Corporate Governance in Brazil

Author(s): Flávio M. Rabelo and Flávio C. Vasconcelos

Source: Journal of Business Ethics, Vol. 37, No. 3, Corporate Governance Reforms in
Developing Countries (May, 2002), pp. 321-335
Published by: Springer
Stable URL: http://www.jstor.org/stable/25074757
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Corporate Governance
in Brazil
ABSTRACT. Corporate governance is an issue of
growing importance in developing economies, as
many firms pass through significant transformations
due to the combined forces of sociopolitical changes,
technological progress and economic trends toward
globalization. These elements, along with the struc
tural characteristics of developing economies such as
less developed capital markets and governmental
interventionism, draw a picture for corporate gover
nance practices that may, in some aspects, be funda
mentally different from the practices found in
European or North American contexts. In this paper
we review and discuss the state of corporate gover
nance practices in Brazil, focusing on how the gov
ernance structure of Brazilian firms has been subjected
to important changes in the recent past and how even
more changes are expected to happen.
KEY WORDS: Brazil, corporate governance,
economic development
Fl?vio C Vasconcelos is Associate Professor at
EAESP/Funda?ao Get?lio Vargas in Sao Paulo,
Brazil. Ph.D. in Management Sciences at HEC Paris,
DEA in Sociology at Institut d'?tudes Politiques de
Paris, Bachelor in Law at Universidade de S?o Paulo
and in Public Administration at EAESP/FGV
Previously worked as a consultant with the Center for
Applied Research in Philadelphia, PA, and with
McKinsey and Co. in S?o Paulo.
Fl?vio M. Rabelo is Associate Professor at
EAESP/Funda?ao Get?lio Vargas in S?o Paulo,
Brazil. Ph.D. in Economics at Unicamp (Universidade
Estadual de Campinas), Bachelor in Economics at
UFBA (Universidade Federal da Bahia). Previously
worked as a professor at UNICAMP.
?? Journal of Business Ethics 37: 321-335, 2002.
r ? 2002 Kluwer Academic Publishers. Printed in the Netherlands.
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Fl?vio M. Rabelo
Fl?vio C. Vasconcelos
Introduction: Structural changes in the
Brazilian economy
Since the 1950s Brazilian economic development
strategy has been based on building industrial
capacity, with domestic and foreign capital
mainly directed to the large domestic market,
which has long been regarded as one of the key
assets of the Brazilian economy. In this period
state intervention in economic affairs was quite
widespread and many industries, like oil refining
and distribution, telecommunications, banking,
aviation, insurance and chemicals, had impor
tant state-owned players or received significant
governmental incentives. However, this internally
driven economic strategy went through two
important developments. The first one happened
in the 1970s when the oil crisis forced the
country to increase exports in order to com
pensate for the rising price of imported oil. The
second one happened in the 1990s when, after
15 years of high inflation and low economic
growth, the Brazilian government decided to
open the country's frontiers to many imported
goods, starting a true structural revolution in the
Brazilian economy. These changes were comple
mented by an economic stabilization program
that since 1994 has managed to keep inflation
down, started a massive privatization program and
changed the role of government in the Brazilian
economic development process.
The changes experienced by Brazilian firms
over this period were quite significant. The
economic model that oriented the Brazilian
economy from 1950 to 1990 was centered on the
domestic market and counted on the government
as a proactive economic actor to make direct
investments while driving and regulating private
 322 Fl?vio M. Rabelo and Fl?vio C. Vasconcelos
investments. However, when the Brazilian market
became more open to international trade, the
structure of Brazilian firms also started to change.
First of all, the change in the government's
intended role from an active economic actor to
a regulator impacted many industries. The pri
vatization program resulting from these economic
changes attracted international investors that
brought different governance models to the
Brazilian market. This resulted in a questioning
of the governance models traditionally in use.
Secondly, the deregulation of some markets
induced more fierce competitive behavior in
many Brazilian firms and led them to look at
governance structures to retain control and even
tually increase corporate performance.
Based on this general perspective, in the next
sections of this article we review and discuss the
state of corporate governance practices in Brazil,
focusing on how the governance structure of
Brazilian firms has been subjected to important
changes in the recent past and the nature of
changes that are expected in the future.
Corporate governance theory:
The economic background
Corporate governance theory usually concerns
the ownership structure of firms, the relation
ships among shareholders and the firm's
management, and, in certain views, the more
subtle and diverse relationships existing between
the firm and a complex network of stakeholders
influencing its behavior. To deal with such issues,
corporate governance theory draws on eco
nomics to analyze incentive systems, hierarchical
responsibilities, task allocations and managerial
control mechanisms that aim at aligning the
interests of economic actors such as large stock
holders, small stockholders, firm management
and governmental agencies so that their behavior
will converge.1
Despite being firmly rooted in economic
theory, corporate governance theory departs
from some of the basic assumptions of neoclassic
economic theory, introducing elements such as
information asymmetry, imperfect competition
and incomplete contracts.
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A basic premise of economic theory as it
relates to corporate governance is that the
governance structures only make sense in a world
where information is asymmetric, giving rise to
agency problems that cannot be solved simply
through contracts. In the absence of informa
tional asymmetry, the efforts and costs incurred
by all parties are perfectly known and can be
directly reimbursed, eliminating the need for
incentives within the firm. Likewise, in the
