Many analysts and investors were wrong . In their September 22 report, Banif clearly affirmed that Sadia’s 3rd quarter results would not suffer with the appreciation of the dollar. The reason: they had performed hedging operations to protect their debts in dollars. The Portuguese bank was not alone. Weekly reports by UBS Pactual and Credit Suisse, among others, also presented a good outlook for the food company. Right after the close of trading on September 25, Sadia disclosed a loss of R$ 760 million with the anticipated liquidation of foreign exchange derivatives. What lay behind that number was not their hedge operations performed to minimize the impact that an eventual appreciation of the dollar would have on their debts in dollars, but rather their speculative bets on the currency’s depreciation. The company confessed: “the financial board performed operations related to the dollar’s variation beyond the purpose of protecting the activities exposed to foreign exchange variation.”

On the following day, it was Aracruz Celulose’s turn to report losses from derivatives. “It was really a surprise, nobody was expecting it”, says pulp and paper industry analyst at the brokerage house Ativa, Mônica Araújo. Uncertainties spread through the market. The question was whether other companies had the same problem, and who they were. “With the information publicly available, analysts find it extremely hard to understand operations with derivatives and the risks to which the companies are exposed”, affirms professor Alexsandro Broedel of the Institute Foundation for Accounting, Actuarial and Financial Research (Fipecafi) and member of the Accounting Pronouncements Committee (CPC). With the current Brazilian regulation, the requirements for showing the financial instruments used by companies are extremely weak. “Many are considered off balance operations (with no need to be recorded)”, completes the professor.

In the case of Sadia, the company claims that it was the fault of finance and corporate development director, Adriano Lima Ferreira. They explain that he overused derivatives, seeking to gain from trading operations, in addition to the hedge. “As there is little transparency in derivatives, it’s difficult to know what’s going on. The company’s accounts are not clear”, stresses an experienced industry analyst, who had been feeling troubled by this item in company balance sheets for the past two months.

Derivatives appear on the financial statements disclosed each quarter, but marking to market is not required. Therefore, it is common for the operation’s result to appear only after liquidation, as a form of loss or gain. Sometimes, there are mentions in the explanatory notes. “An analyst who really wants to understand the possible effects of derivatives must call the Investor Relations departments and ask for information”, says Broedel. After Sadia’s notification, this was exactly what happened. Analysts ran to the executives to ask for further explanations. “These facts put the market on alert. We are now keeping an eye on companies who engage in significant derivative operations with commodities, interest and the dollar”, says Lucy Souza, president of the Association of Capital Market Investment Analysts and Professionals (Apimec) in São Paulo.

At Sadia, outstanding derivatives are mentioned in explanatory notes, but are not registered until liquidation. Hence, they may bring surprises. “But we already suspected that the company’s treasury was very aggressive, and engaged in trading operations for purposes of speculation with financial profits”, acknowledges the same analyst, who was attentive to the undecipherable numbers in the financial statements of food and agricultural companies. After announcing the loss, Sadia’s first conference was not enough to elucidate the analysts about their hedge positions. The company was unable to provide details on the operation that generated such losses. Investor Relations (IR) director, Welson Teixeira Junior, also acknowledged that the company held currency futures amounting to US$ 12 million (marked to market) issued by American bank, Lehman Brothers, which filed for Chapter 11 bankruptcy in September.

Aracruz’s operations were mentioned in more detail in the notes that accompanied last quarter’s financial statement. The company closed the month of June short of US$ 360 million in BM&F (Securities, Commodities and Futures Exchange). Furthermore, they had a debt swap position in local currency that amounted to US$ 387 million. In other words, the American currency’s 11% appreciation in a single month could cause damage. “It’s very complicated for the market to know the company’s exact exposure in derivatives. At each quarter, the company shows a snapshot of that situation, but does not explain the risks upon a different variation than the one foreseen”, says Guilherme Kobylko, variable interest manager at Banco CR2. One of the main difficulties is knowing what the risk policy is: whether the company only uses derivatives to protect debts and exports, or to speculate in the market. “All strategies are legitimate, but this remains to be made public to the investor”, completes the manager.

