"Never before in the history of this country...", the favorite speech-opener used by President Lula to emphasize Brazil's advances in recent years, would also define the massive increase of capital that Petrobras intends to undertake in order to develop the country's pre-salt oil reserves. The operation, a private offer of shares restricted to the current shareholders, promises to be not only the largest in the Brazilian capital market, but also the most controversial in recent history. Evidence of this is that the Brazilian Institute of Corporate Governance (IBGC) and the Association of Capital Market Investors (Amec), both with the support of other market entities, have publicly rebelled against the operation. In late October, they submitted suggested amendments to Bill 5,941/2009, which assigns exploitation rights for up to 5 billion barrels of oil to be extracted from the pre-salt layer.

Before we get into why, in the view of both institutions, Petrobras's mega-subscription will be the biggest swindle in the Brazilian capital market since the changes to the Brazilian Corporate Act in 1997 – which permitted the privatization of telecommunications in the country without entitling minority shareholders to sell their shares at fair prices (tag-along) – it would be worthwhile to describe the operation in some detail. The bill, which was under debate in the Brazilian Chamber of Deputies upon this edition's closing, establishes that the Federal Government will cede to Petrobras the exploitation rights over part of the oil present in the pre-salt layer. The Federal Government, which holds 32.1% of the company's capital, will take part in an increase in capital by putting in federal bonds. But it will receive them right back, probably on the same day, as Petrobras will use these same bonds to pay the government for the oil exploitation rights. So wouldn't it be more natural for the government to use the exploitation rights, instead of bonds, as currency to subscribe the increase of capital? That is precisely the source of the investors' first complaint.

If the government's contribution were being made via the exploitation rights, the operation would be subject to the eighth article of the Brazilian Corporate Act, which provides for the valuation of assets used to form a company's capital – and, by analogy, its increases of capital. The law requires that the value of such assets be approved in a shareholders' meeting where the asset assignor is not entitled to vote. Therefore, in the case of Petrobras, only the minority shareholders would decide on the value of the exploitation rights held by the Federal Government, without the government being able to interfere. By making its contribution via public bonds priced at market value, it becomes highly likely that the report will not require a shareholder vote for approval. "Subscribing with government bonds is clearly an artifice to evade this article of the law", says Mauro Cunha, chairman of the IBGC.

The law seemingly provides nothing to assist with minority shareholders' defense

If Cunha is right, then subscribing with bonds is an evasive maneuver to escape not only the law. In Petrobras's corporate governance and good practices code, issued in 2002, the company's managers undertake to consult minority shareholders, especially preferred shareholders, on matters such as the valuation of assets to be used to pay for the company's increases in capital. In the proposed amendment to the bill, the IBGC and Amec suggested that Petrobras's board of directors should strictly observe the spirit of the law and of the company's code, even though the subscription is occurring with government bonds. They propose that the minority shareholders be consulted and that a valuation report on the value of the concession rights be produced, and that the respective shareholders' meeting be held for its approval with the controller abstaining from voting. "The idea is to reflect the company's governance policy", says Cunha.

When contacted by CAPITAL ABERTO, Petrobras did not confirm whether it will submit the petroleum valuation reports to its shareholders. But it did inform, through its press relations department, that "in keeping with the best corporate governance which has been guiding its actions, [the company] will attempt to implement procedures that will convey transparency and comfort to its minority shareholders". "The (market's) reaction is premature", assesses Luiz Leonardo Cantidiano, a former CVM chairman, who is Petrobras's attorney in the operation and also an IBGC board member. For Cantidiano, subscribing with government bonds is much more adequate than with the exploitation rights, given that these rights still do not have a clearly defined value. "The contribution could cause an incorrect formation of capital", he argues. "No one intends to do something that will wrong or harm the market. Neither the Federal Government, nor the Brazilian Congress, nor Petrobras."

For the IBGC and Amec, Petrobras could pay the Federal Government in other ways, without exposing minority shareholders to such extensive dilution

FEAR OF PRECEDENT – Regardless of the intentions behind the measure – or the law, or Petrobras's code, for that matter – investors are concerned with the example of bad corporate governance that this operation could represent. And for two reasons. This is a gargantuan contract entered into with a related party – between the company and its controller, the Federal Government – a theme which usually generates resentment among investors. It is widely known that this type of operation opens countless opportunities to favor the controller at the expense of minority shareholder interests. Also, even without knowing all the details of the operation, it is already possible to predict that this will be a capitalization of astronomical proportions, meaning a high chance of dilution for the minority shareholders.

In the public consultation for Bill 5,941, Petrobras's CEO, José Sergio Gabrielli, mentioned that oil to be extracted from unproven reserves have been valued in the rest of the world at an average of US$ 5 per barrel. Considering that the company's increase of capital would serve to assign the exploration rights to 5 billion barrels, one need only do the math to calculate a minimum value of US$ 25 billion for the operation, meaning that the minority shareholders will have to put in upward of US$ 15 billion to keep up with their former positions. Not to mention that this capital increase will also be used to raise the funds required for investing in developing the pre-salt reserves. According to Petrobras, this could be up to three times the calculated value of the exploitation rights to 5 billion barrels.