context of a perfectly competitive market, the
interests of all parties involved in the firm are
automatically aligned, thus making obsolete and
futile the discussion of governance mechanisms.
When the hypothesis of perfect information is
relaxed, the idea of agency problems emerges.
In most studies of corporate governance, the
typical agency problem is one involving share
holders and managers. Incomplete contracts
theory assumes that it is not feasible to write a
contract that specifies the actions to be taken by
each party in every possible event related to their
transaction. The transaction costs associated with
writing such a contract would be too high. The
involved parties would have to be able to predict
all relevant circumstances and establish action
plans to deal with each one of them. Further,
each of these plans would have to be negotiated
between the parties and written in such a manner
as to be enforceable by a third party (e.g. a court
of law) if a conflict should arise.
The need for corporate governance mecha
nisms arises from these important limitations to
the perfect competition model. Because contracts
cannot be written to eliminate all uncertainty,
there is a need for organizational arrangements
that go beyond written contracts. Because infor
mation is unevenly distributed and does not flow
freely from one economic agent to the other,
there is a need for mechanisms that try to align
the interests of different economic agents, and
because competition is not perfect and not
capable of perfectly aligning the interests of
diverse individual agents, there is a need for
structural arrangements and deliberate policies to
define how decisions are to be taken in organi
zations, who will be responsible for their conse
quences and what rules are to be followed when
contracts do not apply.
 Corporate Governance i,, ^mzil 323
Corporate governance issues in Brazil
A relevant question for developing countries is
the role of the state in creating efficient gover
nance structures. In Brazil, important infrastruc
ture sectors, like petrochemicals, steel and
telecommunications, have been created under
state guidance and state ownership. The state
assumed the role of amassing the necessary capital
to build, either alone or in partnership with local
business groups, key industrial sectors. Under this
scenario, local business groups - all of them
family owned and controlled - have in their
privileged ties to the state a vital source of com
petitive advantage. The analysis by Barca and
Trento (1997) of the origins and development
of governance structures in Italy corresponds in
great measure to the Brazilian case. They show
that, in an environment characterized by high
state intervention, incipient capital markets and
an absence of private sources of long-term market capitalization of at least US$ 500 million2)
finance, governance structures tend to be ineffi
cient. Such an environment hinders mobility in
the market for corporate control due to a series
of reasons: financial obstacles to new entrepre
neurs, particularly those that lack important
contacts within the system; the persistence of the
family control model; and strong collusion
between managers of state enterprises and politi
cians, which aid each other to remain in power.
Such a structure limits opportunities for indi
viduals with entrepreneurial talent, leading to
hazardous effects in terms of long-term growth
and equity.
Another problem with governance structures
in Italy pointed out by Barca (1996), one that
also applies to Brazil, is their incapacity to
facilitate the rapid growth of firms in situations
where capital is lacking (which occurs since the
system does not favor solutions through long
term debt or private risk capital). According to
this author, a scenario was created in which an
entrepreneur, when considering the option of
taking his firm public, knew that he would not
be able by himself to provide potential investors
with the necessary guarantees to overcome the
general failure in the governance structures. He
thus lacked incentives to tap capital markets when
in need of finance and adopted novel forms of
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control. The predominance of short-term debt
and the ample use of collateral are not adequate
means, however, to finance rapid growth. In
support of this claim Barca (1996) mentions the
fact that, with some notable exceptions, large
Italian firms have repeatedly failed in their
attempts to develop multinational strategies. This
is much more relevant in the Brazilian case,
where we shall see that hardly any corporation
would qualify as multinational and the sizes of
our major private corporations (measured in
terms of earnings and market capitalization) are
disproportionately small considering the size of
the Brazilian economy.
Widely held firms are the exception in most
countries, as pointed out by La Porta et al.
(1998). These authors analyze the ownership
structure of the top 20 firms, in terms of market
capitalization, and of 10 "medium firms" (the
smallest listed companies in each country with
in a sample of 27 countries. Since Brazil was not
included in their sample, we replicate here the
methodology.3 We have thus excluded from both
samples of firms all affiliates of foreign firms.4
Banks and utilities are excluded from the sample
of medium firms.
Firms are firstly divided into widely held and
those with ultimate owners. There are five
categories of ultimate owners: (a) a family or
individual, (b) the state, (c) a widely held finan
cial institution, (d) a widely held corporation and
(e) miscellaneous (a cooperative, a voting trust,
or a group with no single controlling investor).
A firm is said to have an ultimate owner (con
trolling shareholder) if this shareholder's direct
and indirect voting rights in the firm exceed 20%
(another cut is made at the 10% threshold).
Table I shows that in a sample of large
Brazilian firms only one qualifies as widely held
using the 20% criterion and none if the 10%
criterion is used. The state is the predominant
ultimate owner, followed by families.5 In the case
of medium-large firms, three are widely held
under the 20% criterion and none under the 10%
criterion. The most relevant ultimate owners in
this sample are families. It should be noted that
the widely held firm in Brazil is quite different
from the widely held concept in countries like
324 Fl?vio M. Rabelo and Fl?vio C. Vasconcelos

