Frustrating Expectations

What is a capital market?

In the past, the capital market was seen as a bunch of operators yelling on the phone, buying and selling shares. Such thing does not exist anymore. The technology has dematerialized the trading floor and made it easier to understand that the market is not that. The market is confidence. It’s an environment where buyers and sellers feel safe to trade assets. Investors need to know they will choose their investments based on genuine information. That the fund managers that will be managing their funds are competent and honest. And that they will be entitled to a proportional share of the invested companies’ results – whether they are positive or negative. When one buys 1% of a company, he/she must have 1% of its result. Not more than that – as he/she would be benefited on a disproportional basis – nor less than that, as he/she would be damaged.

That confidence goes beyond the compliance with laws and regulations. Given the complexity of the capital market relationships, there are a number of tacit agreements made among its participants that are as or even more important than formal agreements. A company that usually pays high dividends and suddenly stop doing so, with no further explanation, is not necessarily breaking the rules. But it’s certainly undermining the implicit agreements entered into with its investors, who will get disappointed and can opt to sell their shares. These tacit or implicit agreements are what the market calls as “soft law”, that is, “quasi-legal instruments.”

The implementation of the Novo Mercado by the former Bovespa – today B3 – was one of the world’s most successful self-regulatory initiatives in the past decades. By applying a checklist of critical governance items, the segment tried to avoid some of the most evident risks that can affect the fair treatment of minority shareholders. It was successful in most of its objectives. However, its credibility has been significantly affected over time as a result of actions taken by some companies listed in the segment. In most cases, these actions do not directly disobey the letter of the law – but affect its spirit, its essence, undermining the confidence of investors in the system as a whole.

Cosan was the first example of that. Accepted in the Novo Mercado, whose core principle is the “one share, one vote” concept, the company decided to restructure itself and created a holding in a tax heaven, with differentiated voting powers that imparted high financial leverage to the controlling shareholder. In practical terms, it broke the premise that its political power must be proportional to the allocated funds, in this case through a pyramidal structure, boosted by the offshore holding’s super voting shares[1].

Cosan also harmed the spirit of the Novo Mercado when it tried to take over the control of the then ALL with a high premium over the market value. The structure was based on the company’s shareholder composition, on its agreement with shareholders and on its bylaws. With that, another pillar of the Novo Mercado’s structure was damaged – the tag along right, that is, the right of all shareholders to be equally treated when a company is sold.

After that, others companies were sold without carrying out public offerings: Tenda, Grupo X’s companies, and Usiminas[2], among others.

The most creative case affecting the spirit of the special listing segments took place in 2015: the advent of Gol’s “super preferred” shares that, without even a pyramidal structure, allow a extremely high leveraged power to controlling shareholders.

Now we are witnessing another company joining the group of organizations that hide themselves behind the formalism, corroding the essence that inspired the creation of the Novo Mercado. Unfortunately, we are talking about a pioneering company – a company identified with the segment’s movement itself, the second one authorized to include the “NM” letter in its stock ticker symbol: Sabesp.

The São Paulo State Government submitted a bill to the Legislative Assembly, approved in the beginning of September, requesting the creation of a holding that will hold Sabesp’s control. The declared intention is to attract investors to the new company as they would bring additional capital to be invested in São Paulo’s basic sanitation system. The new company could even issue preferred shares. Hypothetically speaking, the government could continue to control the company, reducing its participation in Sabesp’s total capital from the current 50.3% to some 17%. Accordingly, it would be emulating the structure of the old “one third, two third” companies (that is, one third of shares with voting rights, two thirds of shares with no voting rights), allowed by the Brazilian law until the 2001 reform, which limited preferred shares to 50% of the capital.

Is the government doing something illegal? Definitely not…

To some extent, it is casting doubt on its own credibility. In its several prior public offerings, the Novo Mercado regulations were essential so that investors could feel comfortable to believe both in the company and in its controlling shareholder. Now, after receiving the funds of these offerings, the controlling shareholder distances itself from the concepts that guided the creation of the Novo Mercado, leveraging and creating an inherently more conflicting structure than the existing one.

Unfortunately, attracting private investors to a “controlling group” would not be sufficient to eliminate such conflicts nor mitigate the corporate governance problems that are inherent to state-owned enterprises. We have already seen other situations like that and the result was the creation of highly complex and inherently conflicting structures that proved to be costly to the company and shareholders. Cemig and Sanepar are only two examples of that.

Neither do we want to analyze the use of the new structure to attract private investments for an essential sector. But it’s important to note that, as part of an environment of realistic tariffs and in which agreements are respected, such investments could be made feasible by Sabesp itself or other operators, under a point of view of strict financial rationality. If shareholders agreements, bylaws, golden shares and other creative elements are needed to attract private capital, we may be dealing with lack of economic rationale.

Unlike the cases involving Gol and Cosan, – in which B3 could have used its discretionary power to ban or impede the corporate restructurings that made its regulations become ineffective – with the publishing of the new law, nothing can be done to prevent it from being implemented. As already mentioned, it does not directly disobey any existing law or regulation – only circumvents them.

The importance of the ‘one share one vote’ concept has been reiterated by institutional investors across the world. In countries where the protection of investors is fragile, as it is in Brazil, it becomes even more important. Its power resides in limiting the conflict of interest among decision makers (controlling shareholders) and the funds providers (minority shareholders). Here, it’s worth quoting the professor Dan Ariely[3], from the Duke University: “Dishonesty is almost always caused by a conflict of interest.” In other words: no matter how well intentioned the initiative may be, if it creates conflicting structures, it will be an incentive to problems in the future.

There are different nuances as to the approach the regulation should have regarding ‘the one share one vote’ issue. Some specialists claim that any structure that diverge from it must be banned – that was the approach adopted by the Hong Kong Stock Exchange, for example, which banned Alibaba from conducting its IPO in the Chinese market. Others believe that the market should be free to analyze and price different structures – if a company offers a poor governance structure, that’s ok. This will be adjusted in the price.

However, it’s unanimous that selling an asset with specific characteristics and eliminate them later on is very negative to the market’s credibility. It’s the “well, but” culture… the fine print in daily agreements. In the capital market, a deal is a deal. But to agree with something and deny that later on, yet on a legal basis, hurts credibility.

Another example of a frustrated expectation took place in 2005, when Banco Nossa Caixa went public.  The bank’s largest asset was the exclusive access to the payroll of the state’s public servants. In private meetings with investors, the bank’s and the controlling shareholder’s representatives reiterated that it was an inalienable asset. Shortly after, the institution found a legal way to resell the payroll – what means that investors had to pay twice for the same asset. Everything in compliance with the law. But not in compliance with the practices of a company that wants to build a long-term partnership with its capital providers.

If the intended operation is made concrete, the State Government will be mortgaging the credibility built over the years as one of the most reliable state-owned enterprises for investors – and primarily the goodwill created with the pioneering spirit of Sabesp in the Novo Mercado.

As the Anglo-Saxon saying goes, “fool me once, shame on you; fool me twice, shame on me.”

[1] Shares with multiple voting rights.

[2] Although Usiminas is not listed in the Novo Mercado segment, in theory, a public offering should have been made to common shareholders under the terms of the Article 254-A of the Law 6,404/76.

[3] Author of Predictably Irrational, The Honest Truth about Dishonesty and Payoff, among other books.