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Impact of recent legislative developments on private equity investments in Brazil

Venture capital investment relies strongly on the quality of rights of minority shareholders of the target company and the quality of corporate governance standards as a whole. The easier the enforceability of shareholders' rights, the more transparent the management of the company will be and the friendlier the environment for private equity investments. Augusto Cesar Barbosa de Souza of Vieira, Rezende, Barbosa e Guerreiro examine how far Brazil has developed laws to encourage foreign investment.

The last amendment to the Brazilian Law on Corporations (Law No 6,404, dated December 16 1976) was made in 1997 which, among other things, modified several rules with the effect of removing certain hindrances to enable the government to accelerate its privatisation programme. After a long legislative process taking over four years, on October 31 2001, Law No 10,303 was enacted by the President. The law restored certain provisions eliminated in 1997 as well as added certain corporate governance principles in order to enhance the Brazilian capital markets. Several changes to some aspects of corporations were introduced by Law No. 10,303, including their capital structure, minority shareholders' rights, management and divestiture. The amendments were also aimed at strengthening the Comissão de Valores Mobiliários (CVM), the Brazilian securities and exchange commission.

While the amendments are general in nature, they impact on private equity investments, particularly in regards to the establishment and management of private equity ventures, their funding mechanisms, access to capital markets and eventual divestiture. Below is a short analysis of some of the most important innovations affecting corporations, and in particular private equity investments, comprising both corporate governance and some minority shareholders' protection aspects.

Capital structure

Since an amendment to the Law on Corporations was passed in 1990 revoking all provisions dealing with bearer and endorsable shares, Brazilian corporations have been forced to structure their capital on the basis of nominative voting shares (ações ordinárias) and, optionally, nominative preferred, usually non-voting shares (ações preferenciais). The maximum permitted amount of preferred shares, which could not exceed two-thirds of the corporation's capital, enabled investors to structure the company's capital in such a way that shareholders holding less than 17 per cent of the company's capital could control the company. This possibility has been eliminated by Law 10,303, which determines that preferred shares may now be issued up to 50 per cent of a company's capital. Consequently, the control of a company by a certain shareholder or group of shareholders will require a considerably larger minimum investment.

The types of advantages to which preferred shareholders may be entitled have remained basically the same. However, in order to be offered and negotiated in the capital markets, preferred shares must grant shareholders at least one of the following advantages:

• the right to receive minimum dividends equivalent to 25 per cent of the company's net profit, in which case the holders of preferred shares will have priority (in relation to holders of common shares) in receiving such dividends up to an amount equivalent to 3 per cent of the share value calculated in accordance with the company's net worth value and the right to receive dividends under the same conditions applicable to holders of common shares, when dividends equivalent to the minimum priority dividend granted to holders of preferred shares have already been paid to common shareholders;
• the right to receive dividends at least 10 per cent greater than dividends granted to holders of common shares; or
• the right to be included in public offers for the sale of the company's controlling shares, whereby preferred shareholders are entitled to at least the same dividends granted to holders of common shares.

Management

One of the most discussed amendments relates to the composition of the board of directors (conselho de administração) of a corporation and to the ability of different groups of shareholders to elect their members.

Composition of the board

According to the new wording of Article 141, paragraph 4, of the Law on Corporations, the following categories of shareholders of open capital corporations may now elect one member of the board of directors and its relevant substitute:

• holders of common shares of open capital corporations representing at least 15 per cent of all voting capital (ie minority shareholders); and
• holders of preferred shares of open capital corporations, with or without limited voting rights, representing at least 10 per cent of the company's corporate capital (to the extent that any right to elect members of the board of directors granted by the company's by-laws is not exercised).

Should the number of shares held by each of those groups not reach the minimum level for the election of a board member, the two groups of shareholders may combine their shares and jointly elect one board member and its relevant substitute, provided that their shares jointly correspond to 10 per cent of the company's capital. Such innovations will nevertheless apply to the ordinary shareholders' meeting (assembléia geral ordinária) to take place in 2006 only.

One additional innovation introduced by Law 10,303 concerns the ability of shareholders bound by shareholders' agreement to elect board members. New article 141, paragraph 7, of the Law on Corporations establishes that whenever the election of board members is made by multiple vote (voto múltiplo) and one of the two groups of shareholders mentioned above exercises its right to indicate a board member, the shareholders bound by shareholders' agreement that represent more than 50 per cent of the company's common shares will be entitled to elect the same number of board members elected by all other groups of shareholders plus one, regardless of the total number of board members prescribed in the company's by-laws. Consequently, although the new law expressly provides for the election of board members by minorities, the control of the company by a certain group of shareholders may remain unaffected.

Qualified majority requirements within the board and veto rights

The new law also makes it possible for the by-laws of a corporation to determine that the passing of certain decisions of the board of directors be submitted to the vote of a qualified majority. This provision finally concludes certain discussions on the very possibility of imposing qualified majority requirements on decisions taken by the board of directors.

In addition to non-individualized veto rights deriving from qualified majority requirements, the new law granted to the board members indicated by minority shareholders and holders of preferred shares the right to veto the indication of the independent auditor of the company, provided that such board members present a reasonable justification.