TABLE I
Control of large publicly traded firms in Brazila

Firm Market Capt. Control (20%) Control (10%) Alone

Nov. 1999 US$ mil.

PETROBRAS 19 686 425.43 State State Yes

ELETROBAS 10 935 590.64 State State Yes
CIA. VALE RIO DOCE 8 164 966.59 State State No
ITAUBANCO 7 037 071.23 Family Family Yes
TELESP 5 319 731.85 Widely held corp. Widely held corp. Yes
BRADESCO 5 198 360.87 Miscellaneous Miscellaneous Yes
BRAHMA 3 950 363.12 Family Family Yes
BANCO DO BRASIL 3 281 549.03 State State Yes
UNIBANCO 2 904 571.06 Family Family No
SABESP 2 747 398.53 State State Yes
CIA. BRAS. DISTRIBUI?.Family 2 556 401.25 Family No
CEMIGb 2 514 620.78 State State No
CIA. SID. NACIONAL 2 462 230.85 Widely held Family -
ITAUSA 2 262 071.85 Family Family Yes
TELESP CEL. 2 228 067.89 Widely held corp. Widely held corp. Yes
ELETROPAULO 2 175 679.41 State* State No
ARACRUZ 1 767 821.35 Family Family No
State
COPEL 1 704 057.71 State Yes
EMBRAER 1 449 070.48 Miscellaneous Miscellaneous No
State*
LIGHT 1 371 568.91 State No

1. Widely held 1 0 0.60

2. Family 6 7
3. State 9 9
4. Widely held financial 0 0
5. Widely held corporation 2 2
6. Miscellaneous 2 2

a The state telecommunications holding company, Telebr?s, was privatized in 1998. In the privatizati
this large company, which not long ago accounted for nearly 80% of the trading volume in Bovesp
divided into 12 holding companies, each owning a group of the local telephone companies. This
problem for determining the sample of these large firms. The 12 holding companies do not issue s
shares they all form part of the RCTB system, which in November 1999 had a total market capita
US$ 27.4 billion. Three of these holding companies were sold for prices which would place them am
large firm sample: Telesp Participates, Telesp Celular Participates and Tele Norte Leste Partici
first two control only one local telephone company. It was decided to include in the sample these t
companies (Telesp and Telesp Celular) but not the holding companies themselves, which would crea
tion problems.
b Has a foreign shareholder with 32.96% of voting shares.
Source: CVM and BOVESPA.

the U.S. and U.K., since all firms classified as this concentrated ownership structure, th
Given
relevant agency conflict in Brazil is one between
such in our sample have clear control blocks
formed by a small group of shareholders. controlling and minority shareholders. When w
It is clear that the issue of separation ofmove
own to the section on the Brazilian capita
ership and management is not an important market,
one we will explore in depth the nature
these
in the realm of corporate governance in Brazil. conflicts and the threats of expropriation

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 Corporate Governance in Brazil 325

It is also evident that despite the privatization Business groups

process initiated in the early 1990s, the state is
still an important shareholder in large Brazilian
corporations.
Another dimension analyzed by La Porta et al.
(1998) is whether the firms ownership structure
is a pyramid.6 Pyramids are common in many
countries as an instrument to enforce the control
of dominant shareholders over the group firms.
With their use it is actually possible to control
some firms even with a very small share of the
total capital. These authors have emphasized the
importance of pyramids in the corporate own
ership structure of their sample countries. They
believe that pyramidal ownership is a more
important mechanism, when compared to shares
with differential voting rights, used by control
ling shareholders to separate their cash flow
ownership from their control rights. Such struc
tures are instrumental in providing controlling
shareholders with power disproportionate to their
cash flow rights. Table II shows that more than
half of the firms that have families as their
ultimate owners use pyramids in their ownership
structures.
As it has been shown, ownership structure is very
concentrated in Brazil. The main agents in this
structure are the state, local family-owned
business groups and affiliates of multinational
corporations. The presence of subsidiaries of
multinational corporations has been very impor
tant since the beginning of the country's
industrialization drive, and they almost entirely
control key sectors like the auto industry, food
and pharmaceuticals. With the gradual liberal
ization of the economy and the privatization
process their importance has been growing,
especially in sectors such as telecommunications,
banking and energy. An important part of the
Brazilian economy is thus not directly affected by
existing governance structures, since these foreign
affiliates are seldom established as public com
panies in the country and are not dependent on
the local market for finance.
Local Brazilian capital is mainly represented by
family-owned business groups. These business
groups7 are similar to hierarchical groups found
in continental Europe.8 The control of these
groups is exercised by a dominant shareholder
or a coalition of shareholders, which dominate
the boards of virtually all group companies. In
Brazil, the dominant shareholders of the business

TABLE II
Family control in sample of large and medium-sized publicly traded firms in Brazil (using 20% criterion)

Firm Management Pyramids

ITAUBANCO Yes Yes

BRAHMA Yes Yes
UNIBANCO Yes Yes
CIA. BRAS. DISTRIBUI?AO Yes No
ITAUSA Yes No
ARACRUZ Yes No
Average of large firms 1.00 0.50
KLABIN Yes No
CIA. SUZANO PAPEL Yes No
INEPAR Yes Yes
GERDAU Yes Yes
VCP Yes Yes
Average of medium-sized firms 1.00 0.60

Source: CVM.

