LLB, PhD, Lecturer in Law, Law School, University of Hull, Hull, HU6 7RX.
Email: L.A.Whitehouse@hull.ac.uk.

*I am grateful to the British Academy, the Economic and Social Research Council, the Nuffield Foundation, the Socio-Legal Studies Association and the University of Hull for funding aspects of this research. I would also like to thank the anonymous referee for their constructive comments on an earlier draft of this piece and the representatives of Fannie Mae who provided such invaluable information.

Copyright © Whitehouse 2003.
First published in the Web Journal of Current Legal Issues

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On 3 October 2002, Railtrack’s ownership of the British rail infrastructure came to an end. In response, the Government established Network Rail, a private company limited by guarantee that will reinvest profits into the railway infrastructure in the pursuit of a safer and more reliable railway system. Upon closer inspection, however, it becomes clear that these reforms raise serious concerns in respect of the accountability of Network Rail, its status as a private sector organisation and its implications for the Treasury and the tax payer; concerns that could have been avoided had the Government adopted an alternative approach, known as a ‘government sponsored enterprise’. To this extent, therefore, Network Rail represents an opportunity missed by the Government to gain increased control of the railway infrastructure at a significantly reduced price.

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The railway administration of Railtrack Plc (Railtrack) in October 2001 offered the Government an unprecedented opportunity to reform an industry that had become synonymous with under-investment, failing safety standards and poor customer service. Railtrack, in particular, had become the focus of intense criticism for its tendency to prioritise the interests of its shareholders over and above its duty to renew and maintain the railway infrastructure (Byers 2001a, col 20 and Efford 2001, col 761). In an effort to avoid a repetition of these criticisms, the Government has established a successor to Railtrack that, as a private sector company limited by guarantee, will be devoid of shareholders, enabling it to be run ‘for the benefit of the whole railway, concentrating on its core priorities of operating, maintaining and renewing the rail network’ (Darling 2002, col 971).

While it seems reasonable to conclude that Network Rail will improve upon the performance of Railtrack - some would argue that it would be difficult not to do so - the Government, in its haste to eject shareholders from the ownership of the railway infrastructure, has failed to recognise the potential which private equity finance could play in assisting it in the achievement of its aims. Support for this proposition will be offered in the form of an account of a company, currently operating in the US, that benefits from the advantages of private equity capital while successfully pursuing public policy objectives. Having started life in 1938 as a federal housing agency, Fannie Mae became a privately owned company in 1968. Despite the fundamental alteration in its funding source, Fannie Mae continues to serve the same social welfare goals, namely, to facilitate access to home-ownership for low and moderate income families. In offering Fannie Mae as an alternative to Network Rail, this paper will conclude that, while Fannie Mae is not an ideal model, it would appear to offer a more effective and prudent alternative to the Government’s current proposal to reform the railway industry.

On 3 October 2002, following the High Court’s decision to discharge the railway administration order made in respect of Railtrack, Network Rail became responsible for the ownership and operation of the 19,000 miles of track, 2,500 stations and connections to 1,000 freight terminals (Sixth Report 2001, para 8) that constitute the British railway infrastructure. Despite the prominent position it now holds within a railway system that has been described as ‘fundamental not only to transport, but to economics and the quality of people’s lives’ (Dunwoody 2002, col 323) Network Rail has not, as yet, been fully formed. The Government have, however, made clear certain details in respect of Network Rail’s internal governance structures and its financial backing.

Created by the Strategic Rail Authority in October 2001, the same month in which Railtrack was put into railway administration, Network Rail will have between 100 and 120 members (rather than shareholders) including representatives of the train and freight operating companies, the public and other interest groups, with the Government’s interests represented by an appointee from the SRA. The company will be managed by a board of directors chosen initially by the SRA and subsequently by its membership. Appointments to the board include Ian McAllister, formerly with Ford Motor Company Ltd, as Chairman, John Armitt, former Chief Executive of Railtrack, as Chief Executive Officer and Ron Henderson, formerly Chief Executive Officer of Tuberail, as Finance Director.

The internal governance structures adopted by Network Rail mean that it will operate in much the same way as any other private sector company, with the membership responsible for the supervision, appointment and dismissal of the board of directors who, in turn, will be responsible for the day-to-day operations of Network Rail. The quality of the corporate governance mechanisms adopted by Network Rail, however, comes under question when it is noted that the membership will be chosen by an ‘independent appointments committee’ set up by the board of Network Rail (Lord Macdonald 2002, col 1515), and Office of the Rail Regulator, 2002, para. 8). Despite the apparently ‘independent’ nature of this appointments committee, it seems reasonable to question whether the board of Network Rail will be held accountable by a membership that it itself has chosen. The issue of accountability is of particular concern within the railway infrastructure for the reason that Railtrack’s well publicised failure to maintain a safe and reliable rail system was due, in part, to the decisions of its board and in particular, the poor targeting of investment (Office of the Rail Regulator 1997, para 2). The success of Network Rail will, in much the same way as that of Railtrack, depend upon the efficiency of the board in undertaking and implementing such decisions. If these decisions are not monitored effectively, Network Rail may well repeat many of the failings of its predecessor.

