Posted by Bruno von Dreifus and Pedro Cafaro (Associates from Trench, Rossi e Watanabe*)
*In cooperation with Baker & McKenzie
In contrast with the “one share one vote” principle promoted by the Novo Mercado segment of BM&FBovespa (the principal stock market in Brazil), the Brazilian securities market now debates the possibility of reinventing the preferred share through the so called “super-preferred shares”.
As of the end of the 1990s, BM&FBovespa worked with listed companies to promote an environment of growing corporate governance, disclosure and protection of minority shareholders. The pinnacle of such campaign is the well-known Novo Mercado listing segment of BM&FBovespa, launched in 2000, in which participant listed companies must abide by certain rules aimed at protecting investors, such as: (a) issuance of only common shares with full voting rights; (b) a minimum percentage of 20% of independent board members; and (c) right to receive 100% of the price paid to the controlling shareholder in case of a change in control.
The use of preferred shares suffered from other disincentives, such as the 2001 change of the Corporations Law that reduced the limit of preferred shares from 2/3 of the issued shares of the company (i.e., at least 1/3 of the total number of shares had to be common) to 50% of the issued shares of the company.
These developments resulted in common shares becoming considerably praised in the Brazilian stock market and, jointly with the Novo Mercado segment, have contributed to a growing market with considerable liquidity and developing corporate activism.
The common share, however, is not a solution in all cases. Particularly in regulated segments in which the participation of foreign capital is legally restricted, the existence of limitations on and disincentives to preferred shares have created difficulties for the capitalization of certain companies through the equity market. For example, Brazilian airline companies may only have 20% of their equity interest held by foreigners. It is in this scenario that preferred shares have been revisited, particularly with the discussions of super-preferred shares.
Brazilian super-preferred shares are designed as preferred shares with the usual limitation on voting rights, but with a significant increase of their economic rights in comparison with common shares, in certain cases, reaching multiples as high as 75 times the economic rights of the common shares.
As presented, the main objective of these super-preferred shares was to create an alternative for companies to issue additional shares to capitalize and not dilute the political control of the controlling shareholder (which would still hold the majority of common shares), whilst complying with regulated sector restrictions on foreign investment and legal restrictions on the percentage of preferred shares.
Naturally, these discussions have brought up skepticism by rekindling the debate on the separation of control and ownership of the company, and sparking a discussion on whether or not issuance with such multipliers would be in violation of the 50% limitation of issued preferred shares.
On the separation of control and ownership, preferred shareholders contribute substantially more capital than the common shareholders, but hold only non-voting shares. On the other hand, the control and direction of the business of the company – and, therefore, the decisions on the use of the investments made by the preferred shareholders – are subject to the discretionary control of the common shareholders. These decisions may not be aligned with the interests of the preferred shareholders.
Additionally, the main advantage for holders of super-preferred shares is their right to receive a substantially higher dividend distribution than common shareholders. However, this advantage only exists if the company effectively has profits and if common shareholders decide on a relevant distribution of dividends. Brazilian common shareholders have only the obligation to approve a distribution of the minimum mandatory dividends (often of 25% of the net profits in listed companies, but which may be lower), and the common shareholders may decide to allocate the remaining amount differently (e.g., reinvestment in the company).
On the possible violation of the legal limitation, a decision by the technical body of the CVM (the Brazilian Securities and Exchange Commission) considered that super-preferred shares would be a violation of the principle behind the 50% limitation of issued preferred shares as it would substantially disassociate the economic investment from the shareholders’ political rights. However, the decision of the technical body was overturned by the CVM’s Board of Directors, which favored a more literal interpretation of the 50% limitation between common and preferred issued shares. Such decision did not take into regard the economic investment between different classes of shares, but rather the numerical component, leaving up to the investors to determine whether super-preferred shares are aligned with their interests or not and, thus, if it would be successful in the market.
It still remains to be seen how super-preferred shares will be accepted by the Brazilian market. Nonetheless, to the extent this trend advances, it should motivate a rise of negotiations between interested investors, companies and controlling shareholders to carefully structure super-preferred shares in the bylaws of listed companies.