The Third Meeting Of The Latin American Corporate Governance Roundtable

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The Third Meeting Of The Latin American Corporate
Governance Roundtable
Main Board Issues in Latin America
Eliane Aleixo Lustosa
Mexico City, April 8th - 10th, 2002
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Summary
1. Brazilian Pension Funds Industry brief
overview 2. Petros Investment Policy 3. PF and
Capital Market regulatory framework 4. PF and
Corporate Governance empirical evidence 5.
Conclusions
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Brazilian Pension Funds IndustryBrief Overview

Source ABRAPP
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Brazilian Pension Funds Industry Brief Overview

• Pension Funds Total Assets US 62.0 billion
  (15 of GDP) (1)

• Pension Funds Investments In Equity (1)
• - Present - US 19.5 billion (32 of Total
  Assets)
• - Potential - US 37.2 bilhões (60.0 of Total
  Assets)

• Pension Funds presence in the Stock Markets (2)
• - Present - 11.7
• - Potential - 22.3

(1). Source Abrapp. August, 2001. (2)
Considering Brazilian MarketCap of US 166.7
billion.
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Brazilian Pension Funds Industry Brief Overview
Monthly average trading volume in Bovespa, NYSE
and Nasdaq from Jan to May, 2001 US billion
Total Pension Funds Equity investments US
billion
( B )
( A )
1 day
1 month
19.5
0.3
6.5
Brazil
5,000
47.6
1,000
US
Source NYSE, BOVESPA, ABRAPP, BLOOMBERG,
Petros OBS Time necessary to divest the whole
portfolio Brazil 3 months, USA 5 months
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Petros Investment Policy

• Petros is a non-profit private organization,
  established in 1970 as the pension fund for the
  employees of Brazils state-owned oil company,
  Petrobras
• Petros is a multi sponsored Plan. Currently, it
  has 23 sponsors, 17 are private companies and 6
  are state-owned
• Petros has more than 90 thousand participants
• Petros is the second largest pension fund in
  Brazil (US 6.2 billions assets)

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Petros Investment Policy


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Petros Investment Policy
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Petros Investment Policy

• As a major shareholder, Petros has the ability
  to indicate members of Board of Directors in 14
  listed Companies, operating in sectors such as
  energy, telecom, capital goods, food, textile and
  petrochemicals
• Petros also appoints 5 members of Consejos
  Fiscales in different companies.

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Petros Investment Policy

• In the past, Petros used to appoint Petrobras
  retired employees that had not exactly the right
  profile to accomplish their duties as Directors
  and members of Consejos Fiscales
• Main problem they usually became captive of the
  managers objectives and were not concerned about
  the investment return for the shareholders they
  were supposed to represent
• Nowadays Petros appoints only external
  professionals and its own executives and officers
  with experience in corporate issues and the
  ability to perceive eventual controlling
  shareholders and management misbehavior

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Pension Funds and Capital Market Regulatory
Framework

• GOVERNAMENT ENTITIES
• Conselho Monetário Nacional (CMN) - council
  that, amongst other responsibilities, rules the
  investment of pension funds assets and reserves
• Secretaria de Previdência Complementar (SPC) -
  Ministry of Social Securitys agency in charge of
  supervising pension funds
• Comissão de Valores Mobiliários (CVM) - agency
  that encompass all matters related to the
  Brazilian Securities Market. CVM is equivalent to
  the Securities Exchange Commission (SEC) in the
  USA.

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Pension Funds and Capital Market Regulatory
Framework
Federal Constitution - Art. 202 determines that
pension funds legal framework is independent
from the Social Security System. Joining a
private pension fund is facultative Resolution
CMN 2.829 and 2.850 Set guidelines for asset
allocation, investment policy and other
procedures Federal Law 6.404 The Brazilian
Corporate Law Law 10.303 Alters and adds
provisions to Law 6.404 and Law 6.385, which
governs the securities market and creates the
Brazilian Securities Commission, respectively.
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Pension Funds and Capital Market Regulatory
Framework

• Improvements in the Brazilian corporate
  governance scenario
• The Brazilian Development Bank (BNDES) intends to
  adopt more selective criteria in terms of
  corporate governance in order to finance
  companies
• The Brazilian Securities Commission (CVM) made a
  great effort to approve a new Corporate Law, that
  brings additional protection to minority
  shareholders
• Bolsa de Valores de São Paulo (BOVESPA) created
  three different levels of companies, according to
  their corporate governance rules
• Brazilian Federal Agency in charge of
  supervising pension funds (SPC) determined that
  they shall publicize their votes in Shareholders
  Meetings.

