Let the sheriff work

Nobody said it would be easy to please everyone. Recurrently criticized for its supposedly inefficient performance regarding many problems of our capital markets, the Brazilian Securities and Exchange Commission – CVM – usually comes under criticism for opposite reasons. When it takes courageous decisions that repel acts harmful to investors, it is eventually subject to strong criticism from several interested parties.

One of such criticisms is related to alleged “innovations”, that is, decisions that surprise players or revert precedents previously established by the regulator itself.

It’s groundless criticism. In fact, it’s dangerous criticism. It’s somewhat similar to the legal arguments used by public agents involved in criminal investigations or in the most infamous “accounting tricks” recently used by some government spheres in Brazil. It’s based on the argument that things “have always been like that” and, therefore, the regulator could not ‘innovate’ and start to sanction postures that used to go unpunished. The main argument would be the “legal certainty” one.

The legal certainty principle cannot be an obstacle for the evolving of how regulations are interpreted. It’s important to remember that the regulator must keep updated and be attentive to the loopholes and subterfuges that are sometimes (or usually) used by those under the jurisdiction to sidestep the essence of existing regulations. The regulator cannot be stuck to past views while the society evolves by leaps and bounds.

This posture, which Brazilian experts name a “guarantist” posture, implies that every “innovation” made to sanctioning decisions must be valid only for future cases, not for past ones. Taken to its extreme, it makes regulating and sanctioning measures completely inefficient.  A specific innovation would be subject to a sanctioning process only after that the regulator voices its “new” interpretation – implicitly legalizing all the past acts not previously analyzed  by the “sheriff.” After the “warning”, the agents would stop practicing the irregular act.

They would invent other ones, however. And that is the problem. The posture would result in a “cat and mouse” relationship between the sanctioning regulator and those subject to the sanction, but would never “catch” anyone. Laws would become dead letters and the only ones to benefit from that would be the intermediaries that would have a huge market to sell their “innovative” solution to bypass laws and regulations. That is, it’s a huge “Brazil cost” where the society loses and intermediaries gain.

The situation is even clearer when it comes to the Corporate Law. The acts 6,404 and 6,385 are strongly inspired by the Anglo-Saxon law. To mention only two examples, there are the fiduciary duties of care and loyalty, which would be virtually impossible to be regulated on an efficient basis under the exclusive point of view of the Continental European law.

To evolve, the Anglo-Saxon legal tradition, known as common law, is strongly based on the uses, customs and on the interpretations made by courts and regulators – that is, the jurisprudence. It is, therefore, naturally open, what means it’s perfectly possible – in fact, it’s essential – that legal decisions go against precedents with time, thus reflecting the evolution of the society and regulators’ answers to innovations that try to violate the essence of the law.  And nobody accuses the American or the English legal systems of legal uncertainty.

There are debates around the penalties arising from the review of the jurisprudence (which become reduntant when the regulator follows a transparent decision process and modulates its sanctions). However, the same cannot be said in relation to issues not previously analyzed by the regulator.

A good example of that is the votes of  members of management of of the  board of directors, as shareholders, to approve the financial statements that they have presented themselves. One such case was recently judged by CVM with the subsequent punishment of controlling shareholders that approved their accounts based on the loophole of using fully owned holding companies as the voters. We have not found any process ever judged about this issue, what means that CVM has not changed its interpretation – it has only dealt with a problem about which it has not previously voiced its opinion.

It’s the same situation as those related to other controversial decisions taken by the regulator. Recently, CVM has punished pension funds for voting as minority shareholders in shareholders’ meetings of companies under common control (the pension fund of Company A voted in the meeting of Company B, while both A and B have the same controlling shareholder). The regulator was criticized for innovating when it has only applied the logic to have the law obeyed, appropriately modulating its decision.

The fallacy of the “guarantist” posture when applied to the capital markets becomes even more evident when it comes to insider trading practices. It’s a recently new penal type, with only two cases judged to date. A survey about those that have been judged by the CVM reveals a serious difficulty to make the legal mandate concrete. The regulator’s interpretation, therefore, has been evolving. Does it mean that when it is faced  with a new situation that it considers to have “crossed the line”, it must only issue a warning and wait for the next one? Of course not. If it does that, we can be sure that no one will be ever considered responsible for the crime of using privileged information in Brazil.

The criticism about board of directors being banned from voting on their own accounts also lacks a logical basis. One of the main difficulties in the evolution of our capital markets has exactly to do with the grey areas among the “little boxes” that comprise one company’s corporate governance system. The governance is a system of checks and balances, what is brilliantly reflected in our Corporate Law (in 1976, the Brazilian Corporate Law already addressed the external directors issue). If management bodies are not dully separated from a company’s ownership structure, companies will never be managed according to the best practices. A good example is the excrescence of shareholders’ agreements that include specific voting instructions to the directors (due to the unfortunate Article 118, Paragraph 8, included in our law as a result of the pressure of some controlling shareholders interested in perverting the mentioned checks and balances). The mechanism is condemned by the good practice, as it’s clear in the Code and in the Guideline Letter #1 of the Brazilian Institute of Corporate Governance – IBGC.

When a proper structure of checks and balances is missing, the law dismantles. For this reason, there’s nothing more natural than to encourage companies to establish these structures adequately. Directors manage accounts and report them. Owners deliberate over them. It’s simple. To claim that, if implemented, the regulation is equal to transferring the power of controlling shareholders to minority shareholders is an argument that, instead of making the situation clear, makes it more confusing.

The law is right, therefore, when it establishes that controlling shareholders are banned from voting on the process to approve their own accounts. Likewise, the CVM is also right when it does not allow the total farce of having structures 100% controlled by the directors to bypass that mandate.

No doubt that the issue related to the approval of accounts could be  improved. The case in point is the exemption of directors’ responsibilities upon approval of the financial statements. It’s an idiosyncrasy of the Brazilian legislation. According to the Article 134, Paragraph 3 of the Corporate Law, the  unconstrained approval of accounts implies the automatic release of directors’ responsibilities, except in the event of errors, misconduct, fraud or simulation.

This provision can be considered a weapon of mass destruction when it comes to the accountability in Brazilian listed companies. Firstly, one must consider that great corporate scandals are not immediately discovered. Both their effects and the destruction of value take time to happen and, consequently, investors are not promptly warned that some directors may have not fully met their duty of loyalty and diligence, as provided in the Articles 153 and 155 of this same law. If directors eventually managed to claim that the approval of financial statements exempt them from their duties, the law is being transforming into a dead letter.

The always watchful “guarantists” will say that it’s not true: they will claim that the exemption does not apply in the event of errors, misconduct, fraud or simulation. But, in the real world, it’s not exactly like that. Any legal action that starts from this broad discussion is doomed to become irrelevant. Our investors are not going to spend time and money to file an action in our complex judicial system to claim their rights in a fight that will take decades and which cards have already been laid against them, with extremely strict criteria to admit one’s responsibility.

The problem is also affected by the absenteeism and the minor importance given by investors to the approval of accounts. Some attorneys also claim that the approval of accounts and financial statements is two distinctive things, making the issue even more complex. And there is more: there are the unanimous approval, the approval by the majority and the “unconstrained approval” that nobody knows exactly what means.

All this conspires to make the mentioned provision a huge problem for the capital market. There’s an urgent need of revision, as the former Chairman of CVM, Marcelo Trindade, has suggested with authority in an article published recently.