While the internal governance procedures adopted by Network Rail may prove inadequate in ensuring the accountability of its board, the Government have sought to compensate for this deficiency through the imposition of external constraints. Any profit made by the company, for example, will not be distributed to shareholders in the form of dividends but reinvested into the railway infrastructure with the ultimate objective of delivering ‘a safe, well-maintained rail network that is fit for the 21^st century’ (Byers 2001, col 956). In addition to this objective, the Government has also established incentive packages for directors that are dependent upon ‘safety, meeting financial and efficiency targets, and providing a quality service to customers’ (Department for Transport, Local Government and the Regions 2001, p 2).

These rather general aims are complemented by the more specific directions offered by the SRA’s Strategic Plan (SRA 2001) and the Government’s ten year plan for transport (Department for Transport 2000). Network Rail will also be subject to the unique regulatory framework set out in the Railways Act 1993 (as amended by the Transport Act 2000) under which the Office of the Rail Regulator (ORR), an independent statutory officer, soon to become a regulatory board (ORR 2002, para 19f), is responsible for monitoring and enforcing Network Rail’s licence to operate the railway infrastructure and for ensuring the company’s accountability to the public interest (ORR 1997, para 2). The Rail Regulator had cause, on a number of occasions, to castigate Railtrack for its failure to satisfy the duties set out in its Network Licence (ORR 1999, para 1; ORR 1999a, para 12 and ORR 2000). Whether the new regulatory board will find it necessary to undertake a similar level of intervention in relation to Network Rail remains to be seen.

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The substantial funding required by Network Rail to operate, maintain and improve the railway infrastructure, amounting to £14 billion (including £7 billion worth of debt acquired from Railtrack) will be obtained, initially, in the form of loans from a number of commercial banks. While this would seem to confirm Network Rail’s private sector status, these loans will be supported by the SRA in the form of standby loans, which Network Rail can draw upon to repay the lenders in the event of default. The SRA will also offer a ‘contingency buffer’ (Darling 2002, col 972) of £4 billion should Network Rail experience unforeseen expenditure. Should this prove insufficient to cover the debts of the company the Government has indicated, by means of a ‘comfort letter’ to lenders, that it would be willing to step in and repay the loans (Secretary of State for Transport 2002, para 20). This funding will be in addition to the subsidies already paid to the train operating companies in order to enable them to pay the track access charges imposed by Network Rail (Stittle 2002, p 50).

The Government’s willingness to underwrite the debts of Network Rail has raised questions regarding its status as a private sector company. The Office for National Statistics (ONS) has determined that Network Rail’s expenditure and liabilities will not count as public sector expenditure (Darling 2002, col 972). In contrast, however, the head of the National Audit Office (NAO), Sir John Bourne, has suggested that Network Rail should be accounted for as a subsidiary of the SRA and should appear as part of the SRA’s accounts on the basis that ‘the Government is the party bearing the risk that would normally be borne by equity capital’ (National Audit Office 2002).

The contradictory decisions of the ONS and the NAO have been resolved to some extent by the Statistics Commission, an independent body set up ‘to help ensure National Statistics are trustworthy and responsive to public needs’ (http://www.statscom.org.uk). The chairman of the Commission, Sir John Kingham, indicated that while the ONS had applied properly international accounting conventions, the ONS and the NAO should produce a joint statement on the reasons for the differences in their approach that should indicate ‘the conditional nature of the classification decision, the possible scale of the Government’s guarantees and the likelihood of their being called in...’ (Statistics Commission 2002). While the extent of the Government’s financial commitment in respect of Network Rail will be dependent upon its success in raising revenue sufficient to cover its debt repayments, it is clear that substantial state funds have already been employed in the initial stages of Network Rail’s creation.

