Brazil - The rights and wrongs of government

"The privatization programme has been very aggressive but the government continues to be the largest minority shareholder in the country," says Gabriel Wallach, in charge of Latin American equities at Baring Asset Management in Boston. "They are proposing to change the law to improve minority rights. My investment philosophy in the Brazilian privatization programme has been always to hold the class of share that would benefit the government."

The existence of two classes of shares in Brazil, only one with voting rights, has been a source of controversy for many years. In a number of cases the purchasers of control, often foreign multinationals, have used their leverage to buy out the minorities - which usually hold non-voting preferred shares - at rock-bottom prices. Although there is little or no chance of the law being revised to abolish this distinction between share classes, what is proposed will give minorities greater powers and restore their rights to sell shares to new owners at comparable prices when control changes. This right was axed in the 1997 Kandir Law just ahead of the privatization programme.

"Minority rights in Brazil are improving, and are likely to continue to improve, although there will still be some important differences between this market with its civil law code and the US and the UK with their common law," says Thomas Atkinson, director of equity research at ING Barings in São Paulo. "Rather than making decisions according to principles such as that of the reasonable man or the normal course of duty, in Brazil judges go by the letter of the law and every issue has to be covered by a specific piece of legislation. So no matter what law is passed creative controlling shareholders may sometimes find ways to circumvent rules."

Over the past 18 months battles between minorities and controllers have led the securities regulator the Commisão de Valores Mobiliaros (CVM) to issue instructions that have beefed up the rights of minorities and paved the way for new legislation. The most high profile case was that of Telesp, the São Paulo telephone company, which was bought by a consortium led by Spain's Telefónica in a privatization auction.

Strategic buyers of Brazilian telecom assets paid the government a large premium for control, partly in the knowledge that the country's lop-sided corporate law would allow them to take advantage of tax benefits disproportionately to other shareholders and buy minorities out cheaply.

The Kandir Law actually gave the government an advantage at two stages of the process. First, it allowed the splitting of holding company Telebrás into 12 companies rather than selling subsidiaries, which would have meant sharing the control premium with minorities and paying income tax on the profit, almost half of which would have gone to state and municipal governments rather than the federal one. Second, by abolishing appraisal or withdrawal rights of shareholders of actively traded companies to sell shares back to the company, when a company is split up or merged, it paved the way to further disadvantage minorities after the sale.

"Privatization was done this way [selling strategic stakes at a premium] because government needed hard cash to support the real," says Roberto Rocha, equities director with Deutsche Bank in São Paulo. "The government still has electricity and power generation to privatize and the signs are that it could do a partial pulverization [selling small amounts of shares to many individuals] with these but it will first need to change the law regarding minority rights."

This proposed reform and a new CVM ruling in December come too late, however, for Telesp minorities who were diluted when the controlling consortium increased its stake from 13% to 20.6%. Telefónica's aim was to realize the tax value of the R4 billion ($2.2 billion) control premium which formed part of the R5.8 billion purchase price. The premium counted as goodwill and could be amortized over five years at R800 million a year giving a tax offset of R272 million, worth a total of R1.01 billion net present value using a discount rate of 12.5%. Since a controlling consortium is unlikely to have sufficient income to take advantage of this benefit the Telefónica consortium decided to sell it to Telesp paid for with new Telesp shares.

Apart from concerns about dilution and the discount rate used, minorities worried about paying in advance for a tax concession that could never come to fruition, given that tax rules in Brazil change frequently. Under new CVM rules the share payments for tax benefits can only be made yearly as they arise and if they can be used. Though other companies' restructuring plans are caught by the ruling, the Telesp one received shareholder approval three days before the change and sneaked through.

Telefónica, which has since announced plans to take private Telesp and three other Latin American subsidiaries, has incurred the wrath of minorities over various issues, another being the price paid for internet assets transferred to a new company, Terra Networks.

"Telefónica was not managing the companies to the benefit of the minority shareholders in Latin America," says Baring's Wallach. "They wanted value created for shareholders in Spain. I am not sorry to see the subsidiaries delisted."

One Brazilian private banker feels that Telefónica muddied the waters for others. "They took huge advantage of the minorities and now others can't restructure in the same way even if they treat minorities fairly." This banker foresees considerable corporate restructuring ahead of the next set of reforms likely to become law later this year in a bill sponsored by federal deputy Emerson Kapaz, a toy manufacturer from São Paulo.

One of the cases that inspired Kapaz to seek changes in the law was that of JC Penney's treatment of minorities in Brazilian store chain Lojas Renner in late 1998. After buying control from the firm's family owners, JC Penney, advised by CSFB Garantia, then offered preferred shareholders two prices: R25 for the first tranche of 1.2 billion shares and R20.49 for the remaining 480. The idea was to inject a degree of urgency into the proceedings with minorities rushing to sell at the higher price and fearing getting stuck with illiquid stock. The price paid for the controlling shares was not disclosed. The prices offered for the preferred shares were slightly above market value but the market was very depressed following the Russian crisis. A number of other multinationals took advantage of this situation to buy out minorities in their Brazilian subsidiaries.

But gone are the days in Brazil when minorities accepted their fate lying down. Rio de Janeiro-based fund manager Dynamo had about 10% of Lojas Renner stock, including voting and preferred shares, and was determined to get a better deal. Dynamo managers were particularly incensed because they had spent a lot of time advising Lojas Renner on its capital structure and use of management incentives such as stock options. Even though Dynamo had a representative on the board it heard nothing about the final deal until it was announced.