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 326 Fl?vio M. Rabelo and Fl?vio C. Vasconcelos
groups are families. The combination of dual
class shares and pyramids allows the families to
control many firms with a small percentage of
total capital. This is particularly evident in the
cases of the firm Trikem, a major petrochemical
producer controlled by the Odebrecht family, and
of Gerdau S.A., a large steel firm controlled by
the Gerdau family. In all these firms, the
founding families are the sole controlling share
holders.
Prior to the privatization process, all large
privately and locally owned Brazilian firms had
a similar ownership structure. The only notable
exceptions were the petrochemical firms, where
one found control blocks composed of local
business groups, affiliates of multinational com
panies and the state. This is due to the fact that
the petrochemical industry in Brazil was created
through state intervention, and it was state
planners who organized local capital in partner
ships with foreign firms and a subsidiary of the
state-owned oil company (Petrobras) to consti
tute the novel firms.
We might add here that however important
these groups were and are in the Brazilian
economy, none of them was ever able to develop
a consistent multinational strategy. If they are
compared to their Korean counterparts (the
chaebols), it is evident that the state policy to aid
and concentrate local capital was not able to
generate competitive global firms. When the
state was no longer able to provide funding under
privileged conditions to these groups, their
growth strategies were seriously disturbed. As we
will see below, privatization and economic
liberalization opened new opportunities to these
groups but also posed the challenge to tap reliable
sources of long-term finance to be able to take
hold of these new opportunities.
Results of privatization
The privatization process initiated in the early
1990s is probably the most significant event in
the sphere of corporate governance since the end
of the industrialization phase in Brazil. In this
process, state-owned companies in sectors such
as steel, mining, petrochemical, telecommunica
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tions and energy - some of them among the
largest and most valuable firms in the country -
were transferred to the private sector. The
government structured the process in terms of
sales of control blocks of these companies instead
of a dispersed sale of shares in market. This
option was certainly wiser given the country's
governance structure that adds significant
premiums to control blocks of shares. A pulver
ized sale of shares would hardly have given birth
to widely held companies in the country; we
would only have seen a concentration process
take place in the secondary market and the state
would only have transferred the control
premiums to the private sector.
The first two sectors to be privatized - steel
and petrochemical - did not attract the interest
of foreign investors. In the case of the petro
chemical firms, privatization was an opportunity
for local groups to assert their control rights over
certain companies that were considered strategic
to their growth (Rabelo and Silveira, 1998).
Privatization then led to a concentration of
ownership in most firms, something that was
feasible given the not so large amount of capital
required. Shared ownership was preserved only
in the large central material suppliers, since none
of the local groups had enough leverage to
assume sole control and also because none of
them wished to give up its stake in these strategic
firms. One might conclude then that in this
particular sector privatization did not really lead
to new forms of control.
Another picture emerges when we come to
the steel sector. In this instance, the amount of
capital required to purchase the control block
of some major firms sold by the state
(Cia. Sider?rgica Nacional, Usimininas, Cia.
Sider?rgica de Tubar?o and Acesita) was too large
for any local investor to acquire it alone. Local
business groups then had to build partnerships
with other groups, pension funds, investment
fund managers, banks and foreign investors in
order to be participants in the process. The
experience of shared control, without state inter
vention as in the petrochemical industry, was
effectively started in the country.
These partnerships are also present in the
largest privatized Brazilian mining firm and in
 Corporate Governance in Brazil 327
the privatized aeronautics firm (Embraer). The
presence of foreign investors was increased by the
privatization of energy and telecommunication
firms. In some cases the control of privatized
firms in these two industries was acquired by
foreign firms, without the presence of local
investors in the control block. Particularly in the
case of the telecommunications industry, the
financial incapacity of local groups to capture the
most interesting of the privatized firms was clear.
Privatized banks were mostly acquired by locally
owned banks, even though there is a growing
presence of foreign capital in the Brazilian
banking sector, explained basically by the
acquisition of local banks.
The efficiency of the governance structures
ruling these jointly controlled firms has yet to
be tested. The agency problem facing them is still
not the classical one involving owners and
managers. Two agency conflicts may emerge in
these new structures: (a) one between control
ling and minority shareholders (already present
in the country) and (b) one between controlling
shareholders themselves (the new type of
conflict). These latter conflicts are particularly
interesting given the diverse nature and invest
ment horizons of the controllers.9 When we
move to the issue of board functioning in Brazil,
we will deal with the views of some of these
players regarding these new governance struc
tures.
The private benefits of control
Evidence of the benefits of control of Brazilian
companies includes the large premiums paid for
control. An important research procedure is to
measure the size of these control rents. There are
two possible approaches to this matter: measure
price differences between voting and non-voting
shares (Lease et al., 1983) and between block sales
and the exchange price of the stock following
the announcement of the deal (Barclay and
Holderness, 1989). The first approach is feasible
when the difference between the two classes of
shares is limited to voting rights, which is not the
case in Brazil. Non-voting (or preferential) shares
generally have a better dividend policy and enjoy
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greater market liquidity in Brazil. That is why
in many firms the market value of non-voting
shares is superior to that of voting shares.
The second approach would seem more
appropriate then to study control rents in Brazil.
There are, however, some major obstacles to
accomplishing this task. First, the amount of data
available is not sufficient to replicate in Brazil the
study of Barclay and Holderness (1989, p. 30).
Second, the majority of block transactions to
which this research had access involved non-cash
payments (subscription of new shares and con
vertible bonds) that are not easily valued (Barclay
and Holderness, 1989, p. 380). Third, in some
cases the firm that sold a block of voting shares
did not negotiate such shares in the stock
exchange, so one has no price reference to
compare with.
In the case of the electricity company Cemig,
