Governance issues in SOE’s within the Baltic states

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By Paulius Martinkus – President of the Baltic Institute of Corporate Governance

 

 

When facing double digit contraction in real GDP in 2009 Estonia, Latvia and Lithuania realised that financial performance of state-owned enterprises (SOEs) and their dividend contributions to state budgets could become a viable alternative for raising taxes. Improving corporate governance practices was the key to unleash the profitability potential of SOEs.

Estonia became a member of the Organisation for Economic Co-operation and Development (OECD) in 2010 and it has made significant improvements in corporate governance already since the invitation to negotiate on accession to the OECD in 2007. Financial performance of 32 SOEs can be observed from aggregated annual reviews which are produced by the Ministry of Finance (http://www.fin.ee/state-assets). It is common practice to appoint independent members to the board of directors (to avoid confusion I refer to the board of directors as a non-executive body that supervises a CEO or the management board of a company) in SOEs.

Lithuania started to put major efforts into complying with the OECD guidelines on corporate governance of SOEs only in 2010. Remarkable results were achieved in producing aggregate reports on SOEs (http://soe.ukmin.lt/). The Lithuanian government owns 137 SOEs and the 10 largest SOEs that account for over 80% of financial results[1]. Independent professionals are elected to the boards of directors of several major SOEs.

Latvia unfortunately has not reached tangible results yet; however, it is going through accession to the OECD procedure and compliance to the OECD guidelines on corporate governance of SOEs is among key requirements; thus, visible results are expected to show up in next couple of years. Generally there are no boards of directors in Latvian SOEs except for few exceptions which can serve as examples to follow. The Latvian government owns 40 SOEs[2].

Despite positive shifts in governance of SOEs, all three Baltic states have many issues to tackle when it comes to benchmarking best governance practices according to the OECD.

The Board of Directors

The most important tool for improving corporate governance is to have professional board of directors. The majority of Latvian SOEs and several minor Lithuanian SOEs still do not have a board of directors and management is supervised directly by the shareholder. The shareholder is one of many stakeholders, thus there are underlying conflicts of interests breaching one of the core duties of the directorship – duty of loyalty to the company. Also, the representatives of the shareholder are not motivated to perform a proper due diligence as they do not have a personal liability or remuneration from decision making; thus duty of care is not exercised properly either. Finally, asymmetric information and moral hazard from the management side is a classic agency problem, which could be resolved by having an active and professional board of directors.

 

“A professional and independent board of directors will safeguard the SOEs from political intervention on a management level”

 

The board of directors are politicised and professional independent directors; only a minority in the boardroom. A high level of political affiliation and insufficient competence in the board of directors is a result of an opaque appointment process[3]. Performance reports, board assessments, definition of required skillset and a public selection process could improve the quality of the board as well as give public confidence in SOEs.

Having officials from ministries on the board of directors is still a common practice and it stipulates major problems:

  1. Competence is skewed towards the legal and public administration skillset;
  2. Officials do not express personal opinions in discussions as they are voting as instructed by the ministers; thus duty of care and duty of loyalty are in obvious breach;
  3. Usually officials who are elected to the boards are responsible for the same industry policy formation initiatives; thus they are in the conflict of interest and potentially having power to favour one of the market players;
  4. The board dominated by the major shareholder’s employees would tend to impede minority shareholders rights.

Independent board members are the straightforward solution to the problem.

The Management

The Baltic Institute of Corporate Governance performed a study on CEOs in Lithuanian State-Owned Enterprises[4] which revealed that there was not enough transparency in the selection process. Ministries usually interfered in the selection process bypassing the board, firing was not based on performance and remuneration tying to performance was only a formality. A high level of politicisation was observed in the analytical article on the Politicisation of CEO Appointment in Lithuanian State-Owned Enterprises[5]. Despite the downward sloping trend in politically affiliated appointments, the politicisation of management still remains a major concern in Lithuania. The increase in the number of independent board members would relieve the management from reckless political interventions.

