The current debate in the United States about how to regulate Wall Street focuses on laws, regulations, and monitoring. But lawmakers may want to look to history for guidance, to Brazil 100 years ago, when transparent governance and investor protections came from places we might consider unlikely today: the companies themselves.
During that period, investor protection laws in Brazil were relatively weak—yet investors bought equity on a “massive scale,” according to Harvard Business School professor Aldo Musacchio, bankrolling corporate growth and economic development for decades. What gave investors the confidence to risk their money?
In a recent monograph, Musacchio reports that Brazilian companies were transparent about their operations, including the disclosure of executive compensation—something not even done today with any regularity.
Brazilian companies a hundred years ago also provided investor-friendly provisions that protected shareholders from abuses by large shareholders, managers, and other corporate insiders—protections that were even better than what was offered in the country in the late 20th century. “These provisions ranged from limits on the number of votes a single shareholder could have to restrictions on the number of family members who could act as directors simultaneously,” Musacchio says.
We interviewed Musacchio about the research findings that underpin his new book, Experiments in Financial Democracy: Corporate Governance and Financial Development in Brazil, 1882-1950, which studies the relationships between law, corporate governance, and economic development. We also asked him what turn-of-the-century Brazil can teach us about government bailouts today.
Sean Silverthorne: What does the book contribute to the literature in your field?
Aldo Musacchio: When I wrote the book, most of the discussion on corporate governance was focused on the legal system and the corporate laws of countries. The conclusions were a bit deterministic. If a country followed the French legal system, for instance, then corporate governance was supposed to be bad, and there was little debate about what companies or managers could do about it. For me this just sounded too simplistic.
Moreover, the focus on national laws led to policy recommendations that were sometimes too complicated to implement, which led to efforts by governments and development agencies toward reforming the legal system or improving the court system. There is nothing wrong with that, but what if the real agents of change were the corporations themselves—their founders or their current shareholders?
In the book I advance what I think is an overlooked point: Companies can overcome the shortcomings of the legal system in which they operate. If investor protections are weak in national laws, companies can offer protections in their bylaws that compensate for those weaknesses. It is easier to change a country one corporation at a time than trying to change legal practices. Once many corporations adopt strong investor protections in their bylaws, others have to follow.
Q: Why did you subtitle the book “Experiments in Financial Democracy”?
A: During the late 19th century, Alfred Neymark, a French statistician, conducted a series of studies on the size of stock markets across countries and on the ownership structure of railways and other companies in France. In one of his books he argues that France was the largest “financial democracy” in the world, because of the large number of shareholders that French railway companies had (not to mention the Suez Canal).
Since I found similar results in an effort by Brazilian corporations to attract small shareholders, I thought that Brazil was also a financial democracy. Yet, in Brazil there was a clear cycle: It started in the late 19th century and ended in the first two decades of the 20th century. Therefore, what I observed appeared to be more like an experiment. In terms of the book, the argument is that the experiment seemed to have worked to propel the diffusion of equity ownership and the growth of equity (and bond) markets.
Q: It’s commonly believed that a country’s economic development relies on investor protections offered by national laws and regulations. So why did investors flock to Brazil’s stock and bond markets between 1882 and 1915, when national protections were relatively weak?
A: Investors in Brazil felt protected when they purchased these instruments for two interesting reasons. First, equity investors were protected because corporate bylaws included provisions to protect the rights of small shareholders. For instance, corporate bylaws could limit the voting power of large shareholders, limit family participation on boards, and force disclosure of financial statements and executive compensation.
Second, for bonds, the story had more to do with what the courts were doing. I found that bondholders were always first in line during corporate bankruptcies. They usually got paid something, and they were important in determining what would happen to a company, especially during reorganizations. The legal system protected creditors strongly. That is why I found that the corporate bond market as a percentage of GDP (a common measure of the development of these markets) was higher in 1910 than what it is today.
Q: How did Brazilian corporations protect their investors? Was this a deliberate move to draw more investment? Does this shed light on today’s common one-share, one-vote practices?
A: The book is a bit critical of the idea that “one-share, one-vote” is magic for good corporate governance. When I started writing my Ph.D. dissertation, the World Bank, the International Corporate Governance Network, the OCDE, and so on were promoting this principle as a way to overcome the abuses of managers or controlling shareholders who expropriated small shareholders or tunneled corporate resources to their affiliated firms.
Well, if you think about it, outside the United States corporate ownership is relatively concentrated, so having one-share, one-vote in a company that has 51 percent of the equity owned by a family may not change practices. In the book I argue that disclosure is perhaps the most important rule; there were also provisions such as limits on the number of maximum votes a shareholder or a proxy could hold, which made large corporations truly democratic in the sense that decisions were consensual.
