The acquisition of state-owned companies

Author: | Published: 10 Oct 2001
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Privatizations and, accordingly, the acquisition of state-owned enterprises by private investors have a long tradition in Germany. Formerly state-owned companies such as Volkswagen and e-on are well-established in the German private economy today. Moreover, the acquisition of state-owned companies dominated German business transactions during the early 1990s, when the former east German and state-owned Volkseigene Betriebe were privatized by the Treuhandanstalt, the governmental institution established in the course of the reunification for administering and privatizing the east German economy. This field is witnessing a revival, since large parts of the economy formerly dominated by state monopolies are subject to privatizations.

Not only large scale public offerings, like the initial public offerings of Deutsche Telekom in 1996 and Deutsche Post in 2000, are in the centre of this development. The privatizations of many state-owned enterprises via trade sales or investment bank-led auctions cause significant legal and political problems. Against the background of past and future privatization projects, this article will describe several issues arising in connection with the acquisition of a state-owned company, taking the wave of privatizations of municipal utility providers, the so-called Stadtwerke, as an example.

Privatizations of Stadtwerke

One city after the other starts privatizing its Stadtwerke. The Stadtwerke are responsible for energy production, heat and water supply and waste management in their city. They are regularly operating the power supply network in their region, and own several power plants, refuse disposal depots and waste incinerating plants.

Until the 1990s, the Stadtwerke were the only energy supplier in their respective region and they still, despite the continuing liberalization, dominate the regional energy supply markets. Large Stadtwerke as the Stadtwerke München, the Stadtwerke Düsseldorf or the Stadtwerke Hamburg have annual turnovers of up to euro1.7 billion ($1.9 billion).

The Stadtwerke are of paramount importance for actually selling energy and other utility services to end customers and companies. Therefore, large and international utilities and multi services providers with an interest in the German utilities market find it appealing to purchase stakes in the Stadtwerke, in order to improve their market shares and customer bases in Germany. At the same time, the privatization of these former state monopolies is – as other privatizations before – an excellent opportunity for the corresponding municipalities to generate considerable revenues from selling such assets.

Two-step process of privatization

In most cases, the full privatization of the Stadtwerke, which used to be municipal undertakings formally and legally not separated from the local authority itself, requires a two-step process. A first step, the formal privatization, is achieved through the transformation of the municipal undertaking into a corporation under private law, which is formally separated from the municipality itself. The only shareholder of such corporation is regularly the municipality or a holding company wholly-owned by the municipality. The process of transforming the Stadtwerke is governed primarily by the German Transformation Act (Umwandlungsgesetz) and the State law governing the laws of municipalities (Gemeindeordnung). This first step of privatization has already been performed by most municipalities in the past decades and does not cause substantial legal or political problems.

Once the municipal undertaking has been transformed into such a private law entity, like a joint stock corporation (Aktiengesellschaft) or a limited liability company (Gesellschaft mit beschränkter Haftung - GmbH), the municipality may, in a second and far more important and sensitive step, sell all or a part of the shares of the company to a private investor and thereby substantively privatize the company. This is where potential purchasers enter the scene, together with their legal advisers and an investment bank, in order to bid in (most often) an investment bank-led auction.

Basic merger and acquisitions issues

The acquisition of state-owned companies as Stadtwerke causes the same set of legal issues as any other company purchase. The legal documents to be negotiated and drafted are governed by private law and deal with the transfer of the shares itself, the purchase price and a set of representations and warranties granted by the municipality or its holding company to a buyer concerning the legal and economic status of the company to be sold.

The purchase price, the assessment of the purchase price and related tax issues are key points in the negotiations. Investment banks are busy with evaluating the company for their client, the potential buyer. The legal advisers involved negotiate appropriate mechanisms for assessing such price, eg via a flexible purchase price model.

The representations and warranties granted by the seller are the second core point in the negotiations. With respect to these covenants, the fact that the seller is not a private company, but a state entity, should not be underestimated. State entities are usually more reluctant to grant a sufficient set of representations and warranties to the purchaser. In the early 1990s, the Treuhandanstalt often insisted on far-reaching limitations of its liability and asked for almost complete exclusions of any kind of express or implied warranties. Today, state entities follow this example and often attempt to avoid granting warranties in order to limit the financial risks resulting from potential warranty and liability claims.

Special contracts safeguarding the public interest

However, not only these more or less common company purchase problems rule the negotiations. The political environment of the sale of a state-owned enterprise lead to unique contractual provisions to be negotiated. In the sale of the former GDR industry after 1990, the Treuhandanstalt insisted that the purchasers undertook several representations and warranties as to the future of the privatized company. Purchasers had to guarantee, for example, that they make certain investments, that the company will keep a minimum number of full-time employees and that the purchaser will not resell or substantially restructure the company for several years to come after the privatization.

In today's acquisitions of Stadtwerke, similar provisions are typically negotiated. The municipal governments want to ensure that the Stadtwerke continue to provide power and other utility services within their geographical markets and that the role of the Stadtwerke as an important employer in the region and part of the municipal community will not be deteriorated by the sale. Therefore, the purchaser may often face negotiations where the seller insists that certain standards regarding electricity and water supply or with respect to the waste management will be continuously met by the Stadtwerke after the privatization, and that the purchaser undertakes far-reaching and long-lasting warranties in this respect, maybe even binding the purchaser for decades.

