of shareholders.For example,in the election for a twelve-member board,the preferredclass of shareholders may electa specifiednumberof directors and the commonclass of shareholders electthe rest. may - 65 - APPENDIX B * share exchanges with another corporation; and * share repurchases. Inspectionrights. Shareholder's possess the right to inspect the corporation's books and records in order to protect their ownership interests.2 For certain materials, the shareholder possesses an automatic right of inspection. However, for more sensitive materials, where the risk to the corporation is great if the materials are used for an improper purpose, the shareholders are subject to a higher burden prior to inspecting. An automatic right of inspection applies to the following corporate materials: * articles of incorporation and bylaws of the corporation; * board resolutions; * minutes from recent shareholder meetings; * names and addresses of current officers and directors; * written communication to shareholders; and * the most recent annual report. The higher burden applicable to sensitive materials basically requires that the shareholder specify in sufficient detail the proper purpose for the inspection and that the requested records are directly related to the shareholder's stated purpose. Examples of a proper purpose include the desire to evaluate one's investment and a desire to deal with other shareholders as investors. Examples of an improper purpose include the pursuit of personal goals unrelated to stock ownership, such as the stealing of trade secrets, and the desire to pursue social or political goals. The proper purpose standard applies to the inspection of: * minutes of the board of director's meeting; * accounting records; and * shareholder lists. Shareholder communication. Shareholders are authorized to communicate with each other to protect and maximize their interests. The shareholders have the choice of (i) bearing the expense personally for the communication or (ii) having the corporation bear the expense of the shareholder's communication by including the communication in the corporation's annual proxy materials. The shareholder's right to communicate at the expense of the corporation is limited by securities laws in order to protect the corporation from the cost of frivolous communications. Enjorcing shareholder rights. In both the UK and the US, the law provides significant protection to shareholders. Shareholders may enforce their legal rights against the board of directors or officers of the corporation; often for a breach of a fiduciary duty owed to the shareholders by the directors or officers. In the US, shareholders may bring (i) a direct action, where the shareholders sue the corporation in their capacity as shareholders or (ii) a derivative action, where the shareholders sue the corporation not in their capacity as shareholders, but on 2 in In the US, severalstatesrequirethata shareholder, orderto inspectthe corporation'sbooksand for records,holdsa minimumamountof stockin the corporation a minimum periodof time. See N.Y. Bus. Corp. L. § 624. APPENDIX B - 66 - behalf of the corporation. In the UK, legislation such as the Insolvency Act of 1986 protects shareholders from abuse by directors and officers. Closely held corporations distinguished. The shareholder rights described above apply when examining widely-held or publicly traded corporations but differ significantly when examining closely-held corporations (usually involving no more than thirty shareholders). In addition to the small number of shareholders, a closely-held corporation differs from a widely- held corporation in that the shareholders are more active in the management of the corporation, the shareholders often look to the corporation for employment and the shareholder's investment interest is not easily transferable, since it is not registered for public sale. In closely-held corporations, the small number of owners also participate in the management and the supervision of the corporation. To account for this unconventional overlap in duties by the shareholders, a number of control devices usually are implemented through a "shareholder's agreement." Such control devices include super-majority voting provisions, vote- pooling agreements, voting trusts, share classifications and irrevocable proxies. The net effect in the closely-held corporation is that the owners also act as the managers but are still monitored for abuse in their managerial position.3 The role of institutional shareholders. Institutional investors-mainly pension funds, mutual funds and insurance companies-often possess a substantial or controlling interest in corporations. Because the institutional investors control such a large percentage of the shareholder vote, they are able to be more active and effective in guiding the corporation's activities. Accordingly, institutional investors often act as a strong check on the directors and officers of the corporation. Board of Directors Composition. The Board of Directors is responsible for supervising the affairs of the corporation and therefore, oversees the actions of the officers of the corporation. In a widely- held corporation, the Board of Directors is usually composed of a combination of inside directors, quasi-inside directors and outside directors. Inside directors concurrently occupy a position in the corporation as an officer or employee of the corporation. Quasi-inside directors have a significant non-director relationship with the corporation, such as acting as the corporation's outside council or investment banker. Outside directors have no other ties to the corporation. In both the UK and the US, the percentage of outside directors (called non- executive directors in the UK) serving on a Board is increasing with the goal of preserving partiality. (See Figure B-3 below.) 3 Thediscussionbelowfocusesprimarilyon thecorporategovernance structureof the widely-held refersto the structuredifferences corporationand whereappropriate, displayedby the closely-held corporation. - 67 - APPENDIX B Selection of the board of directors. Regardless of whether the shareholders elect an annual Board, a staggered Board or a classified Board, they must follow one of two voting methods in selecting the directors-straight voting or cumulative voting. Straight voting allows shareholders with a majority of the votes to exclude the wishes of shareholders with a minority of the votes 100 percent of the time.4 Cumulative voting, on the other hand, allows shareholders with a minority of the votes to elect a representative number of directors on the Board (correlating roughly to the minority's representation as a shareholder) and thus, not be excluded by the majority shareholders 100 percent of the time.5 Figure B-3. Board of Directors r -- ~~~~~BOARD OF DIRECTORS RIGHTS& RESPONSIBILITIES * Reviewcorporation's * Change the natue of the performance corporation'sbusiness COMPOSEDOF: * Elect and replace officers * Approve major contracts * Inside Directors * Approve dividend payments * Review and approve .. copoaio' ,inancia * Quasi-insideDirectors * Approve corporatefinance, corporastonts O Dnancial debt and equity statements * Outside Directors * Inspect booksand records COMMITVEES , Audit * Compensation , Executive * Nominating Rights and responsibilities. The Board of Directors, as supervisor over the corporation (particularly its officers) typically has the following rights and duties as provided in the articles of incorporation: (a) review the corporation's overall performance; (b) elect, replace and determine the compensation packages the officers; 4 Understraightvoting,each shareholder one voteper sharefor each directorpositionup for gets election. The shareholder must the placethe voteor voteson the directorof his or her choicefor each directorposition. In otherwords,a shareholder maynot groupall of his or her votes (forall of the director positions)and place themon one directorposition. 5 Cumulativevoting,similarto straightvoting,assignseach shareholder voteper sharefor each one directorposition. Thedifference, however,is that a shareholder may groupall of his or her votes (assigned for all of the directorpositions)and votethemon one director. This methoddiffersfrom straightvoting wherethe votes had to be spreadout over all of the directorpositions.Therefore,cumulativevotingallows a twenty-percent to minorityshareholder electcloseto twenty-percent the board. of APPENDIX B - 68 - (c) declare dividend payments; (d) raise capital via the issuance of new securities or the incurrence of new debt; (e) change the nature the corporation's business; (f) approve major contracts; (g) review and approve the corporation's financial statements; and (h) inspect the corporation's books and records. For most of these functions, the Board of Directors will act on the recommendation of the senior officers of the corporation. Often, therefore, the Board will act as a "rubber-stamp" for the officer's actions. The director's rights and duties will be discussed below. (a) Review the corporation 's performance. The general duty of the Board of Directors is to review the corporation's performance, and when the corporation is performing poorly, institute changes. (b) Election and replacement of officers. The Board is responsible for electing and replacing the officers of the corporation, including, for example, the CEO or president, vice president, secretary and treasurer. The board must also determine the compensation packages for each of these officers. (c) Declaration of dividends. The Board is responsible for declaring dividend payments for the shareholders of the corporation. Statutory law requires that certain minimal financial standards be met prior to the payment of dividends in order to protect the creditor's rights. The minimum standard protects creditors from a financially unsound corporation transferring its remaining capital to the shareholders (as dividends) prior to declaring insolvency or dissolving, thereby leaving nothing for creditors who have priority to the corporation's assets in such a case. (d) Raising capital. The Board is responsible for approving the corporation's plans for raising capital either through the issuance of new securities or the incurrence of new debt. (e) Changes in the business of the corporation. The Board of Directors is responsible for approving any changes in the business of the corporation (which is specified in the articles of incorporation), usually subject to approval by a majority of the shareholders. Requiring Board approval protects against sending unsound proposals to a costly shareholder vote. (f) Approving major contracts. The Board is responsible for approving major contracts into which the corporation is entering. For example, the Board would be required to approve a long-term lease negotiated by the officers due to the substantial commitment it imposes on the corporation. - 69 - APPENDIX B (g) Reviewing and approving the corporation 'sfinancial statements. The Board, especially the outside directors, is required to review and approve the corporation's financial statements. Independent review and approval by outside directors protects the corporation from fraud and misrepresentation by the officers of the corporation. The officers have an incentive to cheat because their compensation packages and employment security is tied to the corporation's financial performance. (h) Inspection of the corporation 's books and records. A director has a virtually absolute right to inspect the corporation's books and records; subject only to the limitation that the director is not acting with manifestly improper motives. The rationale for this broad right as compared to the cautious right granted to shareholders is twofold: first, the directors are few in number and therefore are easy to monitor; and second, the directors require uninhibited access to the corporation's books and records in order to properly supervise the affairs of the corporation. In sum, the role of the Board of Directors is to supervise the affairs of the corporation in order to protect the shareholder's interest. In fulfilling this role, the Board will refrain from managing the day-to-day affairs of the corporation (because that is the role of the officers) but will become involved where the corporate action is large in scope or involves the potential for self-dealing by the officers. Committees. To better fulfill their duties, the Board of Directors often will create committees consisting typically of three or more directors. Each committee will review a particular area of the corporation's affairs and issue reports and recommendations to the full Board. Two primary rationales support the creation of committees. First, in light of the complexity of the business and the infrequency in which the Board meets, a smaller, specialized committee will be better able to keep itself, and therefore the whole Board, well informed of the corporation's business. Second, some board action is best handled by a committee consisting only of outside directors because of the potential for self-dealing by inside and quasi-inside directors ("interested directors"). Almost every widely-held corporation has an audit committee. The audit committee is responsible for reviewing the corporation's financial statements and the accounting firm's audit process in order to make a well-informed recommendation to the full Board regarding the approval or denial of the corporation's financial statements. The audit committee usually consists of a majority of outside directors. The rationale for this is to ensure a disinterested review of the audit process due to the relationship between a corporation's financial performance and an officer's (inside director's) remuneration. In addition to the audit committee, widely-held APPENDIX B - 70 - corporations will sometimes have a compensation committee, an executive committee, and a nominating committee.6 Officers The officers are the high level employees of the corporation responsible for managing the corporation's day-to-day affairs. Officers are distinguished from other employees because they fcrmulate policy and are appointed by the Board of Directors. (See Figure B-4 below.) The officer positions, as well as the powers and duties that accompany them, are detailed in the bylaws of the corporation. The positions generally include CEO, president, chairman of the Board, vice president, secretary and treasurer. The officers are organized in a pyramid structure, usually with the CEO presiding and the other officers falling in below. The officer's actions are governed by "agency law" principles which are enforced through the strong legal systems of the US and UK. Under agency law, the officers possess the authority to act for and bind the corporation (so long as the particular officer's position specifies that authority), and the corporation is subject to liability for the officer's actions (so long as the actions are within the officer's scope of employment). 6 for A compensation committee is responsible settingthe compensation packagesfor the senior officersof thecorporation. Thiscommitteeis composedprimarily,if not exclusively, outsidedirectors of becausethis committee the of determines compensation the insidedirectors. of for An executive committee, composedprimarily insidedirectors,is responsible performingthe Board's functionsbetweenBoardmeetings. Theexecutivecommitteeis primarilycomposedof inside directorsbecausethe committee membersmustbe availableto meeton shortnoticeand be familiarwith the day-to-dayaffairsof the corporation. for A nominating committee is responsible nominating to candidates fill vacancieson the Board of for Directors,whichare thenpresentedto the shareholders a vote. - 71 - APPENDIX B Figure B-4. Officers s; t ~~~~~~OFFICERS RIGHTS & RESPONSIBILITIES · Policy makingfunction * Manageday-to-day affairs PYRAMIDSTRUCTURE Presidentor Secretary Presidn Trasurer Managers Duty of Care and Duty of Loyalty The directors and officers owe fiduciary duties to the shareholders, referred to as the duty of care and the duty of loyalty, which requires the directors and officers to manage the corporation in the best interest of the shareholders. These duties offer adequate protection to the shareholders for their investment while also affording the directors and officers a sufficient degree of discretion in the management of the corporation. The obvious rationale behind holding the directors and officers accountable for careless or disloyal actions is to protect the shareholder's interests. The rationale behind management discretion is to encourage the directors and officers to take risks which ultimately may benefit the corporation. Duty of care. The duty of care applies to "disinterested" directors and officers (those with no self- interests in the decision) and requires that when making a decision on behalf of the corporation, the director or officer act in good faith, with ordinary care, and in a manner that he or she rationally believes to be in the best interest of the corporation. The duty of care is balanced by a principle which states that business decisions made by disinterested directors and officers, even if unprofitable for the corporation, are accorded deference and protected from judicial scrutiny so long as the decision was made in good faith, without self-interest and with adequate information. US courts have termed this principle the "business judgment rule." So long as the directors and officers acted within the scope of the business judgment rule when making the business decision, they will not be held liable. APPENDIX B - 72 - Courts generally will hold directors and officers liable for breach of the duty of care only if the director or officer acted with gross negligence or recklessness when making a corporate decision. Several examples of gross negligence or recklessness include: failing to attend meetings, failing to learn the business of the corporation, failing to read the reports of the corporation, failing to obtain outside counsel when the business is in jeopardy or generally neglecting to act diligently. The officers, and in particular the directors, usually will be permitted to rely on the reports and testimony of others (for example, experts or committees) in making their decisions. Duty of loyalty. The duty of loyalty applies to the actions of "interested" directors and officers which primarily include "self-dealing" transactions. Self-dealing transactions are those in which the director or officer stands to make a personal gain, such as in the award of a corporate contract to the director's or officer's personal business. The actions by interested directors and officers are not per se illegal because they may ultimately provide an economic benefit to the corporation. To protect the shareholders from abuse by an interested director or officer, the business decision is subjected to a higher standard of review (versus the lower, more deferential standard applied under the duty of care) to determine whether the decision should be upheld. That higher standard of review, referred to as the "full fairness" test, requires that the terms of the decision be substantively fair and in the best interest of the corporation and that all material facts relating to the decision be fully disclosed. External Participants Creditors. The creditors to the corporation are the persons or institutions that loan capital to the corporation, and thus hold a debt security in the corporation (compare this with the shareholders who pay capital to the corporation and thus hold an equity interest). The debt security represents the contractual obligation of the corporation to repay the principal plus interest on the loan. As with equity financing, where the shareholders are grouped in separate classes based an variations of their respective rights (for example, preferred stockholders and common stockholders), so too are creditors in debt financing (for example, senior lenders and subordinated lenders). 7 The two methods of corporate finance, debt financing and equity financing may be contrasted based on the different rights that the person or institution providing the capital receives. Generally, debt and equity financing may be contrasted based on the type of corporate control each group receives, the preference status of each group in the case of liquidation or dissolution and the type of return on the capital received by each group. (See Figure B-5 below.) 7 Each of these subclassesoftenare subdivided furtherintoclassA, B, C, etc. For example,class A and class B of preferredstock;classA and classB of commonstock;class A and class B of seniordebt;and class A and class B of subordinateddebt. - 73 - APPENDIX B Figure B-5. Corporate Finance: "Anglo-American Model" Classifications Characteristics A Senior Seo r - X.* Preference corporate |re: to or assets liquidation dissolution B DEBT * Corporate to controlpursuant loanagreement (creditors/lenders) (non-variable) A Subordinatel A * Guaranteedloan payments Subordinat (fixedamount) B . . . . . ..... ................... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. .. . . . . . . . . . . . . . .. .. .. .. . . . .. .. .. .... .... . . . . . . . . . . . . . . . .... . . . .. .. . . . ... . . .. .. . . . . .. . .. .. . . . . . . . . . . . . . . . . . . . . . . . . . ... .. A Preferred * Corporate voting controlthroughshareholder rights(variable) B EQUITY * dividendpayment Discretionary (shareholders) A profits * Abilityto share in the corporation's - Common (increased dividends) B First, equity financing offers a greater degree of variable control (for example, through voting rights) over the corporation's affairs than debt financing. Variable control entitles the shareholders to exercise their authority in the manner they see fit as each situation arises. The creditors alternatively, obtain a fixed type of control over the corporation which is determined in the loan agreement at the beginning of the loan period. For example, the creditors may include provisions in the loan agreement that: prevent the corporation from acquiring additional debt obligations; changing the nature and scope of the corporation's business; or entering into any mergers or joint ventures or require the corporation to maintain certain debt/equity ratios; maintain a minimum amount of working capital; or maintain specific bank accounts for its revenue. It is often stated that the creditors play a crucial role in the corporate governance structure by keeping the directors and officers in check. Second, debt financing offers a higher preference status to the corporation's assets in the case of liquidation or dissolution than equity financing. Therefore, the creditors' investment in the corporation is more secure than the shareholders' investment. Third, equity financing offers an unlimited, but discretionary return to the shareholder in the form of a dividend which is usually paid only if the corporation has sufficient cash. Debt financing, on the other hand, offers a non-discretionary, but fixed loan repayment to the creditor. In other words, the creditor is guaranteed to receive a payment and the shareholder is not. APPENDIX B - 74 - However, if the corporation makes a tremendous profit in one year, the shareholder is able to receive a portion of those profits while the creditor is limited to its agreed upon payment. When examining characteristics of debt holders and equity holders (and each of their respective subclasses), it is important to place all of these categories on a continuum. Placing the categories on a continuum underscores the premise that characteristics strongly associated with one class and its subclasses are not exclusive to that class and its subclasses. Those highly correlative characteristics may nonetheless be present, although less so, in the other class and its subclasses. For example, the characteristic of high corporate control associated primarily with equity holders may be seen with some creditors,8 and the characteristic of high preference status associated with creditors may be seen to a limited extent with some equity holders.9 Stakeholders. The stakeholders of the corporation are those groups or concerns, other than the shareholders, that hold an interest in the corporation. In the Anglo-American model, as compared to the German or Japanese model, these groups play a relatively moderate role. Generally, stakeholders include labor, suppliers, customers, community concerns (education and arts) and environmental concerns. Courts historically permitted the officers and the directors only to consider the shareholder's interests when making a corporate decision. Some of these decisions made in the best interest of the shareholders often produced grave results for stakeholders such as labor. The recent trend by the courts is to permit the officers and directors of the corporation to consider these stakeholder interests when making a corporate decision so long as the decision does not significantly disfavor the shareholder's interests. One rationale for considering stakeholder interests is that the goodwill to the stakeholders results in an indirect benefit to the corporation. For example, when corporations provide educational grants to the community, it improves the community which indirectly benefits the corporation through the increased quality and demeanor of its work force. The position of stakeholder interests in corporate decision making is currently unresolved. 8 Thecreditormayhavecontrolover certainaspectsof the corporationthroughthe contract(debt the instrument).For example, creditormaypossessthe authorityto approvefuturedebt obligationsof the corporation(duringthe creditor'sloanperiod)or the creditormaypossessthe authorityto preventthe corporationfrom sellingcertainassets. 