Virtus in medium est

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If the market is efficient, why are non-voting shares discriminated?
Questions like this are blandly repeated by ‘the more radical liberals’ when they want to criticize many of the regulatory initiatives launched in the capital market. Their proponents assume that the State is not responsible for protecting investors once they should know what to do with their money. Caveat Emptor, cry the libertarians.
Hold it!
Merton Miller used to say to his students that liberals – the way he and his colleagues from Chicago are proud to be called – are not irresponsible. They are not against traffic lights. It’s quite the opposite actually. So that the market works well, there must be rules. And they must be respected. Without them, there’s no market.
The gold test about the “desirability” of a rule is a social cost-benefit analysis. Gains and losses are compared, both private and public and, in the event the result is positive, the rule must be established. Unfortunately, such analysis is almost never performed in Brazil. Therefore, we oscillate like a pendulum between the interventional excesses and the opportunist laissez faire – both with burdensome social costs.
This mindset fits perfectly in the dilemmas of the Brazilian capital market. No master thesis is necessary to show that today we are in a ‘poor balance,’ with approximately 300 publicly-held companies (in India, there are 6,000 ones) and less than 1% of the population exposed to the stock market. There is something wrong with our institutional structure that has been hindering the development of the capital market. Are there too many rules? Is there lack of rules? Are there enforcement problems? The most probable answer is: yes, yes, and yes.
Let’s start by addressing corporate governance issues. In the beginning of the millennium, there was a strong consensus that many of the problems of our publicly-held companies resulted from the inconsistence between controlling shareholders’ and minority shareholders’ interests. The reform of the Corporate Law sought to minimize the problem by bringing down the limit on the issue of non-voting shares, recreating the tag along and facilitating the election of independent directors. Yet Novo Mercado reinforced the integral tag along and banned non-voting stock. The Brazilian Securities and Exchange Commission (CVM) followed the same path: strengthened Audit Committees and created procedures to minimize the conflicts in transactions with related parties. Changes like these prepared the ground for the ‘mini boom’ of IPOs experienced from 2004 to 2008.
However, there was a great deal of criticism. It was said that the Brazilian capital market would become less competitive as a result of the lack of different assets that could be useful or even necessary in specific corporate situations. Companies would quit going public to finance themselves on a private basis, with more freedom.
After the reforms, debates started to focus on the rules and decisions taken by both CVM and self-regulatory entities. The dichotomy between controlling shareholders and minority shareholders – expected to be overcome with the advent of corporations – once again started to guide lawsuits and decisions. Must the regulatory agency ‘protect’ investors, as if they were insufficient, or merely ensure the availability of complete information so that they can take their decisions?
Such reflection was present, for example, in the judging process of the merger between Oi and Portugal Telecom at CVM. The leading vote questions whether the entity must interfere in issues among shareholders, which could be solved based on the majority principle or, in the event of abuses, taken to the competent courts. The assumption seems to be that investors are not only rational, but indifferent in the short, medium and long terms.
Experience has shown that this approach does not result in a healthier capital market. And the main reason for that is in the market’s institutional structure itself.
Market players are part of peculiar institutional arrangements. This is true for the main ‘consumers’ of securities: investment funds and pension funds. These consumers have increasingly become the asset owners. Accordingly, it’s essential to understand their behavior to make an appropriate analysis of the cost-benefit of regulations. And to be able to understand their behavior, we first need to understand the structure of incentives inherent to these specific players.
Investment funds are heavily regulated in Brazil and have very clear characteristics when it comes to the management of conflicts (through the segregation of functions – administrators, managers, custodians, auditors, etc.), transparency (through the publishing of quotas and portfolios) and liquidity. The combination of regulation and competition has led to the creation of products with very high liquidity, with the exception of a few funds that demand more elastic redemption terms. Therefore, as much as many managers classify themselves as ‘long-term investors,’ their long term is as longer as that of their clients.
