When the chips are down - Monday 9th of July 2007

It was clear Evan Davies had become the wrong man for the job. So a rise in share price rewarded Sky City for his exit as chief executive.

But has Sky City got the right culture for recovery? If it hasnt, the board has failed on governance. So a change of directors will be the first critical step to rehabilitation.

At the heart of the culture question is Sky Citys attitude to regulation. Its activities are so tightly controlled it needs excellent relations with regulators to maximise its potential. This isnt easy because it dominates the sector. It is essentially a bilateral relationship between one company and the government.

The company says it works very well with the Gambling Commission and the Department of Internal Affairs. Yes, they debate issues vigorously but all in the spirit of constructive progress.

But ask the regulators and you get a very different view. "Arrogance", "pushback", "they find it very difficult to accept regulation has changed", "its a cultural thing with them" are some of the responses you get.

And indeed regulation has change radically. Sky City was founded and flourished in the 1990s under a supportive regulatory regime. Regulators cared about probity and proper operations. But the legislation also had an economic development dimension. Gambling was seen as a boon to the tourism and entertainment sectors. By all accounts Sky City got on very well with Jock Irvine, chairman of the old Casino Control Authority.

But regulatory change began in 1999 when Judith Collins replaced him. In her term until 2002 when she became a National MP, she was more sceptical about the benefits of the gaming industry.

As a result, Sky Citys regulatory relationship became more formal and distant. Change accelerated when the Labour coalition took office late that year. New appointees to the authority took an even harder line on gambling.

The radical regulatory shift came in 2003 with the passing of a new Gambling Act. Out went the economic development remit; in came "harm minimisation" and other concepts to keep the lid on gambling.

Much of the regulatory function was taken over by the Department of Internal Affairs with the rest left to the Gambling Commission. The latter, which doesnt even have its own secretariat, is a far cry from the relatively independent Casino Control Authority it replaced.

The second big regulatory shift was the ban on smoking. Sky City handled it well by, for example, building outdoor balconies for smokers. Nonetheless, its casino revenues dropped some 12% in the first six months after the ban came into effect in December 2004.

To their credit, company and smokers have adjusted. By the middle of last year, smokers were spending less and less time away from the tables so casino revenues more or less recovered.

But Sky City is still struggling to find new ways to keep stimulating trade. At every turn it runs slap bang into the regulatory regime. Time and again on issues such as allowing larger notes, faster spins or eye- catching new formats for slot machines or faster dealing speeds on gaming tables it butts heads with the regulators.

The core problem is generic wording in the 2003 Act and subsequent regulation. They ban an increase in the "opportunity" to gamble. Sky City believes this means, for example, the regulators should fix the number of slots it can have, but leave it to decide how to develop them. The regulators, in contrast, see any development as an increase in gambling opportunity.

Seeking a ruling to back its view, Sky City took the government to the High Court. It lost and is appealing the decision. Both regulators and company say they welcome the case because they hope it will bring clarity.

Sky City deserves sympathy for the frustration of having this central issue unresolved three and a half years into the new regulatory regime. That said, its clear from the regulators side Sky Citys behaviour hasnt helped.

This is news to Rod McGeoch, Sky Citys chairman since 2004, and Patsy Reddy, deputy chair and a director since 1994 when Brierley Investments, then her employer, started Sky City. In interviews for this column, they both expressed surprise. They believe regulatory relations are constructive.

McGeoch added, however, that regulation was a management not a board issue. He said he had had no contact with the regulators for two years until he called to tell them Davies was quitting. Yet, regulation is the very issue on which Sky City will live or die.

This is symptomatic of a board too distant from its company and too willing to let a chief executive plough on long after the companys performance deteriorated under his leadership.

Davies deserves considerable credit for his achievements in the first eight years of his 11-year run as chief executive. Sky City was truly a start-up, needing Harrahs, a leading US casino company, to run it on a management contract. But Davies and his team learnt fast. They bought out early Harrahs contract and its 12.5% stake in the company.

They went on to other successes such as buying stakes in other New Zealand casinos, building the convention centre at Sky Citys Auckland complex and acquiring the Darwin casino; to under-performing investments such as cinemas here; to outright failures such as cinemas in Argentina; and to ventures that might yet pay off such as the Adelaide casino and the Sky Grand, its five star hotel in Auckland.

But since Sky Citys shares first hit $5 in January 2005, the company has suffered from volatile profits, dividends and share price and a weak balance sheet. It has offered its owners no net progress in nearly three years.

Last years result spoke volumes. Of $120m of net profit for the year ended June 2006, $24m came from one-off tax and foreign exchange gains from restructuring its capital.

"I was on the case in the lead-up to those numbers," McGeoch says. Yet, it took more than a year for the board to take decisive action on this second governance issues in the form of a change in chief executive.

In addition, the board has been too passive on a third governance issue: the employment of husband and wife in senior roles. Heather Shotter, one of the companys first employees, was appointed general manager of New Zealand operations in 2004. She was considered deserving of the job. But she was also married to Davies.

Sky City flouted a near-universal role of good governance. For the sake of transparency so staff know where they stand, you do not employ partners, particularly in senior roles and certainly not when one reports to the other, as Shotter did to Davies.

Instead, the board developed "relationship guidelines" on how they would behave to each other in the workplace and to colleagues. It also had to get special dispensation from the stock exchange to allow them to both participate in Sky Citys share options.

McGeoch says "they both behaved very professionally." Nonetheless, complexities arose. For example, the board not Davies was responsible for Shotters performance and pay reviews. Moreover, she gave a direct report to each board meeting on the patchy performance of NZ operations.

This and other aspects suggest a less than ideal working relationship. And it got even more curious. When Shotter left the company last August, Davies took on her role running NZ operations with no intention of hiring a replacement.

McGeoch says of Davies departure that a change of leadership was necessary "to get the best out of our people, to get people more together for a regeneration of culture and a fresh strategy."

He wont concede the company is suffering from regulatory failure too. Until he does and the board and company address it, Sky City will not maximise its potential.

But dont expect a mea culpa from the board anytime soon. It would amount to a confession of a third - and most crucial - failure of corporate governance. To borrow from baseball, three strikes and youre out.

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