In 2004, a well known finance academic Aswath Damodaran released a book entitled Investment Fables: Exposing the Myths of “Can’t Miss” investment strategies. In it, the author sought to deconstruct six investment strategies exhorted as with “guaranteed returns”, but which showed themselves rarely successful after objective analysis. At several local corporate governance events in the past years, we constantly hear some certain statements about the subject that have seemed to become undeniable truths. However, many of these beliefs succumb to a more theoretically and empirically structured analysis. They are our corporate governance myths.

Seven main myths can be identified: 1) Bovespa’s Corporate Governance Index (IGC) as a proof of the value of governance; 2) the tag along; 3) the entrepreneur must be in control; 4) the poison pill; 5) the prospectus; 6) the higher return on stocks from companies with better governance; and 7) the sustainability. This month’s traditional Governance column will be replaced by summarized thoughts on four of these myths. The remaining three will be discussed in our November edition.

THE MYTH OF IGC AS PROOF OF THE VALUE OF GOVERNANCE – IGC is an index creat by Bovespa that takes into account all firms listed at the three Bovespa’s special listing segments. It is usual to see people initiating their presentations by showing the return of IGC stocks versus Ibovespa. As IGC provided a higher nominal return since its inception, then you have a “proof” that governance creates value. This statement is based on two rarely noted but fundamental assumptions: that IGC is a good proxy for companies with higher governance standards, and that the index have the same risk as Ibovespa index. Both are questionable. Currently, only 41.2% of IGC’s weight is comprised of New Market companies (te higher corporate governance listing segment), whereas 54.2% of its weight is Level 1 companies (the lower special listing segment).

Therefore, we should ask ourselves if Level 1 companies really have higher governance quality, to only then affirm that IGC is a correct proxy for companies with higher standards thereof. Furthermore, it is important to remember that, by April 2004, the percentage of Level 2 and New Market companies in IGC was less than 5% of the index’s weight. Finally, the sum of the weights accounted for by Vale and by the three largest domestic banks still represents about 36.7% of IGC. In early 2004 they represented 61.4%. Therefore, a new question arises: does a high IGC return mean that good governance creates value, or does it mean that mining and local finance markets did well throughout that period?

Regarding the second question, one cannot simply compare the nominal returns of assets with different risks. In fact, the correct thing to do would be to analyze the risk adjusted returns for assets with different risks. For instance, suppose a comparison of the returns of New Market companies, usually smaller and younger, with the group of Ibovespa companies, older and with more stable cash flows. If both groups are comprised by companies with differing risks, then we should have to adjust the effective returns to the expected returns in order to draw any conclusion. In short, IGC is a helpful index, but its direct comparison with Ibovespa, and the subsequent proof of the real gains coming from good governance are not that simple.

THE MYTH OF THE TAG ALONG – Many market agents in Brazil point out good governance as the “voluntary granting of tag along rights (a mandatory bid rule providing minority shareholders similar the right to sell their shares in the same conditions of controlling shareholders in case of control transfers)”. Such granting is undoubtedly a good governance practice. However, other countries also characterized by concentrated ownership structures and family-owned businesses hardly discuss the theme, not considering it a priority on governance discussions. Why, then, do we put so much weight on the tag along rights?

Firstly, tag along is a potential right that may never be exercised if control is not transferred. So, it is possible for a company to have bad governance practices throughout its life, investing in poor projects or even expropriating investors resources, whereas it simultaneously concede the so valued right. The important thing is to understand that that the need for tag along rights derives from the control premium paid for controlling shareholders’ stocks. However, should the controlling stocks really be worth so much more than the others if, at the end, all shareholders were paid exclusively from dividends?

Two studies, by Nenova (2003) and Dyck and Zingales (2004), attempted to answer this question, achieving a similar conclusion: the premium for ordinary stocks varies significantly across countries, being higher in countries with poor investor protection and higher probability of controllers obtaining certain benefits not shared with other stockholders (the so-called private benefits of control). In both studies, Brazil was placed among the three countries with the highest control premium, indicating that controlling shareholders here seem to reap many more benefits than those of other countries. In short, tag along is so valued in Brazil because, in its absence, the control premium would be extremely high, much higher than in most other countries. Thus, we arrive at a conclusion against the local common sense: despite a good governance practice per se, the more relevant the tag along right is for a certain company, probably the poorer the perception of its governance practices will be. Therefore, as companies improve their corporate governance, controllers will have less and less ways to reap extra benefits, thus reducing the relevance of tag along rights.

THE MYTH OF THE ENTEPRENEUR WHO MUST BE IN CONTROL – Without any doubt, talented entrepreneurs/managers are key to the success of most businesses. Based on this assumption, many corporate agents affirm that it is essential to keep them as controlling shareholders of the business after the IPO, based on their enormous “expertise and importance” to the company. On behalf of such special capabilities, they suggest that any mechanism is valid in order to keep control of the company in the hands of such people: issuance of nonvoting stocks, listing in foreign jurisdictions that allow multiple voting rights among shareholders of the same class, etc. As a justification for such devices, they argue that keeping the entepreneur as controlling shareholder will assure his or her permanence at the company and, consequently, a better result for all shareholders.

Unfortunately, this is a fragile argument after careful analysis. If the entepreneur were really truly essential to the business’s success, any controlling shareholder or controlling group would be interested in keeping him or her at the head of the management team. As an example, take the case of Apple, founded by its current CEO, Steve Jobs. Few people notice, however, that Steve jobs currently holds a paltry 0.63% of the company’s stocks. Even so, in recent years, no relevant shareholder has formally considered to replace him, given the common view of the importance of his expertise for the company’s success. So, it is not crucial for Steve Jobs to eternally remain as controlling shareholder in order to maintain his leadership of the company’s management team. Hence, such a governance myth seems to stem more from some controllers’ desire to arbitrarily and permanently define their businesses’ headings on their own than from a systematic value creation for all shareholders.

THE MYTH OF THE NEED FOR A POISON PILL – Many Brazilian companies with dispersed ownership structures justify their poison pills as mechanisms to avoid a sudden concentration of stocks, which could hypothetically harm shareholders through a reduction of shares liquidity or the entry of an “undesirable” controller. In order to evaluate such statements, nothing could be more helpful than observe the Anglo-Saxon markets, where companies with dispersed ownership have been present for a long time.

First of all, the economic result of such device has not been proved favorable to shareholders. A well-known study produced by a group of Harvard researchers in 2005 displayed a negative correlation between the use of poison pills and stock returns in the United States from 1990 to 2003. Secondly, shareholders, particularly American institutional investors, have clearly pointed their discontent with such clauses. Thirdly, after extensive research, no example was observed in these dispersed markets of companies “waken up with a controlling shareholder”. This is probably due to the fact that, in a pulverized company, an attempt to rapidly purchase a very high ratio of stocks would have obvious consequences: a steep increase in price and operational difficulty in acquiring a substantial percentage of stocks – leading the buyer to formulate a public offering in order to acquire a substantial share of stocks. It is also important to consider that several studies throughout the past two decades have shown that an active market for corporate control is good for the restructuring of inefficient industries, fostering greater economic growth.