9 For example,preferredshareholders havepreference to over commonshareholders the or maybe corporation'sassets in the case of liquidation dissolution.Althoughthe preferencecharacteristic of will associatedwithinsubclasses equityholders,equityholdersgenerally neverhavepreference over or creditorsin the caseof liquidation dissolution. - 75 - APPENDIX C GERMAN MODEL OF CORPORATE GOVERNANCE - 77- APPENDIXC GERMANMODEL OF CORPORATEGOVERNANCE Introduction Two forms of corporationsare most widelyused in Germany,one designedfor a few shareholderswith managementclosely monitoredby those shareholdersand the other designed for a widespreadshareholding. The first is commonlyreferredto as the limited liability company (GmbH), and the second is referred to as the share company or stock corporation (AG). In both firms, shareholdersliabilitiesare limited to their share contribution. GmbHcorporationsdo not ordinarily issue shares. State OwnedEnterpriseshave the AG structure. The corporategovernancestructurevaries slightlyin both AG and GmbH companies, dependingon the number of employeesin the corporation,the amount of capital and the type of industry. For GmbH companieswith less than 500 employeesthe corporate structureconsists primarilyof the shareholdersand a managingdirector. In GmbH companieswith more than 500 employees and in all AG companiesthere is a two tier board structure comprisedof a Board of Managementand a SupervisoryBoard. The SupervisoryBoard is usuallyelected in equal part by the shareholdersand the employeesof the corporationthrough a system of codetermination(see Table C-I.). The SupervisoryBoard is responsiblefor the electionof the Board of Management, who overseethe running of the corporation. A person may not be on both Boards of one corporationat the sametime, althoughthey may be on the Boards of up to ten different corporations. (See Figure C-I below.) Figure C-1. German Model of Corporate Governance(Share Company) ................................. Sturecu Stnjctu-e ' \ ~~~~~~~Appoint Y% Reports & &°En to monhors' \ | Labor Un l Management Board including LaborRelabotns Director ShanOlds (Owles) Indswndentlyruns (daytoday) LCojpan Own ...... ...................... APPENDIXC - 78 - German corporate governance is often referred to as an "insider" model in which a few large stakeholders supervise the firm. This in turn encourages not only competition between companiesbut also cooperationthrough a complex institutionalsystem of ownershipand governance. "Outside" governance,through takeover markets as a means of management control, play a minor role. Legal System The German form of corporate governanceis defined for AG corporationsby the Stock CorporationAct of September6, 1965 and for GmbH corporationsby the Law Concerning Companies with Limited Liabilitiesof April 20, 1892, as amended July 4, 1980. The relationshipbetween ownersand managersis determinedby the statutes of the corporation. Shareholders Companies, banks and governmentsown a large percentageof the shares in German corporations: widespreadindividualshare ownership(direct or through mutual funds) is not as common as in the United States. The Bundesbankin June 1991 gave the following figures for 1990 showing that shares in German corporationswere held as follows: Private Individuals 16% Companies 41% Insurance Companies 11% Banks 10% The Federal and Lander governments 6% External 17% These numbers affect the composition of the SupervisoryBoard which usually reflects ' the composition of the shareholders. A General ShareholdersAssembly(GSA), held at least once a year, is compulsoryfor an AG and optional for a GmbH corporation. Most of the GSA's powers are concerned with the general organizationof the corporation. A resolutionis passed at the GSA in most cases by a simple majority of votes cast. Decisions taken by the GSA must be carried out by the Board of Management. Powers of the GSA: * appointmentof their representativesto the SupervisoryBoard * appropriationof profits * allocation of profit E. Gerun, H. Steinmannand W. Fees, Der mitbestimmteAufsichrat:Eine Empirische Stuttgart, Untersuchung, 1988. - 79 - APPENDIX C * discharge from obligation of the members of the Supervisory Board and the Board of Management * appointment of the auditors * alteration of the statutes of the corporation * liquidation of the corporation * ratify certain management decisions, but only insofar as requested by the Board of Management Banks Acting as owners or on behalf of owners in addition to their traditional role as creditors, banks frequently play a role in influencing management through participation on the Supervisory Board. A typical large German corporation may have 3 or 4 banks with a combined voting block of shares equaling 30 percent or more of all votes. Bank voting power comes from directly owned stock, from investment corporations controlled by banks, and from voting shares on behalf of their clients. Concerning the latter, banks offer custodial service for shares; including administering (e.g., cash in dividends) and voting in place of the client at shareholders meetings. There is no legal limit on a bank's voting rights. Supervisory Board (Aufsichtsrat) Composition. The composition of the Supervisory Board varies according to the amount of stock capital, the number of employees and the type of industry (see Table C-1). In corporations with over 2,000 employees half of the Board is elected by the shareholders and the other half by the employees, or representatives of the employees. Board members are elected for a limited time, usually for four years. Table C-1. Composition of Supervisory Board (1) Amount of Stock Capital - stock capital up to DM3 million: 0 - stock capital more than DM3 million: 15 - stock capital more than DM20 million: 21 (2) Number of Employees - less than 2,000 employees: 1/3 elected by employees - more than 2,000 employees: 1/2 elected by delegates chosen by employees delegation of delegation of employees shareholders - not more than 10,000: 6 6 - not more than 10,000, 8 8 less than 20,000: - more than 20,000: 10 10 APPENDIX C - 80 - The shareholders elect their representatives to the Supervisory Board at the GSA. The representatives of the employees are elected either indirectly by delegates or directly through different groups of laborers and employees. In the election of employee representatives there are four special qualifications which must be observed: (i) only part of the employee's representatives may be union officials; (ii) only employees of the corporation may be elected; (iii) the employees must come from all levels of employees; and (iv) if more than half of the employees are women, at least one of the Board members must be a woman. Duties of the Supervisory Board: * elect and dismiss members of the Board of Management * monitor the Board of Management-with respect to legality and economical effectiveness * give advice to management * grant consent to the Board of Management for certain major transactions * act on behalf of the corporation in a suit against the Board of Management * approve the balance sheets, annual reports and dividend * fix the salaries of the Board of Management The Supervisory Board generally meet three or four times a year. The Supervisory Board is legally responsible for their actions and members may be held jointly and severally liable for damage caused to the corporation. If the Board is negligent in the performance of their duties they may be held jointly and severally liable. These duties and other possible violations for which the Supervisory Board are responsible are set out in the Stock Corporation Act. (They are the same duties as set out for the Board of Management.) President (or chairman) of the Supervisory Board. The shareholders elect the President of the Supervisory Board as one of their representatives on the Board. This decision affects the operation of the corporation as the president may vote twice if a stalemate in the votes of the Board occurs. This permits the shareholders to have one more vote than the workers in certain situations. This may have great impact in the decisions for positions on the Board of Management. Duties of the President of the Supervisory Board. * prepare meetings of the Board * propose the agenda * stay in steady contact with the management * ensure that he/she is be briefed by management on all important occasions * cast the deciding vote if there is a stalemate in a vote on a codeterminated Board Arbeitsdirektor. Under the Codetermination Law of May 21, 1951, corporations engaged in mining, iron or steel producing must have a director on the Supervisory Board who is specially responsible for the employees interests-the Arbeitsdirektor. The Arbeitsdirektor is appointed by the Supervisory Board with the approval of those members who represent the employees. The - 81 - APPENDIX C employees' representatives on the Board have the same rights and duties and carry the same responsibility as the other members of the Supervisory Board. The Arbeitsdirektor is concerned particularly with welfare matters, such as agreeing to the social plan for closure of pits following rationalization. Board of Management (Vorstand) Composition. In accordance with the Stock Corporation Act of 1965, this Board, consisting of one or more members, is elected by the members of the Supervisory Board. Nominations for the Vorstand usually originate from the Vorstand itself, rather than the Supervisory Board. There are no requisite qualifications in order to be a member of the Board. Members are selected for a period of five years and may be removed by the Supervisory Board, before the end of this period, for good cause, such as gross violation of duties or incapacity. Removal may also occur if a majority of shareholders have withdrawn their confidence from the Board member. The members of the Vorstand may choose a President or Chairman among themselves, however, this is not mandatory. Most large AGs have at least nine different departments of management represented on the Vorstand: coordination (chairman), planning, materials, finance. research, production, sales, personnel and law. Duties. * control the day-to-day administration of the corporation * pursue the interest of the corporation * inform the Supervisory Board about important questions of management policy through regular reports * call shareholders meeting in cases of losses amounting to more than half of the stock capital and to inform the shareholders about the situation * represent the corporation in and out of court. The Board's must observe the restrictions on the scope of their authority set out in the articles of the corporation * monitor the individual competence of its own members The Vorstand usually meets once a week. Labor Relations Director In corporations with more than 2,000 employees a Labor Relations Director (Arbeitsdirecktor) must be elected as a Supervisory Board member of equal status. The labor relations director must be chosen by a qualified majority of votes (2/3) to ensure that the influence of the employees on the Supervisory Board is taken into account. APPENDIX C - 82 - Works Council The Works Constitution Act of 15 January, 1972 legally establishes the rights of the Works Council, the body representing workers' interests at plant level in limited liability corporations. The Act covers virtually all German businesses except very small enterprises. Composition. Members are chosen for a period of four years by election from the workforce. The Council meets quarterly. The size of the Council is relative to the size of the corporation. Duties. * consider all matters appertaining to conditions of employment (hours, flexible working, overtime, payment, leave, safety at work, incentives, suggestion schemes) * negotiate with employers, or use the conciliation procedure2 if the negotiation fails. * ensure the employees right of codetermination in issues of dismissals, employees' vocational training, and grievances. * require measures to be taken to ensure security of employment. Employee representatives on the Supervisory Board have a flow of information to and from the Works Council. This forms the background for participation at Board levels. Economic Committee. Larger corporations (more than 100 employees) are required by law to have an Economic Committee. This committee does not have rights of codetermination but does have rights to information on: * the economic and financial situation of the corporation * the production and sales situation * the investment program * rationalization projects and closures * organizational changes, including mergers * proposed changes in method The Works Council Compared to the Unions. Unions have sole bargaining rights on basic pay and conditions, backed by the right to strike. Works Councils do not have this right to strike and must go to conciliation procedures to resolve the conflict. The more heavily unionized a corporation is, the more likely that union officials will be elected to the Works Council. 2 The conciliationprocedureentails a meetingwith a committeewith a neutralchairmanwhich can make a bindingsettlement. - 83 - APPENDIX D JAPANESE MODEL OF CORPORATE GOVERNANCE - 85 - APPENDIX D - JAPANESE MODEL OF CORPORATE GOVERNANCE Introduction Japanese corporate governance promotes the long term preservation and prosperity of the corporation, with less emphasis on shareholders' short term interests. The primary means of monitoring management, outside the internal arrangements for governance, is through a financial intermediary, with comparatively less emphasis on monitoring by the capital market. While the Anglo-American system (and to a lesser degree the German system) also relies on clear legal and regulatory monitoring, the Japanese system provides for a somewhat less transparent, but generally effective, administrative monitoring of management through the Ministry of Finance (MoF) and the Ministry of Intemational Trade and Industry (MITI). Figure D-1 summarizes the main corporate governance relationships in the Japanese model. Figure D-1. Japanese Model of Corporate Governance ...................................................... of Board Directors appoint Shareholders Corporate | resint l_ _ Structure ~Chairman Maongaement Management Mngmn Management Directors acts monitors, Di_ ors i emergencie positions management MainBank manage _ i mon_ __ loans COMPANY Thisappointment mostoftena ratification nominees the Board is of for from chosen withinthecompany APPENDIX D - 86 - Legal System The Commercial Code (1899, revised 1974) in Japan governs the formulation, structure and conduct of companies in Japan. It sets out the rights of the shareholders, the appointment mechanism for the Board of Directors and the powers and duties of the members of the Board and of the Auditors. Shareholders Under the Commercial Code, residual control of the Japanese corporation lies with its owners, the shareholders, who exercise their power through a General Shareholders Assembly (GSA). Financial institutions compose a large part of shareholders, owning about 50 percent of the outstanding shares of stock exchange listed companies. I Non-financial firms own approximately 25 percent of all the outstanding equity of stock exchange listed corporations.2 Shareholders owning at least three percent of the capital of the company may request a court to force the resignation of an errant director. In general, the formal mechanisms of Japanese corporate governance afford only modest opportunity for shareholders to influence day to day corporate operations. The primary opportunity for shareholders to be involved in the corporation is at the GSA, which is held at least once a year in accordance with the Commercial Code. Powers of the GSA: D to elect members to the Board of Directors. O to remove a director from office. O to approve the dividends. The election of members to the Board is generally perceived as a ratification of choices of members which were previously made within the corporation. Rights of shareholders: * Right to information. * Right to vote and to contest Board resolutions as invalid. * Right to participate in profits. * Right to participate in assets in a winding-up. * Right to take up the new issued shares. * Right to withdrawal. Public EnterpriseGovernanceReform Study, Asian DevelopmentBank, Technical Assistance Project1924,Peoplesrepublicof China,p. 20. 2 ibid. - 87 - APPENDIXD Cross-shareholdings: Cross-shareholdings, where corporations join into a corporate group, arose in Japan after the prohibition through legislation of the holding company structure which had been prevalent before World War II. Originally, cross-shareholdings were formed as a means of protection from hostile mergers and acquisitions. In Japan, members of an enterprise group often have significant ownership cross-holdings. In total, non-financial institutions own about 25 percent of all the outstanding equity of stock exchange listed companies. Corporate cross-holdings and supplier/distributor ownership reinforces good monitoring of management and also informal contract enforcement. 3 Main Bank Banks have a combined role of shareholder, trustee and business partner in Japanese corporations. As shareholders banks can own up to five percent of equity in the corporation. In Japan, banks in aggregate hold about twenty percent of enterprise equity and are represented on 4 the Board of Directors. Typically the main bank owns five percent and other financial institutions (including insurance companies, pension funds, etc.) in the enterprise group own another twenty percent. In aggregate, financial institutions own about 50 percent of the outstanding shares of stock exchange listed companies. Because of their vast lending and business experience, banks are well positioned to take a lead in enterprise governance. Most companies have one bank with whom they have a very strong affiliation-the main bank. This bank often has a long term lending policy with the corporation, has the largest loan share of the corporation, and holds the largest amount of bank stock (up to 5 percent) in the corporation. (See Figure D-2 below.) ReformStudy,p. 20. PublicEnterpriseGovernance ibid. APPENDIX D - 88 - Figure D-2. Financial Flows OtherShareholders (mostlyfinancial Main Bank institutions) interest from loans occasional buy shares dividends mainloans: up to \ \ / / of shares 1~~~~~~~10% \ ccasional / / ividends/ i oans Company i OteBak interest z_ ff:S g ~~~and #_ ' - ~~~~repayment of loans ShareholdersEquity * The majorityof the financeenteringa Japanesecompanyis throughloansnot shares. This is slowlychanging. Functions of the main bank: * to rescue or liquidate an unstable corporation. The role of the bank in its relationship with the corporation often depends upon the financial stability of the corporation. The more financially independent the corporation is, the less involvement there will be from the bank. The main bank will generally be very involved in companies that are unstable. Under such circumstances the bank may come in and replace management or add management, merge the corporation, or do whatever is necessary to save the corporation. If the corporation does not appear to be viable, the main banks would take the initiative to liquidate them. to elect members to the Board of Directors. There are often representatives from the bank on the Board of Directors of the Corporation. Executives of the main bank will often be offered a position, in mid-career, to work for the corporation. to monitor the corporation. By supplying ex-employees to sit on the Board of Directors or to work in management, the main bank is able to monitor the corporation. This allows the main bank to be aware of any financial difficulties which the corporation may encounter. - 89 - APPENDIX D Board of Directors Composition. The Board is comprised of a president, sometimes a chairman, senior executive directors and other executive directors. The Boards are generally larger in number than those in the United States of America. The president, upon nomination by the current members of the Board and other colleagues, chooses the new members of the Board of Directors. (See Figure D-3) This election is rubber-stamped first by the Board and then ratified by the GSA. Figure D-3. Composition of Board of Directors Outside Shareholders Main Bank Company supply few a / \ members; / \ appoint / makes a Chairmanof the decisionsfor Boardof Board new Directors members some to appointed Board Inside Company of Executives Company The Directors are usually people who have reached high management positions within the corporation. The newly appointed members often continue their role as management at the same time as representing the rights of the shareholders through the Board. The Board is composed primarily of insiders (lifetime employees of the corporation) and a few outsiders (former lifetime employees of other organizations who entered the Board late in their careers). The head of the labor union is occasionally appointed to the Board upon retirement. Members are elected to the Board for a period of two years, which is often renewed repeatedly until retirement. Duties: * to represent the interests of the shareholders. * to call the GSA as provided for by the Code. * to decide the policy of the corporation concerning the administration. * one or more of the Directors is empowered to sign documents on the corporation's behalf. APPENDIX D - 90 - President The positions of president and chairman are combined in many companies. In companies which have both positions, the current president will often become the future chairman. The candidate for president is selected from within the corporation, often in practice by the previous president of the corporation. The Board of Directors then legally elect the new president. A president, as a member of the Board, is elected for a period of two years which is often renewed until his retirement. Duties of the President: * to ensure that the machine runs well. * to ensure that top personnel matters are properly handled. The president is the principal voice in the determination of strategy. However, a collegial approach to management decisions, which are consensual between the president and the top management, is common in Japan. Board of Directors The Board often functions as a de facto substructure of top executive management. The fact that many of the members of the Board come from management, after working their way up through the corporation for thirty years, makes it more likely that their loyalty will lie with the employees rather than the shareholders. Furthermore, many of the newly elected Board members continue in their positions as high level management making it extremely difficult for the Board to effectively monitor the management. If a decision concerns a matter which is sufficiently important to warrant formal Board approval, the decision will generally first be subject to wide consultation with all the relevant parts of the corporation. This process is very thorough and also very time consuming. In small companies the Board of Directors is often the decision-making body for both policy and day-to- day management issues. In bigger firms, a top management team will generally manage the corporation-this usually is comprised of several members from the Board of Directors. The top management generally meet once a week. Their duties are to discuss key policy matters and to handle broad administration functions of general management. Incentives for management. The structure of the governance system, although important, does not reflect, on its face, the manner in which the system functions. The incentives for Japanese management teams to work well appear to be more subtle than incentives for profit or to not be fired. The position on a management Board is a position of honor and power. It is a demonstration that one has reached the highest level in the corporation. - 91 - APPENDIX D Statutory Auditors According to the Commercial Code, auditors are to be appointed by the shareholders of the corporation. For large companies or those who are registered on the stock market, the auditors must be certified public accountants. Their function is to audit the director's activities to ensure that business is conducted in accordance with applicable laws and with the corporation's regulations and in the best interest of the shareholders. For small companies the auditors may be selected from within the corporation and the role of the auditors is merely a formality without substance. However, all auditors must make reports at the GSA concerning the activities of the Board of Directors. - 93 - APPENDIX E SUMMARY OF THE CASE STUDY SAMPLES - 95 - APPENDIXE SUMMARY OF THE CASE STUDY SAMPLES All of the companies chosen for the case studies are large enterprises operating in the manufacturing tradable sectors in a cross-section of developed and developing countries. It is acknowledged that this sample of SOEs errs significantly in favor of the more efficient SOEs but, this reinforces some of the lessons of experience. These companies were selected for this review primarily because of their relative importance in the State sector and their significance at the national level in terms of financial and economic impact. Infrastructure companies, often referred to as "natural monopolies," Iwere excluded from the sample since these enterprises raise a number of quite specific issues concerning the regulatory framework which are of particular importance to firms in these non-tradable sectors. The companies covered in the cases are described briefly below: (a) Semen Gresik: This Indonesian SOE was established as a legal entity in 1953 and is engaged in the cement industry. Semen Gresik is one of the top three cement producers in Indonesia, an industry which is comprised of nine companies, four of which are in the private sector and five from the public sector. In 1991, Semen Gresik became the first Indonesian SOE to issue shares on the Jakarta Stock Exchange. The public offering comprised 40 million shares or 27 percent of total share capital generating about US$ 140 million. (b) Usinor Sacilor: One of the largest SOE manufacturing operations in France, the company was created in 1986 as the result of a merger of two companies taken over from the private sector by the State. The tonnage of liquid steel produced by Usinor-Sacilor is the third largest in the world after Nippon Steel (Japan) and Posco (Korea). The company is set up as a holding company with four main subsidiary operations with a significant degree of autonomy from the owners (Government) in the running of the companies. The company is subject to rules covering competition from the European Union and does face stiff challenges from both SOEs and private companies in all of its market sectors. In addition, the French Government has imposed a "hard budget" constraint on the company thus imposing strict commercial criteria on the company's dealings with commercial banks. Following the restructuring of the company and the return to This validityof the conceptof "naturalmonopolies"as a rationalefor state ownershiphas been challengedin recent years, particularlywith the privatizationof utilitiesand the break-upof larger utility companiesinto smallercompetingentities. In addition,questionsof economicefficiencyhaveoften been addressedby establishingregulatorysystemsto monitorpotentialabuses of concentratedpower. Importantas they are, the issuesof infrastructureenterprisereformand divestitureare not dealt with directlyin this papergiventhe special featuresof the non-tradablesectors. APPENDIX E - 96 - net profits of Ffrl .5bn (US$282.2m) in 1994, the company is now being prepared for privatization. (c) Statoil: The largest company in Norway measured in terms of revenues, Statoil occupies a dominant position in the economy. The company was established as a SOE in 1972 to engage in the exploration, production, transportation, refining and marketing of petroleum and derived products. The company operates in a truly international market for its downstream products and has had to operate on primarily sound commercial principles, receiving no direct or indirect subsidies from the Government. It is a technologically innovative firm and has, over the years, entered into a number ofjoint ventures and cooperation agreements with other European companies in the sector to secure and expand its share of international markets. (d) Coalcorp: As the major producer of both thermal and coking coal in New Zealand, Coalcorp operates twelve mines and accounts for 50 percent of the domestic market. The remaining market share is supplied by in excess of forty privately-owned mines. Coalcorp is one of the nineteen enterprises which were corporatized under the New Zealand Government's initiative to enhance SOE efficiency. In 1987 the company was transferred from the auspices of a Government Ministry and established in a corporate form with a Board of Directors with dominant private sector participation. The company is expected to operate along purely commercial lines and its financial performance since corporatization has been markedly improved. (e) IRI: In Italy, SOEs have played a significant role in the economy and in the early 1990's accounted for 20 percent of value added and 25 percent of fixed investment. Many of these enterprises have been organized as private joint-stock or limited liability corporations in which the government held a controlling interest through principal State-owned Holding Companies (SHCs). The largest of these SHCs is the Instituto per la Ricostruzione Industriale (IRI), a multi-sector holding company with involvement in: steel, advanced technology manufacturing, food processing and distribution, shipbuilding, civil and industrial plant engineering, telecommunications, sea and air transport as well as banking and finance. The total number of Group employees in 1991 reached more than 408,000. Most recently, the 1992-93 crisis of public finances across the state sector in Italy has precipitated moves towards the privatization of many of the firms in the IRI Group. (f) Sumer Holding: The manufacturing arm of what used to be Sumerbank Holding, Sumer Holding employs over 25,000 in 28 manufacturing units, 435 retail and distributing outlets, primarily in the