LCV

NEWS ABOUT CORPORATE GOVERNANCE - November-December/2003

Year IV – No. 31

Corporate Governance News

Editor: Luciano Carvalho Ventura

Editorial

Corporate Governance and the dividend decision.

Since almost all Brazilian companies close off their fiscal year on December 31 and, it is on that date that the dividend payment decision is made, this editorial becomes entirely apposite.

The main aspect to be examined on corporate dividend payment is whether to apportion a company’s profits among its owners or retain them. In fact, since the days of the Roman Empire, the very word, “dividend” deriving from the Latin dividere, illustrates the essence of this decision. The dividend percentage paid out can be anything from 0% to 100% of profits for the year and prior years, with due regard for the legal restrictions analyzed below.

The problem is that this seemingly straightforward process and one that, specifically in Brazil where it is approached from a technically oversimplified point of view, the truth is that this is a highly complex decision.

I shall not examine in detail academic discussions on the influence of the dividend decision on a company’s share price, particularly since these discussions relate mainly to the restricted world of listed corporations. Nevertheless, this decision directly impacts the company’s share value. To summarize, in our opinion, the reasons for the importance of this decision and its impact on share prices, are: a) resolution of the owner’s uncertainties; b) costs of share sale transactions in the market as opposed to the simpler process of receiving a dividend; c) personal taxes or even differing taxes on capital gains and receipt of dividends.

Let us now examine additional factors to be considered in relation to the dividend decision, without limiting ourselves to the technical requirement of the minimum compulsory dividend, pursuant to Brazilian corporate legislation. This allegedly protects the interests of the minority shareholders whereas, in fact, it often jeopardizes their greater interests.

1) Liquidity position and capacity for obtaining funds – Liquidity position is one of the most vital elements in the dividend decision. This is because a company may have reported a high profit at a given period of time but be unable to pay dividends due to its liquidity position. In turn, the company’s capacity to obtain funds at a capital cost compatible with its profitability could provide greater flexibility in relation to its dividend payment index.

2) Legal aspects – Some legal factors can influence a company’s dividend decision. These can relate to government legislation, company by-laws, or an owners’ agreement representing dividend payment restrictions or incentives. For example, legal requirements can represent dividend payment restrictions. On the other hand, an example of incentives to dividend payment is the fact that, under Brazilian law, company administrators are not permitted a bonus in cases where the dividend paid out is less than twenty-five percent (25%) of total adjusted income for the respective period, even if the minimum compulsory dividend established in the statutes is less than 25% (despite what many people believe, this is permitted under Brazilian corporate legislation).

3) Loan agreements – Loan agreements, long-term agreements in particular, have the power to restrict a company’s capacity to pay out a dividend. Since these agreements are designed to protect the creditor, they may contain clauses limiting dividend payments.

4) Income and dividend consistency – Consistent income is greater security for future profits. Accordingly, a company consistently reporting profits is in a better position to pay high dividend rates than a company recording variable profits. Although dividends derive from income, in practice, they are more stable than income. Dividends adjust gradually to profit levels and, once they have increased, the company should strive to maintain them at this new threshold, even if profits drop to an earlier level.

5) Expansion rate – Company expansion can be financed with any combination of third party funds, new share issues, and retained earnings. Companies in accelerated expansion should pay lower dividends than those expanding at a normal rate, zero rates, or a declining rate.

6) Internal rate of return – If the internal rate of return, including for financial re-investment via retained earnings, is higher than the same risk level rates available in the market, it is advisable for companies to refrain from paying out historic base dividends; this could also be urged by the company owners.

7) Share control – A high dividend payment could lead to the need for a new share issue in the near future. In this event, depending on the time differential between payment of the dividends and the capital increase call, the majority shareholders may lack the necessary funds to subscribe new shares. For this reason, these shareholders should give preference to retaining earnings as an alternative source of financing for new investment projects.

8) The need for an amended capital structure – Some companies retain earnings to pay their debts to third parties with the intention of reducing their financial risk and capital costs.

9) Inflation – A period of inflation can cause many companies to report fictitious profits and, for this reason a prudent approach to dividend payment is recommended.

10) Business cycle – In the event of accelerated expansion of the economy, companies should implement a low dividend payment rate, as a means for financing available investment opportunities.

A company wishing to ensure a minimum level of quality in its dividend decisions should consider the greatest possible number of the above deciding factors.

