Canada: Corporate Governance For Municipally-Owned Local Electricity Distribution Utilities

Last Updated: April 29 2016
Article by Robert B. Warren and Dan Ferguson

Local distribution electricity utilities ("LDCs") have been a source of stable and predictable income for their municipal owners. That is in large measure a result of the fact that LDCs are providing a monopoly service overseen by a regulator charged with the obligation, among other things, to ensure the stability of the LDCs.

One result of these circumstances is that municipalities have in many cases played a limited role in the governance of their LDCs. In addition, the directors of LDCs, including in some cases members of municipal councils, have likewise played a limited role in governance. They have elected, instead, to rely largely, if not entirely on the expertise of management. This is in part because of the complexity of the electricity distribution business, in part because the fact of regulatory oversight, and in part because the range of business decisions was limited by the absence of competitive pressures.

Several new factors are combining to make the focus on the governance of LDCs more important. Technological changes pose a potentially significant challenge to the traditional distribution model, creating the prospect of having to develop new business models with an attendant increase in business risk. At the same time, legislative changes expose LDC governance to regulatory oversight. Finally, the prospect of mergers and consolidations creates a new set of governance obligations and challenges, particularly in circumstances where municipalities, as a result of a merger or consolidation, hold only a minority interest in the LDC.

The governance obligations of directors are based, in the first instance, on compliance with the statutory obligations to act honestly and in good faith, with a view to the best interests of the corporation and to exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances. Directors are obligated to serve a corporation selflessly, honestly and loyally, and to exercise independent judgment.

Directors are obligated to avoid conflicts of interest, which in most cases will involve circumstances where a director obtains, directly or indirectly, a monetary gain as a result of his or her decisions. However, municipal councillors may encounter circumstances where monetary gain is not at issue, but where there may be a conflict between his or her obligations to the municipal owner and his or her obligations to the LDC.

In the circumstances of a merger or consolidation, a municipality may go from being a majority, or sole, owner of the LDC to holding only a minority interest. To protect its interests in those circumstances, the municipality must first ensure that the transaction processes, including the transaction documents, are designed and structured in ways which protect its interests. Once the transaction is completed, the resulting governance structure must include mechanisms, whether in the form of a unanimous shareholder's agreement or a shareholder declaration, that provide, to the extent possible, the municipality holding a minority interest with the appropriate degree of control or influence over, and awareness of, the operations of the LDC.

The governance challenges for directors, and for municipalities, most often arise in the following circumstances:

  1. Resolving conflicts in the respective roles of a director as a member of the municipal council and of the board of directors of the LDC;
  2. Determining whether, or to what extent, regulatory oversight relieves directors, and indeed municipalities, of their governance obligations;
  3. Ensuring that the board of directors, and the governance structure, are properly equipped to deal with the challenges of an evolving distribution sector; and
  4. Ensuring that the proper transaction governance mechanisms are in place in circumstances where, as a result of a merger or consolidation, a municipality holds only a minority interest in the LDC.

I Introduction

Several factors have recently converged to place an increased focus on the governance of municipally-owned local electricity distribution utilities. ("LDCs").

While there is a risk in generalizing, it has often been the case, particularly for smaller LDCs, that directors have played a largely passive role in the governance of LDCs. Several factors have contributed to that phenomenon. One is that electricity distribution is a highly technical operation, with the result that directors without specialized knowledge have deferred to the expertise of management. A second is that the business of LDCs, governed as it is by the seemingly opaque rules of regulatory economics, can reinforce the need to rely on the expertise of management. Finally, the fact that LDCs are regulated, something which has offered a substantial measure of stability to the business of the LDCs, has allowed many directors to adopt a "hands off" approach to the performance of director obligations. The directors of LDCs, and in particular, the municipal councillors who are directors, have in many cases been able to rely on a reasonably-predictable stream of income from LDCs without having to engage too deeply in the oversight of the LDCs.

A parallel, and related, phenomenon is that the municipal shareholders of LDCs in many instances have taken a passive, or non-interventionist, approach to the business and affairs of LDCs, for the same reasons. Staff and politicians at the municipal shareholder level, faced with the technical complexity of LDC operations, and secure in the knowledge that the regulator will both protect the interests of ratepayers and assure a predictable and steady stream of dividends, have in large measure left management to run the LDCs as they see fit.

One unfortunate result is that the management of LDCs have in some instances come to resent what they regard as intrusive oversight by municipal owners, and to resist the necessary changes in governance.