textile sector. By the early 1980s almost all of its operations were in financial difficulty and lagging behind the growing private sector in production. Following reforms in the 1980s, the banking unit split off (and has since been privatized and made profitable) and most non-textile - 97 - APPENDIX E production was also split off in separate enterprises, some of which have now been privatized. Today, Sumer Holdings' remaining operations are all losing money. Market share and productivity have declined in favor of private sector companies. Early reform efforts have been disappointing. Although Sumer Holding is in the form of a corporation under the peculiarities of Turkish law, the majority of state-owned corporations, are not subject to the same commercial laws as are privately owned corporations. Their debts are guaranteed by the Treasury; their assets could not be seized for non-payment of debts. Yet their management does not report to the Treasury but rather to a Minister whose objectives are primarily largely non-commercial (regional development and local empowerment). Sumer Holding's senior managers are civil servants and pressures form public sector unions make it hard to release or reshuffle them. Sumer Holding is currently undergoing a consolidation of its potentially viable assets in preparation for divestiture. (g) Hindustan Machine Tools (India): Established with the collaboration and equity participation of Oerlikon of Switzerland to produce machine tools in 1953, HMT became a fully owned undertaking of the Government of India in 1957. One of India's largest producers of machine tools, HIMThas diversified its businesses and now produces a broad range of industrial and consumer goods (machine tools, tractors, printers, bearing, watch, lamp, etc.). HMT has a workforce of more than 27,000 and its turn-over in 1992-1993 was about Rs. 8 billion (US$240 million). Though HMT has grown rapidly since its creation through the 1980s in terms of sale and production, its profitability has remained low and declined since the mid- 1980s, except its tractor unit. Due to protectionist measures, HMT has not been motivated or able to take advantage of "state of the art" technology that might otherwise have been imported. HMT's performance is monitored through targets stipulated in a Memorandum of Understanding (MoU) signed with Government each year. The MoU sets production and sales targets, however, the MoU takes into account Industrial Policy and employment targets and a growth pattern, based in part, on regional development. (h) Ksiaz Porcelain Factory (Poland): Built in the 1970s with production commencing only in 1980s, KPF, with over 1,400 employees in 1990, never reached full production of its line of tableware and other consumer products. Its situation deteriorated significantly in 1991 when loses totaled almost 50 percent of sales. Exports accounted for 72 percent of sales in 1990. In the same year, KPF had significant overstaffing with only 70 percent of labor in direct production. Product quality was very poor with the domestic markets taking the worst production. Exposure to competition in 1990-91 resulted in liquidation. KPF went into liquidation in June 1991. Management was replaced by a liquidator appointed by the local government. The liquidator sought a restructuring business plan which resulted in the creation of a limited liability company "Ksiaz Porcelain Factor, Ltd." (KPFL) in October 1991, with state owned enterprises (primarily a commercial bank which was KPF's main creditor) APPENDIXE - 98 - as shareholders. The Executive Board is supervised by a 9-member Supervisory Board representing shareholders. Production at KPFL recommenced in June 1992. By 1994 it was marginally profitable due to improvements in quality and direct foreign marketing. - 99 - APPENDIX F SEMEN GRESIK (INDONESIA) - 101 - APPENDIX F SEMEN GRESIK (INDONESIA) Case Study In Corporate Governance Company Information Background and Legal Status. Semen Gresik is a state-owned enterprise (SOE) engaged in the cement industry and based in Gresik, East Java. The company was established as a legal entity in 1953 by the Bank Industry Negara acting on behalf of the Government of Indonesia following the discovery of sizable limestone deposits in the area. In 1969 the company was established as a "Persero" under Government Regulations number 9/1969. A "Persero" is a limited liability company with at least 51 percent Government ownership. Private sector limited liability companies operate under similar commercial legislation, although separate regulations apply to management and operations of SOEs. Operations. Semen Gresik operates in East Java about 16 km from Indonesia's second largest city, Surabaya, on a 750 hectare site comprising a physical plant of 15 hectares and adjacent limestone and clay deposits. The company owns an additional 200 hectare limestone deposit on the nearby island of Madura. Production began in 1957 with an initial installed capacity of 250,000 tons per year (tpy) using a wet process system. Subsequent expansions of productive capacity were undertaken in three phases over the period 1961 to 1976 and involved investment in the dry process system resulting in installed capacity of 1.5 million tpy. Cement production capacity was further expanded to 4.1 million tpy in 1994 following a major investment program financed by an initial public share offering (IPO) in 1991. The additional capacity is located in Tuban, some 100 km from Gresik. A further capacity addition of 2.3 million tpy has been decided at Tuban and is expected to come on stream in 1997. Almost 90 percent of the company's output is accounted for by Portland Type I cement although it also produces Types II, III and V as well as Portland pozzolanic cement. These products have applications in general construction purposes such as house and building construction, roads and bridges; dams, piers and heavy footing construction; modem construction techniques such as products that set and harden rapidly; applications that require high sulfate I Gresik also has equity participationsin sevencement-relatedbusinesses:(i) Etemit Gresik(23 percent SG participation): producer of construction components from asbestos; (ii) Panesge (65 percent SG): managementconsultingand data processingservices;(iii)KawasanIndustriGresik (65 percent SG): industrialestate development;(iv) Varia Usaha(25 percent SG):cementtransportationand distribution;(v) SwadayaGraha (25 percentSG):real estate,contractingand engineering;(vi) Industri Kemasan Semen Gresik (60 percent SG): paper sacks for cement, flour, and animal and shrimp feed; (vii)UnitedTractorsSemenGresik(55 percentSG):joint venturewith Astra International'slisted heavy equipmentsubsidiaryUnitedTractors. APPENDIX F - 102 - resistance; sea water construction and mass concrete applications. The following table provides selected operational data for Semen Gresik for 1989-1994. Table F-I. Semen Gresik: Selected Operational Indicators, 1989 - 1994 1989 1990 1991 1992 1993 1994 Design capacity ('000 tons) cement 1,500 1,500 1,500 1,500 1,800 4,1001 Actual production ('000 tons) cement 1,278 1,346 1,406 1,462 1,732 2,139 Capacity utilization (%) cement 85% 90% 94% 97% 96% 97%2/ Energy efficiency Fuel (Kcal/kgclinker) 1,359 1,276 1,319 1,313 1,1193 1,095 Electricity (Kwh/ton cement) 170 171 165 156 143 133 I October 1994 when 2 3 million tpy addition of Tuban capacity came on stream 2/ January - September 1994 3/ Improvement in energy efficiency due to plant optimization project Cement industry and comnpetition environment. Total cement industry capacity in 1994 was about 21 million tons and is expected to increase through capacity expansions and new projects to 37 million tons by 1999. The industry is comprised of 10 companies, of which 5 are in the public sector. Semen Gresik is one of the top three cement producers in Indonesia and is the dominant supplier to one of Indonesia's fastest growing regions-East Java. It represented 12 percent of total domestic capacity in 1993, which increased to 18 percent in 1994 following its capacity expansion. The largest Indonesian producer--Indocement-accounts for about 50 percent of domestic capacity and has a dominant market position in West Java. It is majority privately owned, with a minority Government participation of 27 percent. The five state-owned cement producers together account for 30 - 40 percent of total domestic capacity in 1993. The three other companies-Semen Cibinong, Semen Andalas, and Semen Nusantara-are fully privately owned, and account for about 20 percent of the market. Semen Andalas and Semen Nusantara have been acquired by Indocement and Semen Cibinong respectively. A new company, PT Semen Kodeco is expected to come on stream in 1997 with a capacity of 2.3 million tpy. The Indonesian Government intervenes in the domestic cement market by setting regional benchmark prices, and by allocating regional markets based on proximity ("defined natural markets"), installed capacity and projected cement demand. Export of cement also needs to be authorized after domestic cement needs have been met. This market control is realized by the Ministries of Industry and Trade in consultation with the Association of Cement Producers which includes all the private cement companies and SOEs. These arrangements have tended to restrict competition in the domestic cement market and may have contributed to periodic price fluctuations. Government is actively considering deregulation of cement pricing and marketing arrangements as an incentive for investment promotion in the sector to avoid future supply bottlenecks. - 103 - APPENDIXF Human Resources. Semen Gresik employs approximately 1,800 permanent employees. Labor turnover has been low. The company operates a series of regular training programs for staff including courses on management training, total quality control, and safety. In addition to basic salaries, employees receive food allowances and other benefits such as a pension program, employee accident insurance, and other medical and health facilities. The company also owns and operates a number of "social assets" for the benefit of its employees and their families, including employee housing, educational facilities (kindergarten through senior high school, and a technical high school), recreational facilities, and transport facilities to carry employees to and from work. Financial Performance. As shown above, Semen Gresik has operated at relatively high capacity level. It has also displayed a strong financial performance. Operating with its relatively old plants in Gresik, it has shown good profitability, posting high rates of return on sales, assets and equity, a high dividend payout ratio, and a favorable debt/equity structure. The high returns on assets and equity in 1990-91 are due to non-operating income from the sale of Semen Gresik's holdings in PT Cibinong, as well as financial income on the process of the sale and of the IPO in 1991. Financial performance in 1994 is expected to be less favorable due to commissioning of the new Tuban plant, but is expected to improve in 1995 as the new plant would reach capacity and realize efficiency gains. The following table highlights key indicators of Semen Gresik's financial performance during 1989-1994. Table F-2. Semen Gresik: Selected Financial Indicators, 1989 - 1990 1989" 19901 1991/ 1992" 1993" 199421 Total assets (Rp bin) 161 382 661 892 969 994 Sales revenue(Rp bin) 104 128 156 166 218 172 Oper. incomeas % of 12% 21% 17% 13% 18% 15% sales3/ Returnon assets (%)3/ 8% 43% 13% 9% 5% 3% Returnon equity(%)3/ 8% 55% 13% 12% 7% 4% Dividendpayoutratio N.A. 10% 50% 50% 50% 50% (%) Currentratio (times) 4.1 3.8 31.9 13.8 2.4 3.8 LT Debt to equity ratio 1:99 0:100 0:100 24:76 28:72 21:79 1/ Audited 2/ As of September 30, 1994,unaudited 3/ The very high returnon assets and equityin 1990wasa resultofgain on sale of SG's holding in PT Cibinong Public share offering. The Indonesian Govermnent has been increasingly reluctant to increase its capital participation in SOEs and has encouraged the companies to seek long-term investment financing from the capital market. In line with this policy, Semen Gresik in July 1991 became the first Indonesian SOE to issue shares on the Jakarta stock exchange to finance its APPENDIX F -104- 2 capacity expansion project at Tuban. The public share offering comprised 40 million new shares, or 27 percent of total share capital, and generated about Rp. 280 billion ($140 million equivalent). Shares have a nominal value of Rp 1,000 ($0.50) and were sold initially at Rp 7,000 per share with a price/ earning ratio of 16. The share price dropped to Rp.2,900 during the period of tight money policy announced by the Government later in the year in line with a general drop in the Jakarta Stock Exchange index. Semen Gresik's share price recovered, and in November 1994, traded at Rp. 7,600. Of the new shares sold, some 34 million (85 percent of total) are now held by foreigners, mostly institutional investors.3 Corporate oversight and management Before public offering The corporate governance and asset management system for Indonesian SOEs is set out in Law No. 3/19834 and Government Regulation No. 55/1990.5 Since 1969, Semen Gresik has been organized as a limited liability company (Persero) with the shareholder, i.e., the State, being represented by the Minister of Finance. The technical minister i.e., Minister of Industry or Director General in related ministry chairs the periodic (bi-annual) shareholder meetings which review company results and approve the annual budget. As other Indonesian SOEs, Semen Gresik is managed by a Board of Directors which is appointed by the Minister of Finance based on the recommendation from the technical minister. Supervision is carried out by the Board of Commissioners whose membership typically includes representatives from the technical ministry, the Ministry of Finance as well as the military. The Board of Commissioners typically met once a month. Corporate accounts were audited annually by the GovermmentAuditor (BPKP) which submitted its audit opinion to the Minister of Finance. In the case of Semen Gresik, the Board of Commissioners was made up of 4 representatives from the Ministry of Industry, and a representative from the Ministry of Finance. The second half of the 1980s saw renewed Government efforts to improve efficiency and productivity of Indonesia SOEs. Based on a Presidential Decree in 1988, an assessment was made of the financial soundness of each SOE and a program developed for restructuring in each case. The proposed measures varied from changes to a more commercial legal status, mergers, 2 IPO timing was actuallydelayedfrom 1990to 1991due to late processingof a Government regulationwhich set up guidelinesfor managementof "going public" state-ownedenterprises.See footnote3. 3 SemenGresik listeda total of 70 millionshares(of w:iich40 millionnew shares)which allowed foreignersto buy some 35 millionshares. Foreignersare allowedto hold only 49 percent of listed companysharesin Indonesia. 4 Law on Proceduresfor Promotingand Supervising DepartmentalAgency(Perjan),Public Corporations(Perum),and LimitedLiabilityStateCorporation(Persero). 5 Regulationon State TradingCompanies(Persero)GoingPublicThroughthe Capital Market. - 105 - APPENDIX F management contracts, joint ventures, public share issues, to liquidations. Semen Gresik's IPO took place as part of this program. In 1989, the Government also introduced a system to monitor financial performance of each SOE on an annual basis, following an evaluation on the firm's profitability (profits before tax/operating assets at book value), liquidity (current assets/current liabilities) and solvency (total assets/total liabilities). To reflect technical differences among subsectors, additional non-financial performance indicators were introduced in 1993. Financial performance indicators now account for 70 percent of enterprise evaluation and technical indicators tailored to each subsector or enterprise make up the balance.6 Upon evaluation, the scheme classifies SOEs each year into four groups: very healthy, healthy, not so healthy, and not healthy. Remuneration of SOE management is linked to the level of healthiness of the company. Semen Gresik has been clarified as very healthy under the scheme. All Indonesian SOEs are required to submit a long-term corporate plan (usually five-year plan) to the Minister of Finance to be endorsed and validated. The plan, which includes objectives and targets to be achieved during the five-year period, is further translated into annual workplans and budgets. Annual plans consist of targets and objectives to be realized during the current year and are the operating guidelines for the Board of Directors and a monitoring tool for the Board of Commissioners. They are also used to measure management's performance. While the reforms have led to a more modem system of oversight and management of Indonesian SOEs, their implementation and impact have fallen short of expectations. The main corporate oversight and management issues which impede the further commercialization of SOEs are as follows: (i) inclusion of non-commercial objectives in SOEs mission; (ii) conflict of interest between the dual roles of technical ministries in supervising sector SOEs and regulating all enterprise activity in their sectors; (iii) the requirement to follow onerous government procedures which delays decision making especially with regard to financing, procurement, and 7 labor reduction; (iv) remaining inadequacies in performance evaluation and management compensation system; (v) inadequate financial transparency. Impact of public share offering Following the successful public listing in 1991, Semen Gresik was accorded special SOE status as set out in Government Regulation 55/1990. This brings the status of Semen Gresik more in line with that of private sector firms. Given the minority share of private holdings in the company, however, Semen Gresik is still considered a state-owned enterprise. As stipulated in Regulation 55/1990, therefore, the Minister of Finance maintains veto power with regard to: (i) a change in the company's share capital; (ii) capital participation or relinquishment of capital 6 In the scheme, SOE's profitabilityis weighted52.5 percentof total evaluation,liquidityand solvencyeach contributes8.75 percent,and each of three additionaltechnicalindicatorsspecificto each subsectorprovides 10percent of the evaluationweight. 7 Regulation 55/1990 gives considerably more freedom to SOEs which have been approved for listing in the stock exchange. APPENDIX F - 106 - participation not conducted through the Stock Exchange; (iii) establishment of a subsidiary company; (iv) relinquishment of part or all of the company's share; (v) liquidation, merger, or reorganization of the company; (vi) amendment to or change of articles of association; (vii) profit distribution; and (viii) Board of Directors' compensation, and Board of Commissioners' honoraria. Company management and oversight have been affected in significant ways, however, following the public share offering. Regulation 55 allows SOEs that have publicly sold shares to be exempted from the cumbersome regulations on Government supervision and monitoring, and onerous Government procurement regulations, while enjoying greater flexibility in sourcing of funds. This brings the status of Semen Gresik more closely in line with that of private sector firms, and allows it greater flexibility. Supervision of the company is now delegated to the Board of Commissioners, which decides on all matters of investment, funding, budgets and procurement. Regular SOEs need to refer to Government on these issues. A shareholders meeting takes place once a year chaired by the President of the Board, rather than two such meetings chaired by Ministry officials for regular SOEs. Semen Gresik's Board continues to be made up of Government officials, but is felt to be more professional than for other SOEs. Private sector representation on the Board is under consideration. The new status has also permitted to extend greater incentives (both salaries and bonuses) to company management and personnel in order to bring remuneration more in line with the private sector. In 1993, bonuses have equaled 5 months of salaries. There is also greater freedom in moving staff around to realize efficiency gains. This is important as the new investments allow to improve labor productivity considerably. A very significant impact of the IPO is the much greater scrutiny of performance by the private shareholders. Public reporting now takes place once every three months, while company finances are audited by a reputed international audit firm in line with international accounting and audit standards. Company performance is also scrutinized by external financial analysts which publish regular recommendations on the attractiveness of Semen Gresik' s shares for current and potential shareholders. The much closer scrutiny has led to greater transparency of Semen Gresik's performance and has created a greater sense of accountability by company management for efficiency improvement. While Semen Gresik's performance has been good, further efficiency improvements are expected as a result of the new investments coming on stream. Together with the closure of the remaining outdated wet-process facilities in the coming year, this will allow considerable savings in production costs as energy efficiency would increase further and labor productivity would improve. In a recent development, Semen Gresik is expected to expand further through the acquisition of two other cement SOEs through a rights issue. The consolidation is expected to provide the company with additional critical mass to provide a countervailing balance to the large private sector cement companies and allow greater synergy in operations and marketing. While increasing the scale of Semen Gresik's operations, it would also spread the above discussed benefits of IPO status to the two SOEs that would be consolidated. - 107- APPENDIX G USINOR SACILOR (FRANCE) - 109 - APPENDIXG USINOR SACILOR (FRANCE) Case Study In Corporate Governance Brief History of the Company Background Information. The oil crisis of 1974 had a negative impact on the European steel industry and French industry in particular. The French State, responded to the decline of the industry by giving grants and lending money at a subsidized rate to the remaining steel companies. In 1984, after further declines, the State acquired two companies from the private sector-Usinor and Sacilor. In 1986 the two companies were merged to form a single state- owned enterprise-Usinor Sacilor, today Europe's largest steel company. From 1986 to 1995, the company embarked on a major restructuring effort resulting in significant increases in productivity and a profitable balance sheet in 1994. Ownership of the Company. Until Table G-1. Ownership in 19931 the July 1995 privatization, the French state No. of Shares Value % held a direct 80% ownership interest. As in French 149,235,516 5,969,420,640 80 the case of all French SOEs, a state owned State bank also holds equity, in this case, Credit Credit 37,308,879 1,492,355,160 20 Lyonnais. Although ownership is vested in Lyonnais the Treasury and although it may be Total 186,544,395 7,461,775,800 100 required to fund the company, the Treasury has no independent power to exercise its ownership rights. Rather the exercise of state ownership rights is with the Prime Minister. Objectives of the government. The initial objectives of the French government, as owners of Usinor Sacilor, were to halt the rapid deterioration of the steel industry and address the accompanying social problems, particularly declining employment in politically sensitive areas. By the early 1990s, as the industry stabilized and reliance on the government decreased, the objectives of the government changed to the following: (i) financial independence; and (ii) employment maintenance and growth through globalization in regions with unemployment problems. Legal Status. Usinor Sacilor is organized under French corporate law and must comply with it on the same basis as any privately owned company. A State Owned Enterprise law defines the relationship between the SOE and the owner-the government. Usinor Sacilor,Annual Report 1993. APPENDIX G - 110 - Company Information Product Lines. Usinor Sacilor is divided into three subsidiary product groups-flat products (Sollac), long products (Ascometal & Unimetal) and stainless steel (Ugine). These groups are then further subdivided. Of the steel produced in 1993, 66.6 percent was used for flat products, 25.6 percent for long products and 7 percent for stainless steel and alloy. The remainder is distributed for diverse metallurgy activities.2 Flat Products represent two thirds of the steel produced. Eighty-eight percent of the steel produced by Usinor Sacilor is produced in France, 9.5 percent in Germany and 2 percent in the United States, this balanced by wholly or partially owned interests in including Belgium, Canada, Germany, Great Britain, Italy, the Netherlands, Spain and the United States. Productivity. Productivity ratios at Usinor Sacilor are considered at or above the level of international standards and are the best ratios in Europe. Employment. Since Usinor Sacilor's foundation in 1986, its workforce has been decreased from approximately 250,000 to 61,500 employees in December 1994 (79 percent in France, 11 percent in Gerrmanyand 5 percent in the United States). The termination of Table G-2. No. of Employeesat Sacilor in 19934 employees in 1993 affected 3,356 people in France and 1, 265 people Activities France Germany Rest of Total overseas.5 This year the number of World redundancies is expected to decrease Flat Products 22,723 6,264 2,158 31,145 to 1,800. Usinor is expected to Long Products 10,190 798 417 11,405 achieve the reduction without need for dismissals. Most jobs will be lost StainlessSteel 9,787 286 2,781 12,854 through retirements and Other Industrial 10,486 39 622 11,147 reconversions. Compensation for Activities redundantworkersis provided Business/Sales 453 323 657 1,433 according to the social laws in France and the accords in force in each Group Total 53,639 7,710 6,635 67,984 country. The group also has a number of partnerships with regional authorities to place former steelworkers in new jobs. Technology. In 1993, the research budget was increased to FF 1.1 billion and research for the corporate group was centralized. At the beginning of 1993, a wholly owned subsidiary- Usinor Consultants-was created to respond to the growing demand for technical assistance 2 AnnualReport 1993,p. 3. 3 ibid. 4 AnnualReport 1993. 5 AnnualReport 1993. - 111 - APPENDIXG directed to the group. Usinor Consultants undertakes contacts and seeks offers for technology contracts on the behalf of Usinor Sacilor. Among the contracts already negotiated are (i) a technical assistance project to build a blast furnace in Piombino, Italy, and (ii) a project to commence galvanization installation at Galmed, Spain. Significant Changes over the Last Five Years. The most significant change in the last five years has been the July 10 sale of equity to the public and the earlier partial divestiture of some of the subsidiaries. Last year the stainless steel sector had 49 percent of its stocks floated on the stock market. Financial Performance. Since nationalization, certain activities of Usinor Sacilor have been very profitable while others have sustained a loss. Unimetal from the long sector has constantly run a deficit and has been cross-subsidized from the other subsidiaries. The strongest sectors are the Flat Products and Stainless Steel. The last year has shown an improvement in financial performance as demonstrated in the chart below. Table G-3. Key Financial Data6 (in millionsof francs) 1989 1990 1991 1992 1993 1994 Consolidatedturnover 97,0 96,1 97,2 87,0 75,3 79,5 CashFlow 14,9 8,7 3,1 1,3 -1,2 5,6 Industrial Investments 4,2 6,1 6,0 5,0 3,4 2,8 Externalgrowth 1,9 7,1 2,0 2,4 1,5 Net profit 6,8 3,2 -3,0 -2,4 -5,7 1,0 Shareholder'sEquity 25,7 28,9 27,2 23,7 20,0 22,1 Debt 22,0 28,9 30,0 29,5 24,4 17,4 Net finance Charges 2,1 2,8 3,1 3,2 2,2 Market Share and Competition. Usinor Sacilor competes freely for the French and European market against other European SOEs and various private sector companies.7 Private 6 AnnualReport 1993. 