Stock Exchange Regulation in Brazil - Recent Developments
By Pablo Bentes
I - Introduction
Despite the catastrophic scenarios foreseen by various local and international analysts, Brazilian stock exchanges have arrived in the new millennium much healthier than expected. Bovespa, the stock exchange of São Paulo, which represents almost all stock trading in Brazil, remained unaffected by the "Millennium Bug," reaching the record high of 15.000 points1. This recovery has been largely due to Brazilian mid-size and smaller investors, who have begun to invest in stocks as opposed to fixed-income funds. An expected growth of 2 to 4 percent in the year 2000 GDP, coupled with lower interest rates, reinforce general optimism as to the future prospects of the Brazilian stock exchanges. Many analysts believe that foreign investors will begin returning now that Y2K concerns are largely settled.
Although the immediate prognosis is generally good, long-term growth in the Brazilian stock market is unlikely barring considerable reform to the regulatory framework. Existing statutes of the CVM (Comissão de Valores Mobiliários, similar to the SEC) have proven insufficient to promote the development of Brazilian stock exchanges and most importantly, the consequent financing of Brazilian business.
Among the regulatory issues of importance to local and foreign investors, the scarce protection offered to minority shareholders is of greatest concern. CVM recently identified this regulatory deficiency, enacting a series of administrative measures to provide greater peace of mind to domestic and foreign investors. The following article will discuss the most important recent regulatory developments: CVM's Instructions numbers 319 and 320. The Instructions are specifically designed to protect minority shareholders vis-à-vis mergers and acquisitions of listed companies, especially newly-privatized utilities.
II - Background
Law number 4.728, of July 14th, 1965 provided general principles for the development of an institutionalized stock exchange in Brazil. At the time, Brazilian stock exchanges comprised all kinds of papers issued by the nascent financial system, including commercial letters of credit and real estate mortgages of dubious origin. Laws numbers 6.385 and 6.404, dated December 6th and December 15th, 1976, respectively, set up the legal framework necessary for the development of the Brazilian stock market, introducing the concept of securities2 and creating the CVM.
Since almost all listed companies were state-owned during this period, the model adopted by Brazilian legislators concentrated private stock trading in preferred shares, which grant priority in the distribution of dividends, but no offer no political influence within the company3. Minority shareholders' rights were of little concern given that the Government retained the controlling position of most listed companies.
Recently, the privatization program carried out by President Cardoso has fundamentally changed the stock exchanges. Private consortia, almost invariably led by multinational economic groups have purchased controlling shares of Brazilian public utilities. These groups have implemented aggressive management practices; some of their recent actions have made clear to minority shareholders the weaknesses of existing statutes.
Such groups have paid huge premiums for controlling positions in privatized companies, and in many cases, taken advantage of regulatory deficiencies. For example, Brazilian tax statutes allow the purchaser of a given company to amortize the total amount of the premium paid in five years. Exploiting a regulatory loophole, Telefonica de España, which controls the State of São Paulo Telephone Utility, decided to merge and consolidate the holding company Telesp Participações S.A. into the operational company Telesp S.A., amortizing a portion of the premium previously paid in the controlled (operational) company. The total amount of the premium not amortized would constitute a "premium reserve account," which would then be used to issue new shares of the consolidated company, all in the name of the controlling shareholder Telefonica de España. This restructuring also reduced the taxation on the previously paid privatization premium to almost zero and diluted the interests of minority shareholders in the company. Although many minority shareholders questioned the reasoning for the restructuring, it was absolutely legitimate from a legal standpoint, pursuant to existing statutes. On the day Telefonica announced its corporate restructuring, two other private telephone operators filed with the CVM for a similar operation. CVM in turn enacted Instructions numbers 319 and 320, setting new conditions for mergers, acquisitions and other restructuring operations of listed companies.
III - Instruction CVM number 319 - Mergers and Acquisitions of Listed Companies
CVM's new regulation addresses the issue of minority shareholder protection by setting forth extensive procedures to be observed by listed companies which decide to merge or consolidate. New CVM rulings relate most importantly to: (i) quality and quantity of information available to minority investors on mergers, acquisitions and split-ups; (ii) accounting rules for the amortization of premiums in mergers and acquisitions of listed companies; (iii) substitution of shares of non-controlling shareholders in mergers or acquisitions; (iv) the abusive exercise of controlling position and (v) dividends to non-controlling shareholders.
(i) Disclosure of Information4
Pursuant to Article 2 of Instruction 319, the terms of mergers, acquisitions or split-ups of listed companies must be reported to CVM, the stock exchanges and the general public at least fifteen days before the General Shareholders' Assembly in which such operation is to be discussed. Minimal standards for such publications are also established in the statute. The company must report the reasons for the operation and its possible benefits, the costs involved, corporate agreements which will be executed by the parties, number and class of the shares which may be substituted, evaluation methods of assets and liabilities of the consolidated company, the relationship between present and future stock composition, and any other conditions under which the operation will be realized.
(ii) Accounting rules for amortization of premium in mergers and acquisitions 5
CVM's Instruction 319 changed the accounting rules for premium amortization in mergers and acquisitions of listed companies. Strict accounting criteria have been fixed by the regulatory agency in order to avoid the manipulation of accounting rules to the detriment of minority shareholders.