However, there is now the prospect of material changes in both the business and regulatory environments for LDCs, arising in part from the deployment of distributed energy resources, combined with increased consumer choice, both of which may threaten the stability of the traditional LDC business model. Pressure to adapt to those changes, which bring with them increased business risk, puts increasing pressure on LDCs to enlarge the scope of their businesses and adopt new business models, with increasing levels of risk. At the same time, recent amendments to the Ontario Energy Board Act, 1998 ("OEB Act")1 expose officers and directors to the risk of prosecution, or at least an increased measure of oversight and accountability, for the failure to adhere to governance obligations.

These factors, together with the encouragement of the provincial government, have prompted a number of municipalities to consolidate or merge with other LDCs to form larger LDCs. These consolidations and mergers create new governance concerns, particularly as municipalities move from being the sole or majority shareholder to a minority position. The consequent changes in equity interests and dividend streams must be properly addressed, first in the merger transaction processes and documents, and then in the governance framework. The roles, responsibilities, rights, obligations and accountabilities among management, directors and shareholders, in the development of the documents effecting the merger/consolidation, and in the governance framework for the post-merger entity, must be carefully considered.

All of these developments prompt the need to review the governance practices of LDCs and, in particular, the governance obligations of their officers and directors. These developments also prompt the need to review the roles of municipal shareholders in the governance of the LDCs. Unless, and until, there are changes in the tax rules which currently limit private sector involvement in the electricity distribution sector, municipalities will remain the principal owners of LDCs.

In this paper we seek to accomplish three basic objectives, as follows:

  1. To describe the basic governance obligations, and to a more limited extent, good governance practices, of the officers and directors of LDCs;
  2. To examine how recent developments in the electricity sector and changes to the OEB Act may affect those obligations and practices; and
  3. To examine governance roles and responsibilities of a municipal shareholder in the circumstances of a merger or consolidation, particularly where the shareholder holds a minority interest in a merged LDC.

To provide a practical focus for the discussion, we examine a number of circumstances where the issues of how to fulfil governance obligations are particularly complex. They include the following:

  1. Resolving potential conflicts in the obligations of directors who are also members of municipal councils;
  2. Balancing of the obligations of directors to their LDC, and to their shareholder municipality, and to the LDC's ratepayers;
  3. Assessing the impact of regulatory oversight on the obligations of officers and directors;
  4. Balancing the obligations of officers and directors, to the LDC and to the municipal shareholder, in the context of a possible sale of the LDC, or the purchase of another LDC;
  5. Assessing the impact on officers and directors of recent changes to the OEB Act; And
  6. Mitigating the risks, particularly for municipal shareholders, posed by potential consolidations and mergers.

Two qualifications should be placed on the discussion which follows. The first relates to a distinction between (1) governance obligations which are, by and large, legal in their nature and arise primarily from statutes, and (2) good governance practices. Adhering to the latter would include adhering to the former, primarily to mitigate any risk which the failure to follow legal obligations might entail, but would not be limited to following those obligations. The focus of much of the discussion in this paper is on governance obligations rather than governance practices and on identifying where and when appropriate governance practices need to be developed, rather than on attempting to prescribe specific governance practices.

The second qualification is that much of the focus of the discussion which follows is on private corporations. The governance obligations of publicly-traded corporations are more detailed, and more complex, than are the obligations for private corporations. That said, however, while the governance obligations and governance practices of publicly-traded corporations may not apply to private corporations, they can in many respects provide a useful guide to how officers and directors of private corporations, particularly LDCs, should conduct themselves.

In a private corporation, particularly one with only one shareholder, that shareholder can exercise a substantial measure of control. It can, for example, remove officers and directors who fail to perform their governance obligations. The irony is that many municipal shareholders of LDCs do not exercise that authority, and have played a limited role in the governance of the LDC.

Finally, and by way of an overview observation that should inform any consideration of governance, we note the following statement of the Supreme Court of Canada: The establishment of good corporate governance rules should be a shield that protects directors from allegations that they have breached their duty of care.2

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Footnotes

1 Ontario Energy Board Act, 1998, S.O. 1998, c. 15, Sched. B.

2 Peoples Department Stores Inc. (Trustee of) v. Wise, [2004] 3 S.C.R. 461, 2004 SCC 68, at para 64 ("Peoples").

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Robert B. Warren
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