Historical Notes: Octavio Gouveia de Bulhoes, Participating Preferred Stock. Octávio Gouvêia de Bulhões, Preferred Stock

Historical Notes (Continued)

Octávio Gouvêia de Bulhões, Participating Preferred Stock

Octávio Gouvêia de Bulhões : (1906-1990) One of the most important Brazilian economists of the 20th century.

Bulhões was a graduate of American University (Chicago).

He attended Bretton Woods (1944) with the Brazilian commission and created the Superintendency of Money and Credit (SUMOC) — the precursor to the Central Bank — in 1945.

He reformed the curriculum for economic studies (1945), headed the Brazilian delegation on the U.S.- Brazil Abbink Mission (1949), and headed SUMOC in 1954-1955 and 1961-1963.

Fundacao Getulio Vargas, Praia de Botafogo, Rio de JaneiroEconomists from the Fundação Getúlio Vargas, like Octávio Bulhões, played a key role in the 'Economic Miracle'

He was Minister of Finance from 1964 to 1967, promulgating in three years the most progressive economic reforms of the century:

  • the introduction of 'monetary correction' of debt,
  • the reform of the government bond market,
  • the reform of the capital market,
  • the establishment of an independent central bank,
  • the establishment of the national housing system and real estate securities,
  • an inflation-protected retirement fund for all employees, and
  • Decree-Law 157 which allowed tax payers to divert taxes into investment in the stock market.

In the brief three year tenure of President Castelo Branco, Minister of Finance Octávio Gouvêia de Bulhões, Minister of Planning Roberto Campos, Central Bank President Dênio Nogueira, and Development Bank President José Garrido Torres, virtually all of the economic reforms that resulted in the Brazilian Economic Miracle were in place.

Octávio Gouvêia de Bulhões was the principal figure in a group of pragmatic economists associated with the Fundação Getúlio Vargas headquartered in Rio de Janeiro, that included Eugênio Gudin, Mário Henrique Simonsen, José Garrido Torres, Dênio Nogueira, and Roberto Campos.

After the Revolution of 1964, Minister Bulhões asked Ney Souza Ribeiro de Carvalho, President of the Câmara Sindical of the Rio de Janeiro Stock Exchange to contract John Schroy to develop a plan for the modernization of that institution.


Participating Preferred Stock :

Although the Brazilian capital market got its start in the 1950s and 1960s, before a Securities and Exchange Commission was established, the corporate law which had been in place for decades, combined with the self-interest of issuers, provided investors with substantial protection.

Napoleon BonaparteBrazilian corporate law can be traced to the Code Napoleon

Brazilian corporate law had its roots in the Code Napoleon and continental Europe.

Unlike the United States, there was only one corporate law for all of Brazil and this was codified into a small volume that was sold on newstands throughout the country for a nominal price.

In the 1950s and 1960s, jurisprudence, or court interpretations of the law, was not of much consequence in practical business relations.

In fact, in those years, most business people and investors could buy a copy of the corporate law off a newstand and use this as a guide, without ever resorting to lawyers or the courts.

Although I was in business in Brazil for 23 years and managed investment funds and a leading broker-dealer, I never had to resort to the courts nor was I ever sued by a client. Business operated on the basis of reputation and personal contact. The courts were unnecessary if one conducted dealings fairly with clear contractual understanding beforehand. In the brokerage business, if a client complained, I would simply undo a deal and return the client's money. If the client suffered a loss due to our mistake, I would make the client whole. If the complaint was unjustified, I would sever relations with the client.

The codified corporate law was meant to be accesible to the public and easy to understand, as indeed it was.

