New Year's 2009: Chile Adopts IFRS: Are Investors At Risk?

On December 19, 2008 in an early Christmas present of sorts, Juan Andrés Camus y Jorge Errázuriz, the founders of Santiago based investment manager Celfin Capital, announced that they would voluntarily compensate clients who lost money on investments connected to a US$50 billion dollar fraud perpetrated by New York financier Bernard Madoff.

The Madoff scandal has been an unwelcome shock to already jittery investors and is a glaring reminder of the value of transparency and effective risk management. On New Year’s Day, 2009 major Chilean firms will begin adopting a new set of accounting rules, the globally recognized International Financial Reporting Standards (IFRS). The switch to IFRS will bring added transparency, but also new challenges to investors interested in pro-actively managing their holdings.

Although in the long-run shareholders and companies alike should benefit from the adoption of IFRS, a common language of universally accepted accounting standards, in the short-term the shift to the new system may pose certain risks.

In the short-term, the transition to IFRS may pose risks for shareholders if regulators, auditors, executives, and directors are unfamiliar with the new system. Daniel Joignant, an accountant with Deloitte Chile told local press sources that “accountants being trained today are still being taught the old standards, which means that their studies will be out of date by the time they graduate.” El Mercurio, a daily Spanish language Chilean newspaper, reported that only around one fifth of the country’s accountants have a high level of familiarity with the new system.

It is important to note that Chile is markedly different from many of the European countries that have already adopted the IFRS rules. In Chile most companies are controlled by insiders. Controlling shareholders are common and independent directors are not. Under IFRS the lack of board independence could emerge as an important concern for investors.

In the short term, companies will have to determine if their boards contain members with significant financial expertise who are familiar with the new system, a significant undertaking in a market where directors are often selected because of their personal connections to company insiders.

Chilean securities market laws do not require companies to form independent audit committees. The duties typically handled by independent audit committees in other markets are the responsibility of Chilean executive committees, meaning that in Chile there is often less independent oversight of accounts than in other markets.

Because IFRS is a principles-based rather than rules based system, it relies heavily on listed companies and their accountants and auditors to make decisions about how to classify and disclose accounts. In Chile, a country with a high incidence of controlling shareholders and a weak presence of independent directors, the switch to IFRS will enhance transparency but also highlight the need for increased independent oversight. Overall, the switch to IFRS will underscore the need for investors to critically analyze financial statements and monitor relationships between listed Chilean companies and their external auditors.

When investigators from Chile’s National Accounting Association were looking into a 1994 futures trading scandal at Chile’s state controlled copper producer CODELCO, they found that Chilean accounting rules included no provisions regulating the determination of the value of forward trades in the derivatives market. More recently, U.S. investigators looking into Mr. Madoff’s murky New York financial operations failed to find anything amiss. Maybe the widespread adoption of a universal accounting system like IFRS will enhance investors’s ability to actively analyze their holdings and more effectively detect and manage risks.

The Downside to the “Cemex Way”: A Lack of Independent Board Oversight

After taking over as CEO in 1985, Lorenzo H. Zambrano laid the foundation of a business model and culture that helped Cemex S.A.B. de C.V. (BMV: CEMEXCPO) build itself up and move beyond Mexico’s borders with a string of successful acquisitions.

One of the first companies to effectively harness the value-adding power of information technology and centrally coordinated management, Cemex quickly became one of the world’s most profitable companies and cemented its place as a global leader in the construction materials industry. Recent financial troubles indicate, however, that the company may have placed itself at risk by failing to shed many of the weak governance policies that are common in the Mexican market.

Although members of Mr. H. Zambrano’s family, which founded Cemex in 1906, no longer hold a controlling stake, they continue to dominate the company’s board. For example, only one of Cemex's 13 directors is free of any conflicts of interest or ties to the Zambrano family. The company has not split the positions of chairman and CEO and has not appointed an independent lead director. The company’s board includes six members of the Zambrano family, two of whom serve on both the audit and the nominating/remuneration committees. (The company's CFO, Rodrigo Trevino, is also a cousin of the CEO.)

Six of the company's other directors are considered to be non-independent because they are relatives of company executives, have been involved in related party transactions with the company, or have other business relationships with Mr. H. Zambrano.

Only one of the company’s five audit committee members is independent from management and the controlling family. The fact that 80% of the committee’s members are non-independent and two of them are members of the Zambrano family effectively compromises the committee’s ability to provide independent oversight of risk-management policies. The fact that the company’s CFO is also related to the company’s founding family further complicates this issue.

Although very strong in other areas of risk-management disclosure, Cemex has never disclosed information on risks relating to its insider-controlled board structure. The lack of independent board oversight may have prevented doubts from being raised over the potential downside to Mr. H. Zambrano’s strategy of borrowing heavily to finance acquisitions in mid-2007 even as warnings were being issued about the failing health of the housing and construction sectors.

After moving to acquire Australian rival Rinker for US$14.2B in 2007, Cemex is now saddled with a debt load of US$16B. Cemex is in particular trouble because it has only $560M in cash and a poorly planned debt structure that will force it to refinance $8B, half of its outstanding debt, by mid 2010.

On December 11, 2008 Cemex's share prices tumbled after the company failed to swap US$418M of short-term commercial paper for longer-term notes. In the midst of a global slowdown, Cemex is now faced with a formidable challenge to restructure its debt and is currently in talks with creditor companies. Cemex is a company built on a solid foundation. Once it regains its footing, investors should hope that the company protects itself by updating its governance policies to bring them in line with the other world-class aspects of its business.

Financial Crises: If Hindsight is 20-20, Why Does History Repeat Itself?

With investors dumping foreign-currency denominated assets and parking their cash in safe havens, slowing foreign direct investment, lagging foreign demand, and slumping commodity prices, the after-effects of the U.S. financial crisis will have an acute affect on Latin America's growth prospects for the next few years.