Below, we comment on dividend decision aspects in Brazil and the US, with due regard for the enormous differences between these two business communities:

- Among these peculiarities, as a result of the legal structure of the minimum compulsory dividend, very few Brazilian companies make full use of the dividend decision as an advanced management tool and the existence of preference shares that receive special treatment in relation to their rights to the dividends paid out by the respective company. Note should also be taken of filing the related agreement, interest on the company’s own capital that, in its capacity as a hidden dividend, appears to be a unique concept in global legislation. Further, in relation to Brazil, unlike many countries, including the US, the dividend paid to the owner, unlike capital gains, is income tax exempt in order to avoid unfair double taxation.

- Recently, the US Government decided to reduce dividend taxation. With this, dividends came right back into fashion in the US share market, superseding the all too frequent share repurchase policy. An excellent example of how flexible this dividend decision is in the US, is the case of Citigroup, which announced an annual dividend increase from US$ 0.80 to US$ 1.40 per share, i.e., seventy-five percent (75%) based on its increased profits for the second quarter of this year as compared to that of the previous year of only five percent (5%).

- Whether or not a company is publicly quoted, it should be noted that the dividend decision is even more important for owners of unlisted companies since they lack the liquidity available in the share market to owners of listed companies. Thus the former are unable to substitute dividend income for security sale income or even take advantage of the so-called clientele theory.

- Lastly, dividends are exclusively company owner material, and the related decision is part of Corporate Governance.

IBGC – The Brazilian Institute of Corporate Governance

The IBGC remains actively engaged in its mission to contribute to exploit the concept of Corporate Governance in Brazilian companies. It held the Fourth National Corporate Governance Congress in São Paulo, with the traditional inaugural dinner on November 9, 2003 and continuing throughout the 10th. As in the past, this Congress was attended by eminent Brazilian and foreign speakers, and attracted a record attendance of close to 300. Shortly thereafter, on November 26, 2003, the Institute’s Southern Chapter based in Porto Alegre gave a talk on “Demystifying Governance”. Highlights of this talk were three successful case studies, namely, Natura, Randon, and Excelsior Alimentos. The speakers were José Guimarães Monforte, a member of the Board of Directors of Natura and vice-president of the IBGC, Astor Schmitt, corporate and investor relations director of Randon Participações S/A and vice-president of the FIERGS/CIERGS (Federation and Center of Industries for Rio Grande do Sul) system, and Clóvis Baumhardt, Chairman of the Board of Directors of Excelsior Alimentos, former director of BANRISUL (Banco do Estado do Rio Grande do Sul). Another important item was the debate panel that discussed “Corporate Governance: Practices, Trends, and Prospects”, coordinated by Geraldo Hess. Hess is a deacon of Brazilian independent board members, a member of the board of directors of Goldman Sachs in Brazil, and also a member of this organization’s International Advisory Board. Over the last eighteen years, he has served on approximately forty Boards of Directors in Brazil and ten overseas companies.

The IBGC closed a year of numerous and important actions in the field of Corporate Governance with a talk entitled “Values and Governance” given in São Paulo on December 19th, by a distinguished Brazilian executive with an unparalleled reputation in the global scenario, Alain Belda, Chairman of the Board and CEO of Alcoa since 2001

Succession in the context of Corporate Governance

Succession is a highly relevant Corporate Governance topic since it involves risk, and minimizing and managing risks is an intrinsic part of any good Corporate Governance procedure. It is probably for this reason that US Boards of Directors of companies that implement a high level of Corporate Governance strive to ensure that their companies maintain a regularly updated plan for replacing their CEO’s.

It is a well-known fact that the succession process can be entirely unexpected or previously planned. A flawed choice of successor or a badly conducted process sets the course for risk and could undermine the company’s image in the market. For obvious reasons, an unexpected succession process is infinitely more risky than a planned process. Undoubtedly, one of the most effective ways in which to minimize the inherent risk of these processes is to implement permanent successor training programs.

As a rule, succession is even more complex in family businesses. This is because, depending on a company’s degree of professionalism, one family member must be selected from among other family members either to succeed the CEO, who is often the company founder, or another very senior executive. This implies an apparent disregard for the other family members involved in the company’s business and, thus, requires additional circumspection in administering the inherent political aspects. In these cases, the need for successor training is even greater, given the few alternatives to be considered in the selection process. Recently, journalist Célia Domingues interviewed this editor on the topic of Successor Training for the Ação do Programa Nacional de Treinamento (PNT) da Associação Brasileira dos Distribuidores Ford – ABRADIF Magazine. The text of this interview can be found in full in the LCV website Technical Material section (www.lcvco.com.br).

Brazilian Pension Funds continue to encourage good Corporate Governance practices.