According to the law, dilution is not a problem, provided that all the company's shareholders are granted preemptive rights. In the case of Petrobras, their stakes may be reduced, but in return, they will be part of a capitalized company with rights over valuable areas in which to exploit black gold. For the IBGC and Amec, however, Petrobras could pay the government for the exploitation rights in other ways, so as not to expose minority shareholders to such an aggressive dilution of their capital. One example would be to settle accounts by paying royalties or by using a profit-sharing system, in which Petrobras would transfer part of its profits from pre-salt oil to the Federal Government. The latter model, for that matter, will be the one used by the private concessionaries that win the rights to the remaining pre-salt areas. "This increase of capital is unnecessary", says Cunha.

The IOF puts foreign investors at a disadvantage in relation to the Federal Government in Petrobras's capital increase

Alternatives have been proposed by members of the Chamber of Deputies, but they were rejected by rapporteur João Maia (PR-RN). Congressmen Ronaldo Caiado (DEM-GO) submitted an amendment suggesting that the ceding of rights be replaced with a profit-sharing agreement. In the rapporteur's assessment, changing the model "would require a longer petroleum extraction period and would add uncertainty and risk to the process". Caiado submitted yet another suggested amendment, this time to forbid the ceding of rights as part of the increase of capital. The proposal was curtly rejected. "In practice, such forbiddance would render the capitalization of Petrobras by the Federal Government unfeasible". Another suggestion has been submitted by Congressman Fernando Coruja (PPS-SC), for whom capitalization by the Federal Government should be limited to R$ 10 billion. The suggestion was rejected because, according to one of the justifications presented by the rapporteur, the government's contribution is associated with the volume of oil that will be assigned, "which could be valued at up to US$ 100 billion".
For those who came to the conclusion that the government has chosen to follow through with a capital increase due mainly to an interest in expanding its shareholding control over the promising Petrobras, Brazil's Finance Minister, Guido Mantega, fueled this theory at one of the Chamber of Deputies’ public hearings.

The minister declared that it would be positive for the government to increase its share in Petrobras and, therefore, receive more dividends. He concluded by saying that minority shareholders wouldn't have the firepower to keep up with the government's injection of capital.

NO GROUND TO STAND ON – Although the initiative is questionable from an ethical point of view, the law seemingly provides nothing to assist in the minority shareholders' defense. In the opinion of lawyer José Alexandre Tavares Guerreiro, no abuse of control is taking place, for the government is paying to increase its stake. He also disagrees that Petrobras should call a meeting to decide on the valuation of the exploration rights and, much less, require a voting abstention. "That would go against the principle of a majority, established in article 129 of the Brazilian Corporate Act", he affirms.

Cantidiano observes that, regardless of whether the exploitation rights are assigned, an increase in capital is essential for Petrobras to invest in the pre-salt areas. "And that increase of capital must be large, because the project is", he says. Regarding investors' argument that the operation will lead to unjustified dilution, attorney José Orlando Lobo, a partner with the Lobo & De Rizzo office, affirms that the only way to prove this theory is through the subscription price, which has not yet been defined. "Only that element would characterize such a violation".

Investors and other market agents are left with the uncomfortable reality that was clearly revealed by this operation: it is still possible to set up an operation – and a major one, at that – where the controller's interests will prevail along every step of the way. "This operation tests the boundaries of the law", affirms André Camargo, coordinator of the Insper Institute of Teaching and Research (formerly known as Ibmec São Paulo). "We must reflect about the message that this increase of capital will convey to the market", says Pedro Rudge, a partner at Leblon Equities.

UNEQUAL TERMS — It is worth remembering that the operation's probable legality does not eliminate the possibility of complaints being filed with the CVM. One of the points that are likely to come under attack is the differential treatment given to the company's shareholders – whereas the Federal Government will pay in capital with bonds issued by the Treasury, the other shareholders will have to contribute their own funds. The imbalance is blatantly obvious because it is embedded in the very base of the proposed model. Even if minority shareholders were allowed to contribute to the increase of capital with the same type of government bond, the result would be ineffective. They would have to disburse their own funds to acquire such bonds, which would once again tip the scales in the controller's favor.

The limitations faced by minority shareholders do not end there. Many of Petrobras's investors initially acquired shares in the company using funds from their Severance Indemnity Fund (FGTS) accounts, in a federal program launched to stimulate investments in the stock market. In this increase of capital, however, they will not be allowed to use FGTS resources for subscription, although many Congressmen and the BM&FBovespa have submitted suggestions to the bill's rapporteur, requesting that this possibility be included.

But the pressure was not altogether in vain. In principle, the shareholders of Mutual Privatization Funds (FMPs) – funds created to invest FGTS assets in shares of companies that are undergoing privatization – could not participate in the subscription. The reason is that FMPs are limited by regulations to invest only in shares of companies that are undergoing privatization. In the bill amendment presented on October 28, FMPs were allowed to raise capital among their shareholders for the purpose of participating in Petrobras's subscription. But in this case as well, the capital may only be paid in with new funds, and not by using the FGTS.

Finally, foreign investors will be at a disadvantage in relation to the Federal Government in this capital increase. In October, the government implemented a 2% tax on financial operations (IOF) applicable to foreign investments in fixed-rate and equity products in Brazil. "The government not only said that the minority shareholders have no firepower, they also upped the IOF", complains Amec superintendent Edison Garcia. "They added insult to injury."