Who pays for the control premium?

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A lot of ink has been spilled over the lack of efficiency of the tag along rights in Brazilian companies. The major claim made by minority shareholders in the 90’s was incorporated to Novo Mercado and, right after that, to the Corporate Law through the Law 10.303. One decade later, dozens of companies were sold with minority shareholders lacking access to the terms enjoyed by controlling shareholders.
Usiminas is one among the many examples of that. In 2011, the Ternium Group acquired a stake of the company’s controlling group owned by Votorantim and Camargo Correa for R$ 36 per share, when its market price was R$ 20. Later on, prices dropped to the current R$ 7.
There is no free lunch, however. A company’s value is the result of its assets (including cash flows) minus its liabilities (debts). If such value is of 100 monies, this is the exact amount to be shared among its shareholders. If someone decides to pay 80 for a 40 percent stake in the company (controlling stake), this means the remaining 60 percent are worth 20. There’s no magic.
It’s important to highlight that we are talking about the control premium exclusively appropriated by controlling shareholders. In the case of mergers and acquisitions, it’s natural that a buyer offers a value above the market’s to encourage shareholders to sell their shares. This difference can be motivated by different perception of the company’s value and its market value (that is, an investment opportunity) or by the buyer’s ability to add value to the company through management or synergies. When this value is shared among all shareholders, the operation favors all parties. The problem is when only some shareholders take advantage of that. Accordingly, they receive a value above the market price – and this market price is not affected by the operation once remaining shareholders cannot sell their shares by this same price.
Lamy Filho and Bulhões Pedreira, authors of the Corporate Law, had a premonition when they stated, in a letter sent to the then-current Finance Minister Mr. Mário Henrique Simonsen, that “the difference between controlling and minority shares is, in general, relatively small because, except when the control is abusively exercised in favor of controlling shareholders, it does not ensure advantages that justify a much higher price of controlling shares.”
In other words, the excessive control premium would only be justified by the abuse of this same control.
The dispute among Usiminas’ controlling shareholders shows exactly that. In successive interviews published in the media, its representatives mutually accused themselves of abuses. The Argentines accused the Japanese of not having invested in the company and of being much more interested in taking advantage of the benefits offered by the contracts dealing with the transfer of technology that Usiminas signed with Nippon. Yet the Japanese accused the Argentines of bringing an excessive amount of employees from Ternium and providing them with salaries that were not in compliance with the decisions taken by the company’s Board of Directors. Ternium is also Usiminas’ counterpart in a number of commercial agreements, among which, the contract dealing with the supply of slabs.
Unfortunately, for minority shareholders, both parties are right. What we have been seeing in Usiminas is a dispute between two groups to share the company’s estate deviated from minority shareholders to benefit controlling shareholders. It’s the material evidence of controlling shareholders’ disproportional and unjustified gains that eventually explain the high premiums paid for controlling shares. If the lesson of the patrons of the Brazilian Corporate Law is still valid, that is the division of the fruits of the abuse. In other words, the control premium is paid by the company itself and, therefore, by its minority shareholders.
Some years ago, our regulators opted to interpret the Article 254-A of the Corporate Law on a restrictive basis. Ipiranga and Copesul cases, for example, shocked minority shareholders, who saw themselves before a reality in which the protections for which they have bitterly fought for faded away in the legalese of the moment. It was the password for attorneys to conduct a number of operations dealing with changes in control in which minority shareholders were at a loss. The combination of an inefficient tag along policy with the possibility of shareholders’ expropriation through tunneling practices is a fatal mixture for our capital market. When an investor buys an X stake in a company’s capital, he/she does not know the stake he/she will be entitled to in the company’s discount cash flow. In an ideal world, that stake should be X. In Brazil, as a rule, it has been lower than X. And to make things even worse, it’s virtually impossible to measure the dimension of such spoliation. The embezzlement of minorities’ value depends on the controlling structure, on the aggressiveness of controlling shareholders and on the opportunities of tunneling operations.
What is the meaning of buying a pig in a poke when one does not even know whether he/she will actually take the pig home? What kind of investor would be willing to invest in a market like that?
Amec has already expressed its opinion about the fact that the current interpretation of the tag along right in Brazil[1] leaves much to be desired.  Yet it’s not possible to inhibit all attempts of sale of control without the due offer to minority shareholders, it’s necessary to be attentive to the partial sale of control and related operations, which result in changes of the majority equity ownership. Indirect sales, through restructuring operations, mergers and capital increases must be carefully analyzed to avoid the improper appropriation of the control premium. Ancillary agreements can also be a tool to conceal premiums – as shown by the excessive compensation of a former controlling shareholder as the chairperson of the Board of Directors of a joint venture with a partner.
The sale of a significant portion of shares at a price different from the market’s price must be a yellow light – or maybe a red light – for CVM’s risk-based supervision. And even without the review of the jurisprudence about the applicability of the tag along right, such operations must be analyzed for the detection of the control abuses anticipated by Lamy Filho and Bulhões Pedreira.
[1] Refer to the Tag Along Ma Non Troppo Article published in April, 2013.