The fuss created by the minorities in Lojas Renner led to the first of the two recent CVM instructions in February 1999. This states that if the controlling shareholder buys 10% or more of any class of share a public offer must be made to shareholders of the same class. Furthermore, if one-third of minorities in a class agree to sell to the controlling shareholder, a new offer for all the remaining shares is necessary. "This is to prevent controlling shareholders from buying minority shares in stages at progressively lower prices as liquidity dries up," says ING Barings' Atkinson in a paper entitled "Brazil's rising shareholder protection". The new CVM rules also state that when control changes the prices have to be made public.

The irony is that most of the arguments over minority rights in Brazil have involved foreign companies taking advantage of rules that are less stringent than those in their home countries. "It's a strange thing. We supposed that if a US firm buys a Brazilian firm, minorities would get the same treatment as in the US [the launching of a general offer] but it doesn't work like that," says Pedro Eberle, a partner in Dynamo.

In fact the reverse has been the case. Multinationals have decided it's worth paying a hefty control premium for Brazilian assets because they can get away with short-changing minorities. Although multinationals are now much more cautious about degrading the environment or employing child labour in emerging markets, for fear of the consumer backlash in their home countries, the cause of shareholders' rights has not yet become internationalized.

Fortunately in Brazil the self-interest of the government is bringing about reform. Under the corporate law proposed by Kapaz the withdrawal rights that suffered under the Kandir law are set to be reinstated where the free float falls below 20% and in the cases of dissolutions, split-ups, mergers and incorporations. It's also proposed that when control changes, minorities have the right to sell at 80% of the price paid for control, and preferred shareholders with 15% of stock can elect a board member.

"Today if you want to close a listed company or make an offer you just need the approval of the guy who has voting shares. Under the new bill you will need agreement of the class of shareholders you are going to redeem," says Ana Novaes, of fund managerPictet Modal. But Novaes adds that a recent proposal to make the changes dependent on a company's bye-laws could scupper the whole reform. A company could just change its bye-laws to negate the new law.

The board structure of a Brazilian company is another tricky area. The real power lies in the administrative board but it is unusual for anyone but the controlling shareholders to have seats there. Minorities with large blocks might get representation on the fiscal council but this has no power.

"Things are not working the way they are," says Sergio Goldman, head of equity research for Santander Investment in Brazil. "It might be necessary to make the functions of the fiscal board more explicit as well as how the minorities participate in it. More broadly there could be a case for reducing the proportion of preferred shares from two-thirds of the total to 50%. Abolishing preferred shares altogether is unrealistic."

It's the relationship between voting shares and preferred shares that is the crux of shareholder rights problems in Brazil and has led to a certain amount of cynicism among investors. When asked about the problem of minority rights one fund manager replies: "Minorities don't have rights in Brazil only obligations."

The system was devised in Brazil with the aim of allowing family companies to list while retaining control. But since voting shares can be as little as one-third of the total, a family can keep control by having just over half the voting shares amounting to only 16.7% of total capital. If a holding company is used to participate in the operating company control can be maintained with only 2.8%.

It's not only the proportions that have led to abuses. Originally, preferred shares were supposed to function like their namesakes elsewhere, providing a fixed dividend, calculated as a percentage of nominal paid-in capital, as the reward for not having voting rights. But in periods of high inflation companies took to paying out the dividends just before revaluing the capital in their books so that the dividends were almost worthless. Now some analysts would like to see all shares turned into voting shares but given the impact on family owners this would be politically unacceptable and would also be going back on a legal contract.

"There was an idea to give preferred shareholders the same rights as ordinary shareholders but that would mean going to companies like Telefónica and saying: 'Actually you didn't buy control you only have 20% would you like to buy some more?' " says ING Barings' Atkinson. "The other possibilities are to say no more new preferred shares, to change the proportions of the classes to 50% each, or to say the proportion of voting shares in a company cannot deteriorate further."

Minority rights campaigners have been heartened by recent statements by government officials. The new president of the CVM, Jose Luis Osorio de Almeida Filho, said during his inauguration that the commission was committed to protecting minority shareholders, specifically mentioning the cases of dissolution and liquidity reduction. Osorio's appointment breaks with a trend of having lawyers at the helm of CVM. Osorio is an investment banker who has worked at Garantia, Icatu and Lehman Brothers so has first-hand knowledge of the issues. His previous position was privatization co-ordinator at the development bank BNDES where he stated that the government would not go ahead with pulverization without mechanisms to protect minorities. Osorio is close to central bank governor Arminio Fraga and finance minister Pedro Malan who are both committed to improving capital-market efficiency.

The debate over whether future privatizations in Brazil should be done by pulverizing or selling strategic stakes or a combination of the two, the favourite option, is very much alive. Under this latter option the government would sell strategic stakes and then pulverize the minority holdings. This could apply to the government's minority holdings in Companhia Vale do Rio Doce and Petrobrás (where it also holds the controlling stake). These two stakes alone have a market value of R15 billion, which could increase with better minorities legislation since it would affect the price the strategic holders might eventually pay for minority interests. No wonder the government wants to reform the law.

Is the government in danger of going too far in favouring minorities now that its own interests are parallel to theirs? Some have expressed concern about the rise of the professional minority activist in Brazil, buying into situations where he is likely to be bought out and then creating noise to get a higher price.

"It's certainly not ethical to buy control and then expel the minorities but nor is it ethical for an asset manager to buy into a company simply to make money out of his position in subsequent sale negotiations," says a senior executive with a Brazilian bank. "Finding the right balance is not going to be easy."

Some anlaysts feel the government would have fewer difficulties if it hadn't changed the law on minorities so completely in the first place. "It was a terrible mistake to change the law to allow the privatizations to happen," says one. "It would have been better to have made changes that just covered privatizations and not to affect all companies. The new corporate law has rules only for privatizations." What is interesting is what will happen to corporate law after the privatization programme is finished? Perhaps with the government no longer a shareholder it will then finally be able to take a more detached view of what should happen.

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