7 Thereare no barriersto entry in Francefor companiesbased in countrieswho are membersof the European Union. The European market, however, is protected against imports from non-EU countries, in particular to Eastern European countries which have large production capacities. The main producers of steel in Eastern Europe are Poland, the Czech Republic, and Slovakia. The two most important trade measures adopted to date have been Voluntary Restraint Agreements and anti-dumping duties. It has not been uncommon for the EU steel industry to use anti-dumping proceedings which may impose punitive duties, payable on importation, on imports from third countries. A tariff protection system was set up in Europe after the creation of the European Coal and Steel Community. During the crisis period from 1980 until 1986, tariffs were used to protect the European APPENDIX G - 112 - companies, such as those from Germany and British Steel, are able to compete for the French market which has reduced the market share of Usinor Sacilor, in France, to 50% despite the fact that the company is responsible for 85 percent of steel production in France. There is also very stiff competition in the steel industry from mini-mills which produce long products such as bars and beams. The market price for steel in France is regulated by the EU. Usinor Sacilor must ensure that its prices are in line with the European market. Market regulation mechanisms are used under the European Coal and Steel Community Treaty (ECSC) in order to protect, encourage, and stabilize the community steel industry.8 From 1980 until 1986, the EU used the ECSC to regulate the market through fixing prices. The prices were based on data gathered by Eurofare, an association of large steel producers. The data collecting procedures are still functioning which enables companies with this data to adapt output to short-term evolution of the market. Under the ECSC treaty the EU has the option to fix prices at any time. This treaty is due to expire in 2002, from which date it is likely that the coal and steel industry will be governed solely by the provisions of the EU treaty. Corporate Structure Members of the Board and their qualifications. The Board of Directors of Usinor Sacilor is comprised of representatives from the government, the private sector and the employees. The Prime Minster is responsible for the selection of the Board members. A short list is proposed by the different government ministries and the business community, and the Prime Minister makes the final decision. These selections are then ratified by the Parliament. The CEO of Usinor Sacilor is the chairman of the Board. For nine years, that person has been Mr. Francis Mer, reconfirmed as Chairman in June, 1995. The boards of each of the subsidiaries are composed of the CEO of the subsidiary, representatives of the employees of the subsidiary, the CEO of the Holding Company, other members from within the company, and some members of the community with experience. The members are selected by the CEO of Usinor Sacilor and put to the General Assembly of the Subsidiary. The General Assembly is composed of the owners of the subsidiary company and are primarily representatives of the government. The Boards are considered to play a role of "puppet boards," with their actions primarily controlled by the HloldingCompany. This will change in the stainless steel sector where the company is no longer wholly owned by the government. producersfrom internationalcompetitors,in particularBrazil and SouthKorea. Since 1986,tariff protectionhas not beenused. 8 Jean FrancoisBellis, TheChangingEC TradeRegulatoryEnvironment, Steel Worldpp. 13-16. - 113 - APPENDIX G Figure G-1. Usinor Sacilor PrimeMinister Treasury Ministry of Industry Appoints l Monitors . . .... ..... .... .. . . ..... .. .. . . . . . . .ni t ors .ecutive iet roup Board of (CEO Subsidiary & Owns Directors CEOAs,FHnancal :~~~~~~~~~~~~~~~ Corporate Monitors Managecompany Structure andsubsidiaries USINORSACILOR Subsidiaries CEO/Board CEO/sbard CEO/Board SUbSldlarleS ~Flat Pr;oducts StainlessSteel LongPjroducts SOLAC UGINE ASCOMETAL Duties & Outputs of the Board. The function of the Board is to assist the CEO. The Board is an informational channel for the government, enabling monitoring of the company to be more efficient. The Board has no executive power in the running of the company. Responsibility is usually delegated from the Prime Minister to the CEO rather than the Board. Subjects which are discussed at Board meetings do concern matters of extreme importance, however, in general the Board does not make decisions on these matters. However, board meetings are an ideal time for Ministries or others dissatisfied with the running of the company to put their complaints on the table. The Board of Usinor Sacilor meets biannually as do the Boards of the subsidiaries. It appears that the CEO's objectives for the company, rather the government's objectives take precedence at the board meetings. The CEO of Usinor Sacilor uses the Board meetings to explain the strategies of the company and the developments which have occurred in the previous months. There is generally a preparatory meeting to arrange the agenda for the Board meeting. Board representatives of the employees are not invited to the preparatory meeting. Remuneration of the Board members. A position on the Board or dirtos of the of holding company is primarily an honorary position which entails only token remuneration. There is no remuneration for the members of the Boards of the subsidiaries. APPENDIX G - 114 - Limits on management's ability to operate. The management of the company, which is primarily controlled by the CEO, is independent from the Board concerning day-to-day matters. The management team is not responsible to the Board although the board members are free to complain at board meetings concerning the actions of the management. The management's ability to operate is rarely inhibited unless the Prime Minister is involved. The agency responsible for monitoring the chief executive group is the Ministry of Industry. The Ministry of Industry is responsible under law for monitoring all state owned enterprises. It periodically contacts the company concerning recent activities, however, there is no strict monitoring procedure. The Ministry of Industry represents the French steel industry in international affairs-including discussions and negotiations on behalf of the government and the industry. This representation provides an incentive for the Ministry of Industry to monitor the company. Compensation, Bonus Systems and/or Sanctions for Management Performance. Members of the Corporate management are paid full time salaries, which correspond to the salaries of management in the French private sector. There is no bonus system for management of the Holding Company. The companies each have their own bonus systems. In Ugine, for example, there is a profit sharing scheme. At the end of the year, 20 percent of the profits are spread among the employees according to their salaries. Since part of Ugine's shares have been sold, now shares are being used as a bonus award for employees. There is a limit on the amount of shares which can be sold, since the state desires to retain 51%. How the Chief Executive Officer is chosen, by whom, and how he/she is replaced The CEO of the company is elected for a three year term by the Prime Minister of France. This term may be renewed at the end of the three years at the Prime Minister's discretion. The Prime the Minister also has the power to replace the CEO dharing term. The process of selecting a president is as follows: The Prime Minister is pr-vic'd with a number of names. These names are provided by several groups; from within the company, a few from the steel sector, and a few from outside sources (usually political choices). The Prime Minister then chooses a candidate from the list. This choice is ratified by the General Assembly of the Holding Company-which is comprised of government officials representing the owner of the company. The selection is then discussed and approved by the parliament. There are two important informal criteria in choosing the CEO. The first is political and the second is educational. The political aspect usually ensures that the new CEO will support the political party represented through the Prime Minister. The education requirement ensures that the CEO went to one of the Grandes Ecoles. If there are no candidates who attended one of these schools there will be pressure, both from the schools themselves and from within the government, so that an alumni from the Grandes Ecoles be added to the list. In 1988, the current CEO, Francis Mer, was elected. His term has been renewed twice and his present term of office ends in 1998. - 115 - APPENDIXG Autonomy of the CEO in the Management of Usinor Sacilor. The CEO has a great deal of autonomy in the management of Usinor Sacilor. For example, in 1992, the European steel industry suffered a recession. The effects were felt by Usinor Sacilor. Instead of asking the Treasury for money, Francis Mer explained the reasons for the loss to the government, how he could finance the loss and demonstrated that he didn't need financial support from the Treasury. The CEO's autonomy in managing the company allowed the French government to play a minimal role in acquiring funds for the company when the SOE was having financial difficulties. The autonomy of the CEO has conflicted with government objectives in decisions concerning employment targets. The government agreed in 1993 to the decrease the number of employees of Usinor Sacilor by 10 percent over the next three years. Usinor Sacilor, with the approval of the government planned to close a large plant in Lauren, an area with high levels of unemployment, meant the loss of about 3,000 jobs. Mr. Mer hoped to partially rectify the situation by building a small plant in the area which would employ 700 of the redundant workers. The Ministry of Industry was discontent with this decision and wanted a medium-size plant, creating twice the number of jobs to be built instead, thereby decreasing the loss of employment. Mr. Mer resisted these requests of the Ministry of Industry and the issue went to the Prime Minister. Only under orders of the Prime Minister was decision made for the medium-size plant to be constructed. Corporate Finance How the Budget is Set. Each subsidiary is required to prepare a document outlining financial requests for the following year. A meeting is then held between the CEO and the management team of the subsidiary at which the proposal is presented. The CEO will then approve or deny the request. If the request is approved, it will then pass to the Ministry of Finance for review and final approval. How the Company isfinancedc Usinor Sacilor was recapitalized by the Treasury, in both 1984 and 1986. In 1987, the Treasury stated that it would no longer supply financial assistance to Usinor Sacilor. Today, the major source of financing for Usinor Sacilor is through borrowing money from both state owned and private banks. Credit Lyonnais was formerly the primary creditor for Usinor Sacilor. Now, Credit Lyonnais, in the process of being privatized, is no longer providing loans to Usinor Sacilor. Despite Usinor Sacilor's status as a SOE, which implies that the government will pay for defaults on loans, banks do not provide loans easily. A risk exists that, unless there is assurance of repayment, in writing, by the Treasury, that the State Owned Enterprise will not repay the loan. There are no special conditions granted to Usinor Sacilor, such as receiving loans without delay or receiving longer terms of repayment. Any special treatment granted to the company is due to the fact that Usinor Sacilor is a large enterprise with which a bank would like to do business-not because it is a state owned enterprise. Nevertheless, the assurance of repayment (through the Treasury) by a government-backed enterprise probably plays a role in the granting APPENDIX G - 116- of some loans. Risks of bankruptcy and liquidation are less and the company obtains a better investment rating. Usinor Sacilor is free to go to whomever it pleases to request loans. In 1992 and 1993, the Holding Company had commercial papers issued in the United States. Usinor Sacilor can also obtain loans from commercial banks on security or collateral. Equipment has been mortgaged in the past for this purpose. Other mechanisms to help with financing are used. For example, in 1994 the floatation of 49 percent of the stocks of Ugine-the stainless steel industry-helped to accelerate the process of freeing Usinor Sacilor from debt. The debt/equity ratio of Usinor Sacilor was 75/25 according to the 1994 annual report. Finance of the Subsidiaries. The debt level of Usinor Sacilor was controlled until 1992 through the Holding Company. In 1992, the subsidiary companies were granted the right to go out on their own in search of financial support. The reasoning behind this was that the Holding Company had reached the ceiling limit on loans with most of the banks in France. Now, if one of the subsidiary companies wishes to borrow money from a bank they have automatic approval, up to a certain level, from the Holding Company. Unimetal, the weakest subsidiary, has 90 percent of its debt with the Holding Company as it does not have the financial stability to obtain loans easily from the banks. There are also limits on the power of the management of the subsidiaries, which restrict buying and selling powers of the subsidiaries without approval. These limits are included in the regulations of the company. The main limitations are imposed on the subsidiaries by the CEO of the Holding Company. Financial surpluses from the subsidiaries flow upwards to the Holding Company. This may result in the demoralization of the management of the subsidiaries as they watch the profits they achieved cross subsidize other sectors of the company. The sectors of the company which are operating at a loss continue to be granted funds from the Holding Company. The CEOs of the profitable subsidiaries are complaining because they do not want to supply any more money to the profit losing companies. Lately, there has been a push by the CEOs of the individual subsidiaries for privatization of the industry by product line. The problem then arises that in order to do this, the weaker subsidiaries would need to be liquidated. The govenrnmentrefuses to do this. This cross subsidization has held back advances in stronger sectors of the company. Subsidies from the State. The French government is restricted in the subsidies which it may grant to Usinor Sacilor under the EU agreement. The permitted subsidies include those for research and development, and investments to comply with environmental policy. The cofinancing of research and development projects provided by the governrmentamounts to approximately 5 percent of the total amount of the project. In 1993, the government's - 117 - APPENDIX G contribution for environmental protection constituted 8 percent of the amount that Usinor Sacilor spent in this area. The government pays partial compensation to the redundant employees. The amount to be paid by the government is negotiated with the Steel worker's Union. The government pays about 50 percent of the redundancy fees. In addition to what the company provides, the government provides services are services such as compensation and retraining. This is a typical part of the social safety net. Dividends. By law profits of the corporation must revert to the owner of a company-the Treasury. In the years that Usinor Sacilor has operated at a profit they have paid dividends to the Treasury. The amount of the dividends is negotiable and the amount paid in the past has been 5 percent of the net profits. This action sends a message to the company that there is an owner. Usinor Sacilor did not distribute any dividends in 1991 or 1992 due to the difficult financial times. The dividends are set by the General Assembly, attended by representatives of all of the shareholders, under proposition of the Board of Directors. Assessment of Performance to date Effectiveness of the company in carrying out the government's objectives. In general, Usinor Sacilor has been carrying out the government's primary objectives, in that it has been financing itself without the support of the government and improving efficiency. The second objective of the government, is to help the unemployment conditions in certain regions. This social objective has been resisted by the company's management but has been achieved in certain regions. Early in February 1995 Ministry of Economics announced that it was looking for banks to advise the government on the sale of Usinor Sacilor. The decision to privatize Usinor Sacilor is thought to be based on the groups fast return to the black and the government's ambitious targets for privatization income.9 It is estimated that there could be a total of Ffr 12bn-20bn in equity on the sale.10 The state will probably unburden itself of the majority of Usinor shares, retaining approximately 10 percent. I" 9 "Usinor ShedsJobs as PrivatizationLooms." Metal Bulletin, January, 1995,p. 19. 12 10 "Usinor Privatization"p. 32. "1 "Usinor Sacilorfait le forcingpour &reprivatiseavant I'ete." les Echos, 12-13May, 1995,p. 8. - 119- APPENDIX H STATOIL (NORWAY) - 121 - APPENDIXH STATOIL(NORWAY) Case Study In Corporate Governance Company Information Legal Status. Founded on June 2, 1972,as a 100 percent state-ownedcompany, Statoil (Den norske stats oljeselskap a.s) is, "either on its own or through participationin or together with other companies, to engage in explorationfor and production,transportation,refining and marketingof petroleumand derived products, as well as other activities." The company is 100 percent state-owned,and operates on a commercialbasis. The basis for establishing Statoil was the prospectof the State's direct participationin developingand benefitingfinancially from the potentially large oil and gas resources in the Norwegian sector of the North Sea. Statoil operates several Norwegian oil and gas fields, the most importantbeing the giant Statfjord field. In 1996 the Statoil operated gas field Troll will be on stream. Troll is the centerpieceof Norwegian future gas deliveries to Europe. Activities. Statoil is a fully integratedoil companywhose activities include: * Exploration and Production - including development and operation of offshore installations. * Oil Trading and Shipping - the sale of crude oil supplies, including the Norwegian government's crude oil, sale of refined products and natural gas liquids,and maritime transport. * Refining and Marketing - the operation of refineries in Sweden, Denmark and Norway and the marketingof products * Petrochemicals and Plastics - the operation of petrochemical plants in Norway (polyethyleneand other plastics) development,production and marketingfor olefins, polyolefins, specialtyproducts and finishedplastic componentswere combined in 1994 with Neste (a Finnish company) which merged the bulk of its petrochemical business with that of Statoil into a new company Borealiswith its headquartersbeing in Copenhagen. The new company is owned 50-50 by Statoil and Neste. * Natural Gas - the export of gas. In 1986, the Gas Negotiating Committee was established to negotiate gas sales abroad. Statoil chairs the Committee,which also includes two other Norwegianoil companies-Norsk Hydro (51 percent state) and Saga Petroleum (100 percent private). APPENDIX H - 122 - Employment. Statoil is the biggest company in Norway, by revenues and profits and the second largest by employment. At the end of 1993 Statoil employed 14,560 people. On January 1, 1994, some 2,400 employees from Statoil's petrochemical business were transferred to the new company Borealis. Statoil's employees are located in 13 countries. Figure H-1. Employment 16,000 14,338 14,560 12,160 12,000 8,000 4,000 0 i:<. T. -3 E 1991 1992 1993 1994 Technology. Extensive restructuring and reshaping of work processes were implemented by the Exploration & Production division of Statoil during 1993 in order to reduce costs and strengthen the acquisition of expertise. This process permitted the company to undertake new operator commitments without any significant expansion in new recruitment. Statoil, in cooperation with Norwegian engineering company MCG, developed a new storage-free submerged turret loading (STL) system which attracted considerable international interest. A separate company, Advanced Production and Loading (APL), was established by Statoil and MCG to market technology, equipment and technical services. In 1993 Statoil Norge became the first oil company in Norway to introduce a new unleaded and environment-friendlier petrol aimed at cars unable to use conventional unleaded grades. Market Share and Competition. About 25 oil companies are active on the Norwegian continental shelf, including many of the major internationals and the three Norwegian companies-Statoil, Norsk Hydro, and Saga Petroleum. Statoil is also exposed to fierce international competition in both refining and marketing activities. Statoil is the largest trader of North Sea oil, selling 1.4 million barrels of crude per day in 1993. This represents more than a half of Norway's production of crude oil and natural gas liquids (NGLs) which was at 2.4 million barrels/day in 1993. In 1994, Statoil moved into third position among the world's largest oil exporters. The acquisition of BP's 240 Swedish service stations network in 1993 made Statoil the leading petrol retailer in Scandinavia, wfth an overall - 123- APPENDIX H market share of about 25 percent. In addition, Statoil acquired 160 service stations in Ireland and opened service stations in Germany, Poland, Latvia and Russia during 1993. At the end of 1993, Statoil operated some 1,900 stations in nine countries. Statoil's share of total oil product sales was roughly 23 percent in 1993. Figure H-2. Overall Market Share 100 80 60 40 31.5 25 ~~ ~ ~~~~~20 21.7 20 nn 0 F] F, Scandanavia Norway Sweden Denmark Ireland 1993 Northern Europe remains Statoil's principal market for crude oil. However, increased exports to the USA and Canada have helped to strengthen the competitiveness of and market differentials for Statoil's various crude oil grades in relation to other crudes on the market. Statoil's markets for oil products include European countries and USA, and recently Mediterranean and Far East. Statoil is pursuing gradual expansion in new markets around the Baltic. Technical Procedures. Parliament decides on the opening of new exploration areas and the Government allocates, by license, exploration acreage to companies in yearly or bi-yearly concession rounds. Concessions are given to oil companies on the basis of proposed activity programs (plans for wells, seismic coverage, etc.) and competence. Statoil as well as the other Norwegian companies have been given preferential treatment compared to international companies. Concessions have been given to consortias of about 3 to 8 companies, with mixed ownership, but generally, cumulatively more than 50 percent Norwegian. Allocation of fields is decided on by the Ministry of Industry and Energy through the competitive bidding process with usually 20-25 companies participating. Strategic Alliances. Several years ago BP and Statoil entered into a strategic alliance, with participation distributed as follows: BP - 60 percent, and Statoil - 40 percent. The objective: to work together internationally on oil (primarily) and gas development, alternating operatorship per project. Capital expenditures for this effort remain modest. Financial Performance. ROI for Statoil was between 10 and I I percent in 1994 on the after tax basis, compared to a long-term level of around 12 percent for the major international companies. APPENDIX H - 124 - Table H-1. STATOIL - Consolidated Financial Results Key figures (NOK million) 1993 1992 1991 Operating Revenues 81,057 74,526 74,558 Operating Profit 12,429 12,575 13,238 Profit before Taxation 11,980 9,884 13,191 Net Profit 3,394 2,300 4,254 Interest-bearing Debt 25,742 24,606 20,610 Shareholder's Equity 26,507 24,205 23,210 Investments & Acquisitions 13,427 10,609 10,425 Cash Flow 12,590 12,911 11,385 Before-tax Return on Capital Employed 28.3% 28.0% 34.3% After-tax Return on Capital Employed 7.8% 6.7% 11.0% Return on Equity 13.4% 9.7% 19.5% Equity Ratio 29.6% 28.3% 28.9% Capital Employed = Total assets less non-interest-bearing debt Equity Ratio = Shareholder's equity as a percentage of total balance less SDFI-related accounts payable Exchange Rates: NOK/USD December 1991 5.9615 December 1992 6.8685 December 1993 7.387 December 1994 6.882 Figure H-3. End December Exchange Rate 8 7.387 7 6.8685 6.882 5.9615 1 - .- X -I-.