the controlling shareholder (the state of Minas
Gerais) opted for a partial privatization, selling a
minority control block of its voting shares in a
public auction.10 The announcement was made
on May 21, 1997. The sale agreement included
a clause that granted veto power to the purchasers
over certain operations of the firm and also
assured board representation. On May 28, 1997,
a group of local and foreign investors bought
32.96% of Cemig's voting shares for R$ 1.13
billion. In the closing session of the day of the
formal announcement, Cemig's voting shares
were priced at R$ 27.40. This means that at
market prices, the block of 32.96% of voting
shares was valued at R$ 512 million, meaning
that acquiring investors'paid a control premium
of 120.7%.
The controlling shareholders of the aeronau
tics firm Embraer (pension funds and a local
investment bank) established an agreement with
a group of French firms in order for these firms
to purchase 20% of the voting shares, outside the
shareholders' agreement. This operation was
announced on October 25, 1999, and had the
following structure: 15% of voting shares were
purchased through a public offering to minority
shareholders and 5% were acquired through a
private deal with investment bank. On October
26 Embraer's voting shares were traded at
R$ 6.90 and the group of French firms paid
 328 Fl?vio M. Rabelo and Fl?vio C. Vasconcelos
R$ 8.47 in the public offer, with a premium of
22.75%. There is no information available on the
price negotiated with the investment bank. The
relatively low premium may be explained by the
fact that this block was not included in the share
holder's agreement, diminishing its control value.
A third case is that of the privatized energy
company Light. The state still kept (through
National Bank for Economic and Social
Development (BNDES)) a block of voting shares
in the company that it put up for sale in a public
auction on March 16, 2000. The block (9.23%
of voting shares) was purchased by the French
firm EDF, already a controlling shareholder of
Light. The acquisition meant that EDF is now
the defacto controller of Light. The block acqui
sition was concluded with a price of R$ 391.00
per thousand shares, while the exchange price
at the end of the day of the auction was R$
235.00 per thousand shares, implying a premium
of 66.38%. Two other cases analyzed for this
study involved firms that did not have voting
shares negotiated in the stock exchange, pre
venting the measurement of the control
premium.
Resistance to change?
The concentrated ownership structure of
Brazilian family-owned business groups and the
warding off of strategies that involve a dilution
of control is a clear indicator of the existence of
significant private benefits of control, although
such benefits are not easily measured. It might
be expected then that controlling shareholders
would oppose any measures that mean a reduc
tion of their control rents. In fact the public
position of these shareholders towards governance
matters, usually voiced by the Brazilian
Association of Public Companies (ABRASCA),
is an indicator of their possible opposition to
some measures that might improve governance
in the country.
According to ABRASCA's evaluation the
protection afforded to minority shareholders is
not a major concern for the development of
capital markets in Brazil. The problem lies
elsewhere: high interest rates, tax structures and
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high costs of issuing equity. The solution to these
problems would probably call for larger and less
expensive government lending through BNDES
and fiscal incentives. Later on, this paper will
argue that although these matters exert negative
effects on capital market development, they are
not the main obstacles.
Business groups do face, however, an impor
tant dilemma. It is becoming increasingly diffi
cult for them to grow without sacrificing the
high existing levels of controls. Such a strategy
was possible when the state was still able to
provide finance under privileged conditions11 and
grant fiscal incentives. It has already been men
tioned that none of these groups did ever develop
a consistent multinational strategy. Since the late
1990s the challenge is even harder; now it is a
question of being able to preserve their local
market space in face of greater competition from
foreign firms. In the analysis of the privatization
process it was seen that Brazilian business groups
could not amass sufficient funds to acquire the
more promising firms in the telecommunications
and energy sectors. Many of these groups are
demanding better financing conditions from
BNDES in order to place competitive bets in the
auctions for next privatizations.
One possibility that has been explored by a
few family owned business groups is to sell a
minority control block of a core firm to a foreign
company. This was done by the Pao-de-Ac?car
group, which in 1999 sold 30% of its voting
shares to the French group Casino, and by the
Organiza?oes Globo group, which sold 15% of
its strategic cable TV company to Microsoft. This
strategy allows the controlling family to enhance
the firm's growth potential, while keeping a large
part of control benefits and capturing the control
premium in the block sale to a foreign firm.
The Brazilian capital markets and the
financing of the private sector
We will begin this section with a brief analysis
of the origins of the Brazilian stock market.12
When analyzing the current state of the Brazilian
capital market it is useful to distinguish the debt
securities market from the stock market. While
 Corporate Governance in Brazil 329
the former has been relatively successful, the
latter is quite underdeveloped. Looking at the
history of the stock market helps us understand
the grounds for this fragility.
Strong government intervention is behind the
creation of the Brazilian stock market. During
the first military government, which came to
power in 1964, policy makers awakened to the
need to foster a local stock market. The initial
measure adopted for this end was to grant fiscal
incentives to firms that became public and to
those who purchased their shares. Further incen
tives, of a regional and industry-specific nature,
were afterwards offered to local public firms.
Another important instrument used to stimulate
the capital market was BNDESPar, the invest
ment arm of the BNDES. The mission of this
institution was to acquire shares issued by
Brazilian firms and help place them in the
market, offering credit to buyers. This financing
was undertaken with subsidized interest rates.
BNDESPar remains an important shareholder in
the country.13 The third instrument used by
Brazilian authorities was the creation of a com
pulsory demand for shares, when a minimum
percentage of investments in shares was estab
lished for the portfolios of pension funds and
insurance companies.14
The government of Gen. Ernesto Geisel
(1974-1979), which had a strong developmental
impetus, assigned a very clear mission to the local
capital market: provide funding for private locally
owned firms. According to this rationale, state
owned firms should continue to rely on the state
for funding, while multinationals should seek
capital from their headquarters. It was under this
government that the Brazilian corporate law was
reformulated in order to invigorate the growth
of the stock market. This new law allowed a
higher limit for the proportion of non-voting