There were certain provisions in corporate law that worked to the benefit of public shareholders, even without intervention of a securities market regulator:

  1. Resolutions of shareholders, to have legal standing, had to be published in the Official Gazette. This included changes in corporate by-laws and articles of incorporation, decisions regarding distribution of profits, election of directors, mergers and acquisitions, and other corporate acts.
  2. The financial statements of a corporation had to be published in the Official Gazette once a year and approved by the General Assembly of shareholders.
  3. Corporations could issue non-voting preferred shares that had prior claim on profits and assets in the case of liquidation and the rights of preferred shareholders could not be changed without approval of the majority of holders.
  4. In the case of capital increases, all shareholders, preferred or ordinary, had preemptive rights to subscribe to new shares of the same type in proportion to their holdings and these rights could be sold on the exchange.

Furthermore, income tax law required that retained corporate profits in excess of 100% of authorized capital, must be either distributed as dividends or as new shares, fairly to shareholders in accordance with their stock holdings.

Brazilian NewstandThe easily understood corporate code could be purchased on Brazilian news stands.

The results of these rather simple rules were as follows:

  1. Most Brazilian companies were owned and operated by family groups and by raising money by selling preferred shares, the insiders were able to maintain control with only 26% of the capital. This allowed the owner-managers to take a long-term view of a business, without fear of constant battles against hostile takeovers. It also protected investors from unethical practices of 'professional managers', such as stock buybacks and market manipulation to give value to stock options.
  2. Almost all stock sold to the public during the 1950s and 1960s were fully-participating, non-voting preferred shares with a guaranteed dividend of 8 to 12 percent of par value. Because of the rule requiring incorporation of reserves in excess of 100% of capital, and because of the high rate of inflation, each year companies were required to distribute stock bonuses to preferred shareholders. Usually these stock bonues ranged from 15% to 35% of holdings, which meant that the preferred dividend was automatically increased each year as the par value of shares held by public shareholders increased.
  3. Brazilian Official GazettePublication of corporate acts in the Diário Oficial provided disclosure to investors
  4. Because of the rule on preemptive rights and the demand for capital to finance the Economic Miracle, companies conducted rights issues almost yearly. These offerings gave current shareholders the right to subscribe to new shares in a certain proportion based on current holdings, usually at a price far below market value. Because of pricing practices, shareholders were best advised to either to sell their rights on the exchange or to exercise the rights. If a company was not doing well and its stock was selling below par, it was impossible to have a successful rights offering, since stock could not be offered at less than par value. Consequently, in order to have constant access to capital for expansion, Brazilian public companies had strong motivation to treat shareholders fairly.
  5. Because of the use of participating preferred shares and constant recourse to preemptive rights offerings, companies were under pressure to correctly report profits. If profits were under-reported, shares would fall in value and the yearly rights offerings would fail. If profits were over-stated, there was a real cost to owner-managers because of the preferred dividends and the requirement to issue bonus shares that would increase dividends.
  6. Cervejaria BrahmaIn the 1950s, blue chip stock of Cervejaria Brahma had an 8% fully participating preferred dividend and traded at six times earnings

Foreign investment bankers, accustomed to the New York market, hated Brazilian corporate law, especially preemptive rights rules, since this cut them out of the underwriting market.

Once a company got a foothold in the public market, it could combine fair treatment of shareholders with judicious use of preemptive rights and continue to raise capital indefinitely, without recourse to investment bankers.

The preferred shares offered by Brazilian companies in the early days of the capital market were in most respects a better deal for investors than common shares offered to American investors in the U.S. market today:

  1. Dividends were guaranteed and automatically increased with profits;
  2. Preemptive rights protected investors against dilution of holdings;
  3. Stock prices were not distorted by takeover bids and other actions related to corporate control. This kept prices reasonable and cash yields high.
  4. Shareholder funds were not wasted on useless mailings and legal fees related to voting and takeover bids.
  5. There were no capital gain taxes on the sale of shares or preemptive rights. Bearer shares were permitted and made up most of the trading market.
  6. Because there were no professional managers focusing on short-term paper profits and manipulation of stock prices to give value to stock options, interests of investors were more closely aligned with those of owner-managers.

Unfortunately, after the 'lost decade' of the 1980s and the globalization of the market, the laws and rules of the Brazilian market have changed and there has been a convergence with New York rules, that has not always been in the best interests of investors.


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