-! Q: -D E - Dec. Dec. Dec. Dec. 1991 1992 1993 1994 - 125 - APPENDIXH Figure H-4. Return on Figure H-5. Shareholder's % Capital Employed % equity 40 -30- O Before tax 30- _ 30 | ~~~~~~After tax|___ 20- 20- 10 10 0 0 ----- 1991 1992 1993 1991 1992 1993 Asset Management Model StateParticipation. The development of Norwegian oil and gas BoxH-1. Features Statoilconducive its efficiency of to policies since the early 1970s have emphasized national management and * Separation government of ownershipfromday-to-day control, buildup of a Norwegian petroleum management industry and State participation at the upper * Commodity product,highlycompetitive * Statoiloperatesforexport,not for domesticmarket levels. The Norwegian Parliament (the * Non-corrupt management Storting), and a dedicated Ministry along * Hardbudgetconstraint with the Norwegian Petroleum Directorate, * ActiveprivatesectorBoardmembers,including are in charge of management and control. Chairman * Remuneration/incentives management for comparableto privatesector Relations with the government. Until the mid-1980s, Statoil was virtually Observed negatives independent in its decisions and policy from * Earlysocial/employment objectives to sub- led the government. Statoil's management was optimallocation on-shoreactivities of * Borrowing implicit has government guaranteeand mayput Statoilat advantage privatesector over companies alsoput statefinancesat risk ifmarketprices but In December 1984, the Storting fall adopted a resolution to divide Statoil's financial participation in most of the production licenses between the State and Statoil. Statoil's participating interest is divided into two economic shares: one is the company's own financial involvement in the various licenses, APPENDIX H - 126 - and the other is the State's Direct Financial Interest (SDFI). Thus, a part of Statoil's gross revenues from its production activities in the various fields is automatically transferred to the State, and a corresponding part of Statoil's expenditures (investments, operating costs, etc.) associated with the individual fields is covered by the State through the SDFI. The split between the direct financial interest of the State and Statoil's own financial interest, is decided on the basis of the individual circumstances of each case. The operational involvement of the State in the petroleum industry is, however, still handled entirely through Statoil. Role of the Ministry of Industry and Energy. The Ministry of Industry and Energy (MIE) plays two roles: owner/regulator for natural resources and representative of the owner of Statoil. For its first function, MIE has the overall responsibility for ensuring that administrative and financial controls are exercised with respect to exploration for and production of petroleum on the Norwegian Continental Shelf. In this respect, the MIE acts for the State as owner of the resources, not as owner of Statoil. Furthermore, the Ministry ensures that control is exercised with respect to exploration for and production of petroleum so that these activities are carried out in accordance with the energy policy of the Storting. The responsibility for petroleum activities rests with the Oil and Gas Department. The Oil and Gas Department has the following functions: (i) preparation and implementation of exploration policies, such as opening of new areas and awards of new licenses; (ii) development and operation of gas and oil fields; (iii) making economic analyses of the petroleum sector, including estimates to form part of the National Budget, the Governmental Budget and long-term programs; and (iv) follow-up of the State's financial interests in the petroleum sector, including the owner's administration of Statoil's and the State's Direct Financial Interest (SDFI). MIE's role as representative of the owner in the corporate governance of Statoil is discussed below. Non-Economic Objectives. In the 1970s, location of on-shore organizations for operating oil fields was heavily influenced by the MIE, leading to the organizations being spread out along the Norwegian North Sea coast to cover different regions and create jobs evenly. After the mid- 1980s the situation changed drastically, especially after 1986 when oil prices took another deep dip, the government involvement thinned out and Statoil management was governed only by the commercial objectives in its operational activities. Ownership Function of the State. The State uses two methods to maintain its role in important decisions: the state-run shareholders' meeting-the General Meeting, and state appointment of the members of the Board of Directors. The State can play a role in major strategic and financial decisions, but rarely intervenes in day-to-day operations. State/ MIE approval is required for such issues as company's strategy, acquisitions/divestments, and major projects. As for the issues concerning debt/financing, domestic pricing, resource allocation among activities, and operations, they are all resolved by Statoil autonomously from the State. Board of Directors. The Board of Directors of Statoil is composed of a maximum of nine directors. Six directors including Chairman and Vice-chairman are elected by the General Meeting, i.e., in essence are appointed by the State through the MIE. Three directors are elected by the employees in accordance with regulations made under provisions of the Norwegian - 127 - APPENDIXH Companies Act concerning the right of employees to be represented on the Board of Directors and in the Corporate Assembly of companies limited by shares. The Board usually consists of the following individuals: * president of labor unions * presidents of private companies * civil servants Usually 2/3 of the members come from the industry, i.e., private sector; Chairman is generally chosen from the industry or academia; there are representatives from the labor unions, and also workers of the company (usually two employees). The members of the Board are chosen for a term of two years, and could be replaced. The Board of Directors functions in general as Western private company boards. Remuneration. The remuneration of the Board of Directors' members follows the norms in the industry in Norway. Being a member of the Board is not a full-time job, the Board meets with intervals of one to few months. Corporate Management. The President of the company is appointed by the Board of Directors at the recommendation of the MIE (similarly to the Chairman of the Board of Directors). But the President is not a member of the Board. The President of the company, independently of the Board of Directors, chooses his management team. The management remuneration system is exactly the same as in the private sector. The President's salary is stipulated by the Board. Statoil is considered to be among the best run companies in Norway and the one where politics are separate from commercial objectives. Although Statoil's financial results have been below industry norms for some years, in 1994 Statoil had the largest profits in history (nearly I billion US dollars before tax). This was due to huge efficiency increases. APPENDIX H - 128 - FigureH-6. StatoilCorporateGovernanceStructure State (Shareholder) Delegates management control & in of itsinterest Statoil Ministryof Industry and Energy(MIE) Adninisters /!| Assembly General Supervises I// |(P=rtiament) and supervises! \'Approves // / corporate Supernrses planer of |Board Directors| and Appoints j supervises EO denhUC |Preoi Manages |OperatingDivisionsandi Subsidiaries Corporate Finance How the Company Is Financed. Statoil was originally financed by the fund transfers from the Treasury. Later, the Government imposed a hard budget constraint on Statoil's capital requirements and subsequent expansions have been financed by the cash flow and through the borrowing on international and domestic markets. Borrowing is in the form of issuance of bonds and obtaining lines of credits from the commercial banks. All these transactions are reflected on the balance sheet of the company. There is no formal Treasury guarantee securing the borrowing activities, however, for the lenders Statoil's status as a secure borrower may be implicit through government's ownership. - 129- APPENDIX I COALCORP (NEW ZEALAND) - 131 - APPENDIX I COALCORP (NEW ZEALAND) Case Study in Enterprise Reform Company Information Background Information. New Zealand is a parliamentary democracy which has a mixed economy with both private and state owned enterprises. Since 1984, New Zealand has implemented major economic reforms with the primary goal of enhancing economic efficiency. As part of those reforms, the government transferred commercial operations from conventional government agencies to nineteen state owned enterprises (SOEs).I Before this transfer, the New Zealand government had tried to achieve a mixture of commercial and social objectives through the activities of departmental (i.e., enterprise) commercial operations; for example, promoting employment and keeping prices low for consumers. This led to a confused and conflicting set of objectives for the department itself, the inability of the government to monitor its performance, and the lack of accountability on the part of departmental managers. The end result was often a failure to achieve either the social or the commercial objectives. In order to rectify this situation the government set up a new institutional structure in the State Owned Enterprise Act which was implemented in 1986. Section 4(1) stated that the principal objective of every state owned enterprise shall be to operate as an effective business and to this end be: (a) as profitable and efficient as comparable businesses that are not owned by the Crown; (b) be a good employer; and (c) an organization that exhibits a sense of social responsibility by having regard for the interests of the community in which it operates and by endeavoring to accommodate or encourage these when able to do so. In order to encourage this goal there were three key features of the operating environment which were established by the government: (a) the separation of commercial objectives from broader social objectives; (b) a competitive market in which the SOE would sell its product; and (c) effective control and monitoring by the state. and Robert Anderson,The Establishment Controlof State OwnedEnterprises:the New Zealand Experience. 1990. APPENDIX I - 132 - The regulations, for the establishment and the functioning of the SOEs, are codified in the State Owned Enterprises Act of 1986. Under this act, SOEs are conferred the legal status of a limited liability corporation and, as such, are governed by the general laws applicable to all corporations. This was an explicit attempt to develop a legal structure for SOEs in order to mimic the best features of private sector companies. The SOE Act also refers to the relationship between the company and the owner, and to the monitoring procedure. In 1987 the State Coal Mines, which had been under the auspices of a ministry of the New Zealand government, was transformed into a SOE and renamed CoalCorp. Productive Capacity. CoalCorp is responsible for the operation of 12 coal mines and has two major businesses: (i) a domestic business based on Huntley Coal, and (ii) an export business based in the South Island. The enterprise holds licenses for over 120 million tones of bituminous and sub-bituminous coal amounting to 15 percent of total New Zealand reserves. Products. CoalCorp has both opencast and underground mines which produce both thermal and coking coal. New Zealand coal is used to produce coke, activated carbon, cement, steel, briquettes, chemicals, and electricity. Human Resources, Employee Welfare, and Social Assets. The number of employees at CoalCorp has greatly diminished, since incorporation in 1987, allowing for greater efficiency in the organization. There were 530 employees in 1994, down from 1,861 in 1987. Prior to corporatization all employees were covered by the Public Service Association for salaried workers or were part of the United Mine Workers Union. Presently, twenty percent of the staff are employed on an individual contract basis outside of union coverage. Several small New Zealand towns, situated near mining operations, are inextricably linked to CoalCorp's future. These communities receive additional, although limited, support from the company in addition to the direct impact ofjob creation. For example, CoalCorp provided a car for the Huntly community constable. Market Share. CoalCorp's annual output accounts for 50 percent of the New Zealand domestic market. CoalCorp is responsible for 65 percent of total coal production in New Zealand. The remainder is produced by forty to fifty privately owned firms. (1992 Figures) Coalcorp competes in the commercial heating market with other coal producers. Since the establishment of the SOE there have been general adverse conditions in New Zealand, particularly due to the recession. The demand for New Zealand Coal has been greatly depressed and opportunities for Coalcorp in the electricity generating sector have been eliminated. However, Coalcorp feels that their position is sound in the bulk thermal market, and there is significant potential for long term growth. With the depression of sales to the domestic market, CoalCorp has been looking more and more to foreign markets. In 1992, CoalCorp made a decision to greatly expand their existing - 133- APPENDIXI export market. As a consequenceof a concertedmarketingdrive, export income for the 1993-94 year amounted to NZ $68.70 million,an increase of 49 percent over the previous year. FinancialPerformance. Figures I-I through 1-6below set out the summaryfinancial data for the period 1987-1994. From its incorporationin 1987until 1994,CoalCorphas achieved marked improvementin its performancedespitegenerallyadversemarket conditions. This excludesa setback in 1992-93,due in part to a fire and explosionin the Huntleymines and the cost of restructuring. The encouraging statisticsfor 1993-94demonstratethat CoalCorp has resumedits upward growthtrend in terms of output,productivityand overall financial performance. Figure 1-1. Tonnes soldlemployee Figure 1-2. Return on Shareholders Funds (Percent) 25- 21 4000 3,768 20 - 2,945 1s 16 3000- 2,667 2,492 | 15 16 1_900 10- 2000 -31,700 6 2000I rj I I I I 5-10+~~~~~~~~~~~~~~~~~~~~~1 1000 0 0 0a, 0 a, a, a,~~~~~~~~~~~~~~o ) a, a, a, a, a, a, a, ~~~~~~~~~-10 500~~~~~~~~~ ~ a, i502 172 .- N t,5 Figure 1-3.Sales 280Figure 1-4. Profit before tax and S0 - a||, (000tonnes) | | | |' | ~ 280extraordinaries 50 I,1 li 570 a, | - 2500 2,2025000- (Smillions) 24,443 00 0 a, 0, a, a, a, 0 0 0 a, 0 a, 2000 1,7000 20000 1.520 1,550 15,805 16,862 1500 is1oo 11,742 1000, 10000704 6,186 5,780) 500 0D a,- I , I I I2 40 0o a,m, a a 7 T cc~~~oo , ,a a, a a, , ) , a, a a, a,.- 0 ccno co CD w t~~~~~a a, a a, a, a, a a. -~~~~~~~~C co- - co- APPENDIX I - 134 - Figure1-5. Exports Figure1-6. Net Profitafter tax and (000 tonnes) extraordinaries 1000 950 20000 (5 millions) 16,959 800 ~~~ ~~~~67515000 600 560 5 10,882 409 1D - 8,935 7,000053 400 326 200 0 0 co o 0 - ': a, I? o a)C , aq a 0 a, m a 0 Hoevr ti yarNw 9 3: a) eladha be -5000 fredtoete v SO nt MO join ~~~~~~~~~~~~~~~~~~~~-5 9 venur Si inodrt However, this year New Zealand has been forced to enter into a joint venture in order to develop its west coast coal because the New Zealand Government will not put up the money. The joint venture partner chosen for CoalCorp's west coast project is Australian Pancontinental Mining Group which would pay $NZ48 million to CoalCorp to acquire a 60 percent interest and operational control of CoalCorp's west coast coal resources. The funds would be used by CoalCorp to meet its 40 percent share of expected capital costs of the proposed expansion. The joint venture is likely to be established on July 1, 1995. Asset Management Model Formal Representation of Government Ownership. The shares of each SOE in New Zealand are held by two government Ministers on behalf of the Crown. These Ministers are the Minister of Finance and the Minster of State Owned Enterprises. The duties of the shareholders are primarily to monitor and control the commercial performance of the SOE through a board of directors. The shareholders are not expected to pursue broader social objectives through the company. Other Ministers of the government are responsible for ensuring the achievement of social objectives; indeed, the SOEs are not responsible for social objectives that reduce profitability unless compensated in full by a payment from the state. Board of Directors. CoalCorp is monitored by a board composed of five to seven directors from the private sector. Board members are appointed and removed by the shareholding ministers, often after recommendation by the Crown Company Monitoring Unit or the Treasury. Ministers and government officials do not usually sit on the board, nor are managers of the company appointed to the board. The appointment of private business men and women to the board has gone a long way to ensuring the availability of sound commercial and business experience necessary to monitor and to provide strategic guidance to the managers of the SOE. This further avoids the problem of pursuing social objectives which may arise if ministers, or government officials, are appointed to the board. Of the thirty people in Coalcorp's - 135 - APPENDIX I Corporate office, only two were associated in the past with the State Coal Mines and only a small proportion of the employees are ex-ministry of Energy or public service staff. Membership on the board is part time employment and is remunerated as such. Board meetings take place monthly. The relationship between the board and the state is regulated by the State Owned Enterprise Act. However, the relationship between the board and the company is determined by normal commercial practice. The board of directors: (a) sets overall strategic targets and direction for the SOE; (b) ratifies major decisions of the Board of Directors; (c) ensures that the Statement of Corporate Intent (SCI), discussed below, is consistent with the objectives and criteria set out in the SOE act; (d) is accountable to the shareholding ministers, whose appropriate channel of communication with the company is through the board rather than the CEO. (e) manages the SOE in the best interests of the owner; (f) appoints the full-time managers of the SOE; and (g) determines compensation standards and incentive schemes for the senior management. The principal duty of the board is to manage the SOE in the best interest of the State. The board has broad authority over the operations of the SOE. No constraints are placed on the SOE that do not apply equally to private industries. For example the board may hire and fire employees, set prices, and invest in new plant and equipment. However, based on best practices in the private sector, the board does not usually make day to day operational decisions but determines broad strategy and ratifies major decision of the management. The board is responsible for the appointment of the executives, including the CEO. Statement of Corporate Intent (SCI). Each year the SOEs must prepare a public statement of corporate intent in a style approved by the shareholding ministers. The key elements of the SCI are set out in the SOE Act and include: (a) the nature and scope of the business activities of the SOE; (b) performance targets for the next three years; (c) level of the dividend to be paid; (d) information to be provided to shareholding Ministers during the year; 2 ibid p. 15. APPENDIX I - 136- (e) procedures to be followed when the SOE invests in any other company or organization; and (f) any compensation that the SOE expects to receive from the government for pursuing non-commercial objectives. The shareholding ministers, who may find it difficult to monitor the company through annual reports, rely on the performance targets put forward by the managers to assess the abilities of the management. If the company does not achieve its projected targets, the management may be fired by the Board. The preparation of the SCI involves the submission of a draft of the SCI, by the company, to the Ministers. The Ministers will then provide comments on the draft. A meeting is usually held between the board and the Ministers to discuss past performance and future targets. There are often differences between objectives of the shareholding ministers and the Board of the SOE in preparing the SCI. These involve: (a) Financial targets: Shareholding ministers want these increased to create a greater incentive for the Board and management to improve efficiency. The board and management's performance are measured against these targets so they argue it is not practical to achieve such high targets; (b) Dividends - both levels and frequency of payment; and (c) Diversification and expansion: the government may wish to reduce its involvement in commercial activities while the well managed company may wish to expand. The SOE submits financial reports and an audited annual report each year, to both the Board of Directors and the shareholding Ministers. If the figures in the reports are not compatible with those in the SCI, the company is asked to explain the differences. The state enterprise's statutory statements and reports, which are delivered to the shareholding ministers, must be put before the House of Representatives. Other Factors Influencing Corporate Governance. Government policy since 1984 has been to remove most statutory barriers to competition and to assure that SOEs are not given competitive advantages compared to private enterprises. SOEs must pay the same taxes as private enterprises and must borrow from private financial institutions without state guarantees. The assets of the former government departments were "sold" to the SOE at a price that approximated their market value as if offered for sale to other buyers. This assured that the SOE does not have a competitive advantage compared to other enterprises. The state provided a mixture of equity and debt capital for the SOE to purchase these assets. The interest rate on the debt was set at the normal commercial levels, and the debt principal was to be repaid in two to three years. Presently, the SOE is responsible for arranging debt financing from private institutions without government guarantees. - 137 - APPENDIX I The enterprise now relies largely on its base business for profit. For the first two years after corporatization the profits of the company were significantly affected by aid from the Crown: (i) the revenue from coal stockpiles and stores was transferred to the corporation at no cost on 1 April, 1988, and (ii) the commission for surplus properties and other assets sold as agent for the Crown. These short term gains no longer have a major effect on the functioning or profits of CoalCorp. CoalCorp is responsible for paying dividends to its owner - the government. The dividend payments for the proceeding year are set out in the SCI. If the company is not able to provide these dividends, the management is responsible for explaining the reason for this shortfall in its targets. APPENDIX I - 138 - Box 1-1: Factors Encouraging Positive Commercial Performance At Coalcorp Internal 1. Separation of Owner, Board, and Management. Shareholders * CoalCorp is 100 percent owned by the New Zealand government. * There are two shareholding ministries--Minister of State Owned Enterprises, and Minister of Finance-- who formally represent government ownership. Board of Directors * The shareholders monitor the company through the board of directors. * The members of the board of directors are chosen from the private sector. * The board deals with strategic targets and directions for the company. Management * Elected and dismissed by the board of directors. * Manage day to day affairs. * Compile a Statement of Corporate Intent (SCI) which must be ratified by the board of directors and the Ministers. * Must comply with the SCI. 11. Separation of Social from Commercial Objectives * The shareholding ministers are only responsible for commercial objectives. * Separate ministers have the duty to find options for social objectives. * The Company will not be required to accomplish social objectives unless duly compensated, as in the private sector. III. Competitive Rates of Pay and Incentives * The Board establishes the competitive wages for the managers. * The Board determines incentive schemes for senior management. External IV. Competition * CoalCorp's annual output accounts for 50 percent of the New Zealand domestic market. * Laws and regulations protecting State Owned Enterprises from competition have been abolished. * CoalCorp has an expanding market overseas subjecting the company to competition from other state owned and private companies. V. Finance * CoalCorp pays the same taxes as private corporations. * The government does not guarantee loans or debts for the company. * CoalCorp is expected to earn a rate of profit and pay dividends to the State comparable to private companies. Additional Monitoring. A State Owned Enterprises Steering Committee and Crown Company Monitoring Unit also monitor the performance of all of the SOEs. The committee is composed of individuals from the private sector who advise the Minister on strategic issues. The - 139 - APPENDIX I Monitoring Unit, also composed of private sector individuals, advises only the Minister of State Owned Enterprises. The members of the Unit determine whether day to day actions by the management are in the best interest of the company. The monitoring unit advises the Minister on whether the Statement of Corporate Intent of each state owned enterprise is reasonable. For example, if the members of the unit believe that the Statement of Corporate Intent has underestimated the company's capacity to function profitably, they will advise the Minister to return the statement to the management for further review. The Government Audit Office is also required by law to audit the state enterprises financial reports. Figure 1-7 summarizes the corporate structure. Figure 1-7. CoalCorp (New Zealand) Advise Repnil I. (Financial) _t Appoint Steering Advise Ministers Shareholding Finandal Committee (strategic) Minister of Minister of Inforriabon Dividends Advise SOEs Finance (day-to-day) -Fiancial E~~~~J_ ~~~Info :.... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . .. . . . . . . . . . . . . . . . . . . . . . Monitor .. . . . . . . Owns of Sector Board Diredors (Pnvate Members) Corporatel Structure Financial Monitor info Apoint CEO COAL Central CORP. Management 1 ................................................................................................................ Privatization. In 1988, the New Zealand government stated its intention to sell shares in CoalCorp to the public. The process was stalled in 1989 when the an injunction was granted to the Tainui Maori Trust Board, pending a decision relating to the Maori interests in land owned by CoalCorp. However, in late 1994 a negotiated agreement was being discussed which would allow the government to implement its policy of privatizing the company. This is a particularly significant decision since it reflects the government's recognition that the best way to lock in the hard-won efficiency gains from a "corporatized" company like Coalcorp is to move from mimicking the market to full exposure to market forces through private ownership. - 141 - APPENDIX J IRI (ITALY) - 143 - APPENDIX J IRI (ITALY) Case Study In CorporateGovernance CompanyInformation Legal Status. [RI (Istituto per la ricostruzione industriale) is a State-Owned Holding Company(SHC),an ndependent Autonomous Management Agencywhich,untilmid-1992, was neithera joint stockcompanynor partof the civilservice. Until1992it had beenunderthe controlof a Ministry of State Holdings (Ministero delle partecipazioni statali or MPS), two cabinet comrmittees, and theparliament.Throughthis holdingthestate has a controlling interest(impresea partecipazione statale)in sectoralsubholdings operatingcompanieswhichareprivatejoint-stockcompanies,not and nationalized participation privateinvestors.Thus,the only"non ones,oftenwitha substantial of private"entityis [RI itself. Eventhoughit was "nonprivate"froma strictlyjuridicalpointof view,IRI alwaysactedas a BoxJ-1. Rationalefor IRI's existence in Italy privateholding group. This was the basic innovation - 1933- HUwasestablished a rescue as operation by introduced thefoundersof [RI, whochosenot to forthe Italian banking system and some of the folow the modelof nationalized a companies, model major Italian manufacturingcompanies. alreadywidespread otherparts of Europeandin in Italy. Theypreferredthe framework joint-stock of - 1945 - Allied Authoritiesconcludedthat the IRI companies, whichtheyconsideredto be better Group presencecould be positive for the Italian economy. IRI began to play a major role in the attuned to a marketeconomy,and thereforeeasierto of reconstruction Italy. be privatized. - 1960s and the 1970s - the Govemment gave RI a Evolution of IRI. MI was set up in 1933, as somewhatdifferent and wider role by entrusting partof therescue for the Italianbankingsystem (andburdening)it with two additional tasks: of 1929.The fo.lowing th bankingcrisisofMI- role to contribute to the development of the TherolMezzogiorno followin thebankingcrisisof192. (the economicallyunderdeveloped was as a shareholder initially conceived a as regionsof SouthernItaly); temporaryone: industrial companiesand bankshad - to rescue lame-duckprivatecompanies to be turnedaroundand thensold backto the market, which had sufferedthe 1973 and 1978oil shocks. or liquidated.From its inception, wasquitefree IRI portlioanepdoinfcMI dd privaiee its to pivuidatiedFr - last tenyears- the main effort of RI was directed at the restructuringof its companies and ensuring manyof the companiesin the first threeyears),and the developmentof their international to allowprivatecapitalto be investedin its competitiveness. companies. It was ableto behaveexactlyas any otherprivateindustrialand financialholding. or From 1933to 1960[RI neverreceived, expectedto receive,cash supportor any other of specialprivilegefrom theGovernment.