In order to gain control of the British railway infrastructure, Network Rail was required to submit a bid to the administrators of Railtrack for the purchase of the beleaguered company’s assets. The bid of £500 million proved successful with the major part of it, amounting to £300 million, being supplied by the Government. Although seemingly uncontroversial in and of itself, this contribution of state funds constituted a U-turn in Government policy and led ultimately to the resignation the then Secretary of State for Transport, Local Government and the Regions, Stephen Byers. His initial refusal to contribute state funds to what was effectively a compensation package for the private shareholders of Railtrack (Byers 2001, col 963) was reversed on 27 June 2002 (one month after Byers’ resignation) when Network Rail agreed with Railtrack Group to acquire Railtrack. Although the compensation package was less than had been hoped for, a majority of the shareholders of Railtrack’s parent company, Railtrack Group, voted in favour of the bid at an Extraordinary General Meeting held on the 24 July 2002 (http://www.railtrack-group.co.uk/news 25 July 2002).

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The degree to which Network Rail will prove successful in remedying many of the problems apparent within the rail system must, for the time being, remain a matter for speculation. The Government may take heart, however, from the apparent success of a similar project undertaken in Wales in respect of Welsh Water. Glas Cymru, a company limited by guarantee, purchased Dwr Cymru (Welsh Water) in May 2000. It now supplies water and sewerage services to over three million people living and working in Wales and some adjoining areas of England, with 1.2 million household customers and over 110,000 business customers (Glas Cymru 2002). In the twelve months to 31 March 2002, Glas Cymru announced profits of £24.1 million while simultaneously reducing the water bills of their customers, with customer bill rebates planned to be worth £23 million by 2005 (Glas Cymru 2002). The company has suggested, however, that comparisons with Network Rail are misguided:

While the company may claim that comparisons are unjustified, further research into the similarities between Network Rail and Glas Cymru may prove worthwhile. It is clear, however, that Network Rail has not enjoyed as smooth a ride in its first few months of existence. Controversy surrounding the compensation package paid to the shareholders of Railtrack coupled with the resignation of Stephen Byers and the ongoing question as to the company’s status as a private or public sector company have led to a less than auspicious beginning. While its future may well prove to be less controversial, it is possible to argue that these difficulties could have been avoided had the Government adopted a different corporate structure in respect of the successor to Railtrack.

Of the options available to the Government, Network Rail, a ‘public interest company’ (Darling 2002, col 971) funded partly by private debt finance and partly by Government subsidy but privately managed, would appear to be the most appropriate. A purely private company, guided by the goal of ‘profit maximisation’ (see Hopt and Teubner 1985 and Parkinson 1996), would have looked a little too much like Railtrack and a purely public company would have led to accusations of re-nationalisation, a claim which the current Labour Government would be keen to avoid (see Whitehouse 2003). What the Government appears not to have considered, however, is a further option which falls somewhere in between the structure adopted by Railtrack and that adopted by Network Rail. This alternative can be described as a ‘government sponsored enterprise’ (GSE), which makes use of private equity finance in the achievement of public policy goals, thereby avoiding significant direct state subsidy and any question regarding its classification as a private sector enterprise.

The extent to which this corporate structure would prove successful in replacing Railtrack requires further analysis but comparisons within the United Kingdom are difficult to find. There is, however, a working example available in the form of a GSE currently operating in the US, called Fannie Mae. The following section of this article offers an account of Fannie Mae, its structure and operations and, in offering it as an alternative to Network Rail, highlights the advantages to be gained in making use of the GSE model. Before moving on to this account, however, it is necessary to take note of the reservations expressed in relation to the efficacy and reliability of the comparative study method (see, for example, Doling 1997, chapter 2). One such reservation, directly relevant to the account which follows, is that the organisation or regime under inspection may be so context-specific as to offer no insight into the operation of Network Rail.

Despite the very specific nature of the United States system, however, an examination of it can still prove helpful, as Zweigert and Kotz (1998, p 39) argue, ‘different legal systems give the same or very similar solutions, even as to detail, to the same problems of life, despite the great differences in their historical development, conceptual structure, and style of operation.’ While it may be possible to point to specific differences between Network Rail and Fannie Mae regarding matters such as their customer-base, scope of operation, assets and income-source, the objective, in offering this account, is not to suggest that Fannie Mae can be readily transposed onto the European or domestic railway structure. Rather, it seeks to offer an alternative vision of the role played by the state and state funding in the management and operation of national assets. To this extent, therefore, this research project falls within the category of comparative studies, ‘which analyse objectively and systematically solutions which various systems offer for a given legal problem’ (Cruz 1999, p 7). Fannie Mae serves as perhaps one of the most relevant, practical and arguably successful examples of this alternative solution.