Limitation on characteristics of board members

The usual practice by which private equity investors indicate some of their representatives to compose the board of different private equity investments in one sector may also be affected by the recent innovations. Law 10,303 introduced a new mechanism to protect the company's interest, in that it submits to the prior approval of the company's shareholders' meeting (i) the election of board members holding similar positions in competitor companies; and (ii) the election of board members that may have conflicting interests with those of the company.

Exercise of controlling powers

Different aspects of the exercise of controlling powers by a shareholder or group of shareholders, coupled with a focus on minority shareholders' protection, were comprised by the innovations of the Law on Corporations. These include withdrawal rights of minority shareholders dissenting from certain decisions at shareholders' meetings and tag-along rights of minority shareholders upon sale of control of open capital corporations.

Rights of dissenting shareholders

The basic innovation of Law 10,303 regarding dissenting shareholders refers to their ability to withdraw from the company upon reimbursement of its shares if it is decided at the general shareholders' meeting that the company will be spun off. Although not controversial, this right had been removed in an effort to enable the Brazilian government to implement its privatisation programme more efficiently through restructuring all companies to be privatised without special regards to minority shareholders.

The restoration of the right of dissenting shareholders to withdraw from the company upon it being spun off and the existing similar rights in case of mergers by acquisition and mergers by amalgamation complete the set of situations regarding corporate conversion and transformation at which such rights are granted. However, the right to withdraw upon the company being split will only exist in the following circumstances:

• the spin-off gives rise to a change in the company's corporate purpose, except when the portion of the company's net worth that was spun off overflows into a company with the same corporate purpose of the spun off company;
• the minimum compulsory dividend is reduced; or
• the spin-off implies a participation in a group of companies.

The right of dissenting shareholders to withdraw from a company upon it being split will depend basically on whether the split will adversely affect the dissenting shareholders' position in the company or not.

Tag along

Among the recent developments, the restoration of the tag-along provision in case of transfer of control of open capital corporations is of paramount importance.

The tag along right was originally granted upon transfer of control of open capital corporations, by allowing their minority shareholders to be given the same treatment as was given to the selling controlling shareholder (ie minority shareholders would be entitled to sell their stake under the same price and conditions offered to that of the controlling shareholder). Upon the implementation of the Brazilian privatization programme in the mid-1990s, the right to tag along was revoked with the purpose of releasing the government from obligations to minority shareholders of public open capital corporations upon the sale of control of such companies to private investors.

The tag along right restored by Law 10,303 is somewhat different from the original tag along provision. Under the new regulations, minority holders of common shares (ie shares with voting rights) of open capital corporations will have the right to tag along in case of a public offer for the sale of the controlling shares of the company, regardless of whether the transfer occurs directly or indirectly. However, the price applicable to minority shareholders exercising such right may be as low as 80 per cent of the price per share paid for the controlling stake. In any case, the granting of the right to tag along will be deemed a condition for the transfer of control to take place.

The new controlling shareholder will also be entitled to offer minority holders of common shares the possibility of remaining in the company. In such a case, the new controlling shareholder will pay the minority shareholders a premium equivalent to the difference between the share's market value and the price per share paid to the former controlling shareholder(s).

The rules to apply to public offers for the transfer of control and to the granting of tag along rights are to be further established by the CVM. This additional incumbency corroborates CVM's duty to look over the whole capital markets and again evidences its enhanced responsibility for implementing more efficient corporate governance controls.

Arbitration

Considerable progress was made through the insertion of the possibility for companies to have established in their by-laws the ability for disputes between the company and its shareholders and between minority and controlling shareholders to be solved by arbitration.

In addition to avoiding resort to courts (courts frequently do not completely understand the level of complexity that usually characterizes the conflicts between controlling and minority shareholders' and between these and the company), submission of conflicts to arbitration will enhance celerity and efficiency to the company's upper management and will thereby mitigate any adverse impacts that longer and more turbulent disputes may have on the company's quotidian management and performance.

Implementation of changes

The effects of the changes of Law 10,303 will apply immediately to new companies. Companies already existing at the time of publication must amend their relevant by-laws to fit the changes within a year of its publication. Under certain circumstances, however, specific provisions on some amended items will apply:

• the 50 per cent limit of preferred shares will apply to new companies immediately; in case of closed capital corporations the new limit will apply as of the time the corporation becomes an open capital corporation (ie when there is a public placement of shares or securities by the corporation);
• open capital corporations that wish to issue shares in order to fit the new 50 per cent preferred shares limit may disregard the right of first refusal of holders of preferred shares to subscribe for new shares, whereby the former two-third limit may not be restored; and
• open capital companies willing to issue new preferred shares must comply with the minimum preference requirements listed in item I above.

Future developments

Although the changes introduced by Law 10,303 were rather limited, they certainly improved the level of corporate governance in Brazil and the consequent transparency of Brazilian corporations, creating a stronger capital market.

The changes proposed in the bill that originated Law 10,303 were probably excessive in a market that, having been deeply affected by the privatisation programme and the boom in the private equity industry, is still consolidating. It is therefore likely that additional progress will be made in the nearer future, when the Brazilian economic scenario is more mature to receive, understand and implement such changes and consequently grant investors, including private equity investors, an enriched approach towards Brazilian companies.

Vieira, Rezende, Barbosa e Guerreiro Advogados, Av. Presidente Wilson 231/18 Andar, Rio de Janeiro RJ 20030-031, Brazil, 55 21 2217 2888, www.vrbg.com.br
 

© IFLR 2002

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