shares in the total capital of the firm: from the
previous 50% the limit increased to 67% (two
thirds). Family-owned firms could then issue new
shares without endangering their control
position.
The entire government orchestration in this
field came to a halt with the virtual bankruptcy
of the Brazilian state in the 1980s. Under great
pressure from the growing public debt, much
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aggravated by the international debt crisis that
afflicted Latin America, the Brazilian government
lost its ability to continue the generous scheme
of fiscal incentives and of privileged financing to
local business groups.
It is reasonable to say that Brazil lacks an
equity culture; real shareholders (in the Anglo
Saxon understanding of the concept) have been
rare and controlling shareholders do not see
minority shareholders as partners. Quite the
contrary, attitudes from a shareholder that are
considered natural in the U.S., like showing up
in a shareholders' meeting, may cause managers
(controlling shareholders) to virtually panic.
The role of the domestic capital market as a
source of finance is a minor one, particularly that
of the stock market. Rocca et al. (1998), in a
very thorough study of the Brazilian financial
system, have argued that the state's fiscal
problems, with the ensuing enormous need for
finance, have seriously compromised the func
tioning of the domestic financial system and the
development of capital markets. The state's large
demand for funds is an important factor in the
very high interest rates that have prevailed for
many years in Brazil and for the difficulty of
developing internal sources of long-term finance
for the private sector. A recent study (Rodrigues
J?nior and Mel?, 1999) focusing on the financing
patterns of Brazilian firms, using a sample of 24
firms, found that the stock market provided only
6.5% of financing needs. The major source was
clearly internal funds (63.9%) followed by debt.
This study contradicted former ones, like Singh
(1995), that attributed greater importance to the
stock market in developing countries.
An important characteristic of Brazil's stock
market is its degree of concentration. Data from
Bovespa for January 2000 show that the 10 largest
firms represent 50% of total market capitalization
(474 firms). This data may be somewhat distorted
since the 12 telecommunications holding com
panies resulting from the privatization process are
traded as a block (receipts from former state
holding company), which alone accounts for 17%
of Bovespa's capitalization. If we exclude this
block of shares from the analysis, we have the
10 largest companies accounting for 41% of total
capitalization. Rocca et al. (1998) mention a
 330 Fl?vio M. Rabelo and Fl?vio C. Vasconcelos
World Bank study (Demirgu?-Kunt and Levine,
1996) which calculates this same per
centage at 30% in the 1986-1993 period. Market
concentration is more evident if we look at
trading volume at the stock exchange. In the last
four years, the 10 most traded shares in Bovespa
accounted for 60% to 80% of total trading
volume.
Traditionally, the stock market has been
dominated by state-owned firms. According to
data from Econom?tica (a consulting firm
specializing in capital marketing research) and
Gazeta Mercantil newspaper, in June 1997, state
owned firms represented around 80% of daily
trading, considering the 20 most traded shares
in the stock exchange. After the privatization of
the telecommunications network in 1998, private
firms answered, in mid-1999, for 64% of total
trading volume.
Capital markets, governance and
economic development
At this juncture one might pose a question
regarding the relevance of stock market devel
opment for the Brazilian economy: Should the
growth of capital markets be a major issue for
public policy, and which measures might foster
this growth? There is a respectable literature that
argues that financial development positively
affects economic growth (King and Levine, 1993;
Levine and Zervos, 1998; Rajan and Zingales,
1998). La Porta et al. (1999), citing some more
recent research (Beck et al., 2000; Wurgler, 2000
and Morck et al., 2000), list three channels
through which finance can contribute to growth:
saving, factor accumulation and efficiency
improvements. An efficient stock market is an
important component of financial development.
Stock markets are particularly important when
it comes to providing capital to technology-based
enterprises (including bio-technology). The
experience of Silicon Valley in the U.S. shows
that capital markets are fundamental to fostering
these types of firms. Initial risk capital is provided
by venture capital funds in the hope of realizing
large profits in the event of an initial public
offering. One of the major difficulties of private
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equity and venture capital funds in Latin America
is precisely the exit problem, since the absence
of well-developed capital markets does not make
an IPO as feasible or attractive (Rabelo, 2000).
The lack of an efficient stock market may hinder
Brazil's ability to grasp opportunities linked to
the New Economy (see below).
One might raise the issue that the growing use
of foreign stock markets by Brazilian firms may
eventually replace the need for a local stock
market. In fact, many Brazilian firms are issuing
ADRs in the New York Stock Exchange, and
recently the Madrid Stock Exchange has allowed
Brazilian firms to list directly their shares
(without the use of depositary receipts), which
makes the process less expensive.15 One of Brazil's
largest companies, Cia. Vale do Rio Doce, is
already listed there. There are two caveats here.
First, informational asymmetries will certainly
restrict access to foreign stock markets to a
limited number of Brazilian firms; new ventures
will have difficulty tapping equity finance in
foreign stock exchanges. Second, how much can
a country without a convertible currency and
subject to speculative crisis depend on foreign
sources of finance? These sources are quite
volatile, which is clearly proved by the effects of
the Mexican, Asian and Russian crisis on
international financial flows to Brazil.
A local stock market is also necessary to facil
itate the growth of the private pension industry.
Even in countries where pension funds are
allowed to invest in foreign assets, the great
majority of investments are made in the local
market. Recent government measures may foster
the growth of private pension assets in the short
term future.16 Efficient governance structures ?
i.e., effective mechanisms for the protection of
the rights of outside investors (shareholders and
creditors) - is a sine qua non for the development
of capital markets. It is basically through its influ
ence on financial development that improved
corporate governance will enhance the compet
itiveness of Brazilian firms.
 Corporate Governance in Brazil 331
The role of institutional investors (pension fund and
investment fund managers)
A factor that may have a great modernizing effect
on governance mechanisms in Brazil is the
growth of institutional investors, particularly
pension funds (Rabelo, 1998). The scope and
effectiveness of pension fund activism is certainly
a major issue in the discussion of the future of
corporate governance in Brazil. When we looked
at the privatization process it was possible to see
the extent of their participation in the control
block of many important privatized companies.
