We have already briefly explored the topic of appraisals in this session (The “Majority of the Minority,” Dec/13, and “That Simple,” May/14). Now it’s time to tackle this subject head on.
In the 90’s, market activists claimed for basic parameters that attested that specific corporate events took place based on fair terms for all parties. This involved some legal issues (the tag along, for example), some procedural issues (to ensure that shareholders could really choose, without the pressure of a spade on their heads) and also some value issues.
This concern has been incorporated into our corporate legislation in several situations – notably through the Laws No. 9.457, of 1997, No. 10.303, of 2001, and No. 11.941, of 2009. The term “fair value” appears three times in the amendment to the Law No. 6.404. The term “appraisal value” appears twice. And the terms “economic value” and “fair price”, once each. That is to say, every single initiative designed to update the corporate legislation sought to incorporate the notion that specific actions need to be based on balanced decisions among the parties, reflected in a fair price.
And the way to reach such fair price involves the appraisals. The term “appraisal” is mentioned 13 times in the legislation, maybe half of them in the original texts, and the other half, in the amendments. The legislation also addresses the accountability of appraisers, what suggests the high importance of the topic.
But unfortunately, that’s not what happens in practical terms. If we survey the cases judged by the Brazilian Exchange and Securities Commission (CVM) for the last years, we do not find a single conviction of appraisers, managers or controlling shareholders to become final and binding as a result of a poor evaluation (in fact, there was one ‘warning’). That is, our evaluations are either fantastic or we have a serious enforcement problem.
Based on investors’ practical experience, our problem is the second option. Amec has widely identified situations in which worthlessness appraisals were used to serve as the foundation for relevant corporate transactions or accounting entries. A brief list of the situations found includes:
Problems with assumptions
- Assumptions inconsistent with the market’s or the company’s reality;
- Growth expectations that go from null to exaggerated and, sometimes, to infinite;
- Assumptions that are contrary to other ones published by the same appraiser;
- Under-evaluated or over-evaluated capital expenditures;
- Deliberate ignorance of risks and contingencies;
- Perpetuity projections based on the top of the cycle margins ;
- Margins and returns basically different from historical results, with no clear reason;
- Double counting of either cash or debt;
- Evaluation of similar assets based on different approaches;
- Disclaimers that exempt managers’ from their responsibility;
- Wrong or incomplete disclosure of appraisers’ remuneration;
- Unquestioned use of assumptions given by the interested party
- Conditions imposed to appraisers (and the prior determination of the evaluation result)
The list could be much longer. But it already shows the quantity and diversity of problems investors have to deal with. And all this without a single example of a case that had become a problem for appraisers or their contracting parties.
The result is that many of the rules included in our corporate legislation fall into the void once they can be circumvented by means of appraisals that are previously ‘ordered’ to bring a specific result. And appraisers do all they can do to circumvent their eventual accountability through highly elaborated disclaimers. Some of them, basically state that “this appraisal is the direct result of the assumptions supplied by management, what means we are not accountable for the information herein.” Considering attitudes like that (which have been successful), appraisals have become mere spreadsheets with the appraisers’ logos, prepared to attest pre-established figures. Nothing but a rented spreadsheet.
CVM has been trying to suppress abuses. In 2002, it issued the Instruction 361, which brought an unprecedented level of details about the rules to be followed by appraisals. Issues that should be obvious, but that have become gaps to make ends meet. In this same line, the entity issued the Legal Opinion No. 35, of 2008, which reiterated the accountability of advisors regarding the criteria of evaluation and its transparency. Unfortunately, none of these two instruments closed the gap on distorted evaluations. In 2007, CVM rehearsed a move to go over the essence of these appraisals, in a decision of a sanctioning process. But unfortunately, it did not get away with it.
International practices have been more successful when it comes to fair appraisals. In the US market, for example, the integrity of appraisals is assured by a highly litigious culture and specialized courts that directly determine an analysis of the essence of the evaluations. Known as ‘entire fairness,’ this analysis scares market players. To avoid them, appraisals go through governance processes, which are the most common practice, to assure fair decisions for all shareholders. We discussed this topic some months ago, when we talked about the majority of the minority. And, as we mentioned, the purity of the concept is fundamental for the role it plays: if this majority is contaminated by the interested parties, it damages the process. In Delaware’s courts, such situation takes to the carrying out of the entire fairness analysis, in which the appraiser is part of his/her own appraisal.
Unfortunately, these controls do not work here. As we saw in recent corporate transactions, the majority of the minority is recurrently tainted by interested parties – that, through legal contortions eventually deny the obvious. Even the independent committees, equally inspired by the common law and that CVM has imported through the Legal Opinion No. 35, have been showing to be of little value once many times they find ways to justify their position aligned with controlling shareholders (in situations in which the independence was not just for show). Cases of committees formed by members linked to controlling shareholders are not uncommon. And cases in which members have been made accountable, even when results were clearly unfair or object of protests by independent board members, are unknown.
It’s time to reflect about the consequences of this reality.
Transactions through which the value is transferred from one group of shareholders to another group, “legitimized” by biased appraisals, have been occurring. And the protections expected from Novo Mercado continue to be threatened once a controlling shareholder can establish that a company is to leave a segment by simply approving an appraisal in a Shareholders’ Meeting – a Shareholders’ Meeting in which he/she votes! If appraisals are allowed to have any result, circumventing the protections of Novo Mercado is a very easy task.
There are two non excluding ways of solving this problem. The first one is a regulatory supervision posture that assumes the responsibility of inhibiting the most severe cases of biased appraisals. A supervision that values the effective concept of the majority of the minority and punishes managers and appraisers who do not fulfill their fiduciary duties.
At the same time, it is up to the capital market players to make a critical self-reflection and question whether the current situation is sustainable. It’s time to follow the US example and submit evaluation instruments to a self-regulatory process, therefore inhibiting ‘ordered’ results and exemptions of responsibilities in the disclaimers tiny letters. It’s great to make money with operation A or operation B. But if this individualist attitude continues, the permanent damage for the market will more than offset occasional gains.
And we will destroy the golden goose.