In his speech at the 25th Session of the Intergovernmental Working Group of Experts on International Standards of Accounting and Reporting (ISAR) held in Geneva during the week of November 3, 2008 André Baladi, the representative of the International Corporate Governance Network (ICGN), a U.K. based not-for-profit company, explained that the current crisis is not unique but rather part of a chain of similar cyclical crises that have periodically rocked financial markets since capitalism’s inception.

Mr. Beladi mentioned collapses and crashes that took place in Europe in the early 1700s, in the U.S. in the 1900s, and more recently at companies like The Bear Stearns Companies, Lehman Brothers Holdings Inc., and Societe Generale S.A. (Paris Stock Exchange: GLE) (Soc-Gen).

The notion that free market capitalism and financial markets are susceptible to periodic crises is backed by a substantial body of academic work based on the research of financial economist Hyman Minsky’s pioneering research. Many economists have explained that the current crisis affecting financial markets follows the trajectory of previous boom and bust cycles. The most recent Economic Outlook Report from the International Monetary Fund explains that “financial systems are inherently procyclical” and are affected by the business cycle in which the “buildup of financial imbalances [is] followed by a sharp correction.”

Public outrage in the aftermath of a crisis-induced series of high-profile corporate collapses is likewise not a new phenomenon. In 1720, investors who lost fortunes in the controversial collapse of the “South Sea” stock bubble were furious. After the crash, Thomas Gordon, an influential classical liberal whose ideas helped paved the way for thinkers like John Locke, Adam Smith, and Milton Friedman condemned the “execrable arts of stock-jobbers” and argued forcefully that the public good would be best served if harsh punishment was served to the directors who presided over the company behind the collapse.

In the wake of a new wave of corporate collapses, as global markets are besieged by volatility, compensation policy and corporate governance reform will yet again sail to the center of the legal and regulatory agenda.

History repeats itself. Hindsight may be 20-20, but memories of economic downturns tend to fade in the exuberance of subsequent upswings. Following the current crisis, we should hope that public attention is turned not only in the short-term to “execrable stock jobbers” and highly-compensated CEOs but also to key corporate governance reforms that could help better align executive and shareholder interests and better promote long-run financial market stability.

Caught in the Storm: Bad Currency Bets by Comerical Mexicana

Perhaps overconfident after five calm years of economic stability and steady growth, several Mexican companies bet hard on derivatives tied to the value of the country’s peso and were caught unprepared for the storm that blew in from Wall Street. From June 30, 2006 to June 30, 2008 the Mexican peso appreciated steadily and smoothly against the dollar. During this time many Mexican companies entered into profitable derivative contracts linked to the rise of the peso. However, as panic induced by the U.S. financial crisis spread, investors scrambled to trade foreign holdings for dollar denominated assets, inducing a sharp decline in the value of the Mexican peso. Several Mexican companies were unprepared when the country’s currency devalued sharply by 29% between September 15 and October 15, 2008.

The Wall Street Journal reported that the CFO of Controladora Comercial Mexicana S.A. de C.V. (BMV: COMERCIUBC), one of the companies worst affected by this crisis, was literally on vacation during late September as the world’s financial markets starting showing stress fractures. He reportedly returned from Europe on October 1, 2008 to find the family-controlled retailer on the brink of bankruptcy.

On October 28, 2008 La Comer (as the company is colloquially known in Mexico) reported third quarter 2008 losses on derivative contracts totaling US$0.5 billion, or 12.5% of 2007 revenues.

The company’s attempts to seek bankruptcy protection in the Mexican court system have been denied. Mexican press sources have reported that La Comer is using extrajudicial proceedings to restructure its multi-billion dollar debt obligations with a list of creditors that includes among others Banco Santander S.A. (Madrid Stock Exchange: SAN), Goldman Sachs Group, Inc (NYSE: GS), Barclays PLC (LSE: BARC), and JPMorgan Chase & Co. (NYSE: JPM), all of which acted as counterparties to the company’s derivative contracts. La Comer’s total debt stands at US$2.5 billion, more than 90% of total assets.

Will Landers, a Latin American money manager at Blackrock Inc (NYSE: BLK), explained to press sources that this issue highlights a need for better regulation and that “from an investor's standpoint there's got to be more disclosure.”

La Comer’s annual report for 2007 offers almost no description of the risks related to the company’s exposure to exchange rate fluctuations. The report discloses that in 2007 and 2006 it reported net gains of MXP 360M (US$ 27M) and MXP 26.6M (US$ 2M) on derivative contracts, but includes only one brief sentence that explains that the company’s financial standing could be affected by a devaluation of the peso relative to the dollar. By contrast, annual reports from other listed Mexican companies included several pages of detailed descriptions of risks relating to currency fluctuations as well as specific calculations of potential losses on derivative instruments linked to exchange rates. For example, one company reported that a ten percent decline in the value of the peso would translate into losses of US$ 250M on derivative contracts.

La Comer's CEO, Chairman, and Vice-Chairman, as well as three other members of the company's board are members of the founding family. Only three of the company's twelve directors can be considerate independent of management and controlling shareholder. The company offers almost no disclosure of information relating to its governance and executive compensation policies. Further, unlike rival retailer Wal-Mart de Mexico S.A. (BMV: WALMEXC), La Comer does not have an environmental management system and does not report its environmental performance, an indication of sub-par management and disclosure. Apparently the Gonzalez family, which owns 72% of La Comer's shares expected investors to trust their management acumen. The company's current troubles are a lesson in the value of transparency.

Given La Comer’s bottom of the barrel governance profile, it is not surprising that the poorly managed company would be caught so unprepared and be so severely affected by recent shocks.