the third meeting of the latin american corporate governance roundtable

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The Third Meeting Of The Latin American Corporate Governance Roundtable

Eliane Aleixo Lustosa Mexico City, April 8th - 10th, 2002

Main Board Issues in Latin America

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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

SummarySummary

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Assets of Pension Funds / GDP

0,00%

2,00%

4,00%

6,00%

8,00%

10,00%

12,00%

14,00%

16,00%

18,00%

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Brazilian Pension Funds Industry:Brief OverviewBrazilian Pension Funds Industry:Brief Overview

Source: ABRAPP

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Brazilian Pension Funds Industry: Brief Overview

Brazilian Pension Funds Industry: Brief Overview

Pension Funds’ presence in the Stock Markets (2)

- Present - 11.7%

- Potential - 22.3%

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)

(1). Source: Abrapp. August, 2001.

(2) Considering Brazilian MarketCap of US$ 166.7 billion.

Pension Funds’ Total Assets : US$ 62.0 billion (15% of GDP) (1)

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( A ) ( B )

1 day 1 month

Brazil 0.3 6.5 19.5

US 47.6 1,000 5,000

Source: NYSE, BOVESPA, ABRAPP, BLOOMBERG, Petros

OBS: Time necessary to divest the whole portfolio: Brazil= 3 months, USA= 5 months

Brazilian Pension Funds Industry: Brief OverviewBrazilian 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

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Petros is a non-profit private organization, established in 1970 as the

pension fund for the employees of Brazil’s 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);

Petros Investment PolicyPetros Investment Policy

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US$ thousands (%)

FIXED INCOME 4.334.556 70,45%

Governament Bonds 2.777.876 45,15%

Private Bonds 1.556.679 25,30%

VARIABLE INCOME 1.065.265 17,31%

REAL ESTATE 400.125 6,50%

LOANS TO PARTICIPANTS 142.889 2,32%

PROJECT FINANCE 209.685 3,41%TOTAL 6.152.520 100,00%

AssetsDecember 2001


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Energy 10.72%Mining 6.71%Telecom 3.20%Food 2.52%Pulp & Paper 1.57%Petrochemical 0.78%Others 2.70%


EQUITY PORTFOLIO: US$ 1.10 BILLION

PRIVATE EQUITY FUNDS

3%

CONTROLLING STAKE29%

STOCK PICKING20%

PROJECT FINANCE20%

INDEXED TO IBOVESPA28%

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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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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

Security’s 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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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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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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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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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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New Brazilian Corporate Law: main backward step

Most of the Shareholders’ Agreements signed by Pension Funds,

basically during the 90’s, 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 company’s interests;



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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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Law 10.303/01 main backward step: an example

The management of a Telecom company was asked to provide

information about the company’s participation in an airplane consortium

The CFO brought some amazing information:

- after taking part in the consortium, the company’s 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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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 evidencePF 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 Shareholders´Agreements to

have additional protection to balance the lack of minority rights in

the capital market;

In the 90’s, with the beginning of Brazilian Privatization Program,

Pension Funds decided to acquire shares in controlling stakes to

be more close to the company’s day by day decisions;

As a consequence, PF became “minority shareholders” that took

part in a “controlling shareholders’ block”;

PF´s fiduciary duties obliged them to be active shareholders.

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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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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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cont.

- Aiming at controlling the company’s 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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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 company’s 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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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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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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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 shareholder´s 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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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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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.

What happened


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ConclusionsConclusions

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 don’t 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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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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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.

the third meeting of the latin american corporate governance roundtable

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