In addition, there are companies like Perdig?o,
Parapanema and Inepar where pension funds are
important shareholders. Considering that at the
end of 1999, Brazilian pension funds had around
US$ 60 billion in assets and 30% of this amount
was invested in shares, we may say that these
funds own approximately 15% of the total value
of companies listed in the S?o Paulo Stock
Exchange (Bovespa). Of the circa 358 Brazilian
pension funds, 11 have stakes in major com
panies that exceed 5% of voting shares, which
makes them potential actors in the corporate
governance scenario.
Some investment banks and investment funds
are also becoming active in the realm of gover
nance. Large commercial banks are usually more
timid, given their commercial interests, which
might be compromised in the event that the
funds they manage adopted a more active attitude
in terms of governance. One of the investment
banks we interviewed had members on the
boards of 13 firms. Management believed that
activism was an effective way to gain more
respect from portfolio firms (greater disclosure
and enhanced ability to influence), thus adding
value to the bank's investors. Some investors were
attracted to this bank precisely because of its
posture as an active investor. This bank also
managed one of the three "governance funds"
existing in Brazil, with US$ 110 million in assets.
These "governance funds" are quite an ingenious
instrument; they gather minority shareholdings
of institutional investors and combine them to
exert pressure on portfolio firms in order to
enhance performance.
From our contacts with local investment banks
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we also gathered information on the role of
foreign investment funds. It was hoped that these
funds would put pressure on portfolio companies
to comply with disclosure and right minority
shareholders, standards similar to those of their
country of origin. They do in fact demonstrate
interest in matters related to governance, but
most of them fear taking more concrete action,
like filing suits with the securities exchange com
mission or going to the courts. The deterring
factor seems to be the complexities of Brazilian
legislation and the inefficiency of the country's
judicial system.
In the last quarter of 1999, a group of asset
management firms and investment banks created
the National Association of Capital Market
Investors (ANIMEC), whose purposes are to
push for legal reform in the direction of greater
investor protection and to provide a channel for
investors to organize collective actions. An
interesting case arose in March 2000 in which a
telecommunications holding company made a
public offer to buy minority shareholdings in its
subsidiary firms at a price considered low by
minority shareholders. In response, two invest
ment banks associated with ANIMEC (them
selves having shares in the subsidiary companies)
decided to tender a higher offer for these same
shareholders, thus diminishing the risk of
liquidity loss for those discontented with the
holding company's offer.
Is there still a role for the state?
A major issue of concern is the role the state
should play to enhance existing structures of
corporate governance in Brazil. Some academics
and politicians have been suggesting a more
active industrial policy, which implies a greater
level of state intervention in the economy. Such
a policy would use the National Bank for
Economic and Social Development as one of its
main instruments and would consist of choosing
certain business groups in sectors where they are
considered competitive (petrochemical, steel and
pulp and paper) to lead a restructuring process in
the aforementioned sectors. A move of this sort
was sketched in the beginning of 2000 by
 332 Fl?vio M. Rabelo and Fl?vio C. Vasconcelos
BNDES, which would have established a special
purpose company with a private business group
(the state bank would have put in a large amount
of risk capital and acted as an active partner) to
acquire one of the central material processing
firms in the petrochemical sector. This move,
however, was aborted when BNDES changed
presidents in late February 2000. Critics fear this
approach would be a reenactment of old state
policies, leading to an exaggerated level of inter
ventionism and sharing undue risks with the
private sector. Those who favor a more active
industrial policy argue that without it local
business groups cannot face the competition of
foreign firms and the undesired result would be
a greater level of denationalization of Brazil's
industry.
It certainly is true that Brazilian firms face a
strong handicap when it comes to access to long
term sources of finance. The question is whether
the answer to this challenge is to accept a greater
measure of state intervention in the economy or
to strive to improve macroeconomic conditions
and institutional factors that cause high interest
rates and inhibit the development of a local
capital market. As we have discussed in earlier
sections, there is urgent need for a more inde
pendent and agile securities exchange commis
sion, for a better corporate law and, foremost,
for a more efficient judicial system. Likewise,
improved macroeconomic conditions (especially
fiscal discipline) would lead to lower interest rates
and a better international perception of country
risk, helping local business groups to tap foreign
sources of finance with lower spreads and for
longer periods. Those who do not believe in the
benefits of an active industrial policy argue that
the state should concentrate on these macro
economic and institutional matters and let the
private sector find its own solutions.
Conclusion
This study has shown that ownership concentra
tion is a fundamental characteristic of Brazilian
corporate governance structures. We believe, like
La Porta et al. (1998), that existing ownership
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structures are primarily an equilibrium response
to the domestic legal environment that com
panies operate in. For this reason we emphasized
the legal and institutional framework that
regulates the local capital market and the func
tioning of boards in the country.
The dominant form of organization of local
Brazilian capital is the family-controlled business
group. When studying these groups we analyzed
the role of the state in the creation of existing
governance structures. An important conclusion
in this section was that decades of state inter
vention and active industrial policy were
incapable of producing globally competitive local
business groups. The financial crisis suffered by
the Brazilian state at the end of the 1970s prac
tically excluded any possibility of state
leveraging of local business groups. In this par
ticular point, the Brazilian experience is quite
different from that of some Asian countries, like
Korea, where state protection was able to
produce large business conglomerates, some of
which have been able to place themselves com
petitively in the global economy.
A landmark event for the understanding of
governance in Brazil was the privatization process
initiated in the early 1990s. As a result of this
process we now have important firms in the steel,
mining, energy, infrastructure and telecommu
nications sectors, whose control is shared by local
business groups, pension funds, investment funds
and foreign companies. The efficiency of these
new control arrangements has yet to be
measured, but their sheer novelty is a welcome