The Petrobrás Private Pension Fund (Petros), Brazil’s second largest pension fund in terms of assets, is leading the formation of a private equity fund, GG, to invest in companies with a committed corporate policy, such as publication of the financial statements, respect for the environment, and good Corporate Governance practices. The green light for this project has been received and, in the words of Petros CEO, Wagner Pinheiro, “This is a Corporate Governance incentive fund, currently in the process of obtaining funds.”

The equity fund is being formed jointly with other pension funds and will have assets of up to R$200 million (US$70 million). Petros will make an initial investment of R$40 million (US$ $14 million) which, if compared with its assets of R$21 billion (US$7.3 billion), is modest, but nevertheless evidences its interest in championing companies that apply or begin to apply good Corporate Governance practices, and it should attract other pension funds. Most important of all, it should have a demonstrably important impact on the Brazilian capital market. GG Investimentos will manage the new fund.

The IBGT (Brazilian Institute of Management and Turn-around) promotes yet another event.

On December 12, 2003, in Florianópolis, Santa Catarina, the newly formed IBGT held another event. Entitled “Restructuring Companies in the Light of the New Recovery and Bankruptcy Law – a Preventive Approach” with the support of the FIESC - Federação das Industrias do Estado de Santa Catarina (Federation Of Industries of the State of Santa Catarina) and special support of the BNDES - Banco Nacional de Desenvolvimento Econômico e Social (National Economic and Social Development Bank), this event had an attendance of close to one hundred (100), including entrepreneurs, executives attorneys, consultants, auditors, and other professionals interested in this topic. The closing panel concentrated on the topic of Corporate Governance and Family Business Governance, within a company renewal context, since it is a well-known fact that Corporate Governance plays an essential role in the renewal or recuperation of companies. This is because companies in either of these circumstances require a long-term view and the authority to introduce change and crisis management skills, respectively. A long-term view is a talent required of the owner(s) of successful companies (company), and the authority to introduce change and crisis management skills require the legitimate power of command truly held only by adherents of Corporate Governance. Additionally, interim management, essential to any corporate renewal or recovery process, requires a very visible Board of Directors and one that is fully familiar with this type of management. For family businesses, this corporate renewal or recovery process becomes even more complex. This is because it involves the combination of company and family interests, a higher degree of hostility to change arising from long entrenched values, but, chiefly because of the higher potential of corporate conflict during this process. According to the Chairman of the IBGT Board of Directors, Jorge Queiroz, other symposia along these lines will held in several major Brazilian cities throughout 2004.

A fourteen century- old Family Business.

A US survey of family businesses showed that only 10% survive for more than 75 years, and a mere 4% attain the 100-year mark. The world’s oldest and best known family business, in chronological order, are: Italy’s arms manufacturer, Beretta, founded 477 years ago, Japan’s ship-building and mining firm, Sumitomo, aged 373, Germany’s school and office material producer, Faber Castell, aged 242, Britain’s financial organization, Rothschild, aged 204, and the youngest, the US clothing company, Levi’s, aged 150. These companies are mere novices in the context of Japan’s Osaka based company, Kongo Gumi. In a recent edition of the US magazine, “Family Business”, the organization has been confirmed as the world’s oldest company, an age measured not in years but in centuries, specifically fourteen (14) centuries. In September 2003, this ancient construction company, specializing mostly in religious temples, saw the transfer of its command to the fortieth (40th) generation of the Kongo family. Fifty-four year-old Masakazu Kongo succeeded his father as the company’s CEO, and is unsurprised by its longevity with its consistent focus on its principal area of business. As famously stated by the Greek poet-soldier, Archilochus, “The fox has many tricks, the porcupine one reliable trick”, meaning, of course, that the fox would never win in an encounter with the porcupine because the latter focuses solely on its one defensive artifice of raising its quills. Kongo’s philosophy arises from his family’s business strategy and he makes no mention of its governance, either family or corporate. Given that the world abounds in examples of family businesses that, despite implementing correct strategies and efficiently running their businesses, finally succumb for reasons of corporate conflict, it would be fascinating to surmise that these centuries of success are also due to an excellent combination of Corporate and Family Governance. It was a great shame that the reporters present at the company’s first interview with the foreign press in fourteen centuries did not inquire about its governance systems.

Surprisingly, in today’s world, the US is willing to negotiate.

Double entry bookkeeping was invented in the fifteenth century by Leonardo da Vinci’s contemporary, Italian monk Luca Pacioli, who lived in Tuscany from 1445 to 1514. Since the invention of this genetics scholar, nothing has been discovered to replace accounting records in the process of evaluating a company’s performance. Consequently, it is absolutely vital for anyone involved with Corporate Governance to be able, at least, to read financial statements.