The Ownership

The ownership of SOEs in the Baltic states is dispersed among sectorial ministries. Estonia (the Ministry of Finance) and Lithuania (the Governance Coordination Centre) have relatively weak coordinating institutions mainly engaged in reporting and transparency, while all the shareholding rights stay within the sectorial ministries. Latvia is underway to establish a central coordinating unit for governance of SOEs which would resemble the Estonian and Lithuanian model. Here we should emphasise that decentralised ownership comes with significant disadvantages:

  • Sectorial ministries assign sector-related objectives while leaving financial objectives like dividend yields as a secondary priority; therefore, SOEs heavily distort the level playing field (cross financing, pricing does not account for cost of capital, procurement procedures bypassed via shareholder decisions);
  • Due to scattered ownership the competences within ministries are not as well developed as it could be in centralised ownership model; therefore, asymmetric information and moral hazard are significant problems;
  • Sectorial policy formation and shareholder rights are granted to sectorial ministries; thus it puts ministries into direct conflict of interests.

Centralisation of ownership either under holding or under a ministry that is least involved with sectorial policies (e.g. the Ministry of Finance) could help to resolve the problems mentioned above. The halfway could be to establish a strong central coordinating institution (i.e. to grant the right to delegate independent members to the board of directors and to veto draft shareholder decisions) which could help to mitigate some of the problems.

What Is Next?

Estonia is a clear leader in introducing the best corporate governance practices in SOEs, followed by Lithuania while Latvia is obviously lagging behind. All corporate governance issues that the Baltic states are facing are relatively easy to tackle; however, it needs clear political leadership and commitment to change. When looking at the experience of the OECD countries we can come to 3 simple advices for the governments of the Baltic states on improving corporate governance:

  • Introduce a board of directors in each and every SOE;
  • Commit to a transparent selection process of independent members to the boards of directors. Delegate this function either to a central coordinating unit or hire an independent recruitment company;
  • Ensure that at least half of the members of the board are independent.

In addition to that Latvia has to commit to the preparation of quality aggregated overviews of SOEs performance. Here even Estonia and Lithuania can serve as the right examples for Latvia to follow.

A professional and independent board of directors will safeguard the SOEs from political intervention on a management level, and lead to more efficient operations through well-defined strategy and result in increased dividend yields for the shareholders i.e. the public.

 

[1] Own calculation based on information provided by Governance Coordination Centre. Raw data can be found here: http://vkc.vtf.lt/static/uploads/20140430-Visu_VVI_finansiniai_rezultatai.xlsx

[2] Hospitals and schools were removed from the list of SOEs. Full list can be found here: http://www.pkc.gov.lv/images/Kapitalsabiedribas/VKS_2009-2012_aktivi_pelna.xls

[3] The Baltic Institute of Corporate Governance, 2012, Governance of State-Owned Enterprises in the Baltic States.

[4] The Baltic Institute of Corporate Governance, 2013, CEOs in Lithuanian State-Owned Enterprises.

[5] Laurišonytė, N, 2014, Politicisation of CEO Appointment in Lithuanian State-Owned Enterprises, Politologija, 2014 2, (74), 68-95.

 

About Author

Paulius Martinkus is the President of the Baltic Institute of Corporate Governance. Paulius graduated from the Baltic Institute of Corporate Governance in 2012 and is a lecturer in the education of corporate governance in state-owned enterprises. He has a Bachelor degree in Economics and Business Administration from Stockholm School of Economics in Riga. Paulius worked as an associate in a private equity fund, as financial controller in a group of companies and he was heading up the central coordination unit for state-owned enterprises in Lithuania. Paulius also acted as secretary to the board in number of companies in Lithuania, Latvia, Estonia and Finland; later he served on several boards as non-executive board member and chairman in private, publicly listed and state owned companies.

The Baltic Institute of Corporate Governance is an internationally recognised driver of best practice corporate governance development in the Baltic region. The Institute delivers value to its stakeholders by promoting global competitiveness of Baltic companies through adoption of leading corporate governance practices. For more information please visit http://corporategovernance.lt.

 

Attribution – photo Poco a poco