|Who will sign that dotted line?|
CVM initiates discussion on liability for numbers used in valuation reports
Investment banks and company valuators are about to get kicked out of their comfort zones. In its reform draft for Instruction 361 on takeover bids (known in Brazil as OPAs), the Brazilian Securities and Exchange Commission (CVM) proposes to increase the liability of company valuation firms. Diametrically opposite opinions have been expressed on the matter. Although some consider that Brazil's capital market needs more trustworthy and well-grounded valuation reports, others fear that the rule will have an adverse side-effect: serious valuators stepping down in favor of less qualified or – even worse – less reliable professionals.
The draft remains open to public consultation until July 9. If it passes as is, company valuators will play a more active role: they will be compelled to certify that they have analyzed the consistency, coherence and reasonableness of information and projections provided by target companies and third parties. Fears are that whoever signs the certificate will be at greater risk of being sued by investors questioning the value offered for their shares during takeover bids, for example.
In order to calculate the value of a company and the price of its shares, valuators use information provided by the target company itself: audited financial statements, management reports, budgets, sales forecasts, etc. Other information such as economic growth estimates are researched by the valuator. Instruction 361 currently states that valuators are not responsible for verifying information received by target companies and may use such information whenever no inconsistencies are detected.
In its current wording, the reform draft suggests that valuators will become liable for client-provided information when it would be more adequate to prescribe liability for due diligence in analyzing this data, observes Thiago Giantomassi, a lawyer with Demarest & Almeida. The regulator believes otherwise. According to Flavia Mouta, an inspector with the CVM's regulation improvement management, the draft merely consolidated and explicitly stated the CVM board's understanding on takeover bids and valuation reports. In her opinion, the rule does not change the valuator’s liability. They will only have to attest to something that they already did: check the data for consistency. Some believe that the certification will leave valuators more vulnerable to third-party liability suits. Precisely for that reason, they would start checking the information more diligently and in greater depth, the CVM understands.
Valuation reports are key decision-making instruments for investors and are mandatory for all OPAs promoted by a company or its controllers. They are churned out in production-line fashion, however. Some institutions limit their work to filling in the blanks of valuation templates with company-provided information. The expected immediate effect is that the change will bring valuating banks out of their apathy: "Valuators will spend more time on their studies", guarantees João Felipe Figueira de Mello, a lawyer with Leoni Siqueira Advogados.
Malcom Montgomery of the Singular Partners investment boutique believes that experienced valuators are able to detect almost every inconsistency in information, but checking up on those inconsistencies puts them in a gray zone of difficult proof. Where can one draw the line to say that a company's information was checked thoroughly enough by the valuator?
This concern is based on the fact that subjectiveness is a major ingredient in the valuation report recipe. For a company's value to be determined, valuators must use growth projections and discount rates. It is well known that such estimates are always subject to a certain degree of interpretation. As if things weren't complicated enough already, there's another relevant factor: the lack of diligence and respect for minority shareholders by company managers, a behavior that the CVM's new instruction intends to end.
Dissatisfaction with valuation reports is an old problem in Brazil. Minority shareholders accuse some authors of "reverse engineering". In these cases, they claim that takeover bidders first establish how much they want to pay for the shares, then the hired valuator bends over backwards to arrive at the desired value.
"Valuation reports have been the backdrop for all the recent problems with merger and acquisition operations [in Brazil]", acknowledges Edison Garcia, a superintendent with the Capital Market Investors Association (Amec) who is still analyzing the CVM's new draft. He observes that according to current laws and regulations, nobody is liable for a given valuation report: neither the company retaining the valuator (after all, the company didn't write the report); nor the valuator, who shirks all responsibility by saying the report was based on information provided by the company. The reports are usually chock-full of disclaimers that undermine the valuation's robustness and credibility.
WIGGLE ROOM — In practice, questioning a valuation report is a complicated endeavor of unlikely success, as valuators and companies enjoy a great deal of wiggle room and can deploy different (but all perfectly lawful) mechanisms to calculate the fair value of shares. Even if the instruction ups valuator liability, that situation would not change dramatically.
One asset manager complains that valuators usually don't discuss the numbers presented in their reports. And investors are often unable to access the assumptions used in a report's preparation. In this manager's opinion, valuators should be forced to make at least one public presentation to each target company's shareholders, who would then have the opportunity to know the work in greater detail. This would increase the exposure of valuators, who would start to think twice before presenting poorly constructed work for the whole market to see: "This solution wouldn't add any extra costs. It would be meeting halfway", he believes.
When contacted by CAPITAL ABERTO to evaluate the CVM's proposed changes, the Brazilian Association of Financial and Capital Market Entities (Anbima) and BTG Pactual bank preferred to remain silent, as the draft is still under public consultation. Credit Suisse, Itaú BBA and Morgan Stanley also refrained from commenting on how the change would impact their activities.
Another delicate issue introduced by the draft instruction is the requirement that reports take into account the gains and synergies obtained from M&A operations, as well as their impact on company value. The requirement would apply for target companies where a buyout was completed before the takeover bid in question. "Many times, not even the company knows how much it will gain from the operation", says Montgomery. "It's sometimes difficult to obtain information from the acquired company. You can only check if the data is correct after the new owner has moved in", asserts Giantomassi. Flavia Mouta of the CVM explains that these synergy calculations are merely a kind of additional comment in the reports. According to her, they would not be included in a company's value.
The impacts of the changes proposed by the new rule are still unknown. A certain uncertainty hovers over the market. "Increasing valuator liability is important, but care must be taken to avoid excess. I fear that competent valuators may abandon the market and less competent ones will fill the void", says a professional from an independent asset manager that often questions valuation reports and fights to defend the interests of minority shareholders. He is worried that top banks will decide the fees charged for valuation services are not worth the legal risks of producing reports.
Others are expecting a less drastic and pernicious effect: "I believe that the prices charged by banks will rise to cover the risk of liability suits filed by minority shareholders", Montgomery predicts. In developed countries, the valuation market is dominated by a small number of firms who charge high prices.
"Higher prices on valuation reports would be a positive thing for the market if the reports made sense. As they're done today, they end up confusing investors", asserts Mauro Cunha, a partner at Mauá Sekular Investimentos. Cunha believes that the signature of a top-tier bank is enough to give investors a false sense of security.