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Pension Funds and Capital Market Regulatory
Framework

• New Brazilian Corporate Law main improvements
• Tag Along - in case of direct or indirect
  transfer of control. Condition public offer to
  acquire the voting shares owned by the remaining
  shareholders, paying 80 of the amount granted,
  per share, for the controlling block
• Board of Directors Election - shareholders
  representing 15 of shares without voting rights
  or with restricted voting rights shall have the
  right to elect and remove a member from the board
  of directors in a separate election
• Non voting shares - the number of non voting
  shares, or subject to restriction on voting
  rights, may not exceed fifty percent of all
  issued shares

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Pension Funds and Capital Market Regulatory
Framework

• New Brazilian Corporate Law main improvements
• Delisting of a publicly-held corporation.
  Condition public offer to acquire all the
  outstanding shares for a fair price. Criteria a)
  net assets appraised at market value b)
  discounted cash flow c) comparison by multiples
  d) share price in the stock market
• Disclosure of the Consejero Fiscal opinion,
  including all dissident votes, in the Annual
  Shareholders Meeting
• Prohibition to officers to hold a position in a
  competing company, specially in the board of
  directors or Consejo Fiscal
• Arbitrage corporations by-laws may establish
  that any disputes can be solved by arbitrage.

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Pension Funds and Capital Market Regulatory
Framework

• New Brazilian Corporate Law main backward step
• Most of the Shareholders Agreements signed by
  Pension Funds, basically during the 90s,
  established a very limited role to the Directors
  elected under the terms of the Agreement all
  the subjects are decided in a so called
  Shareholders Previous Meeting (Reunião
  Prévia), where the major shareholder has all the
  power to decide alone what will be the votes in
  the Board Meetings
• Pension Funds have learned, from their own
  recent experience, that simply following a
  previously taken decision (in the Reunião Prévia)
  may seriously harm the companys interests

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Pension Funds and Capital Market Regulatory
Framework

• New Brazilian Corporate Law main backward step
• Unfortunately, the new Corporate Law brought a
  major retrogression concerning the independence
  of Directors in relation to decisions of
  shareholders
• According to art. 118, the failure to attend a
  general shareholders meeting or a Board of
  Directors meeting, as well as the failure to
  vote on subjects specified in the shareholders
  agreement, by any part, or by members of the
  Board of Directors, elected under the terms of a
  shareholders agreement, assures the damaged
  party the right to vote with the shares belonging
  to the shareholder who is absent or remiss.

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Pension Funds and Capital Market Regulatory
Framework
Law 10.303/01 main backward step an example
The management of a Telecom company was asked to
provide information about the companys
participation in an airplane consortium The CFO
brought some amazing information - after taking
part in the consortium, the companys overall
traveling expenses increased, instead of
decreasing - the company prepaid, in April, the
whole year consortium expenses, although a
significant part were variable costs, that
depends on the hours of flight. As the company
controlling shareholder also controlled the
consortium, and was the main beneficiary of the
airplanes, he tried to constrain the Directors
appointed under the terms of the shareholders
agreement the company already has a regular
auditing and it would be expensive to hire a
special one ...
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Pension Funds and Capital Market Regulatory
Framework
Law 10.303/01 main backward step an example
The Directors, disobeying the recommendation,
asked for a special auditing of the consortium
financial statements With the new art. 118 in
Corporate Law, it will be much more difficult for
Directors to disobey a decision coming from the
controlling shareholder.
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PF and Corporate Governance empirical evidence

• Brazilian stock market is underdeveloped and
  preferred shares cannot be considered as parts
  of the company
• Pension Funds intended to use ShareholdersAgreeme
  nts to have additional protection to balance the
  lack of minority rights in the capital market
• In the 90s, with the beginning of Brazilian
  Privatization Program, Pension Funds decided to
  acquire shares in controlling stakes to be more
  close to the companys day by day decisions
• As a consequence, PF became minority
  shareholders that took part in a controlling
  shareholders block
• PFs fiduciary duties obliged them to be active
  shareholders.

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PF and Corporate Governance empirical evidence

• Pension Funds have been working together with
  BNDES , Bovespa
• and CVM (Brazilian Securities Commission) in
  order to achieve sound
• standards in Corporate Governance.
• The main measures adopted by Pension Funds to
  accomplish this task are
• - Appointment of board members who are highly
  qualified for the position
• - Joint actions, including legal initiatives
• - Close attention and assessment of strategic
  decisions taken by the
• executive boards
• - Pressure for higher level of disclosure and
  transparency
• - Supporting initiatives aimed at respecting
  minority investors interests
• - Supporting changes in the legal framework
  related to capital markets.

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PF and Corporate Governance empirical evidence

• How to achieve nose in fingers out?
• Case n. 1 valuation of assets controlled by a
  related party, to be bought by a listed company
• Controllers were already highly leveraged. The
  acquisition of the assets could be an opportunity
  to socialize their debt
• As a demand of the financing banks, the
  controllers needed minorities approval in the
  board of directors
• Pension Funds signed a MOU, with controlling
  shareholders, including the following main
  clauses
• - In order to avoid conflict of interests, the
  valuation of any asset owned by the controlling
  shareholder should be made by a top investment
  bank

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PF and Corporate Governance empirical evidence

• cont.
• - Aiming at controlling the companys leverage
  after the acquisitions, the MOU determined
  covenants such as debt / EBITDA ratio and
  interest coverage ratio
• For the first acquisition performed by the
  company, an investment bank was hired to make an
  independent valuation
• The bank did its job
• The result of the valuation came to the Board of
  Directors to be approved Petros officers did a
  very careful analysis of the assumptions and the
  DCF calculations
• Conclusion the investment bank had to
  acknowledge two huge mistakes one concerning the
  price of raw materials projections the other
  related to the way they calculated the
  perpetuity. Those mistakes represented a US 200
  million increase over the correct price.

