CHAPTER 1

A Guiding Light for Investors in Brazil

Eduardo G. Chehab

Introduction and Executive Summary

How Brazilian Corporate Governance Bloomed

Corporate governance is a set of practices designed to optimize a company'sperformance, protect stakeholders (investors, employees, and creditors), andfacilitate access to capital. The analysis of corporate governance practices asit is applied to securities markets encompasses transparency of ownership andcontrol, equal treatment of shareholders, disclosure of information, boardeffectiveness, and risk management controls, among other topics.

For investors, this analysis is an important aid in making investment decisions.These practices determine the kind of role investors may play in a company,enabling them to influence its performance. Good corporate governance practicesincrease a company's value and reduce the cost of capital, increasing theviability of securities markets as sources of funding. Companies with agovernance system that protects all investors tend to have higher valuationsbecause investors recognize that everyone will receive the due and appropriatereturn on his or her investments.

In the last few years significant reforms have been made in Brazilian corporategovernance, including the introduction of the New Market (Novo Mercado) conceptand changes in company and securities law that stem from a conviction thatcapital markets should play a much larger role in the country's economicdevelopment than they did in the past. Proponents of capital markets in Brazilbelieve that one of the keys to a healthy and successful market is theintroduction and support of strong corporate governance measures.

Historically, Brazil's capital markets played only a minor role in providingcompanies' financing needs, which were met from companies' retained earnings andfunding provided by financial institutions and state-owned entities. However,the country's enormous social demands and scarce financial resources havelimited the state's ability to maintain its role as a capital provider. Agradual change in funding availability started with the opening of the Brazilianmarkets in the 1990s. Companies faced intense international competition andrequired more capital to upgrade and meet competitive threats. Those capitaldemands could be met only by developing and expanding local capital markets andimproving the domestic economy. In support of those goals, new laws addressedgovernance problems and focused primarily on greater transparency and disclosurerequirements as well as protection of the rights of minority shareholders.

The Brazilian stock market has developed strongly since 2006. Almost U.S.$40billion was raised through equity issuances, along with U.S.$78 billion throughissuances of debentures in the period 2006–2008. At the same time,investor concerns about corporate governance also increased, mainly in regard tothe rights of minority shareholders and corporate enterprise risk management. InNovember 2008, to help address those concerns in Brazil, Standard & Poor's (S&P)launched the GAMMA (Governance, Accountability, Management Metrics, andAnalysis) score, an important tool for selecting companies with higher corporategovernance levels and guiding companies in improving their governance policies.

Market Infrastructure

Summary of Economic History: Brazil Emerges as a Resourceful Dynamo

When Portuguese explorers arrived in Brazil in 1500, the native tribes, totalingabout 2.5 million people, had lived virtually unchanged since the Stone Age.From Portugal's colonization of Brazil (1500–1822) until the late 1930s,the market elements of the Brazilian economy relied on the production of primaryproducts for export, such as sugar, precious minerals, and coffee. Thepost–World War II period up to 1962 featured intense import substitution,especially of consumer goods. A period of rapid industrial expansion andmodernization occurred between 1968 and 1973. Import substitution of basicinputs and capital goods and the expansion of manufactured goods exportshighlighted the 1974–1980 period.

However, the following years, mainly the period 1981–1994, were marked byconsiderable difficulties because of the world oil crisis, a moratorium onpayments of the external debt in 1982 and 1987, and the consequent low increasein gross domestic product (GDP) (average of only 1.4% per year). Thosedifficulties were fueled by several unsuccessful economic stabilization programsthat were aimed at reducing high inflation rates and the impeachment of apresident, Fernando Collor de Mello, in 1992 for corruption.

Finally, in 1994, the Real Plan was implemented, and the annual inflation ratedropped from more than 5,000% to 20% in 1996 and eventually in the range of 5%.

The successful Real Plan was based on three pillars:

• Monetary reform

• Further opening of the economy

• Privatization of several state-owned companies in the steel, power, banking,mining, and telecommunication segments, raising around U.S.$100 billion

After another period of ups and downs, the economy began to grow more rapidlystarting in 2003, strongly influenced by the worldwide trade boom. GDP grew 5.7%in 2004, 3.2% in 2005, 3.8% in 2006, and 5.4% in 2007. In 2008, the economy grewanother 5%. In the beginning...