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Fannie Mae, a privately owned company with stock traded on the New York, Pacific and Chicago Stock Exchanges, operates within the secondary mortgage market in the US, purchasing mortgage loans from primary lenders, such as commercial banks, and reselling them as Mortgage-Backed Securities or retaining them in its portfolio. Although the loans purchased are serviced by the originating lender, Fannie Mae’s income is made up of both the principal and interest payments on these loans. Its size and significance within the secondary mortgage market is significant. In addition to being the third largest corporation, in terms of assets, within America, with a core capital of $23.8 billion (http://www.fanniemae.com/news), the corporation also, ‘currently owns in its portfolio, or holds in trust for investors, one out of every five mortgages in the US’ (Fannie Mae 1999, p 3).

Established in 1938 as a Government agency, the Federal National Mortgage Association (now called Fannie Mae) was created, at a time of severe economic decline, to ensure the flow of funds into the primary mortgage industry and to, ‘bring stability to the United States housing market’ (Fannie Mae 1999, p 3). Fannie Mae’s role within the secondary mortgage market was originally restricted to the purchase of Federal Housing Administration insured mortgages but the gradual extension of its purchasing capacity culminated in the Housing and Urban Development Act of 1968 (referred to as the Charter Act) which converted Fannie Mae from a Government agency to a privately owned company limited by shares (Jacobs et al. 1982, p 193).

Despite being privately owned, Fannie Mae is classified as a GSE, as is its major competitor (and essentially its twin) within the secondary mortgage market, Freddie Mac. As Barry explains, these GSEs ‘are stockholder-owned corporations, and therefore private, but chartered and overseen by the federal Government, and therefore public’ (Barry 1996, p 2). In order to ensure that Fannie Mae satisfies the objectives set out in its charter, the Government maintains a high level of control over the internal decision-making processes within the company by virtue of its control over the composition of the board of directors.

Unlike Network Rail, which has only one non-executive director appointed by the SRA, of the eighteen directors which make up Fannie Mae’s board, thirteen are elected by the shareholders, and the remaining five are appointed by the President of the United States (Fannie Mae 1999, p 3). Of the five designated directors, one must come from the mortgage lending industry, one from the real estate industry and one from the construction industry (Aaron 1972, p 94). It is interesting to note that despite the representation of these various interests, Fannie Mae has proven successful in meeting its charter requirements. This may bode well for Network Rail and its representative board and membership structure, but Fannie Mae’s success derives, in large part, from the establishment of clear and attainable objectives, a factor which the United Kingdom Government must ensure exists in respect of Network Rail.

The regulatory framework surrounding Fannie Mae exhibits characteristics similar to that which operates in respect of the British rail network. In the first instance, Fannie Mae operates under charter in a manner similar to Network Rail’s operation under licence. Secondly, that charter is overseen by the Department of Housing and Urban Development (HUD) with the Secretary of HUD being given ‘general regulatory authority’ (Jacobs et al. 1982, p 194) over Fannie Mae’s operations in much the same way as the ORR monitors the activities of Network Rail. Upon closer inspection, however, it becomes clear that the two companies differ quite significantly in respect of the Government’s involvement, both financial and regulatory.

In comparison with Network Rail’s substantial financial support from the SRA, Fannie Mae receives no direct state subsidy. Its income derives from private equity finance, interest accruing on the loans that it purchases and the private finance markets. Its ability to raise funds in these markets is assisted by its status as a GSE, but whereas the United Kingdom Government made explicit its liability to cover the debts of Network Rail, the United States Government has given only an implicit guarantee in respect of Fannie Mae’s debts. While it may be possible to argue that the demise of Railtrack and the Government’s refusal to assist it financially necessitated the provision of an explicit guarantee in order to instil confidence in Network Rail, a government as well versed in the art of ‘spin’ as the current Labour Government could have made its intentions clear without the need to make explicit the full extent of its liability.

The benefit to be gained in adopting the ‘implicit guarantee’ approach is that it leaves open to question the Government’s financial commitment in respect of the company’s debts but creates the same level of confidence in those willing to lend to the company. As Konstas suggests, the perception that Fannie Mae has ‘the equivalent of the full faith and credit of the U.S. Government’, results in the company having, ‘advantages in raising funds similar to those of the insured deposits at banking institutions’ (Konstas 1997, p 945).

The apparently independent and private nature of Fannie Mae’s finances has resulted in its classification as a ‘private sector company with a public mission’ (taken from an interview with representatives of Fannie Mae June 2001) which, unlike Network Rail’s current position, leaves no room for ambiguity regarding its omission from the Government’s balance sheet. Although both the United Kingdom and United States systems make use of a contingent liability, the potential for this liability to be called in is so remote that the United States Government’s implied liability is not classified as equivalent to public funding, as Popper suggests.