Q: Back then, the salaries and bonuses of top corporate executives in Brazil were easy enough for investors to find. Interestingly, these salaries were generally higher than those in the United States and the UK. Why was public disclosure not moderating executive pay?
A: Yes, the data on salaries that I found for company directors in Brazil in the past were a bit high compared to the UK. This could be a sign of having abusive managers overpaying themselves. Yet I argue that because the scheme of executive compensation was voted by shareholders and was transparent (unlike some of the packages that managers get today in the same firms in Brazil or in other countries), it could not have been that abusive. Moreover, you have to imagine that talent to run a corporation in Brazil between 1882 and 1930 or so was pretty scarce, so they obviously received high salaries—about 10 times higher than the annual salary of a factory worker. If you extrapolate that to the United States today, it would be equivalent to having executives in large corporations making salaries of less than $1 million a year.
Q: The period after 1915 saw a major decline in Brazilian markets. What happened? Why didn’t investor protections persist?
A: I argue that ultimately what matters is the availability of capital. Brazil was a net importer of capital during the period 1870 to 1915, and firms were competing to attract shareholders or bondholders. After 1915, things changed rather rapidly. In a couple of decades the main source of capital was no longer the stock market: Bank credit was used to pay for short-term expenses, and credit from development banks was used for long-term capital needs. I also show that as inflation increased in the 1930s, real returns for investors were lowered significantly.
Q: What is the state of governance in Brazil today?
A: A great thing for me when I was writing the book is that corporate standards in Brazil improved enormously, not only because the regulator became tougher and introduced more transparent disclosure standards, but also because there was a big movement to improve corporate governance led by pension funds and the São Paulo Stock Exchange (Bovespa). Bovespa created “levels” for publicly traded corporations according to how protected small investors were: level 1, level 2, and the highest level, New Market.
Today, most of the IPOs are for companies that are level 2 or New Market. So change is coming from the companies themselves, aided by a strong regulator. Moreover, the stock market has played a big role as well. For instance, Brazilian companies adopted International Financial Reporting Standards accounting before companies in the United States!
This does not mean that the lessons of the book have no application today. I argue that disclosure of executive compensation and the list of shareholders is worse today than during the period I studied. I also argue that family companies do not have the provisions to protect small shareholders as in the past.
Q: Does your research give us some insight today as U.S. policymakers consider ways to strengthen regulations on financial institutions?
A: Yes! The book makes a strong argument that financial development matters.
Larger financial markets are highly correlated with economic growth. Yet during the period I studied, Brazilian authorities regulated banks heavily, especially in terms of disclosure of financial statements (for instance, they had to publish full financial statements two or four times a year), and they had to disclose executive compensation packages. There was some balance between financial development, regulation, and growth, and that is what the new set of financial regulations should focus on. Repressing too much would be a problem.
Obviously, Brazilian bankers at the turn of the 20th century were relatively conservative. They had mortgages on their balance sheets, but monitored them closely. At the end of the book I warn that a big shock to financial markets could change the level of government ownership of banks and corporations in a permanent way. Once the government starts rescuing the financial system from a big shock it is hard to justify not having the government pumping money into the system through other, more inflationary means. That is what happened in Brazil; the credit system is still dominated by government-owned banks. I don’t think the U.S. government will want to keep its shares in the largest mortgage and commercial banks for long.
Q: What are you working on now?
A: I’m working on a book that looks at governance and performance of state-owned enterprises in Brazil.
When we think about BRIC countries (Brazil, Russia, India, China), we sometimes don’t consider how important state-owned enterprises are in these countries. BRIC capitalism is very different from what we know in the United States. The state plays a big role in these countries, and credit for large-scale projects is channeled through government-owned banks.
In the 1990s, we thought all state-owned enterprises would disappear; research—theoretical and empirical—clearly showed that state-owned enterprises were inefficient monsters. Today, the evidence is a bit different. State-owned corporations in BRIC countries have managed to reform their corporate governance and become relatively efficient. Think about oil and banking: Among the 10 or 20 largest companies in the world, there are 8 or so state-owned enterprises from BRIC countries.
The book will explain why some state-owned enterprises are more efficient than others in Brazil as well as how much the country’s development bank, BNDES, has contributed to making the country a world superpower in agribusiness and manufacturing. I think that readers will understand the central role the state has played in the rise of Brazil as the darling of international investors. I hope the book can offer lessons for the reform of state-owned enterprises in other countries. 
About the author
Sean Silverthorne is editor-in-chief of HBS Working Knowledge.
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