This fragility brings a number of consequences, from the lack of interest in medium-size companies’ shares – because of their potential lack of liquidity – to the investment process itself that tends to focus more on medium-term triggers than on the factors that determine their price in the long term.  As a result, a (significant) group of investors willing to buy assets with doubtful characteristics arises, provided they foresee enough reasons for someone else pay higher prices in the short or medium terms. A market for “sardine cans” emerges, in which the content is less important than packaging.
This problem has been spreading and getting worse with the development of passive funds. Regarded as a powerful tool to assure lower costs for final investors, they have been gaining ground worldwide and becoming “owners” of increasingly greater portions of publicly-held companies. In this case, the “sardine can” problem is even worse: not even packaging is worth. If a specific asset is offered in an amount that is sufficient for it to be part of major negotiation indexes, these investors are OBLIGED to buy it.
The libertarians’ great illusion about the capital market regulation then vanishes. The caveat emptor does not work! The proverbial Velhinha de Taubaté [1], who invests her savings in a fund linked to the indexes, is forced to buy sardine cans if they are offered by investment banks, provided the offer is large enough.
So that no one says we are casually focusing on Brazil, let’s take a look at the US market. Today, Google’s market value reaches $200 billion USD. The company represents 7,2% of the Nasdaq-100 index. It’s no coincidence that its major market shareholders are passive funds (Vanguard, State Street, Barclays, etc.). That is to say, whether she likes the supervoting shares structure or not, our Velhinha de Taubaté (or Ohio’s widows) was obliged to buy its shares. This reasoning can be replicated over and over again, including the capitalization of Petrobras in 2010 and the so-long waited Alibaba’ IPO.
The mentioned case, which is likely the world’s largest IPO (USD 20 billion), brings the lack of alignment between the political power and the committed capital to the fore. Given its corporate structure, the company was not accepted by the Hong Kong Stock Exchange – but will be welcomed with arms wide open by the Americans. Activists are horrified. Regardless the best approach – restrictive or liberal – there’s no doubt many widows will buy shares of the Chinese e-commerce giant enterprise without knowing or even being able to give their opinions about the concentration of control in founders’ hands.
These examples confirm that the regulatory approach based exclusively on transparency does not solve the problem. Investors will buy toxic assets not because they do not know what they are doing, but because the institutional structure forces them to.
Therefore, it’s crucial that the regulatory structure establishes limits on the financial creativity with a view to avoiding the creation of biased structures that can result from the interaction between corporate interests and investors pegged to short-sighted institutional incentives. To keep an effective structure to protect investors does not mean to consider them insufficient. It is only a way of offsetting crooked incentives.
It’s important to highlight that, even if these incentives did not exist, the protective regulatory action would be justified based on the new theories about behavioral finances. But this is a topic for another article.
No doubt that these arguments cannot indicate an excessively tied regulatory structure.  If we focus on pension funds, we will see that they fall within even more detailed and prescriptive regulations than mutual investment funds. The resolutions of the National Monetary Commission, which regulates the investment process in pension funds, bring the mark of the government’s heavy-handed approach. By creating a completely prescriptive structure, rules remove from managers the adequate incentives for them to seek the best options for their participants. To do something different from what other funds do can result in administrative and even criminal actions against managers. In other words, if something goes wrong, the manager is crucified. If things go right, incentives are usually small. The consequence: the herd behavior becomes a powerful factor for these investors.
This counterexample allows us to say that the regulation must be neither minimal nor excessive. It must be based on a cost-benefit analysis of both the regulations and the governmental interference, always aimed at the creation of incentive structures that seek the best financial solutions in the long term, with the due alignment of interests among all parties involved. This reasoning is valid both for regulations and their enforcement: regulatory agencies, self-regulatory bodies and market players must timely sign the limits of the game so that we do not get trapped in a poor balance, as it seems to be happening now. If a specific regulation exists and was incorporated into the pricing of assets, it must be applied in its ‘soul’ – and not according to the case-by-case opinions of operation A’s or operation B’s advisors.
As Aristotle said, virtue chooses the mean.

[1] Created by the famous Brazilian writer Luis Fernando Veríssimo, Velhinha de Taubaté was a humorous character who, according to the writer, “ was the last person in Brazil who still believed in the country’s government.”