The difficulty is in knowing whether the company uses derivatives just for protection, or if they also speculate. “This still remains to be made public.”

GUILTY AS CHARGED – Proof that information disclosed in financial statements is not enough could be seen in the reaction from companies after Sadia’s announcement. A swarm of companies, formed mainly by exporters, went to the market to explain themselves and try to contain investors’ fears. On September 26 alone, ten companies disclosed that they would not suffer losses from derivative operations – Cosan, Marfrig, Minerva, Perdigão, SLC Agrícola, Marcopolo, Vale, Invest Tur, Embraer, and Klabin. “This market is very dynamic. In order to have transparency, companies need to commit to providing information”, warns Francisco Papellás, president of the Independent Auditors Institute of Brazil (Ibracon). The measure, however, was not enough to avoid an impact on share prices, which were already plummeting when the companies came out in to the open to show themselves. “The doubt had already been priced”, explains Kobylko.

Banco Fator analysts, Jacqueline Lison and Marcello Gunther, asked Embraer’s Investor Relations department for more information. The company guaranteed that the current position aims only to correct the “revenue-operational expenses mismatch”. In 2Q 2008, Embraer recorded a financial gain of US$ 30 million from foreign exchange derivatives, as per their US Gaap statement (the American accounting regulations). Taking into account that the company had maintained the same position throughout the third quarter, Fator’s analysts estimate that their losses were around US$ 50 million – due to the Real’s 15% depreciation in the past three months.

LET THE NEW LAW COME – Scarcity of information on derivatives, however, may be coming to the end of its days. On their balance sheets, Brazilian companies will have to provide detailed explanation of the characteristics of their operations involving these instruments when they fully adhere to Law 11,638, which provides adaptations to the international accounting regulations (International Financial Reporting Standards – IFRS). “These derivatives will be recorded, classified and marked to market”, confirms Broedel. “All in a standardized way. Currently, each company uses a different model, and many omit this information”, he adds.

The strategies and positions must be described in explanatory notes and also proven by documents. “The new rule’s great advance is marking to market on the balance sheet’s closing date”, comments João Santos, PricewaterhouseCoopers (PwC) partner. “The purpose of the operation, whether hedging or trading, must also be described”, he emphasizes. Indicating the risk to be protected and the type of hedge, among other information, will be mandatory. “The new rule will expose a volatility that was previously only acknowledged upon effective cash outflows”, adds Ernst & Young financial services partner, Grégory Gobetti.

Brazilian companies with ADRs already mark derivatives to market in their financial statements per the US Gaap standard. Aracruz and Sadia are on that list. Petrobras, for example, informs that both their internal commodity risk management regulations and those related to transactions in the financial market only admit the use of instruments modeled in their risk assessment system, which imposes marking to market. Currently in the domestic market, however, Petrobras’s derivative operations are only recorded after contract finalization. Outstanding positions are mentioned in explanatory notes, but are not recorded in accounting. In their policy for transactions in the futures market, the company informs that contracts are only entered into for purposes of protecting their activities.

COMMITMENT AND CONTROLS – Despite bringing more volatility to balance sheets, the international practices promise to reduce derivative operation scares. Nevertheless, they don’t completely resolve the matter. “The market is very complex and broad, the rules can’t be too specific”, explains Gobetti. “The company needs to be committed to transparency and have efficient risk management controls”, he adds.

In the opinion of analysts, Sadia, for example, could have reported the fact to the market earlier. The company had already been suffering losses for about two weeks, but only informed the market when the situation came to a head. The situation also endangered the efficacy of the board’s commodity monitoring and risk management committee. Sadia uses that structure in its corporate governance. The work group focuses on developing strategic actions to reduce the volatility of their main inputs and raw materials.

Another problem that surfaces is how financial analysts and shareholders behave in the face of complex operations. “It does no good to improve the accounting rules if the professionals can’t be bothered to understand the operations before making their analyses”, declares Santos, of PwC. Upon the dollar’s abrupt appreciation, the analysts did not ask companies, especially exporters and those that use commodities, about their currency futures positions. To an analyst who chose not to be identified, “if managers and analysts limit themselves to repeating what companies say, their work will no longer be necessary and there will be no more reason to pay them”.