By Maria Trombly | Securities Industry News | June 13, 2005

Two years ago, Brazil's Novo Mercado ("new market") looked like a complete waste of time.

The plan was for an index of companies committed to a higher standard of corporate governance than was required for listing on the Bolsa de Valores de So Paulo (Bovespa), Brazil's largest stock exchange. The index would be overseen by a new, independent board and listed separately on the Bovespa. The goal was to rescue Brazil's stock market from what looked like a death spiral.

The governance standards were designed to address two major problems with Brazil's public companies. The first was the fact that voting shares tended to be tightly concentrated in the hands of a few insiders--usually a family group. This led to bad management decisions and few protections for other investors.

According to Bovespa CEO Gilberto Mifano--who spoke at the World Federation of Exchanges (WFE) meeting in Beijing earlier this month--local listing requirements permit two-thirds of outstanding shares to be issued as non-voting shares, known ironically as "preferred shares."

The other problem was that when a company's voting shares were sold, the holders of non-voting shares weren't able to cash in--what Mifano refers to as the issue of insufficient "tag-along rights."

As a result, stock market prices on the Bovespa stayed low and new companies were reluctant to go public. In addition, because the rules on delisting contained inadequate protection for non-preferred investors, the number of listed companies was actually decreasing.

To stimulate a new crop of initial public offerings, Bovespa devised the Novo Mercado, which disallowed non-voting shares for a certain class of issuer and required that purchase prices be communicated to all shareholders. A second class of Novo Mercado issuers were allowed to retain the non-voting share structure in exchange for agreeing that important decisions would be made by all shareholders, including the holders of non-voting shares.
While the Novo Mercado lists 52 companies, compared to the 385 companies on Bovespa, it is responsible for 40 percent of total trading volume, and its companies trade at higher multiples than the market as a whole.

In addition, listing on the Novo Mercado required that companies adhere to tighter disclosure requirements, agree to an arbitration panel for dispute resolution, and offer delisting prices at least equal to fair market value.

"Mature and demanding investors wish to invest in a more secure way," Cristiana Pereira, development adviser and head of international relations at Bovespa, told Securities Industry News at the WFE conference.

Setting up a new exchange allowed Bovespa to sidestep the issue of national corporate governance legislation in a heavly bureaucratic country. Listing on the Novo Mercado is completely voluntary.

Unfortunately, Novo Mercado's 1991 launch coincided with one of the worst economic periods in Brazil's history. It wasn't until 2004 that IPOs started to rebound again. Today, 52 companies are listed on the Novo Mercado, compared to 385 companies listed on the Bovespa. But the Novo Mercado companies are already responsible for 40 percent of total trading volume, and are trading at higher multiples than the market as a whole, exchange officials say.

The Novo Mercado is widely hailed as having rejuvenated the Brazilian stock market. "Novo Mercado is pretty close to an ideal international level," says Carlos Sfiretti, head of research at Bradesco Securities in So Paulo, Brazil.

The Novo Mercado's appeal is not limited to young companies just going public, Pereira says. Even old-guard firms are starting to change their corporate governance practices in order to become eligible for the elite listing. "We need to invest more in transparency in order to have more investors ready to finance," says Octavio de Barros, chief economist at Banco Bradesco, Brazil's largest private bank.

Adopting corporate governance measures is "a sign of Brazil's process of becoming mature," he said.

MalavaziNot all companies are able to move up immediately. It may take five to ten years for the entire market to shift to the reporting standards and other Novo Mercado requirements. "Not all companies will be able to issue on Novo Mercado," says Ricardo Malavazi, director of finance and investment at Petros, the second largest pension fund in Brazil. "Such a move involves changing status, and therefore the value of assets already in the market, causing conflicts between holders of voting and non-voting shares."

The Fruits of Success

Currently, Novo Mercado IPOs are oversubscribed and the participation of international investors is averaging 64 percent of the offerings. "We survived the economic and political turbulence, and despite the depression, we managed to keep up our standards on corporate governance," says Pereira. "Now the market is changing--I believe this is the new market."

The success of Novo Mercado can also be attributed to better economic performance in general, more international liquidity, low U.S. interest rates and favorable currency exchange rates for the Brazilian real against the dollar.

What's most impressive is that investment associations are now ordering their members to underwrite only companies that list on Novo Mercado. Institutional investors and pension funds have also expressed a preference for Novo Mercado stocks.

What started as an attempt to change corporate culture at the Bovespa has been extended to investment banks and institutional investors, says Pereira. As a result, the general capital market environment is improved, the brokerages have a better product to offer and investors are better protected and therefore happier. "Novo Mercado indicates patterns of relations between companies and investors that leave us worry-free as investors," says Malavazi.

There are still some problems with disclosure that need to be worked out, Malavazi says, but these are due mostly to inexperience with the new rules. "Investors like the new approach," he says. "No way we want to go back."

The Next Step

Going forward, the Novo Mercado plans to educate small and midsize enterprises on how to get ready for public listings. This includes rolling out a new board--a kind of stock exchange with training wheels--for smaller companies with private equity investments that are not quite ready to go public.

Today, market capitalization accounts for just 56 percent of Brazil's GDP, compared to ratios of 80, 90 or 100 percent in developing Asian markets. "Brazil has a lot of room to grow," says Pereira.

Betta Plebani contributed to this report.