Experience with Novo Mercado

Chichakyan Rimma, School of Governance and Politics, MGIMO University

Abstract: The article examines common arrangement for separating control from cash flow rights: stock pyramids, cross ownership structures, and dual class equity structures. The author describes the ways in which such arrangements enable a controlling shareholder or group to maintain a complete lock on the control of a company while holding less than a majority of the cash flow rights associated with its equity. The author also examines l the solution of modern issues of corporate law on the example of the new market of Novo Mercado in Brazil. In conclusion, the author proposes a theory concerning the consequences and agency cost of these arrangements.

Key words: Separation control from cash flow rights, stock pyramids, cross ownership structures, dual class equity structures, agency costs, Olson’s problem, new market, Novo Mercado.

Introduction: Controlling minority structure companies deserve in-depth studies because they are pervasive outside the handful of companies of developed countries with highly developed equity markets and a tradition of dispersed-share ownership. Our principal contribution here has been to analyze their agency costs. In particular, controlling minority can make efficient decisions with respect to project selection, companies’ roles of control.  We have studied that, the agency costs associated with controlling minority structure companies rapidly increase as the fraction of equity cash-flow rights held by controllers declines. Among other things, the agency costs of controlling minority pyramids resemble in some respects of debt, they are not limited by the contractual protections of controlling shareholders in leveraged companies.

Theoretical Background: Most literature are the basic science papers in the field of dual class equity structures addressing the structure of corporate ownership compares  dispersed  ownership with a controlled  structure in which a large blockholder owns a majority or large plurality of a company’s shares. L. A. Bebchuk, W. J. Friedman, A. T. Friedman, and M. Sawyer develop an alternative approach to explaining why corporate-minority structures arise.

Materials and Methods: The methodological ground of the present Article represents the dialectic scientific method of the socio-political, legal and organizational processes with the principles of development, integrity, consistency, etc. The consistency analysis method is used while researching the object of the analysis. The problem of the role of interested parties in stock pyramids, cross ownership structures, and dual class equity structures and new market, such as the Novo Mercado is analyzed from comparison point of view with application of the historical method and of the object of the analysis method. Some public-private research methods are also used: formally logical or comparative legal method are used to compare decisions of different practices on the same precedent.

Results: In order to solve this Olson’s problem I suggest regulatory dualism to create new markets with enhanced corporate governance rules that prevent shareholders’ control through pyramids.

Discussion: Economics and law studies show that ownership structures that separate control (stronger controlling power) and cash flow rights (over decision making of the listed company relative to the size of the shares) create agency cost problems and are associated with reduced value for minority shareholders. Investors expect a discount on the share price of companies with control structures. The phenomenon of the control mechanisms in companies is very common in modern corporate reality. Control mechanisms take the form of multiple voting rights shares or pyramids of ownerships that make it possible for control to be wielded by someone who owned an even smaller portion of the company [1].

In the USA, corporate pyramids (formation of corporate group by vertical investment) are discouraged through the taxation of intercompany dividends, whereas multiple voting rights shares are allowed but have to be issued before the public offering [2]. In addition, majority shareholders, who want to entrench themselves in control by retaining voting rights shares, pay the costs of this inefficient capital structure when the company initially goes public at a discounted price. Some European countries (for instance, Italy and Portugal) have adopted an opposite solution. However, the most legislators in EU prohibit multiple voting rights shares, but corporate pyramids are commonly used by listed companies and can be created following the initial public offering of the company without approval from the shareholders [3]. In such cases, investors expecting that a corporate pyramidal ownership structure will be created in the future, they will probably reduce the purchase price of the shares when the company goes public.

This arrangement produced a fundamental mismatching of interests between those who held preferred shares and those who controlled the companies. In addition to the conceptual differences between two groups of shareholders, the structural changes taking place within the companies clearly showed that shareholders did not have equitable treatment.

According to R. J. Gilson, Brazil’s use of the Novo Mercado has allowed the country to overcome what he calls the Olson’s Problem. According to the theory of the free rider elaborated by Mancur Olson, small groups can act to advance their common interest more easily than large ones. Large groups face action problems of the Company that reduce their ability to act in their interest [4].Never the less, member of small groups receive a higher per capita participation ( one man – one vote principle) on the benefits of their collective actions and therefore have lower cost in organizing their intensions. The Novo Mercado is a form of regulatory dualism, which can combat the Olson problem by allowing elite groups to remain governed by the same regime [5].

In order to solve this Olson’s problem I suggest regulatory dualism to create new markets with enhanced corporate governance rules that prevent shareholders’ control through pyramids. Regulatory dualism seeks to mitigate political opposition to reforms by permitting the existing business elite to be governed by the old regime, while allowing other companies to be regulated by a new parallel regime that is more efficient.

Additionally, the Novo Mercado is a private initiative, based on the self-regulation power of the Stock Exchange, in order to create receptive environment for public offering. In addition, that site of power offers a developed system for regulating the rights of minority shareholders, while avoiding corporate pyramids, cross ownership structures, and dual class equity structures. The special segment of the Sao Paulo Stock Exchange available to companies that commit to adopting high standards of corporate governance [6]. Multi-party shareholders agreements may also, under certain conditions, make easier to reduce agency costs by combining supplementary board oversight model for companies with a low non-affiliate public float with the absence of a single dominant shareholder that could easily expropriate the minority without peer supervision. Among the most remarkable aspects of the process related to the installation of the Novo Mercado is the acceptance by foreign investors of the stock offerings.

Conclusions: To overall, Brazil’s Novo Mercado offers a paradigmatic example of regulatory dualism as a self-conscious strategy in which the reformist regulatory regime was deliberately implemented to circumvent a strong version of the Olson problem. Because the Olson problem is pervasive, and in no way limited to developing countries.

References:

1. Bebchuk, Lucian A. and Ferrell, Allen and Kraakman, Reinier and Roe, Mark J. and Subramanian, Guhan, Placing Election Bylaws on the Corporate Ballot (2005). Harvard PON Working Paper No. 915403.
2. Houston, Arthur L. Jr., and Carol Olson Houston. 1990. Financing with preferred stock. Financial Management 3:42-54. Storming the Citadel: The Peter Wallenberg business empire. 1990. Economist, 23 June, 73.
3. Bebchuk, Lucian A. 1994. Efficient and inefficient sides of corporate control. Quarterly Journal of Economics 109:957-93. Emerging market business groups, foreign investors, and corporate governance. NBER Working Paper no. 6955. Cambridge, Mass.: National Bureau of Economic Research.
4. Shannon Guy, Private Equity in Brazil: Industry Overview and Regulatory Environment, 2 Mich. Bus. & Entrepreneurial L. Rev. 155 (2012).
5. Hansmann, Henry; Gilson, Ronald J.; and Pargendler, Mariana, "Regulatory Dualism as a Development Strategy: Corporate Reform in Brazil, the U.S., and the EU" (2010). Faculty Scholarship Series. Paper 28.
6. Shannon Guy, Private Equity in Brazil: Industry Overview and Regulatory Environment, 2 Mich. Bus. & Entrepreneurial L. Rev. 155 (2012).