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PF and Corporate Governance empirical evidence

• Case n. 2 capital goods company
• Consultants were hired by minority shareholders
  to make a diagnosis and concluded that the
  company had a good operational situation, but was
  financially weak (imminent default) because of
  mismanagement.
• Based on the consultants report, minority
  shareholders were committed to rescue the company
  under certain conditions. The signed MOU
  established i) dilution of controlling
  shareholders and ii) new management team in order
  to develop a restructuring plan
• The MOU also defined changes in the companys
  by-laws i) free convertibility from ON to PN
  ii) tag along rights iii) absence of a clear
  controlling block iv) deals involving
  subsidiaries and the parent company have to be
  approved by the Board of Directors.

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PF and Corporate Governance empirical evidence

• cont.
• Ongoing changes
• The company is negotiating with suppliers and
  banks to reduce total debt
• Assets out of the core business are being sold
• Dilution of majority shareholders will happen as
  a consequence of conversion of debentures bought
  in the past by minority shareholders
• Follow-up and pro-active contribution to the
  process by a Committee that includes minority
  shareholders.

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PF and Corporate Governance empirical evidence

• Case n. 3 entertainment sector company
• Business plan damaged by environmental problems
  exchange rate devaluation
• Company over leveraged (debt to equity ratio
  5.5x)
• Visitors and attendance below expectations
  (overestimated in business plan) ? insufficient
  cash flow
• Company in imminent default status
• Controlling shareholders proposed unacceptable
  capital restructuring only minority shareholders
  would have to subscribe new equity, injecting
  huge amount of cash and converting debentures
  into stocks under unfair price subscription.

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PF and Corporate Governance empirical evidence

• Cont.
• Solution
• Pressured by Pension Funds, shareholders and
  creditors (banks) made a tour de force in order
  to solve the financial imbalance and capital
  structure
• - postponement of loans and debenture maturity
• - 50 of debentures (held by minorities) were
  converted (at book value per share)
• - only 30 of total cash initially proposed by
  controlling shareholders were injected
• A new shareholders agreement was signed, with
  clauses aiming to guarantee corporate governance
  best practices, management auditing, veto power
  in specific subjects, right of first refusal, tag
  along and drag along clauses.

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PF and Corporate Governance empirical evidence

• Case n. 4 telecom sector companies
• WAP services, provided by XXX company, were
  offered to 4 mobile telecom companies, under
  disadvantageous conditions. XXX company was
  controlled by the same group that controlled the
  telecom companies.
• Board Members had to study the technical details
  of the proposal compared to the alternatives.

• Advantages of doing the job in house, instead of
  hiring XXX
• Lower operational costs
• Keep the strategic information related to
  clients (value added)
• High potential for other internet revenues
• Foreign operators chose to make it in house
  because of poor track record.

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PF and Corporate Governance empirical evidence
What happened
Initial proposition 1) One contract for each
telecom, not considering synergies. 2) Different
conditions for each telecom company 3) High of
revenues transferred to XXX 4) No warrants
concerning database ownership (clients) 5)
Telecom companies investment estimated in R 12.6
million.
Final proposition 1) One proposition for all
operators with economies of scale related to cost
per client 2) Same conditions for all
companies 3) Reduction of the 4) Warrant of
database ownership included 5) Reduction of R
2.6 million of the total amount.
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Conclusions

• The Brazilian capital markets scenario,
  specially the ability of minority shareholders to
  protect their investments, have improved a lot in
  the last two years
• - there is a huge concern of Brazilian
  regulatory agencies with the importance of
  minority shareholders protection to enhance
  capital markets
• - relevant institutional investors, like Pension
  Funds, are much more active in Shareholders
  Meetings and are beginning to be represented in
  Boards of Directors and Consejos Fiscales by
  more qualified professionals
• - the Brazilian Development Bank (BNDES) also
  plays a very important role in this process if
  the Bank uses good corporate governance criteria
  when selecting the projects that will be
  financed, and denies credit to those companies
  who dont follow good corporate governance
  guidelines ? companies will have to look for
  financing in capital markets ? they will have to
  cope with more organized and active minority
  shareholders.

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Conclusions

• More disclosure should be given to episodes of
  conflict of interest involving controlling
  shareholders (related parties). In case of
  misbehavior of third parties, specially banks,
  the regulatory agencies (CVM and the Central
  Bank) should have the appropriate instruments to
  punish. It is quite often that banks choose to
  favor the controlling shareholder, because of
  present and future relationship.

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Conclusions

• International financial investors should have
  the opportunity to exchange more information and
  discuss specific cases with local active minority
  shareholders.
• It would be valuable if international agencies
  like OECD and IFC help them to establish very
  strict criteria to invest and exert voting powers
  in publicly owned companies.