The Third Meeting Of The Latin American Corporate Governance Roundtable

1. 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

2. Summary 1.BrazilianPension Funds Industry: brief overview 2. Petros Investment Policy 3. PF and Capital Market: regulatory framework 4. PF and Corporate Governance: empirical evidence 5. Conclusions

3. Brazilian Pension Funds Industry:Brief Overview Source: ABRAPP

4. 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.

5. 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

6. Petros Investment Policy • 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);

7. Petros Investment Policy

8. Petros Investment Policy

9. 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.

10. 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;

11. 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.

12. 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.

13. 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.

14. 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;

15. 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.

16. 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 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;

17. 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.

18. 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 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 ...”

19. 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.

20. 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 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.

21. 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.

22. 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;

23. PF and Corporate Governance: empirical evidence 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.

24. 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 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.

25. 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.

26. 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.

27. 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 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.

28. 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.

29. 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.

30. 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 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.

31. 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.

32. 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.