Pursuant to article 6 of said statute, the amount of the premium resulting from mergers or acquisitions must be amortized in fixed or deferred assets accounts. Most importantly, pursuant to the second paragraph of the same article, the "premium reserve account" may be incorporated in the share capital (with the consequent issuance of new shares of the resulting company) but only for the benefit of all shareholders.
Nevertheless, any tax benefits arising from corporate restructures of this kind may also be capitalized to benefit the controlling shareholder, provided that minority shareholders are granted the right of first refusal at equal financial conditions6.
(iii) Substitution of shares of non-controlling shareholders7
The provision of article 9 of CVM's Instruction number 319 is one of the highlights of the newly enacted regulation, as far as minority shareholders are concerned. Pursuant to the statute, mergers, acquisitions or consolidations of listed companies may still encompass replacement of existing shares by newly issued shares, according to the resulting company's balance sheet. The calculation adopted for purposes of such replacement, however, may not include the premium paid in the acquisition or merger. Favoring any group of shareholders to the detriment of other shareholders of the same class is also illegal pursuant to article 10 of Instruction 319.
The dilution of the minority shareholders' equity in listed companies as a result of mergers or acquisitions structured by controlling shareholders will no longer be tolerated by CVM.
(iv) Abusive exercise of controlling position8
The following actions shall be considered abusive exercise of controlling position, subject to temporary suspension of the management of the company by the CVM:
- usage of the premium in the calculation of the substitution of shares resulting from any merger or acquisition;
- any debt assumption resulting from acquisitions within the same economic group, in the exclusive interest of the controlling shareholder;
evaluation of the companies involved in mergers or acquisitions not in accordance with their respective market value;
- failure to provide CVM with the information mentioned in (i) above; and
- the establishment of any distinction between the rights granted by shares of the same class as a result of the merger or acquisition.
(v) Dividends to non-controlling shareholders
Finally, pursuant to article 16 of CVM's Instruction 319, dividends to be attributed to non-controlling shareholders may under no circumstance be diminished as a result of mergers or acquisitions of listed companies.
IV - Conclusion
Recent developments in the regulatory framework governing Brazilian stock exchanges indicate that the regulatory authorities have grown responsive to the situation of minority shareholders vis-à-vis controlling shareholders of listed companies. Foreign investors who may now be more willing to invest in Brazilian stock exchanges have roundly welcomed initiatives such as Instruction 319. By protecting minority investors, Brazil has increased the attractiveness of its stock exchanges dramatically.
The newly enacted regulation has even more serious implications for foreign investors interested in the privatizations scheduled for this year. State-owned financial institutions, telephone grants, water utilities, electric generators and distributors, reinsurance, among other important sectors are to be included in the privatization program implemented by the Cardoso Administration.
Still, the issue of minority shareholder's rights remains polemical in Brazil and the privatization program itself may be changed in a near future. The strategy currently adopted by the Government encourages the sale of the controlling shares in one single block in order to increase the premium paid by the bidders. The recent actions of new controllers of listed companies, however, have led the Government to re-examine its privatization model. The privatization model adopted in the near future may more evenly distribute ownership through the issuance of newly privatized companies' shares in the stock market, thereby also promoting the further development of the Brazilian stock exchanges.
Pablo Bentes is an attorney with Suchodolski and Associates of Brazil.
Cut Outs:
Although the immediate prognosis is generally good, long-term growth in the Brazilian stock market is unlikely barring considerable reform to the regulatory framework. Existing statutes of the CVM (Comissão de Valores Mobiliários, similar to the SEC) have proven insufficient to promote the development of Brazilian stock exchanges..."
Recently, the privatization program carried out by President Cardoso has fundamentally changed the stock exchanges. Private consortia, almost invariably led by multinational economic groups have purchased controlling shares of Brazilian public utilities. These groups have implemented aggressive management practices; some of their recent actions have made clear to minority shareholders the weaknesses of existing statutes.
CVM's new regulation addresses the issue of minority shareholder protection by setting forth extensive procedures to be observed by listed companies which decide to merge or consolidate.
CVM's Instruction 319 changed the accounting rules for premium amortization in mergers and acquisitions of listed companies. Strict accounting criteria have been fixed by the regulatory agency in order to avoid the manipulation of accounting rules to the detriment of minority shareholders.
The dilution of the minority shareholders' equity in listed companies as a result of mergers or acquisitions structured by controlling shareholders will no longer be tolerated by CVM.
The recent actions of new controllers of listed companies, however, have led the Government to re-examine its privatization model. The privatization model adopted in the near future may more evenly distribute ownership through the issuance of newly privatized companies' shares in the stock market, thereby also promoting the further development of the Brazilian stock exchanges.
1 Bovespa reached 15,953 points on Wed. 23, 1.999 - (in R$)
2 Law number 6.385, article 2
3 Law number 6.404 , article 17
4 Instruction CVM number 319, articles 2 - 5
5 Instruction CVM number 319, articles 6 - 8
6 Instruction CVM number 319, article 7, paragraphs 1 and 2
7 Instruction CVM number 319, articles 9 - 11
8 Instruction CVM number 319, article 15