Moreover, in this context, employment issues become relevant. The employees of the Stadtwerke to be privatized, as in any privatization, fear that their position might be dramatically weakened through the sale of the company. In a state-owned enterprise, irrespective of whether the employees were employed under private or public law, it was virtually unthinkable that employment contracts were terminated for operational reasons. Becoming a part of the private economy leads to fears of rationalization measures which affect the security of each individual job. In order to accommodate these fears, the municipalities often insist on covenants by the purchaser that no employment contracts will be terminated for operational reasons during a certain number of years after the privatization.

All these issues where the public interest must be safeguarded are of paramount importance for any potential purchaser of a state-owned company. On the one hand, the purchaser must ensure that his entrepreneurial freedom is not affected by corresponding contractual provisions and that he can lead the operations of the company mainly in accordance with his own interests. On the other hand, in the negotiations, the purchaser must be aware that the concerns related to these contractual provisions, as the fear for the water quality and energy supply in the region and the employees' fear of losing their jobs, are an important political factor which might substantially affect the purchaser's success in a bidding process and the negotiations as a whole.

The influence of politics

Potential buyers always have to be aware that they are placing their offer on a "political ground", and that many different political interests must be taken into account. The impact of different political wings, of trade unions and other political groups, should not be underestimated.

The sale of the city's Stadtwerke needs approval of the city's mayor, and the mayor needs the support of the majority in the municipal council (Stadtrat) to decide on the sale. In the municipal council, the sale may well become a political issue and be discussed along party lines. Political parties generally opposing the mayor may use the intended sale of the Stadtwerke to weaken the mayor's position, by alleging numerous times worries about the future of the Stadtwerke, of the energy and water supply in the region etc. The scope of the contractual provisions discussed above will in large part depend on these discussions.

In the investment bank-led auction for the sale of an interest in the Stadtwerke Düsseldorf in the first half of 2001, political opponents of the mayor initiated a referendum against the sale of the Stadtwerke, which was successful and led to the restriction of the municipal government to selling only a minority interest in the Stadtwerke.

Acting on a legal and political playground

These strong interactions between legal and political issues show that the purchaser of a state-owned company has to be aware of the political impact of all its actions. A step which seems to be useful from a legal or economic perspective might harm his political prospects in the course of the bidding process. The purchaser must concentrate on establishing a trustful relationship with all major political actors in the region. Therefore, the purchaser has to know these actors, their main political interests and their influence. Mistakes in this field may have a devastating effect on the position of a bidder in the auction of the Stadtwerke, no matter how high the offered purchase price of this bidder may be.

Regulatory and public law issues

Not only the political impact of such acquisition distinguishes the purchase of the Stadtwerke from the typical company purchase. It also has to be taken into account that the businesses of these formerly state-owned enterprises, which operated as parts of a long-term state monopoly, are heavily regulated by public law.

For example, in the electricity supply sector, pricing is subject to regulatory control under the 1998 Energy Industry Act (Energiewirtschaftsgesetz) and the 1989 Federal Rate Regulation for Electricity Supply (Bundestarifordnung Elektrizität). As the 1996 Telecommunications Act (Telekommunikationsgesetz), these statutory provisions establish a regulatory system designed to establish competition in the former state monopoly. Moreover, for the same reason, the whole energy supply market is, in the course of the continuing liberalization of this market, subject to scrutiny under the Act Against Restraints of Competition (Wettbewerbsgesetz , GWB).

The Stadtwerkes' power plants are subject to various safety regulations. The refuse disposal depots and waste incinerating plants are subject to many statutes and regulations such as the Federal Statute Concerning the Protection against Harmful Effects on the Environment through Pollution (Bundesimmissionsschutzgesetz) or the 2001 Regulation on the Compatibility of Waste Disposal with the Environment (Verordnung über die umweltverträgliche Ablagerung von Siedlungsabfällen).

All this demonstrates that public law also plays a significant role in the acquisition of a state-owned enterprise. A complete awareness of the regulatory framework surrounding the company is of paramount importance in the due diligence process, where legal and economic risks and liabilities are assessed. Moreover, the future prospects of a company are heavily influenced by the regulatory framework and, therefore, have to be carefully scrutinized as well.

Outlook: more Stadtwerke and other industries on the verge of privatization

At the moment the utilities sector is the most exciting field for privatizations, with a new regulatory framework and a continuing wave of activity.

In the long run, it is safe to say that most of the Stadtwerke and other utility providers, such as gas suppliers, will be at least partly privatized. Privatizing the Stadtwerke is a unique chance for the municipalities to generate significant revenues and, therefore, helps ease their budget problems. Moreover, the acquisition of the Stadtwerke has a high strategic relevance for large utility providers, since it is of paramount importance for these entities to enter new markets for the distribution of their electricity and to gain an easy access to new customer bases.

Furthermore, there are still large parts of the state industry to be privatized. The most prominent example during the next years will likely be the IPO of Deutsche Bahn, the German state-owned railway company. Regional public transportation services (Öffentlicher Personen- und Nahverkehr), which are, like the Stadtwerke, mainly operated by municipal undertakings, may follow as the next set of companies to be privatized. Here as well, all potential purchasers should be aware that their success is highly dependent on numerous legal and political factors.

Wilmer, Cutler & Pickering
Friedrichstrasse 95
D-10117, Germany
Tel: +49 30 2022 6400
Fax: +49 30 2022 6500