The frog in the pan

If a frog is put into boiling water, it will immediately jump out to survive. If it is placed, however, in cold water that is slowly warming up, it will not be aware of the gradual heat change, and will be cooked to death. It becomes complacent. It gets used to it.

The metaphor is perfect to describe the situation the Brazilian capital market is experiencing. Our market has already represented approximately 25 percent of the MSCI Emerging Markets index – the major global reference for emerging markets. Today, we represent some 7 percent. According to a recent study conducted by Credit Suisse (2014), we will represent from 3 to 4 percent in 2030. In other words, in 40 years we will have lost 90 percent of our relevance in the global markets without having taken any measure to revert the process. The frog is virtually cooked.

The fact we are becoming less and less relevant results from two main factors. The first one is certainly the macroeconomic landscape. The country’s inability to reach its potential because of mistaken economic policies and the political instability. It is not only that, however.

The capital market’s participants are responsible for the second factor. Despite that we started the “race” with several competitive advantages over other emerging markets, we wasted them, became complacent and other markets eventually exceeded many of our strengths.

Brazil has always been well-regarded for its healthy financial infrastructure. We have a system that is solid, transparent, considerably efficient and built on state-of-the-art technologies. Unlike other emerging markets, when someone invests in securities in our country, he/she does have to worry about having his/her records of ownership deleted or his/her assets deviated. The Brazilian banking and capital markets’ regulatory systems are reliable and, in terms of the letter of the law, comparable to those in more developed countries.

Our banks are solid and, during the crisis, our regulators played a decisive role and ensured the system’s credibility. The Novo Mercado, created in 2001, was welcomed as one of the world’s main innovations for the development of the securities markets.

The problem is that we got stuck in the past. We “laid in a splendid cradle”, as per the lyrics of our national anthem, and stopped evolving. Regulations were loosened, circumventing interpretations were initially tolerated and later on consolidated, rights were violated… and we have not realized that the frog was getting more and more groggy. Let’s see some examples:

  • Brazil was embroiled in the world’s biggest corporate, accounting and corruption scandal and not a single director or service provider was held responsible and punished for the damages caused to the capital markets.
  • B3 grants waivers to important rules of the Novo Mercado and Level 2 regulations to attract more companies even though they affect the system’s efficiency as a whole.
  • The concept of aligning political power and economic exposure, the driving force for the creation of the Novo Mercado and the special corporate governance levels (in addition to the revision of the Corporate Law in 2001) was reverted when companies with “super preferred” shares – which allow the holding the controlling interest with almost no commitment to the capital – were authorized to list in the Level 2.
  • In this same line, investors rely on the concept that common shares are real equity instruments and invest in companies listed in the Novo Mercado. Later on, companies in the segment are incorporated by other companies’ preferred stock as part of more complex operations.
  • Confidential decisions of the Arbitration Chamber are part of settlements that benefit few shareholders to the detriment of most shareholders.
  • Interpretations are created and accepted by the regulators to mask controlling structures – and controlling shareholders are not held accountable for their responsibilities. The concept of control itself is relativized based on interpretations such as “reinforcement of control” or “relevant shareholder with significant influence.”
  • Rules on mandatory tender offers are circumvented, frustrating minority shareholders who expect to be equally treated.
  • In the capital market’s court of appeals, the Federal Union is considered not guilty in the case of controlling power abuse as a result of the casting vote of its own representative in the court.
  • Principle-based initiatives are conducted on a formal basis, harboring operations that are clearly harmful to minority investors.
  • The Brazilian Securities and Exchange Commission (CVM) ignores its own Resolution 390 and signs plea bargains without any “indemnification for the losses incurred by the market” – in theory, a condition for the admission of a proposal on a term of the agreement (Article 7).
  • Poor or highly questionable appraisal reports are accepted as the foundation for corporate operations that materially affect minority shareholders, including situations in which they are forced to absorb the controlling shareholders’ debts.
  • Public offers are conducted amid proven frauds without any punishment in the regulatory or self-regulatory spheres.
  • Supposedly simple concepts such as “transfer of control” and “conflicts of interest” are lost amid complex legal interpretations, weakening the protections to minority shareholders and making the articles 115 and 254-A of the Corporate Law ineffective.
  • Almost 20 years after being considered a crime, no one has ever been convicted to jail sentences as a result of insider trading.
  • Seven years after the implementation of the IFRS, a principle-based system, the formalism continues to reign both when it comes to the preparing of financial statements and to the supervision of the regulation agency to the detriment of the principles listed in the Conceptual Framework of the system.
  • Controlling shareholders continue to have access to more complete information than that disclosed to opposing shareholders as they control both the shareholders’ list and the proxy cards and use them to convince others about their ideas – a right not guaranteed to eventual opponents. There is even a case of a shareholders’ meeting that was cancelled because as incumbents had advance notice of the vote’s results.
  • Companies make use of corporate resources to defend the ideas of their Boards of Directors or controlling shareholders to the detriment of alternative proposals.
  • Companies disclose data about executive compensation that are so complex that shareholders find them difficult to understand.
  • Despite the mandate laid out by the Law 7,913/89, initiatives of the Public Prosecutor’s Office to “avoid losses or ensure that shareholders and investors are paid damages” are unknown.
  • The Judiciary often gives priority to corporate interests, denying the rights of minority shareholders and creating a void of precedent in terms of penalties to officers and controlling shareholders when they deviate from their duties of loyalty.

Any reader who has reached this point in the article is certainly picturing the frog floating in the pan – well-done. Every single case mentioned here involves real situations – many of them strongly criticized by Amec and minority shareholders. The fact is that, as with a cruise ship in the middle of the night, the direction is always the same: towards the iceberg.

We cannot dream of a healthier capital market if we do not address the root causes that allow these cases to continue to happen. We need to wake up, feel the water temperature and jump before it is too late. Otherwise, we will not have a capital market capable of contributing to the development of our country.