[RI companiesweremanagedwith allthe constraints a free (relatively) marketeconomy. APPENDIX J - 144 - of From 1945onwards,IRIplayeda majorrolein thereconstruction Italy,alwaysfollowinga and free and open marketphilosophy, withoutany specialsupportfromthe ItalianGovernment. Government'sassistancecame in the formof endowmentfunds. RI was somehowexpectedto employment over thecountry. supportand fosterindustrial all Theenormoustasksthe government expectedIRIto undertakein the 1960sand the70s clearly couldnot be pursuedby ERIwithoutadditional resources. Resourceswere neededboth to financial a ratio of maintain reasonableinvestment/equity and to facethehuge risk factorstypical the areas abandonedby privateenterprise. Indeed,some investment choicesweremainlymotivatedby social of issues,such as thepreservation jobs or the creationof newones in less developedareas. At times, this also meantacceptinga muchdelayedreturnon investments.Eventhen,publicfundscountedfor onlya relativelysmallshareof RI's totalfinancialneeds. For example,between1970and 1985, Government outlayaccountedforbetween7 and 12percentof the RI Group's capitalrequirements. or Theremaining90 percentwas financedby RI (throughprofitsand depreciation), byprivate shareholders and/orbanks,both Italianand international. Duringthe 1970s RI incurredsubstantial losses. Its recoveryin theform of comprehensive physicaland financial restructuring beganin 1980withthe saleof assetsof certainloss-making i.e., of activities, privatization ALFAROMEO,theraisingof new capitalonthe stockexchangefor the moreprofitable in enterprisesin the group,' a sharpreduction thelaborcoststhroughretrenchment, and of a reorientation certainlarge strategic sectors,in particular,thesubholdings FINMECCANICA, for engineering productsand ILVA,for steel. The heavylossesin the 1980swerelargelyattributed the to high debtleverageof thecompaniescoupledwith a longperiodof veryhigh interestrates. significant, HR's recoveryplanin the steelsectorwas particularly involving winding-upof a the steelsubholding to FINSIDER,the transferof strategicsteelactivities a singleoperatingsteelcompany the of ILVA and finally, elimination non-strategic businesses. In mid-1992,RI underwenta drasticchangein its statutes. Withthe appointment a new of in was Italiangovernment July of 1992,a decision takento convert RI intoa joint-stockcompany underprivatecompanylaw withthe Treasuryas the owner,witha view to eventualsale,i.e., of and privatization its subholdings operatingcompanies. holding Products. RI is a multi-sector companywith bothindustrialand serviceactivities. (see RI's subsectorsas of December31, 1992includedthefollowing FigureJ-1.below): The capital market approach followed a bottom-upstrategy, beginningwith the sale of stock in operating companies. In some instances (i.e., STET and FINMECCANICA)portionsof IRI's holding in sectorholding companieswere sold throughpublic offerings as well. - 145 - APPENDIXJ FigureJ-1. Structureof IRI and Its Subholdings, December1992 BANKS AND FINANCIAL SECTOR I4OLD,NG SECTOR LEADER SERVICES COMPANIES COMPANIES COMPANIES anca Commerirale Finmoccanica iW1a Credito e rien Iallano Stel I ta Cotri Finmare Fincantieri Srine Alitalia Rai Soi After 1992,IRIunderwentsignificant changes: in 1994it released control of two commercial banks(theso- BoxJ-2. IRI Facts in 1991: calledbanks of national interest, in which it held 60-85 majoritysharesin 540companies percentof total shares) left in its portfolio-BCI and * minority shares in around300companies Credito Italiano-through public offerings; SME was . over 400,000 stockholders,who held shares privatized; the civiland industrial plantengineering of equalto 44 percent totalconsolidatednet businesswas restructured a newentitywas formed- and worth(35 percent banks) for Fintecna(Iritecna beingliquidated); the steel is and company,Ilva,was soldto the ItalianRivagroupin March, 1995aftersubstantialrestructuring.The new subsectors structureis shownin theFigureJ-2 below. APPENDIXJ - 146 - May 1995 FigureJ-2. Structureof IRI and Its Subholdings, FINANCIAL SERVICES SECTOR HOLDING SECTOR LEADER COMPANY COMPANIES COMPANIES Cofir3 Finmeccanca Firncantieri Stet 62% Alitalia Finmare Rai Soii Employment. Thenumberof personsemployedin RI fellfromover 500,000in 1984to about 385,000in 1992-a drop of nearly25 percent. Technology.The IRIGroupspentaboutUS$ 1,256millionin 1991in R&Dand employsover 12,500technicians equivalents), (full-time 7,700of whomareresearchers.The groupstructure and areas evolvedcontinuously it had recentlyexpandedintohigh-technology whereit couldhavean in advantage bearingthe necessary heavyresearchcostssuch as biotechnology,communication networksand advancedproduction technology Spi, (Fintecna, Finsiel).Traditionalmanufacturing in or activities, areassuch as cement(Cementir) foodprocessing, beganto be shedfrom theearly 1990s. MarketShare.2 In thedomesticsteelmarket,as of 1991beforemajorspin-offs were initiated, [RI's sharewas about50 percentfor steelalloysand specialsteel laminates, with castiron and flathot- [RI for workedproductsnearing90 percent.In termsof EC production, accounted 8 percentof steel, and I I percentof cast iron, 14percentof specialsteel laminates 12percentof flathot-rolled products. The volumeof its activitiesin theplantengineering sectorplaces[RI in secondpositionin Europeand tenthamongotherleadinginternational 70 groups. In theenergysector, RI controls percentof the Italianmarketfor generating and facilities about 10percentat EC level. role of RI plays an important in theautomation continuous processes,as wellas in the sector;its sharein thesemarketsin 1991was respectively commuteraircraftsegmentof theaeronautic 2 IRI Gruppo 1992-93 Yearbook, pp. 22-24. - 147 - APPENDIX J 10 and 25-30 percent of total production. IRIaccounted for 60 percent in Italy and 12 percent in EC of production in electrified railway transportationsector; for shipbuilding these figures were 70 and 10 percent respectively. In food processing IRI accounted for 24 percent of ice cream and frozen foods, and 15 percent of milk production. In sea transport IRI' s share was 20 percent domesticallyand 3 percent at EC level, and in mass distribution- 5.5 percent. IRI is Italy's leading software manufacturer and the second in Europe. IRI's share in Italian banking in 1991 was relatively low: 8 percent for total domestic deposits and 11percent for total domestic lending. Financial Performance. RI found it difficult to maintain consistent and acceptable levels of profitability. In 1990, the group made profits of around US$735 million but in 1991 total losses amounted to some US$200 million, and escalated to US$2.7 billion in 1992, and US$6.5 billionin 1993. However, net financial debt has continued to drop since 1993. At the end of March 1995, IRI reported a debt of L23,125bn which was L926bn lower than at the end of 1994. Table J-1. Consolidated Financial Highlights of IRI Group (1990-93) (US$ million) 1990 1991 1992 1993 Valueof production 48,632 52,835 54,873 47,483 of whichforeignsales 7,502 8,250 10,253 11,908 Net incorne(loss) 733 (206) (2,683) (6,065) Employnentat yearend (No.) 419,565 408,066 385,580 327,266 R&D costs 1,208 1,256 1,311 N/A Net financial debt 36,587 41,876 47,986 41,850 Invested capital 55,947 62,959 67,072 55,992 The 1993 data was translated at the prevailing exchangerate on December 1993. i.e., lUS$ = 1,680.31Italian lire. b/ Source: IRI Gruppo, 1993. The Group's capital investment in the industrial sector was about US$ 11,774 million in 1991, representing 6 percent of the country's overall investment. Investment largely focuses on services, mainly telecommunications, as a further indicationof the Group's interest in rapidly growing, high- technology areas. Export revenues were approximately US$ 8,250 millionin 1991. Around 76 percent came from manufacturing and plant engineering and 24 percent from the service sectors (air transportation, shipping and telecommnunications).These figures represent 4 percent of Italian goods exports and 6 percent of service exports. Non-economic objectives. Non-economic objectives are mainly defined as creating/preserving jobs and promoting investment in lesser developed areas. These objectives, imposed by the Government on RI Group, adversely affected the financial performance and commercial objectives of its sub-holdings and operating companies. One such example was the regional development programs APPENDIX J - 148 - in southemItaly(themezzogiorno).SOEs havebeenrequiredby law since1959to ensurethat at least investment 40 percentof totaland 60 percentof incremental directedtowardsnewprojectsis locatedin has theseregions. In practice,this requirement notbeenfollowed.Over 1987to 1990,less thana third of totalinvestmentfrom RI was directedtowardsthemezzogiorno. Competition.Despitedisappointing performance, overallfinancial someof the sectoralsub- holdingsand operatingcompaniesof the IRIGroupare nevertheless profitable.However,one can argue thatgovernment has protection createdquasi-monopolistic positionin somesectors. This may in explainthehigh levelsof profitability suchsectorsas steeland telecommunications. The telecommunications 3 sectorhas been dominated the telecommunication by companySHCs and has longenjoyedsignificant tariffprotections.In 1992,STETbroughtin the largestpart of revenues(1,539 billionlire),or 20 percentof total revenuesof the IRIGroup(of7,685 billionlire). In general,a large s by partof MRI'revenuescomesfromthe servicesectors. Priceregulation thestate in thesesectors results in pricesof servicesin Italybeinghigherthanin the rest of Europe. Some pricecontrolsfor and publicservicesexist at boththe national the locallevels,regulated(atthe nationallevel)by an Interministerial Committee. IRI facesa prospectfor increasedcompetition, partlyas a resultof new EuropeanUnionrules. of Subsidiaries [RI haveenjoyedmonopoly in concessions thepast. In 1989IRIhad a 72 percent This marketshare in telecommunications. includedthe entireurban telecommunications networkand halfof the domesticinter-city 4 In telecommunications has almosta complete long distancelines. RI monopoly, with therecentcreationof TELECOMITALIA. Once the marketis openedup, and foreigncompaniesenterthemarket,it is anticipatedthat will competition increase. The 1990lawon competition of policyand concentration enterprises to to established new antitrustagency,empowered reportdirectly the parliament. a Asset ManagementModel and of State Ownership Interest. Stateownership thecompanyis exercisedin theform of a holdingcompaniesstructure. At the levelof the holdingcompanyitselfthe Boardof Directorsis the primaryasset management tool. Up to the 1990s RI has beena holdingcompany law organizedunder administrative and actingfor the stateas a shareholder each of manyenterprises in organizedunderprivatecompanylaw. its into Since1992(following transformation a joint-stock company)RI is itselfa corporation under privatelaw. Subsidiary holdingsand enterpriseswere incorporated joint-stockcompaniesunderthe as privatelaw and areexpectedto follow'criteriaof economic rights viability'. RI exercisesstockholder of accordingto theprovisions ordinary the companylaw. FigureJ-3 illustrates corporategovernance structureof RI. 3 As in the case of broadcasting-RAI company. Anjali Kumar, p.67. - 149 - APPENDIX J Flgure J-3. IRI: Ownershipand VerticalStructure [ t j-~~~approves approves-;5 serviceareaof I examines Treasury 1preftuslyMinistry callingplansof IRI evaluates plan | ofState oiddings) recommendationson awards to IRI's givesgeneralmacroeconomic funds endowment guidelines evaluates costsof non-economic objectives .. w"*_ Sectoral Sectoral Sectoral Sectoral Subholdinq1 2 Subholdinq Subholdin 3 Subholdin 10 ~~~~ ~Enterprise 1 ff0 [In | ~Enterprise 2 CabinetCommittees Standina _ _ * ~~~Enterprise 3 (2nd level subholding) CPI cogrnigtes intePministeri lP TTU_rInterministeral commttee Prograrnming _ _CIPE forEconorric EnteronseOwnershbo: l' through l]]mGovernment, secoral subholding company I imgI]gO Private (also ownership possible subbolding) In held Shares bysubholding -| |||| sector of another (cross- subholding holding); 3 UI holding Direct company ownership to The Purpose of the Holding Company, its Duties and Outputs. According IRI statutes, Ri is an institutionwhich'managesthe holdingsand otherassetsheldby it'. At the end of 1992IRI holding had 563 employees, including persons on loan from group subholdings. Its principal roles are: of (i) to managethe strategicplanning the group'sactivities;(ii)to reviewtheirfinancial implications and requirements. APPENDIX J - 150- The Councilof Ministersis responsible layingdownthe generalguidelines be followed for to and by IRI in the publicinterest. ERIrepresentsits subholdings operatingcompaniesin discussions and to fonnalrelationships the government.On questionsof new projects,IRI conveysan overallproposal of subholding/operating companyto the government, its spellingout in particular financial implications, in termsof the needfor government role support(shareholder's of providing investment capital).The - proposalgoes to thetwo StandingCabinetCommittees CIPI- Interministerial Committeefor Industrial Programming, are whosefunctions to evaluatecalling plans of RI and to make on recommendations awardsto IRI's endowment funds;and/orCIPE- Interministerial Committeefor Economic Programming also whichexaminesserviceareaof RI's plan. ERI keepsits enterprises appraisedof relevant and of governmentpolicyguidelines objectives, generalmacroeconomic guidelines givenby CIPE. In addition,RI usedto ensurethecost estimatesof implementation non- of economicobjectives witha helpof CIPEwhichevaluated thesecosts,but thispracticebecamerather laxby the beginningof the 1990s. IRI's Board of Directors. TheBoard composition variedfrom 8-10to 3 people. Currentlythe Board consistsof 6 persons(civilservantsand technicalexperts). Civilservantsare usuallypart-time, non-executive ministries(indeed,most of themare at the levelof seniorcivilservantsfrom different DirectorGeneral),and technicalexpertsare full-time 5 with no limitson renewingappointments,but in essence,politicalappointees.The Chairmanof the RI Board and theCEO (or DirectorGeneral)in some cases were the sameperson,but withprivatization are thesetwo functions separated,so that the Chairmanwhois politically on and appointedwillhavelessinfluence operational privatization decisions.Thus,the CEO is memberof the Boardonlywhenhe is Chairmanof theBoard. The Board is appointedfor theterm of fiveyears,with theChairmanand Vice-Chairman beingappointedfor three yearterm,renewablenot morethantwice. In practice,sinceIRI was not a joint-stockcompanyuntilJuly 1992;its Boardwas nominal to only. The Board's membersreflected"de facto"consentby morethanaffiliation political partiesin the Government. ChoosingtheBoardMembers. The appointment theChairmanand otherBoardand of by Committeemembersof RI has beenstronglyinfluenced politicalparties. The Chairmanof ERIis appointedby the PrimeMinisterof Italy,and membersof the Boardof ERIare appointedby the and with Councilof Ministersafterrecommendation consultation the Headof Treasury(Minister of StateHoldings)and selectedfromamongthe partyof the rulingcoalition.Thiscan pose problemsfor of of IRI's operationsincethe Government Italyis oftena coalition severalparties,and IRI's Board the reflectsa compromisereachedby the coalition.Traditionally Chairmanis associatedwith the ChristianDemocratparty. 5 Anjali Kumar, p.74. - 151 - APPENDIXJ FigureJ-4. IR's Boardand Management Structure Treasury of Council Ministers recommends (previously Ministry of StateHoldings) exercisesownership Chairman appoints functions the state of andothermembers of Board Directors supervises CEO manages PrivateSectorParticipation.In the presentBoardthereare businessappointeesfromthe privateand academicsectors. The influencefrom theprivatesectoris veryimportant. Boards of Directors at the level of Subholdings and Operating Companies (Lower Levels). IRI's chairman, consultation its Board,appointsthechairman, in with vice-president,generalmanager and otherBoardmembersof subholdings proportion the sharesit holds. Appointments in to are delegatedto top executives the subholding; practice,there wouldbe a consultation negotiation of in or withIRI. Board membersare drawnfrompublicand businesslife,including, the subholding at level, IRI's departmentheads. At the levelof operatingcompany, seniorofficers the Board aredrawn for from the subholding, itselfand the top management the sameoperation.Thereare no limitson IRI of renewalof appointments subholdings operatingcompanies.The remuneration in and offeredto the membersof theBoardsof subholdings operatingcompaniesis standardized the sizeof the and on company. Shareholding Structure. Under IRI, a structure of subholdings (finanziaria) and operating companies(azienda),is groupedbroadlyby sectoralarea of activity.Table 6 illustrates structure. this and The structureis flexible variable whichis largelytheoutcomeof evolutionary development and currentrequirements, ratherthanthe resultof an application a specificformula. Not all first-level of subholdings financial are subholdings theIRI sense;someof them arelargeoperatingenterprises in whichare placeddirectlyunderIRI. Someholdingshavefurtherholdingsbelowthem. Cross-holdings occurquiteoftenwhenIRI directly holdssharesin lowerleveloperatingcompanies.The organizationalconcept,i.e., thethree levelstructure,oftengeneratessignificant inefficiencies: some in APPENDIXJ - 152- of and cases it showsresultsin duplication tasks/responsibilities "power"strugglesthat causedelayin decisionmakingand lead to higheroverheads.Somecriticshavearguedthat,in order to achieve greaterefficiency, shouldbe a leanorganization, IRI probably1/5thits presentsize. PrivateSectorOwnership.An important featureof IRI is the factthat mostof its subholdings and operatingcompaniesbelowthemare partially ownedby the shareholders from the privatesector. Usuallytheir stakeis limitedto no morethan49 percent(i.e.,minoritystake). In 1992,IRI's in shareholding its subsidiaries variedfrom 100percent(ILVA,SPI) to a littleover50 percentfor and STET(telecommunications) around70 percentforSME (food). Other, minorityshareholders are privateItalianor foreignnationals/companies. can Investors purchasesharesin IRI Groupcompanies and throughthe stockexchange,sincesomeof the subholdings operatingcompaniesare listedthere. In cases when IRI has minority sharesin thecompanies(in 1991it had minoritysharesin around300 companies),the majority of ownership thecompaniescouldas wellbe privateItalianand/orforeign. IRI actuallyconcluded alliancesandpartnerships technological/marketing withforeigncompanies which in some cases turnedintoshareholding agreements.One such examplewas in 1991when FINMECCANICA'soperatingcompanyALENIApurchaseda 49 percentstakein an American company,Space SystemLoral(ex-FordAerospace). by IRI's CEO used to be appointed theMinisterof StateHoldings(nowthat thecompanyis is underthe Treasury,this function carriedout by theHead of Treasury)froma shortlistproposedby in the Chairmanof the Board. Untillate 1980stherehas beena highdegreeof stability thechief and executivesover time,with only6 chairmen sixCEOs in fortyyears. Therewere instanceswhere the CEO was the Chairmanof theBoard. Corporate Management Compensation. All senior executivejobs were salaried, with high salarieswhichdid not followthe civilservicepay scale. Salariesof top positionsin the principal holdingsand operatingcompanies in and were negotiated, view of objectives responsibilities, paidand of directlyby RI. Themobility personnel betweenthe variousbranchholdingswas high,and movementsto and fromthe privatesectoralso occurred. Minimumwagesat otherlevelswere determined througha nationalsystemof collective by bargaining, sector. Different at elementsof the contractwere negotiated national,sectoraland for enterpriselevels. Althoughtherearetwo separateemployers'organizations theprivateand public sector,thereis no majordifference betweenthe natureor levelof theirwage agreements.The two are for organizations Intersindfor the publicsectorand Confindustria the privatesector. Both contractsare under privatelaw, unlikethecontractsof publicdepartmental undertakings. Bonus System. Performancelinkedbonuseswereofferedto the seniormanagementof and subholdings operatingcompanies.Theywere up to 20 percentof the basicwage,based on the in 6 Hay pointsystem,whichwas introduced the mid 1980s. 6 Anjali Kumar, p.75. - 153 - APPENDIX J Corporate Finance Equity Financing. Financial structureof theIRI Groupis two-fold--equityand borrowing. of Originalcapitalization IRI came in the formof theMinistryof StateHoldings'transfersof equity, i.e.,endowmentfunds(fondodi dotazione).Thus,equityis providedto RI by the government. RI in turn makesequitycontributions extendsequityloansto subholdings.Subholdings theirturn, and in giveequityand corporateguaranteesto theoperatingcompanies. Endowmentfundsbecametheprincipal channelof government transfersof fundsto RI, restructuring for new investments.(See TableJ-2. for intendedto be used for recapitalization, or government assistanceto RI.) In practice,nettransfersof endowment fundsto RI were heavyin the to early 1980sand were used essentially relieveits accumulated it debt burden,permitting also to extendthe maturityof its debtand convertforeigndebtto domesticdebt. Government'scontributions throughtheendowment dependupon a processof fund allocation negotiations. of Therehavebeen oftendelaysand non-implementation financial contributions.The form of compensation used is a directTreasurysubsidy,forwardedthrough RI to therelevant subsidiaries.This is in accordancewithEC directives. by for RI was reimbursed thegovernmrent implementing non-economic objectives.For example,RI's investment proposalspresentedto thegovernment includeddetailson incremental employment createdin four designated'crisis areas': Naples,Taranto,Genovaand Terni,togetherwith employment the estimatedcost of this additional creation.Untilthebeginningof 1980sInterministerial of CommitteeCIPEpaid closeattentionto calculations costsof non-economic investments which were takenintoaccountwhenpaymentsfrom theendowment fund were made.Now thisdoes not hold as anymore,althoughspecialcases maybe negotiated, in thecase of the steelsector. WhenGovernment in of transfersdeclined themid 1980s, RI beganpartialprivatizations its initially largerenterprises, bondsand warrants,laterthroughthe throughthe issueof convertible placementof new listingsand throughthesales of existingshares. Governmenttransfersthroughthe endowment fund mechanism in stoppedcompletely 1987. for RI alsoreceivedfundsfromthe government thepurchaseof stockin privatecompanieson the verge of bankruptcy-through the GEPI (Gestioni e partecipazioni industriali) fund, which is an independent legalentitywithits capitalheldequallybetweenthe threemajorstateholdings. Total capitallossesper entityon accountof GEPIby December31, 1989amountedto US$250million. After 1990the government revokedfundswhichit had grantedearlierand delayedreimbursements,in on essenceimposeda hard budgetconstraint RI, sinceit couldno longeraffordtransfersand its subsidieswere greatlycriticized EC withregardsto its recentcompetition by policydirectives. Borrowing. Government guaranteed was borrowing effectedalongtwo lines-(i) loansto RI from theEuropeanInvestment Bank (EIB);and (ii)largebondissuesof the RI Group,wherethe holdingcompanymakespaymentsto thebondholder.In bothcases theTreasuryundertakes to and reimbursethe holdingcompanyfor therepaymentof theprincipal interest. But the Government the was not alwaysservicingthedebt on behalfof RI, moreoftenit reimbursed interestexpensesonly APPENDIX J - 154 - by (thesebondswere a substitutefor equity). Bondissuesby IRI (guaranteed the Government) played an important - theywere alternative role the meansof procuring necessary fundingnot otherwise providedby the shareholder. TableJ-2. GovernmentAssistanceto IRI Group(19841989) (US$ million) 1984 1985 1986 1987 1988 1989 Funds (excluding Endowment 2,129 1,124 584 14 - - GEPI) Capitaland InterestRepayment - 30 48 76 81 142 on EIB loans New EIB loans 307 95 741 648 783 572 Bond Issues - 612 783 386 - - Assistance 2,437 1,989 1,789 773 641 558 Profits/Losses - 1,279 -684 -53 -1,325 -798 In commercial the bankingborrowing, financingstructureof IRI has beentargetedtowards maximnizing leverage.In essence,the sameimplicit government guaranteeallowedthe Groupto effect and borrowing three levels- at theIRI levelitself,at thelevelof subholdings, at thelevel of operating at companies. IRI hasextensively usedthis mechanism, especiallyafter 1984whentherewas a rapid declinein government transfers. IRIdid not havean explicitguaranteefromthe Ministryof State Holdings;instead,RI was considered some extenta "sovereign" to creditby virtueof a perception,as itbenefitedfrom an informalumbrella guaranteefromthe Government.This becameveryclearin 1991when a sisterorganization IRIin thestate holdingsystem(EFIM)asked to rescheduleits debt of serviceand the Government not takeover its indebtedness.EFIM wasliquidatedmuchlaterand in did themeantimetheGovernment helpedby all possiblemeansin orderto avoiddefault,whichwouldhave negatively affectedthe overallItaliancreditrating,but theprincipleof an umbrella guaranteewas denied. As to RI, withthe transformation a joint-stock into companyfully(100 percent)ownedby the Treasury,such a guaranteeindeedcameintoexistence becausethe ItalianCommercial Code statesthat is the soleshareholder jointlyand severallyliablefor thecontrolled company'sobligations.As to subholdings operatingcompanies(secondand thirdtiers), this principle and holdsto theextentthereis an explicitguaranteeby RI itselfon theirindebtedness.This is not at all currentpracticebecause: first,some subholdings havelongsincedevelopedindependent access(and creditrating)to financial markets(both domesticand international) basedon theirownbalancesheet,likefor example,STET and FINMECCANICA; second,particularly periodsof financial in the rationing, banks' perception of the creditrisksdeclinesas the borroweris placedcloserto the productive assets:this happenedin the RI Groupwhenadditional linesof creditweremore available operating to companiesthanto subholdings.The termsat whichthe financial community extendingloans to RI's companies was were not differentfromthose of the otherprivatecompanies.Furthermore, therewas a "negative covenant"in the former RI's banksoperational directives, concerning exposurelimitsto ERI's industrialsector. - 155 - APPENDIXJ FigureJ-5. ERI'sFinancialStructure and Financial CapitalMarkets Treasury fp,.oo01yMoerdry dl sate Holdbng.) Budget Banks Commercial Appropriation Cei ie Endowrnent Funds CNegotiated CapitalMarkets .-- BondIssues IRI Gov'tGuarantee Equity Contnbutions anks & Equity Loans Capital Markets Funds Borrowed ~~ .