fact. There is still some way to go, since critical
enterprises such as Petrobras (the oil exploration
company) and Banco do Brasil (the country's
largest bank) continue under state control.
It has been shown that Brazilian capital
markets, particularly the stock market, are small
and illiquid. Capital market operations account
for a small fraction of the total finance needs of
the private sector. It is widely discussed whether
changes in legislation would be able to foster the
stock market. Better disclosure rules and more
effective protection whether minority share
holders appear to be necessary conditions for the
growth of this market. These are not, however,
 Corporate Governance in Brazil 333
the only problems; there are also tax and macro
economic issues that hinder the development of
capital markets in Brazil.
We consider it vital to boost institutions that
capture long-term savings, particularly the private
pension industry. Besides promoting growth and
innovation in capital markets, institutional
investors may become important levers for the
enhancement of governance structures. We found
evidence that large pension funds are adopting a
more active attitude in the sphere of governance.
Private pension coverage is still very low, espe
cially among the self-employed, and there is
considerable space for growth.
The creation of a stable macroeconomic
scenario is a sine qua non for better
corporate governance mechanisms. All through
the 1980s, the country witnessed a high interest
rate policy, which virtually eliminated any local
source of long-term financing for corporations.
It is unquestionable that difficulties in accessing
sources of finance have hindered the competi
tiveness and growth of local business groups.
Moreover, this situation has inspired some
analysts to call for more direct state assistance to
local groups through an active industrial policy,
probably repeating the same errors incurred in
the past.
One might ask, given existing governance
structures and sources of finance, what the
growth potential of local business groups in a
global economy is. These groups are still con
sidered competitive in the petrochemical, steel
and pulp and paper sectors. It is not clear,
however, whether these groups will be able to
develop by themselves new growth strategies. A
tendency that has been becoming more common
since the late 1990s is the establishment of
strategic partnerships with foreign companies. A
greater internationalization of the Brazilian
economy is a very probable outcome, since most
groups will have difficulty competing without the
presence of a strong foreign partner, especially
in those sectors where foreign players are present.
This brief study of corporate governance in
Brazil corroborates the statement of La Porta et
al. (1998) that the challenge to corporate gover
nance in most countries is to restrict the possi
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bility of expropriation of minority shareholders
by controlling ones. An improvement of the legal
and institutional environment is thus a vital move
towards the creation of efficient governance
structures. It also shows that in response to the
domestic situation, the best performing corpo
rations seeking external capital may opt into legal
regimes that are more protective of minorities
without explicit legal reforms (the ADR market).
We were able to identify some forces that may
lead to the improvement of prevailing governance
structures. Among these sources is the growing
activism of institutional investors. Pension funds
are potentially great providers of equity finance
to local corporations, and the fact that they are
demanding higher standards of disclosure and
minority shareholder protection from would-be
partners may work as a significant lever of
change. Finally, if the state grasps its role as a
reformer of the legal and institutional framework
that affects corporate governance, instead of
repeating an interventionist policy in the
economy, the governance practices in Brazil may
be substantially changed.
Notes
1 The concept of corporate governance adopted in
this paper is thus largely influenced by the works of
Hart (1995a), Shleifer and Vishny (1997) and Zingales
(1997).
2 In Brazil, like in other developing countries of the
sample, this second group of firms almost overlaps
with the first.
3 Whereas La Porta et al. (1998) use 1995 data, we
use here data of end 1998 for ownership and
November 1999 for market capitalization.
4 La Porta et al. (1998) define a firm as an affiliate
of a foreign company if at least 50% of its votes are
directly controlled by a single foreign corporate
owner. We have in our sample, therefore, firms that
are controlled by foreign firms, provided that none
of them has 50% of the voting rights.
5 It should be noted, however, that although the state
is still the major single shareholder in Cia. Vale do
Rio Doce, Eletropaulo and Light, these recently
privatized companies are in fact controlled by groups
of private shareholders (local business groups, pension
funds and foreign firms).
 334 Fl?vio M. Rabelo and Fl?vio C. Vasconcelos
6 To be considered a pyramid the firm must have an
ultimate owner and there must be at least one publicly
traded company between it and the ultimate owner
in the chain of 20% voting rights (La Porta et al.,
1998, p. 12).
7 A business group is defined here as a group of
legally independent firms, linked by shareholding ties,
which guarantee common control over all assets of
the group (Buzzacchi and Colombo, 1996, p. 32).
8 Business groups are usually classified in two cate
gories: associative (as in Japan) and hierarchical. The
latter are centered around a holding company and
adopt a pyramidal structure; monitoring and decision
making are usually centrally organized.
9 Pension funds shared the control of the energy
company Escelsa with a group of investment banks,
organized under a holding company (Iven). In August
1999 the banks sold 73% of Iven to a foreign firm
(Eletricidade de Portugal). This foreign firm, which
is now the largest shareholder, has denounced the
existing shareholders' agreement and has tried to
change the management team, arguing that the
company is showing poor performance. The pension
funds are threatening to go to court to protest against
any breaches to the shareholders' agreement.
10 The case of Cemig will be discussed later in this
paper, when the subject of investor protection is
analyzed.
11 Another important question to be answered is the
exact amount of government subsidies for the finance
of family-owned business groups in the 1960s and
1970s.
12 We are very grateful to Ary Oswaldo de Mattos
Filho, who kindly shared with us his deep knowl
edge of the Brazilian capital market.
13 The portfolio of shares held by BNDESPar was
estimated at US$ 7.3 billion in December 1999.
14 The large pension funds of state owned companies
were forced to buy shares with very low liquidity,
hindering their portfolio performance.
15 There are rumors that the London Stock
Exchange is offering the same facility.
16 It can also be argued that the growth of institu
tional investors will exert a positive effect on the
development of local capital markets.
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Escola de Administra?ao de Empresas de S?o Paulo
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E-mail: frabelo@fgvsp. br
fvasconcelos@fgvsp. br

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