The good news is that the world is close to having an international accounting basis, a more all-embracing standard. It is a well-known fact that the US, with its fourteen thousand companies listed on its stock exchanges, applies FASB standards, while the seven thousand companies listed with the European Union’s stock exchanges apply IASB standards. After the series of accounting scandals revealed in so many major US companies that rocked investor confidence in the alleged superiority of FASB standards, during the next few weeks, the FASB authorities intend to propose several amendments to align US accounting standards with IASB standards. This is the first time that the professionals who dictate accounting regulations in the US have ever proposed any explicit modifications to their rules to take international accounting standards into consideration, rather than expect their foreign colleagues to bow to US standards. The highlight of the FASB proposal is that it will probably include a general requirement for companies to apply retroactive accounting changes. This will oblige US companies to recalculate their financial statements by amending results reported over the last few years.

Continuing changes at the New York Stock Exchange, the world’s largest.

Interim NYSE chairman, John Reed, struggles on with his mission to recuperate the credibility shattered by the recent scandals that have rocked the world’s most solvent stock market. Among other changes, he is proposing the following to the NYSE’s true owners, its 1,366 members: a) a reduction in its number of members of Boards of Directors from twenty-seven (27) to ten (10). The eight (8) recommended board members, including two (2) women and two (2) Britons, have practically no direct professional link with the NYSE; b) increase in Board members’ fees to US$75 thousand per annum, from the current average of US$30 thousand plus commission for attending meetings. Reed claims that, even with this new level of fees, these board members will still be paid less than members of boards of the larger listed companies; c) a reduction in the immense salaries paid today to executive directors: d) legal action to recover a portion of the fees of US$ 39,5 million paid to the all-powerful former chairman, Dick Grasso, dismissed for irregularities in September 2003. Reed based this claim on a recent report proving that the amount paid to Grasso on his dismissal was not due; e) a representative of individual investors to have a seat on the Board of Directors who, in Reed’s words, will add “an additional beneficial voice” to the recently formed supervisory body. The administrators of major US pension funds have insistently demanded representation on the NYSE Board of Directors, but Reed has refused such requests, on the grounds that the stock exchange needs entirely independent board members; f) the agreed substitute for the CEO, John Train, 48, was a senior executive with the Goldman Sachs Investment Bank, who will be paid a salary of US$4 million per annum and, as explained by Reed when he introduced Train to the press, “will not be entitled to those strange retirement packages”; and g) the formation of a “superfund” to offset systematic losses sustained by investors on proven violations of share trading rules by so-called “specialized brokers”. Further to this last item, the USA’s largest pension fund, Calpers, is suing the NYSE and seven of its brokerage houses for improper trading. This fact underlines the recent cowboy environment of the Mecca of US capitalism. In its 211 years of existence, this is the first time that the NYSE has been sued for conniving with brokerage manipulation and illegal activities.

Despite all, is the US share market beginning to regain credibility?

The answer seems to be yes. The US Government’s tough intervention via the Sarbanes-Oxley Act, to censure the NYSE and the growing importance given to good Corporate Governance are decisive factors to recuperating the credibility of the US capital market, the lynchpin of global capitalism. One of the strongest indicators that the worst is over is the number of IPO’s placed by new companies with the NYSE. The famous Google site becomes a listed corporation at the beginning of 2004 with highly successful prospects. Many more companies will follow suit. According to Thompson Financial, at least 150 new US stock market placements are expected in 2004, as compared with 84 in 2003 while 2000 was 386. It remains to be seen when the record number of 876 new placement in 1996 will be attained, but the indicators are positive.

As for corporate scandal, this time the ball is in the European Union court, such as the recent Ahold and Parmalat cases, but these are topics for the next newsletter.

CVM (Brazilian Securities Commission)

Extract from “Recommendations of the CVM on Corporate Governance”

Ratio of Ordinary and Preference Shares

III.7

Listed corporations formed before Law 10.303/2001 came into force shall not increase their ratio of preference shares to more than 50%, as established by this law for new listed corporations. Companies with a present ratio in excess of 50% of preference shares may not issue more preference shares.

The purpose of this directive is to ensure that company capital is increasingly composed of voting shares.

Best Corporate Governance Practices

Extract from the Code of Best Corporate Governance Practices – Brazil

The Board of Directors (cont.)

Relationship with the

Audit Board

The Audit Board (if this exists) is elected by the owners. Its attributions and responsibilities are defined in Brazilian Corporate legislation

HAPPY NEW YEAR!.

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