~ HoldinD s ling Holl Holding + Equity Equity & GRS BorrowedFunds Placements<35% Guarantees Capital Marke Operating Or ank Loan OaPei Cp Operating ny Company Com uity Eq Priv. and PoliticalImpact on Finances. Althoughthe subholdings operatingcompaniesof IRI did not receiveany preferentialtreatmentfrom thebanksand otherplayersin thefinancialcommunity, thereare reasonsto believethatsometimesthis was thecasebeforeIRI becamea joint-stock company in 1992. Firstof all,the mere sizeof theseenterprisesmadethema powerfuland big client,which the wouldbe preferableto deal withover thatof theprivatesector. Secondly, implicitgovernment guarantee,i.e.,a "de facto"strongpatronage,made [RIcompaniessecureborrowers,and positioned themfavorablyon the customerprioritylists of thebanks. Theseseemingly harmlessfactorshavea for in great implication the privatesectordevelopment thecountry,i.e.,thelatterwas negatively affected. Sincethe financial is marketshaveonlyfiniteamountsof capitalto lend,and thedistribution the limitedto identifying mostpowerfulborrowers,andif theyarethe ones fromthepublicsector,that will meansthatthe privatesectordevelopment suffer. Bondissuesby ERIGrouprepresentthe sametypeofproblems. Government guaranteeshad on an influence thecreditratingsof thesecompanies, boostingthemup, thus,theratingspicturecould havebeendistorted. Again,fromthe pointof view of investors, theirmoneyresourcesarelimitedand theymaketheirdecisionsbased on theratings,thus,if publicsectordominatesthe scene,one would in its expect theprivatesectorto be crowdedout and havingmoredifficulties financing expansion and is newinvestments.A secondpoint,whichis evenmoreimportant, that oftenmoneyraisedby the IRI Groupthroughthecommercial i.e., paperturnedout to be used inefficiently, themoneywas invested companiesoftento covertheirdebts or debtpayments. intoinefficient APPENDIX J - 156- for Existingpoliticalpatronageof IRI has beensub-optimal thecompanyfrom the commercial of pointof view. More oftenthan notit didn't takeintoaccounttheprofitability thecompany. IRI Grouphas becomeembroiled the patronageand corruption Italian in of politics(considerthe numberof in seniorexecutivesimplicated the scandalsof the lastfew years). of of DividendsPolicy. The formulaon the division profitsor thedistribution dividendsis not complex. At thelevelof operating therewas a requirement transfer5 percentof profits enterprises, to to legalreserves. This is howeverrequiredunder theCommercial Code and it appliesto all companies. a of In one companyAUTOSTRADE, limitof 8 percenton the distribution dividendshad been adopted,but this was a specialcase,based on theconcession its systemregulating activity.In practice, has by any suchrestriction beencircumvented the issuingof new rightsshares. Dividendswere not necessarily if distributed profitsweremade; thepast recordof profitsand losses,as wellas proposals for new investments, were takenintoaccount. At theIRI level,the issueof remittingof dividendsto thegovernment, evenwhenERIdid showprofits,has not arisen. Sofar transfershavebeen exclusively did in the oppositedirection.The government not makeanyexplicitclaimsthatit wants/expects a to dividendpaymentfor its equitycontributions IRI. - 157- APPENDIX K SUMER HOLDING (TURKEY) - 159- APPENDIXK SUMER HOLDING (TURKEY) Case Study in Corporate Governance Introduction Sumerbank was established as a state organization in 1933 as part of the Government's program to promote industrialization. Sumerbank commenced its operations in the textile and banking industries with capital of TL20 million, 5,000 employees, and four factories. During the 1980s, Turkey embarked on a program of economic liberalization which exposed many of the weaknesses of Turkey's State-Owned Enterprise (SOE) sector. Despite the efforts of the Government, SOEs continued to operate inefficiently and produce large losses. By 1990, all loss-making SOEs accounted for TL5 trillion (1.9 percent of GNP) of losses. The Government's renewed answer to the problem of SOE losses was to transform the SOEs into enterprises that more closely resembled private commercial enterprises. Accordingly, the Government in 1984 adopted Decree Law 233 which afforded the SOE's greater operational autonomy through the introduction of a corporate governance structure similar to that of a commercial enterprise. The Government in 1986 also passed Law 3291 which outlined the decision making process and procedures for corporatization and privatization. By 1992, the Government's privatization program had accelerated with the privatization of relatively large cement companies, several agro-industry firms, and the continued sale of minority shareholdings. In July 1993, the Government received a Parliamentary vote of confidence for reform which earned privatization a central role in accomplishing the economic tasks of improving efficiency and reducing the fiscal deficit. In mid-1993, the banking division of Sumerbank was split from its industrial divisions and the resulting companies were called Sumerbank and Sumer Holding, respectively. To date neither Sumer Holding nor Sumerbank has been privatized. Products and Industries Since its formation, Sumerbank developed production facilities in the steel, pulp and paper, food, soil, and chemical industries. Its major interests, however, remained in the textile, garment, and shoe manufacturing industries. Over the past several years Sumerbank has divested itself of many of its non-textile enterprises such as Karabuk Iron-Steel Enterprise, Sivas Cement Factories, Bozuyuk Ceramics, Kutahya Ceramics, Konya Crome, Bolu Laminated and Fibered Panel Factory, and Ordu Soybean San. Sumerbank's, and now Sumer Holding's textile operations utilize 28 enterprises and 7 affiliated companies, produce cotton and woolen yarn, textile items, ready-made articles, hand- APPENDIX K - 160 - made and machine-made carpets, leather articles (shoes, garments), viscon, valex, tiles, porcelain and textile dyes. Sumer Holding distributes its products throughout Turkey using its 17 regional sales directorates, 435 retail stores, and 62 distribution agencies; all of them affiliated with a marketing enterprise headquarters in Istanbul. Move Toward Privatization Historically, SOEs such as Sumerbank have not been managed as commercial enterprises; rather they have been managed as governmental departments. Persistent political interference has deprived the SOEs of the flexibility required to adjust to changing market conditions. Furthermore, non-commercial objectives that conflict with financial considerations have been required by the government; including inflation abatement, employment generation, regional development, support for the agricultural sector, income redistribution and industrial and infrastructure development. In 1986, Turkey adopted its privatization law 3291 to remove State interference from industries such as Sumerbank and to raise revenue. Under the decree, Sumerbank was placed under the control of the Public Participation Administration (PPA) and slated for privatization. The PPA has been converted into the Privatization Administration (PA) and both Sumer Holdings and Sumerbank continue to come under the PA's administration. Presently, Sumer Holding is active in textile production, related chemical industries, and small pipe manufacturing. Sumer Holding comprises approximately 35 plants, 433 retail outlets and several distribution and marketing agencies, and employs 27,000 staff and employees. Sumer Holding's domestic market share is modest with 8.9% in cotton, 16.6% in cotton weaving, 4.2% in woolen yarn, 8.4% in woolen weaving, and 3% in hand-made and machine carpets. Sumer Holdings was to be privatized by Spring 1994. The goal is now for privatization by late 1995; however, the same issues which hindered its earlier privatization still exist. Thirty textile plants are to be privatized via separate tenders between May and August. The PA has sent financial information to 1,200 potential foreign and domestic investors. Reorganization and consolidation in some plants has begun, although the process remains somewhat inefficient. 300 retail outlets have been privatized, primarily through sale to their employees. Analysis of Performance In 1992, Sumerbank (prior to the split) accounted for less than 8% of the major textile production in Turkey. Sumer's exports of $50 million, accounted for less than 1% of Turkey's textile exports of $5.4 billion. Sumerbank posted net losses in 1992 of $960 million. The level of losses in recent years, if anything, has increased. Most losses are due to rolling over debts. Financial performance remains low as Sumer Holdings continues to be susceptible to problems generated by political interference, such as the setting of non-economic goals and a surplus of employees. - 161- APPENDIXK Governance Decree Law 233, adoptedin 1984, describesthe governancestructure in which most SOEs, including Sumer Holding, must operate. (See figure K-1. below.) Figure K-1. Sumer Holding CorporateGovernance Prime Miinister Public Participation Administration Approves Concerned Appointments Minister Councilof Appoints Ministers Boardof Directors High , | (5 members) Planning Supervise Council Impose CEO/ price ~~~~~~~~~Management restrictions Determines employees payscale Manage Holding .'-Owns Sumer ConcernedMinister. Underthe Decree, SOEs are supervisedby a specific minister refereed to as the "ConcernedMinister." The ConcernedMinister is either the existing line minister (for example the Minister of Agricultureor Transportation)or as in the case of Sumer Holding, a newly created Ministerof State under the office of the Prime Minister. Board of Directors/Management.Each SOE has a Board of Directors consistingof six members. The Chairman of the Board is also the CEO (DirectorGeneral) of the SOE. Of the other five board members, two are selectedfrom the upper-levelmanagementof the SOE. Therefore, three of the six board members(including the Chairman/CEO)are part of the SOEs managementteam. The Board of Directorsis responsiblefor supervisingthe SOE by: (a) establishing the SOEs' operating principles and policies; (b) ratifying the annual programs and reports of the SOE, its subsidiariesand affiliates; APPENDIX K - 162 - (b) ratifying the annual programs and reports of the SOE, its subsidiaries and affiliates; (c) appointing the SOEs' assistant directors general and other management, as well as the Boards of Management of the SOEs' subsidiaries and affiliates, all nominated by the Chairman of the Board/CEO; (d) monitor the activities of the CEO; and (e) establish rules for the use/purchase of vehicles by the SOE. The Chairman of the Board, as well as four other board directors are appointed by the Concerned Minister. The one remaining board member is appointed by the Treasury. All six of the appointed directors must be approved by "joint decree" which entails the signed approval of the President, the Prime Minister and the Concerned Minister. Each Director serves a three-year term with the option for renewal. A director of one SOE may not serve on the board of any other SOE. The board is required by the Decree to meet at least two times per month. The frequent meeting schedule as well as the high number of board members who are from the SOEs' management team has been criticized for encouraging the board to manage the affairs of the SOE versus supervising its activities. Subsidiaries. The subsidiaries of a SOE are formed by a board of director resolution of the parent company. Each subsidiary is managed by a Board of Managers. The board of managers consists of a Chairman, who is also the CEO of the subsidiary, and four members from the subsidiary's upper-level management. Government Role. The Government has a role in the overall activities of the SOE. The High Planning Council (HPC) consists of nine members including the Prime Minister, seven ministers and the undersecretary of the State Planning Organization. The HPC is responsible for general economic policy, development plans, the affairs of the SOEs and since 1986, the privatization of SOEs. One responsibility for the HPC is to determine the pay scale for employees. The HPC has been criticized in performing this task because by approving low, non- competitive salaries it has prevented SOEs from attracting high-level employees. The Council of Ministers also affects the SOEs through its role of imposing price restrictions and other types of duties on the SOEs. - 163 - APPENDIX L HINDUSTAN MACHINE TOOL (INDIA) - 165- APPENDIX L HINDUSTAN MACHINE TOOL (INDIA) Case Study in Corporate Governance Company Information Background Information. State Owned Enterprises (SOEs) have played an important role in the Indian economy since 1956, when the Industrial Policy Resolution gave the public sector a strategic role in the economy. The resolution reserved 17 industries, considered to be of strategic importance, for the public sector and empowered the government to regulate all industries through licensing. Massive investments have been made by the Indian government over the past four decades to strengthen the public enterprise sector. State Owned Enterprises manage 55 percent of the economy's (excluding households') capital stock and account for one-fourth of non-agricultural GDP. Established with the collaboration and equity participation of Oerlikon of Switzerland to produce machine tools in 1953, Hindustan Machine Tools (HMT) became a fully owned undertaking of the Government of India in 1957. For many years HMT was the Indian example of how companies can be profitable and innovative in the public sector. In recent years, however, HMT has for the first time been experiencing losses. Activities and Productive Capacity. One of India's largest producers of machine tools, HMT has a diversified business and produces a broad range of industrial and consumer goods (machine tools, tractors, printers, bearings, watches, lamps, etc.). HMT has two wholly owned subsidiaries, HMT International Limited and HMT Bearings Limited, as well as one partly owned subsidiary, Praga Tools Limited. HMT has 16 manufacturing units spread throughout ten states with its headquarters based in Bangalore. Human Resources. A major problem facing HMT is that of extreme overmanning caused by government's use of the company for job creation. HMT has a work-force of more than 28,000. In October 1992, HMT chairman P.C. Neogy implemented a voluntary retirement scheme in order to address the problem. By 1995-96 HMT's workforce should be reduced by twenty-five percent. This should increase value addition per employee from Rs. 1.5 lakh per person to Rs. 4 lakh by 1996-97. Technology. The 1990-1991 HMT annual report recognized the importance of research and development (R&D) to HMT's future business and stated that in the past the company has made significant progress in the development of its products through its R&D efforts. However, a recent article contends that much of the technology being worked on by HMT's R&D APPENDIX L - 166- department has been available for some time in many countries.I In order for HMT to compete domestically and become a global player they must have state-of-the-art technology. Market Share. The HMT machine tools group had 40 per cent of the market share in 1991. The percentage has diminished as sales have dropped in recent years. In the tractor division HMT has 10 to 12 percent of the market share. In terms of global ranking HMT's machine tool industry is number eighteen. Financial Performance. Until 1991 HMT grew rapidly in terms of sale and production, although profitability remained low and has been declining since the mid 1980s (except in tractor unit). For numerous years HMT has been indulging in practices such as overselling, dumping products at low prices at high credits, and booking sales for the following year in advance.2 Since 1991, the decline of investment in the economy together with a sharp reduction in capital goods tariffs affected numerous Indian companies. In 1992-93, HMT, finding it difficult to cope with external and domestic competition, recorded a net loss for the first time in its history. The turn-over in 1992-93 was about Rs. 8 billion (approx. US$248 million) slipping 22 percent from the previous year. HMT was one of 24 state owned enterprises to sell a portion of its equity to public sector financial institutions in 1991 and 1992. Just over 5% of HMT's equity has been sold to date. Significant Changes Over the Last Five Years. In July 1991 the central government of India announced a three-pronged strategy to improve SOE finances consisting of: (i) eliminating SOEs privileges such as entry barriers, protection from external competition, and preferential access to budget and bank resources; (ii) restructuring potentially viable SOEs, liquidating others, and establishing a safety net program to cushion the social cost of this process; and (iii) providing SOEs more autonomy and the mandate to become profit oriented. This approach has had limited success. The profits of profit-making SOEs have not improved, and the losses of loss-making SOEs have not declined. 3 In 1991, the Department of Heavy Industries (DHI), in conjunction with HMT, arranged for a team financed by the Japan International Cooperation Agency (JICA) to assess changes needed to enhance the competitiveness of HMT. In May 1992, JICA submitted a recommendation to the Government for a comprehensive restructuring program of HMT including: (i) organizational restructuring; (ii) $330 million investment for the modernization of production facilities; StuartE. Wicks,HindustanMachineTools,July 1994,p. 25. 2 Meera Shenoy and Devaprasad Purokayastha,"H-MT:Learning to Dance," Business India, February28-March13, 1994,p. 67. 3 India: Recent Economic Developmentsand Prospects, Report No. 12940-IN World Bank: Washington,D.C., 1994,p. 55. - 167 - APPENDIXL (iii) promotion of productivity improvement activities; (iv) promotion of mechatronics (technology combining mechanics with electronics); and (v) intensification of export promotion and expansion of international operations. The study recommended that HMT should be reorganized into three main business groups, focusing on the most profitable lines of business: machine tools, tractors, and industrial machines. The project is to occur in two phases. During Phase I, HMT would be restructured into five main business divisions, including the three listed above plus engineering and consumer goods. Phase II would involve consolidation of the three main groups under the ownership of a holding company. The other groups would become separate companies able to form joint ventures with multinationals and HMT would withdraw from production areas where major and risky developments are required in order to compete with private companies. During Phase II joint venture companies are to be formed with foreign private strategic investment partners and government shares are to be disinvested through public sale. Based on the recommendations of the JICA study, HMT in coordination with DHI elaborated a detailed restructuring program for government approval in May 1993. In January 1994 the Government approved the HMT restructuring program and authorized HMT to engage a professional agency to identify suitable joint-venture partners. By March 1994, HMT Chairman P.C. Neogy had taken the first steps and separated the company into the five divisions as suggested in Phase I. In August 1994, the government decided to privatize the machine tools and tractor divisions. Three private sector companies, Mahindra & Mahindra, Escorts and TAFE showed interest in becoming joint sector partners of the tractor division of HMT. As to date no joint ventures have been entered with these companies. However, the Indian government approved the proposal of HMT and Sudmo Scheicher of Germany to float a joint venture company for process engineering and marketing of automated food processing lines. Asset Management Model Government's Ownership of the Company. The formal representation of the government in HMT is through a Board of Directors. (See Figure L-1.) The Prime Minister, through the supervisory ministries, acts on the behalf of the government to monitor the company through the Board. Supervisory Ministries. The supervisory ministry responsible for overseeing the functions of SOEs, including HMT, is the Ministry of Industry. The Ministry of Industry comprises the Department of Industrial Development, the Department of Small Scale Industries and Agro and Rural Industries, the Department of Public Enterprises, and the Department of Heavy Industry. The most important to HMT is the Department of Public Enterprises. APPENDIX L - 168 - Figure L-1. Hindustan Machine Tools GOVERNMENT Ministryof Industry of Department Public Enterprises appoints Monitors Board of Directors Monitors, appoint/promote nitor ExecutiveCommittee (i. Chairmanand Chairman&MD MD) management day-to-day Machine Hindustan Tools . ....._.......... .. . ......... .......... . .............. Directr D or Director Director Personnel Fance n CP,MP& PJ Cons Prod. The Department of Public Enterprises originated in 1965 in response to a need for a centralized coordinating unit which could make continuous appraisal of the performance of state owned enterprises. The Department of Public Enterprises acts as a central agency for all SOEs and assists in policy formulation pertaining to the role of SOEs in the economy in addition to formulating policy guidelines on performance improvement and evaluation, financial accounting and personnel management. The Department collects, evaluates and maintains information on several of the SOEs and provides an interface between the SOEs and other ministries. In order to accomplish these duties more effectively the Department is divided into five sections: the financial policy division, the management policy division, the MOU division, the administration and coordination division and the permanent machinery of arbitration. The Department of Heavy Industry administers 48 public sector undertakings, including HMT. The department assists the SOEs in their efforts to improve capacity utilization, increase profitability, generate resources, and establish linkages with the user sections. The Department of Industrial Development is responsible for formulation and implementation of promotional and regulatory measures for balanced and rapid growth of the industrial sector, taking into account national priorities and socio-economic objectives. - 169 - APPENDIX L The Board of Industrial and Financial Restructuring is in charge of restructuring or liquidating chronically loss-making enterprises. Duties of the Supervisory Ministry. * setting Board guidelines * issuing government guidelines/directives * creating 5 year capital outlay plans * making foreign investments making foreign technology agreements creating privatization policies * managing share holding, joint venture, or joint working arrangements Dealing with matters relating to the Memoranda of Understanding * assisting interface of the company with Parliament or other departments of government declaring dividends * restructuring Board of Directors. The Prime Minister is responsible for appointing the members of the Board of Directors. The Board of Directors is composed of government officials from the Department of Public Enterprises and the Department of Heavy Industry as well as outsiders such as from the Stock Holding Corporation. A number of directors are also elected from within the company. In 1991 there were twelve Board members up from 6 in 1988. Duties of the Board of Directors. * rolling 5 year corporate plans 3 annual operating plans 3 research and development, technology, products development plans * financial plans v appointment/promotion of executive directors * manpower plans * revision of wages/salaries/benefits in accordance with guidelines issued by the Government. * revision of annual bonus/incentives * pricing approval * borrowing investments * delegation of managerial power Executive Committee. The executive committee is comprised of some members of the Board of Directors, including the Chairman and Managing Director, and the executive directors of the various sectors of the company. These members are appointed by the Board of Directors. The Executive Group is responsible for advising the company on strategic issues. APPENDIXL - 170 - Chairman and Managerial Director. The Chairman of the Board of Directors is appointedby the Government. At HMT the Chairman and the ManagerialDirectorroles have been combined. The present chairmanand managingdirector of HMT is C.P. Neogy. Decisions made by the chairmanare ratifiedby the governmentthrough the Ministry of Industry. Management. To date, SOE managershave been given a mandate to run SOEs as profit- oriented commercialconcerns,but have not been given the authorityto introduce necessary restructuringmeasures, such as large scale retrenchment,corporatereorganization,closure or selling of units, and joint ventureswith private investors. All such measureshave required the approval at Cabinet or Parliamentlevel througha time-consumingand often inconclusive process. The managementtogether with the Board of Directorsis responsiblefor investments. Pricing is decided by individualBusinessGroupExecutiveDirectorsand implementedwith Corporate approval. (See Figure L-2 below.) Figure L-2. Management Relationships Government Capital expenditure decisions Foreign investment Dividend declaration Restruturing Board of Directors Monitor Make plans* Advises Executive HindustanMachineTools on strategic-Ecote issues committee Day to day decisions Plans concering: annual operations researchand development technology Chairman product development manpower 4 Recent India: Developrnnts Prospects, 55. Economic and p. - 171 - APPENDIX L Reporting and Monitoring. Reports issued on a regular basis help the Indian government to monitor HMT. Each section of the corporate structure is responsible for issuing reports on the activities of the company. The Executive Committee compiles a monthly review. The Board of Directors receives quarterly reports from the company management. An annual report, including plans for the future, is produced by the Ministry of Industry in Coordination with the Board of Directors. Furthermore, half yearly results of the companies financial data are published by the press and the stock exchange. The company is also monitored by statutory audits conducted by the Comptroller and Auditor General. Memoranda of Understanding (MOUs). MOUs, which have been used at HMT since the late 1980s, are an annual agreement between the government and the SOE. They are drawn up by the Department of Public Enterprises. The SOE management are to endeavor to comply with the stipulations set forth in the MOU. MOUs provide SOE managers with a clear mandate to focus on financial results. Other Factors Influencing Corporate Governance. Since the elimination of formal barriers to entry in 1991, SOEs in India have faced competition from new entrants in the various sectors. Liberalized markets in India pose major challenges to HMT: * :Competition from foreign producers has eroded market share and profitability in HMT's major products; * HMT has not kept pace with developments in production methods and production design; and * Inability to generate internal capital surplus and fiscal constraints facing the Government have placed severe limitations on HMT's ability to finance investment for improvements in product design, productivity and marketing which HMT needs to maintain its position as market leader. The inability of HMT to keep abreast with private companies in the area of production and technological development has lead to the relative decline of HMT's influence in the field of tractors. * Tractor Business. The tractor business unit is the most profitable among HMT's various business units. However, its market share has declined from the second largest producers in 1985-86 to the fifth in 1990-91. While HMT cannot increase its market share, due to its production capacity and technology development, its main competitors have expanded their production capacity and improved their technology with the help of foreign partners. One of the reasons why HMT's tractor business unit could not expand its production capacity is that it has been obliged to allocate its surplus to other non-profitable business units such as the lamp business unit. HMT tractor unit's market share has eroded due to lack of investment and technological up-grading. APPENDIXL -172- Each individualsectionof HMT is dependenton the headquartersfor directionand 5 generallyreluctantto take initiatives. This encouragesthe managementof the individual with the ability to hide sectionsnot to take full responsibilityfor their actionsand achievements, behind the headquartersas an excusefor not performingwell. 