This is not to suggest, however, that Fannie Mae does not receive any state funding. Fannie Mae’s hybrid status as a GSE offers a number of privileges including access to credit offered by the Federal Treasury should the company be unable to raise funds in the private capital markets (Jacobs et al. 1982, p 194), and exemption from state and local taxes in respect of the ‘Government securities’ that it issues (Dykes 2001, p 1). These indirect subsidies, however, do not affect its status as a private sector company and are enjoyed at a small but not insignificant cost to Fannie Mae’s private status. In particular, the company’s lending capacity is restricted to domestic mortgages with limits placed upon the amount of the loan for different types of dwelling, with a maximum loan limit of $275,000. Fannie Mae is also expected to achieve a number of goals laid down by HUD, including primary focus being given to mortgages for low and moderate income families particularly within city centre areas (Konstas 1997, pp 946-7), as Barry explains.

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It would appear, having undertaken a review of Fannie Mae’s internal governance structure and funding sources that, had the United Kingdom Government made use of the GSE format, it would have obtained increased control over Network Rail at a much reduced price. The savings made as a result of the use of private equity finance rather than state subsidy, however, would appear to involve the pursuit of profit maximisation and the payment of dividends to shareholders, a factor which, it is claimed, led to Railtrack’s poor investment record. The potential for conflict between the profit motive and its public mission has been recognised by Barry, who suggests that the dual personality of a GSE

A review of Fannie Mae’s activities, however, indicates that it employs ‘profit optimisation’ (see Sheikh 1996) and not profit maximisation, thereby ensuring responsible investment activity coupled with an ability to pay dividends to its shareholders. One example of such activity is Fannie Mae’s ‘Trillion Dollar Commitment’. In 1994, the chairman of Fannie Mae pledged a trillion dollars of finance to assist at least ten million families within the United States to obtain mortgage finance. That commitment was achieved in early 2000 and by April 2000, a further two trillion dollars were promised as part of the ‘American Dream Commitment’ with a target of assisting eighteen million families during the next decade. As Fannie Mae’s literature explains

In addition to this Trillion Dollar Commitment, Fannie Mae has attempted to broaden the range of potential home owners so as to include minority families and those with credit ratings which fall below levels currently demanded by mortgage lenders. To this end, Fannie Mae has focused upon the provision of information and education programmes to inform potential home owners of the rights and responsibilities of home ownership.

Fannie Mae’s commitment to and success in achieving its public policy objectives, as set out in its charter, enables it to earn substantial profits despite its significant investment programme. In the third quarter of 2001, for example, Fannie Mae achieved an operating net income of $1.377 billion (http://www.fanniemae.com/news). Its ability to operate on a profitable basis is due in some respects to its status as part of a duopoly, working in competition with Freddie Mac, the two together dominating much of the secondary mortgage market. This, of course, highlights another similarity between Fannie Mae and Network Rail except that the latter enjoys a monopoly position within the British railway industry. In criticising and seeking reform of the privileged status afforded to these GSEs, Dykes has called for the privatisation of Fannie Mae and Freddie Mac on the basis that it, ‘would subject them to more stringent market regulation, create competition, and heighten consumer choice’ (Dykes 2001, p 1). It would seem reasonable to suggest that those calling for the privatisation of these two GSEs take note of the experience of Railtrack within the British rail system.

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It is perhaps not surprising that a Government committed to fostering relationships between the state and the private sector (Giddens 1998, p 64) has chosen to retain the use of a private capital structure in the ownership and operation of the British railway infrastructure. The retention of the profit motive within a private management structure, however, has been combined with the rejection of private equity finance in preference for significant public funding. The outcome for the Government is a degree of control equivalent to that which it exercised in relation to Railtrack at a significantly increased price.

What this paper has shown is that an alternative proposal available to the Government, in the form of a GSE, would have avoided many of the concerns raised in respect of Network Rail. In the first instance, the use of private equity finance would have avoided the United Kingdom Government’s need to provide £300 million in the purchase of Railtrack and the consequent U-turn in policy. Secondly, the provision of an implicit guarantee by the Government in respect of the repayment of Network Rail’s debts would have achieved the same level of confidence within the finance markets as that achieved by the provision of an explicit guarantee. In addition, the private nature of the funding supplied to Network Rail would have avoided any ambiguity in respect of its classification for accounting purposes.

Despite these advantages, the Government, for whatever reason, has failed to take advantage of a corporate structure that has been tried and tested in the United States and found to be beneficial to the state, the homeowner, the shareholder and the economy. The extent to which this oversight becomes a matter of regret may take years to establish but if the first few months of Network Rail’s existence prove to be indicative of its future success, the Government may yet have reason to consider the introduction of a GSE.

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