5 StuartE. Wicks,p. 2. - 173 - APPENDIX M KSIAZ PORCELAIN FACTORY-KPF (POLAND) - 175 - APPENDIXM KSIAZ PORCELAIN FACTORY - KPF (POLAND) CaseStudy In CorporateGovernance KPF - History Legal Status. The Ksiaz PorcelainFactory(KPF)is a State-Owned Enterprise(SOE) which was founded in the 1970sin Walbrzych(Poland)by the localgovernment- Wojewodaof Walbrzych,representingState Treasury. It was a so-called"centralinvestment",planned and financed by the government. Products. The factorytook fifteen years to build,which is quite typicalfor centrally- plannedinvestmentprojects. There were a lot of interruptionsin the constructioncausedby temporarylack of resources. Productionbeganin 1980sbut KPF neverin its short history operated at full capacity. KPF manufactureddecorativeand non-decorative tableware,plates,mugs, tea/coffeesets, dinnersets and otherchina. Outputwas sold in setsor by pieces. ProductionCapacity. KPF consistedof four divisions,all situatedunder the sameroof. The productionprocess was continuous,going throughthe followingphases: Div. 1: Modeling,paste and glaze productions(preparingmaterials,paste and glaze) Div. 2: Throwing division (surface molding, recipients molding, casting, forms productionsection) Div. 3: Furnacedivision(furnace,glazing,sorting) Div. 4: mechanicalornament,painting) Ornamentsdivision(decalcomania, In accordancewith initialplans part of the productionof Division 1 was to be sold to other porcelainfactoriesin the region. However,it turnedout that these factorieswere not interestedand continuedto prepare their own paste. Divisions3 and 4 both producedfinishedgoods: decorative products and whiteporcelainrespectively.Division3 was a technicalbottleneckfor the manufacturingof finishedporcelaingoods: maximumcapacityof the furnace was approximately 10,000tons annually. The structureof KPF's assets was favorable. Machinesrepresented68% of total productive assets and they were relativelymodern. The compositionof total assetswas as follows: (i) ProductiveAssets (71%) - machinesand equipmentwere silo and mills (Division 1, Hungarianand Germanproduction,in operationsince 1986),30 lines for productionplates and cups (Division2, in operationsince 1985-88),biscuit ovens and glaze fire ovens (Division3, Polishproduction,in operationin 1985-87)and APPENDIX M - 176 - and the UK lines for making ornaments. The KPF had also its own cardboard box production line. (ii) Non-core Assets (22%) - means of transportation,a railway siding, different equipment of mechanical division, etc. (iii) Non-productive Assets (7%) - social infrastructure- workers' hotels, canteen, housing and factory clinic. Employment. In 1990 the enterprise had 1,400 employees. The total employment in March 1991 was 1,345, including 744 male and 601 female workers. The employment structure was as follows: 58% Production-Related Workers 20% Support Workers 15% Administration and Service Personnel 6% Managers (Productive and Non-Productive Divisions) 1% Senior Management Quality of the labor force was low. Most of the workers were young, insufficiently trained and lacked motivation. Worker loyalty was virtually non-existent. Given the low level of wages, the workforce turnover was, not surprisingly, high. There was no work ethic; the management had frequent problems with alcohol consumption during working hours and small scale thefts. There were no positive work incentives; In 1991 management tried to introduce negative, pro-quality incentives. There was drastic overemployment in production related sections. In the Production department only 70% of workers were directly related to production. The other were administration and support workers. The lack of good organization, discipline and poor quality of labor had an adverse impact on the quality of production. KPF was recording a 31% rate of defective production, compared to 25% for its competitors. In 1990 56% of final products were of the III category of quality (i.e., the worst). Markets and Competition. KPF sold its output both on domestic and international markets. The domestic market for KPF products consisted of two segments: institutional buyers - army, hotels, motels and dormitories - were buying 11% of production in 1990; the remaining 89% went to approximately 2,000 buyers, including wholesalers,retailers and individual buyers. The biggest customer bought 5.3% in 1989and 3.3% in 1990. Wholesalers constituted approximately 50% of all domestic sales. Their share, however, decreased following the liquidation or restructuring into smaller units of big state-owned and cooperative wholesalers. Private wholesalers appeared but preferred to trade in small quantities. - 177 - APPENDIXM In 1990-91the domestic marketcollapseddue to various factorsincluding: (i) low demand - porcelainwas regardedas a luxury item rather than a daily necessity; (ii) financialproblemsof institutionalbuyers; and (iii) disappearance the old wholesalersnetwork. of Competitionin the domesticmarketwas intense. There were 9 majorproducers of porcelainin Poland (includingKPF),two of which togetheraccountedfor almost50% of the total volumesold. The share of KPF was approximately 9%. Exports in 1989accountedfor 7% of sales;45% was exportedto Yugoslavia,30% to the US, 10%to Hollandand 15%to othercountries. With the collapseof the domesticmarket exports rose to 45 in 1990 and 60 in the first quarterof 1991. In 1990and 1991the Germanmarket becamethe most importantabsorbing27% and 55% of KPF's exports,followedby Italy,France and Sweden. The increase in exports was a typicalphenomenonfor other Polish porcelainproducersas well. The export share in total productionrose from 27% in 1989 to 41% in 1990. For some companiesthis figure reachedeven 70%. This was a potentialstrength:the Polishporcelain industry did not need reorientationto foreignmarkets,becausein 1990already72% of production was exportedwith the largestshare being sold to developedcountries. The increasingrole of exportbenefitedKPF in termsof higherpricesfor its products and a lower turnovertax. The exportpricesfor the samepiecesor sets were from 30% to 140%higher than domesticprices. Initially,the 98% of export was sold throughthe state-ownedforeigntrade companyMinex. In 1990 and 1991 this percentagefell to 61 and 30 respectively.Minex's share was taken over by private intermediaries. FinancialPerformance. In 1990KPF's sales were 60 bn. zl. ($6.3 million). Most of KPF's sales (80%) came from decorativeporcelainsold both domesticallyand abroad. The key problem for KPF was that throughoutits productrange it was making losses(evenon exportsales) due to very high costs of production. The table below shows returnson sales of differentproduct groups: Table M-1. Returnon Sales Sharein Sales Retums On Sales(%) Product Groups (%) Domestic Export DECORATIVE pieces 36 -43 -30 dinner sets 20 -15 5 other sets 15 -25 -6 tea/coffee(sets) 8 -22 -3 NON-DECORATIVE pieces 14 -56 -45 dinner sets 6 -20 0 other sets 0.8 -40 -2.5 tea/coffeesets 0.2 -27 -8 APPENDIX M - 178 - The losses were due to underutilized productive capacities, poor quality of production, high rates of waste, inappropriate pricing, increasing production costs in relation to prices of finished goods. The state of KPF's finances is shown in the balance sheets and income statements for years 1989-1991 (see annex). The situation was dramatic with the liabilities almost twice as high as the current assets. Interest payments and depreciation were the major loss drivers in 1990 and the beginning of 1991. In 1990 the interest payments amounted to almost 30% of sales. The economic reform of 1990 revealed the financial and organizational weaknesses of KPF. Collapse of the domestic market caused a 40% reduction in sales volume. Operational costs grew and the enterprise ended the year with the loss of 28.5 bn. zl., compared to 1.8 bn. of profit in 1989. The loss was equal to almost 50% of 1990 sales. This situation deteriorated further in 1991. At that point the adverse impact of the macroeconomic stabilization program on the financial position of the enterprise became very obvious. Interest rates as of March 1991 were: investment credit 95% short-term credit 95% special short term credit 100% credit overdue 150% The local Bank Zachodni was KPF's major creditor and as the financial situation grew worse it applied a very restrictive policy. Total liabilities to the bank were 31.5 bn. zl of which 2.3 bn. consisted of overdue credit. Liabilitiesto the bank constituted 52% of total liabilities. Corporate Management. General Director was also the CEO. The most important departments were: Technical and Production, Trade, Accounting, and Economic. There were also Personnel and Training, Quality Control, and Development and Investnent departments. The management of KPF was not prepared to deal with crisis situations. Modem management techniques (MIS) were not applied. There was no cost control system, no pricing system, no stocks and distribution management and no proper quality control. Production planning was poor. For example, in 1990 in a situation of falling demand, KPF did not cut production which led to a tripling of the inventory. Another bad decision resulting from the lack of modem MIS was to use a mixture of domestic (low quality) and imported raw materials. This lowered the direct costs of raw materials (whose share in total costs did not exceed 5%) but increased significantly other costs such as storage, transportationcosts, labor, energy, waste, etc. In addition, the expected ''savings" resulted in the fact that the porcelainproduced from this mixture was of poor quality and unattractive; it could be sold only at low prices. Personnel management and work organization in KPF were poor. - 179- APPENDIXM KPF Transformed into KPFL Liquidation. The decision to liquidate KPF was made by the Office of the Wojewoda on the 19th of June, 1991. Since that day the management of the enterprise has been taken over by a Liquidator appointed by the Wojewoda. He was obliged to prepare and submit to the Wojewoda for his approval "A Program of Liquidation" that would include: * an assessment of all of the enterprise's assets; * a program for the disposal of assets; * a program for layoffs; * securing of the documentation; and * a financial program of liquidation. The Law on State-OwnedEnterprises provides a legal base for liquidation allowing it for state-owned enterprises that have ceased to pay debts or dividend taxes. The law establishes two liquidation options: (1) selling-off enterprise's assets and using proceeds to cover liabilities; or (2) selling enterprise as a going concern, i.e. the whole enterprise - assets and liabilities, as provided by the Polish Civil Code. Assets are to be sold at a public auction. There is a certain time-table for liquidation: if the Liquidator is unable to complete the process and repay the debts within this time, he is obliged to file for bankruptcy. When the court declares bankruptcy it nominates a commissioner ("Syndyk") to conduct the process. The Polish courts are extremely slow in dealing with business cases, so the bankruptcy process may last many months and often in the end only proceedings costs are covered. Usually the second option in liquidation is preferred. It does not eliminate the enterprise physically and retains the workforce. But this option is not easy to implement. Most of the liquidated enterprises have high liabilities-to-assetsratio, i.e. high liabilities the potential buyer would have to acquire. This does not provide incentives. The investor who would like to buy such a factory would rather wait for its bankruptcy which would enable him to buy it cheaply from a court-nominated commissioner. The sale of an enterprise by pieces is usually not an easy option either. First of all, machines or equipment if sold separately, i.e. not as a part of production lines, are worth close to nothing. On the other hand, the Liquidator is usually afraid to sell too cheaply, because he could be accused of misdemeanor. Secondly, it may be simply impossible (or totally cost-inefficient)to dismantle the factory's machines. Thirdly, the property rights to land and buildings are very often not defined. Finally, it may prove impossible to find a buyer for the enterprise property whose buildings cannot easily be adapted to suit an alternative function. The Liquidator of KPF decided from the outset that he would take the second option i.e., sale of the enterprise as a whole. He proposed that the selling price should be equal to the value of KPF's liabilities plus the liquidation costs. The public offer was prepared and published in the press. APPENDIX M - 180 - Negotiations. In March 1991, British consulting company - Central Europe Trust (CET) submitted to the Industrial Development Agency (IDA) an offer to prepare a solution and restructuring plan for KPF. The offer was accepted and results of this initial work presented to the IDA's executive board and Wojewoda of Walbrzych. The most important conclusion of the study prepared by CET was that KPF may constitute an attractive investment opportunity, provided it received certain support and its operations were restructured. This notion was based on the following assumptions about KPF's strengths: (i) attractive designs and products which are sought after by export markets; (ii) intrinsic profitability with quality adjustment at low cost, reduced financing burdens, and higher output/capacityutilization; (iii) low cost workforce; (iv) access to the domestic market, when it recovers; (v) big potential for mass production; (vi) relatively modem equipment. The study also showed the requirements for a successful KPF's turnaround: (i) equity financing to solve KPF's short-term debt financing problems; (ii) strategic management - definition of product ranges, definition of targeted market segments, and development of export distribution links; (iii) production - management of inventory, prevention of bottlenecks, and production driven by orders; (iv) cost and pricing management; (v) internal reorganization; (vi) marketing and distribution. In accordance with the findings of this study IDA decided to organize a consortium for restructuring of KPF. In June 1991, IDA signed a contract with CET to conduct negotiations with potential partners in the consortium and to prepare a business plan for the restructured enterprise. The idea of a consortium assumed that it would be organized in the form of a limited liability company that would buy the KPF from the Liquidator and then restructure its operations. The negotiations were long and difficult. CET approached several potential investors, including foreign companies active in porcelain business. Unfortunately, the conditions demanded by potential foreign partners could not be accepted. Among Polish institutions approached, there were banks and foreign trade companies. Simultaneously,CET negotiated with the Liquidator, Wojewoda and tax authorities over the conditions of a KPF takeover. The position of tax authorities was especially important. The potential consortium members (Bank Zachodni and IDA) decided that they would be unable to make a transaction unless part of the tax liabilities of KPF were written off. Finally, the limited liability company "Ksiaz Porcelain Factory Ltd." (KPFL) was established in October 1991. It had the following shareholders: 63% Bank Zachodni S.A., Wroclaw (state-owned commercial bank, major KPF's creditor) 25% Industrial Development Agency 7% MINEX (state-owned foreign trade company, KPF's trade partner) 3% WPEC (local energy supplier) 2% Central Europe Trust (consulting company) Figure M-1. illustrates these relationships - 181 - APPENDIXM FigureM-1. KsiazPorcelainFactoryLtd. of Minister Finance nominates State of | I Boand0 | |Ministry of I i i i ~~~~~~~~Foreign Economi e > | Relations monitors owns Owners 6 lnuti ~~~~~~5 MN7-X7 WPEC 3Z 2. BankZachodni Inuta(state owned WPCCentral Europe (stateowned) De~velopment foreigntrade (localenergy Trust Agency conasupplier) appoint appoint appoint appoint . uperviory Corporate Bor Structure : supervise Board Executive Own jKslzPorcdaln| Ltd. . Factory The shareholders' contributions to the newly established company were as follows: Bank Zachodni: KPF's liabilities and cash IDA: cash MINEX: KPF's liabilities WPEC: KPF's liabilities CET: in-kind contribution (restructuring program, business plan) The executive board of KPFL started to cooperatewith the Liquidator of KPF, negotiating with creditors debt relief and installment payments. They also negotiated the final terms of transaction for buying KPF from the State Treasury represented by the Wojewoda. The contract was signed in April, 1992, and the factory in Ksiaz became the property of KPFL. The long delay of this transaction was caused by the difficulties in achieving consensus among all parties involved. This delay was also the source of additional costs that had to be incurred after the factory had been bought up. APPENDIX M - 182 - to Is it appropriate call this transaction"privatization"?Unlikely. KPFwas boughtby the companyin whichstate-owned institutionshold98% of shares. Bank Zachodniis a profit-oriented commercialbank,but its board is nominated the Ministerof Finance. The Ministerof Industry by and TraderepresentsStateTreasuryas the ownerof IDA. The "owners"of MINEXand WPECare the Ministryof ForeignEconomicRelationsandthe Walbrzych Wojewodarespectively.Out of theseinstitutions,BankZachodniandM4NEX currentlycloseto a "real"privatization.When are that happens,it wouldautomatically makeKPFLa privatecompany. it for Even thoughthe transactionwas nota true privatization, was a precondition successful restructuring.The institutions shareholders KPFLtreatthis companyas a purelycommercial - of unit andthe evaluationof performance its management basedon this attitude. of is Restructuring.The negotiatedpriceof the transaction was 173,499mln. zl. This was preciselythe level of formerKPF's liabilitieson March30, 1992. To repaythese liabilities,KPFL signedagreements with all its creditors.As a result,out of the total amountof 173,499 mlIn.: 69,936 were liabilitiesof KPFL's shareholders 38,900 repaidin cash 31,975 was writtenoff 32,688 was agreedto be repaidin installments The drawn-outnegotiationsledto the newmanagement takingover a companywhichwas no longerproducing. Therewereonly a few employees remainingto maintainthe machineryand equipment. Evenworse,due to the ceasingof productionand the lackof heatingin winter 1991-92, the technicalstateof equipmentand machinery bad. Someinstallations was were damagedand the was neededrepair. Dueto thesefactorsthe periodof re-starting production delayedand costs provedto be higherthan expected. Company Information Products. Taking over the non-producingfactory caused certain adverse effects. All installations,equipmentand machineryhad to be reviewedand necessaryrepairsmade. In doing so, the managementsimultaneously implemented some technological changesand improvements. Actualproductionrestartedin June 1992. As a result,the new mixturefor pastewas developedand the qualityof porcelainproducedhavebeen constantlyimprovingsinceJuly. The ExecutiveBoardof KPFLdecidedin May 1992to starttwo differentinvestment line programswith the view to: (i) start a newproduction (sanitaryceramics);and (ii) improvethe qualityof glazing. Both investment projectswere financedpartlyby a loan obtainedat the Bank Zachodniand in part from company'sown resources. Whenimplemented, they shouldincrease both the marketpotentialof KPFL(newproducts)andthe qualityof its products. in Employment.There are less employees KPFLthan in the formerKPF: 1,030compared seemsto be higher. Dueto high to 1,345. What is important,the qualityof employees - 183 - APPENDIX M unemployment in the Walbryzch region and the fact that the Liquidator laid off all former employees, new management was very careful in hiring new people. About 20% of employees have been trained in special ceramic vocational schools. Markets and Competition. KPF ceased production in April 1991. This was in fact equal to the loss of all markets that the company used to sell to. In the initial period of KPFL's operations the marketing division was not working and the company did not have reliable information concerning the demand for porcelain, both domestically and abroad. The rebuilding of sales channels has became the most urgent task. In the domestic market the management decided to adopt an aggressive tactic selling porcelain at 10-20% discount on prices offered by other producers. KPFL offered also special discounts to wholesalers and favorable terms of payment. The company promoted its production participating in the International Poznan Fare and inviting to the factory more than 60 wholesalers dealing with porcelain in Poland. This strategy proved to be effective and the company reentered the domestic markets relatively quickly. The same process proved more difficult and gradual in relation to foreign markets. Only by the end of 1992 had serious links with foreign clients been reestablished. Currently, the company sells to such markets as: Germany, Greece, USA, Scandinavia, UK, Belgium, and Italy. In the course of 1992 KPFL used its promotional pricing strategy in its foreign markets as well. Financial Performance. A year after restarting production, KPFL was not yet profitable. T'hecosts of restarting, interest payments on investment loans and slower than expected increases in sales meant that losses could not be avoided. Asset Management Model The KPFL is managed by a 5-member Executive Board and supervised by a 9-member Supervisory Board representing shareholders. The company was completely reorganized and executives were among the first employees. After several changes, an organizational structure was adopted in which the General Director and 4 other directors - Technology Director, Marketing and Trade Director, Economic Director, and Financial Director - as members of the Executive Board manage 5 broad corresponding divisions. Major changes in comparison with the former KPF structure are: greater responsibility for others apart from the General Director and members of the Executive Board, fewer levels of management and larger marketing and trade division. Crucial factor contributingto the success of restructuring is to provide the enterprise with the true owner executing its ownership rights. Enterprises possessing a strong and skilled management group (playing the role of "owner") - and KPFL is such an example - tend to deal much better with restructuring than others. This suggests that privatization remains the most certain way of bringing the necessary changes at the firm level. APPENDIXM - 184 - BoxM-1. Restructuring Benefits is Restructuring a continuousprocessand it is too earlyto assesswhetherthe case of KPFhas been a complete success.Nevertheless, has provena successful it caseof govenmment-sponsored restructuring. processwaspossibledueto the following This restructuring severalfactors: (i) (KPF)wasa viablecompany,whichhad a goodproductwith export The objectof restructuring potentialandrelativelymodemmachinery; (ii) had The structureof incentives alreadyin place- the partiesinvolved a directinterestin was restructuring: in The Wojewoda Walbrzych interested savingjobs; of was was in The Liquidator interested quick,successful liquidation; BankZachodniand MINEXwantedtheirold loansto be repaid; IDA,by definition, interestedin successful was in region; restructuring the Walbryzch was in and of CET(the consultant) interested sellingits services the implementation its findings. (iii) resources Financial (thereis no restructuring were available withoutnew investment). (iv) planningprepared CETwereavailable. Good analysisandbusiness by would haveevertakenplace. One other If these factorswerenot in place it is doubtfulthat KPFrestructuring importantfactor is time. The new ownersof KPFL lost a substantialamountof resourcesbecausethe negotiations precedingthe takeoverlasted too long. The time in restructuring processesseemsequally importantas the money involved. Distributors of World Bank Publications ARGENTINA DENMARK JAPAN SINGAPORE, TAIWAN Carlos Hirsch, SRL SamfundsUtteratur Eastern Book Service Gower Asia Pacific Pte Ltd. Galeria Guemes Rosenoerms AU16 11 Hongo 3-Chome, Bunkyo-ku 113 Golden Wheel Building Florida 165, 4th Floor-Ofc. 453/465 DK-1970 Frederiksberg C Tokyo 41, Kalang Pudding, #04-03 1333 Buenos Aires Singapore 1334 EGYPT, ARAB REPUBLIC OF KENYA Oficina del Libro Internacional Al Ahram Africa Book Service (E.A.) Ltd. SLOVAK REPUBLIC Alberti 40 Al Gala Street Quaran House, Mfangano St. Slovart G.T.G. Ltd. 1082 Buenos Aires Cairo P.O. 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Box ST 125 RECENT WORLD BANK TECHNICAL PAPERS (continued) No. 254 Frischtak, Governance Capacity EconomicReformin Developing and Countries No. 255 Mohan, editor, Bibliography Publications: of TechnicalDepartment, AfricaRegion,July 1987to April 1994 of No. 256 Campbell, Design and Operation Smallholder Irrigationin South Asia No. 257 Malhotra, Sinsukprasert, and Eglington, The Performance Asia's EnergySector of No. 258 De Geyndt, Managingthe Qualityof HealthCarein Developing Countries No. 259 Chaudry, Reid, and Malik, editors, Civil ServiceReformin Latin Americaand the Caribbean: of Proceedings a Conference No. 260 Humphrey, PaymentSystems:Principles, and Practice, Improvements for No. 261 Lynch, Provision Childrenwith SpecialEducational Needs in the Asia Region No. 262 Lee and Bobadilla, HealthStatisticsforthe Americas of No. 263 Le Moigne, Giltner, Subramanian, and Xie, editors, A Guide to the Formulation WaterResources Strategy No. 264 Miller and Jones, Organicand Compost-Based GrowingMediafor TreeSeedlingNurseries No. 265 Viswaneth, BuildingPartnershipsforPovertyReductionThe ParticipatoryProjectPlanningApproachof the Women's EnterpriseManagementTrainingOutreachProgram (WEMTOP) No. 266 Hill and Bender, Developing RegulatoryEnvironmentforCompetitive the AgriculturalMarkets A No. 267 Valdes and Schaeffer,Surveillanceof AgriculturalPricesand Trade: Handbookforthe DominicanRepublic A No. 268 Valdes and Schaeffer,Surveillanceof AgriculturalPricesand Trade: HandbookforColombia No. 269 Scheierling, Overcoming AgriculturalPollution of of Water:The Challenge IntegratingAgriculturaland Environmental in Policies the EuropeanUnion of No. 270 Banerjee,Rehabilitation DegradedForestsin Asia No. 271 Ahmed, Technological and A Are Development PollutionAbatement: Study of How Enterprises FindingAlternatives to Chlorofluorocarbons No. 273 Grimshaw and Helfer, editors, VetiverGrassfor Soil and Water Conservation, and Land Relhabilitation, Embankment of and Stabilization: Collection Papers NewslettersCompiledby the Vetivernetwork A No. 274 Govindaraj, Murray, and Chellaraj, HealthExpendituresin Latin America No. 275 of An Heggie, Managementand Financing Roads: Agendafor Reform No. 276 for for Johnson, Quality ReviewSchemes Auditors:Their Potential Sub-Saharan Africa No. 277 Convery, Applying Environmental in Economics Africa No. 278 Wijetillekeand Karunaratne, Air QualityManagement: ConsiderationsforDevelopingCountries No. 279 Anderson and Ahmed, The Casefor SolarEnergyInvestments No. 280 Rowat, Malik, and Dakolias, IudicialReformin LatinAmericaand the Caribbean and No. 281 Shen and Contreras-Hermosilla, Environmental Economic Issuesin Forestry:SelectedCaseStudies in Inidia No. 282 Kim and Benton, Cost-Benefit ControlProgram Analysis of the Onchocerciasis (OCP) No. 283 Jacobsen, Scobie and Duncan, Statutory Interventionin AgriculturalMarketing:A New ZealandPerspective of No. 284 Vald6s and Schaeffer in collaboration with Roldos and Chiara, Surveillance Agricultural Priceand TradePolicies:A HandbookforUruguay No. 285 Brehm and Castro, The Marketfor WaterRights in Chile:MajorIssues No. 286 Tavoulareas and Charpentier CleanCoalTechnologiesfor Developing Countries the No. 287 Gillham, Bell,Arin, Matthews, Rumeur, and Rearn, CottonProductionProspectsfor Next Decade No. 289 Dinar, Seidl, Olem, Jorden, Duda, and Johnson, Restoringand Protectingthe World'sLakesand Reservoirs No. 290 Weijenberg,Dagg, Kampen Kalunda, Mailu, Ketema, Navarro, and Abdi Noor, Strengthening NationalAgricultual Research Systems in Easternand CentralAfrica:A Frameworkfor Action in No. 292 Gorriz, Subramanian, and Simas, IrrigationManagementTransfer Mexico:Processand Progress No. 295 Pohl, Jedrzejczak, and Anderson, CreatingCapital Marketsin Centraland EasternEurope THE WORLD BANK R A partner in strengthening economies and expanding markets to improve the quality of life for people everywhere, especially the poorest Headquarters European Office Tokyo Office 1818 H Street, N.W. 66, avenue d'1ena Kokusai Building Washington, D.C. 20433, U.S.A. 75116 Paris, France 1-1, Marunouchi 3-chome Chiyoda-ku, Tokyo 100, Japan Telephone: (202) 477-1234 Telephone: (1) 40.69.30.00 Facsimile: (202) 477-6391 Facsimile: (1) 40.69.30.66 Telephone: (3) 3214-5001 Telex: Mci64145 WORLDBANK Telex: 640651 Facsimile: (3) 3214-3657 MCI 248423 WORLDBANK Telex: 26838 Cable Address: INTBAFRAD WASH[NGTONDC World Wide Web: http://www.worldbank.org E-mail: books@worldbank.org 1170 1 9 780821 334706 Cover design by Walton Rosenquist ISBN 0-8213-3470-0