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ESG Viewpoint

September 2017

Brazil – many ways to wash a car

Key summary

 Ongoing investigations into large scale corruption in continues to cause political and economic instability

 BHP Billiton and Vale’s remediation efforts to address the 2015 Samarco mining accident are complicated by a crisis of legitimacy Matthias Beer  Progress in corporate efforts to strengthen compliance systems and culture Associate Director Governance and Sustainable Investment are hampered by ongoing political crisis

Background Contact Us In June, we participated in a field trip to Brazil organised by mining company bmogam.com/responsible-investing BHP Billiton (‘BHP’). The purpose was to get a first-hand insight into developments in relation to the 2015 Samarco accident when the collapse of a Institutional business: major mine tailings dam resulted in one of Brazil biggest environmental +44 (0)20 7011 4444 disasters.1 We also took the opportunity to meet with other Brazilian companies, including Vale, , CRR and Ultrapar. [email protected] Discretionary Sales During the entire trip - whether we talked to mining employees or residents in the Samarco region, or corporate employees in offices in Sao Paolo and Rio de +44 (0)20 7011 4444 Janeiro - discussions typically referred to the impact of the ongoing political [email protected] turmoil and corruption investigations in Brazil. With many political and corporate UK Adviser Sales leaders being implicated by these investigations, including two former presidents (Lula and ) and the current president , the country’s 0800 085 0383 political and corporate institutions are facing a fundamental crisis of legitimacy. [email protected] The corruption investigation dubbed “Operation Car Wash”, which was launched in 2014, has brought to light systemic and corruption practices. This has involved dozens of politicians across all major parties as well as senior executives of major corporations, such as oil giant Petrobras, construction company Odebrecht, and more recently the world’s largest meat packaging company JBS. Corruption investigations have spread across borders, heightening political risks across the region. In this Viewpoint, we highlight how this crisis of political and corporate legitimacy is underpinning many of the key, material ESG themes we have been discussing during our time in Brazil.

1 The released tailings created a mudflow that destroyed two villages, killed at least 17 people and polluted over 400 miles of rivers.

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Yet we also highlight ongoing implementation challenges Samarco field trip that are fuelled by the broader political crisis affecting Brazil. Samarco Mineracao SA (‘Samarco SA’) is an Key points in our assessment of BHP’s response to the independently-operated 50/50 joint venture between Anglo- Samarco accident include: Australian miner BHP Billiton and Brazilian Vale. It was  Renova governance: We noted positively that senior forced to shut down operations immediately following the BHP and Vale staff occupy dedicated roles within the 2015 tailings dam collapse. Investors which held the shares Renova Foundation which manages the implementation and bonds of BHP Billiton and Vale were impacted. of a comprehensive environmental and social Samarco SA’s own corporate bonds defaulted. remediation programme. The foundation has a total Since the incident, the two joint-venture companies have budget of $1.6 billion over three years. This is split made concerted efforts to remediate the damage while between environmental and socio-economic aiming to mitigate the financial impacts and rebuild their own remediation projects. Given the scale and complexity of reputation. No date has been set for a possible restart of these activities we stressed the importance of external Samarco SA's operations, as this remains dependant on governance mechanisms designed to provide robust economic viability as well as regulatory approval, which independent oversight. We welcomed in particular the 2 takes into account factors such as operational safety and establishment of an IUCN Panel to ensure independent community support. validation of Renova’s objectives and deliverables. Building and maintaining legitimacy among the wider In March 2016, after a relatively short period of negotiations, population in Brazil is a key challenge for Renova, in a the two companies agreed with government authorities, situation where BHP, Vale and Samarco SA have been under then President Rousseff, to pay up to $5.6 billion to criticised as colluding with the government to arrive at fund a foundation scheme called Renova. This was set up to the TTAC settlement that falls short of popular restore the local environment devastated by the flood and expectations. We encouraged BHP and Vale to pay compensation to the people affected. In addition, illustrate positive impact on the ground from the independent federal prosecutors filed a $44 billion lawsuit remediation programmes and in the understanding that for social, environmental and economic compensation. such examples of good work can help overcome these This federal prosecutors’ lawsuit has in many ways been an legitimacy challenges. expression of popular distrust in the government and  Federal prosecutors’ settlement: We remain companies involved. It is alleged that former President concerned that the final agreement target for October Rousseff strove to present a quick success story in 2017, while satisfactory from a legal perspective, may achieving the initial so called TTAC settlement to ward off still lack sufficient popular support. One of the key mounting pressure coming from corruption investigations at demands BHP and Vale have been confronted with is the time. Although the subsequent federal prosecutor’s the involvement of more robust local stakeholder lawsuit set a much higher financial penalty, it is widely representation at Renova, including at Board level. We expected that the final amount of the settlement will come recognise the challenge for the Foundation to balance down significantly. Yet ongoing uncertainty around the final the need for adequate stakeholder representation with financial bill have weighed on the company’s valuation and the ability to maintain effective decision-making fed into popular scepticism about the adequacy of the capability. We also urged the companies to consider company’s remediation efforts. The final date for entering an options for expanding Renova’s current governance agreement on this second settlement has been set for the framework to elevate the participation of local end of October 2017. stakeholder perspectives. Independent of the amount of We spent three days with BHP in the Samarco region and the final settlement, building legitimacy must be a key had opportunities to meet with representatives from the objective of Renova in order to ensure that the funding Renova Foundation, Samarco SA employees and and delivery of its programs leads to sustainable representatives of communities affected by the accident. positive outcomes. Overall, we gained positive impressions on the progress  Long-term environmental impacts: The insights we achieved in terms of the level of management attention and gained on the trip have given us confidence that the resourcing BHP has committed to addressing the fallout of approach taken on environmental remediation so far the incident. has been comprehensive and credible. We encouraged

2 The International Union for Conservation of Nature (IUCN) is an organisation working in the field of nature conservation and influential and widely recognised independent international sustainable use of natural resources.

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the use of the precautionary principle to factor in potential uncertainties around long-term impacts on eco-systems. The involvement of independent bodies “Today Brazil is undergoing three crises: one of such as the IUCN could provide a particularly important view on addressing outstanding questions. These ethics, one of politics and one of economics” concern scepticism around their assessments of long- Rodrigo Janot, Brazil's Prosecutor General term environmental impacts as well as the extent to which remaining tailings in the river system need to be removed or can be left in place. We asked for robust transparency around the implementation of eventual IUCN Panel recommendations in this context. Of the 86 companies that had fiscal council representatives  Bribery and corruption risks: Although we do not see proposed by minority shareholders, 78 companies had at any obvious concerns with Renova’s compliance least one minority representative elected to the board. controls, there is still a need to clarify the nature of disclosure stakeholders can expect around independent Other developments include a review of the listings verification for the use of proceeds and impact on end regulations for the highest corporate governance segments, beneficiaries. Given the scope of Renova’s budget, the the Novo Mercado. The majority of Novo Mercado risk of abuse is obvious in light of the systemic companies approved additional rules such as requirements corruption that has blighted the Brazilian establishment to conduct board evaluation. However, they voted down in recent years. Renova faces the challenge of other items such as enhanced standardised reporting providing convincing evidence that clearly distinguishes requirements on social-environmental matters. its activities and practices from the Brazilian political- corporate nexus which has led to and Beyond compliance corruption. Effective communication and transparency Additional company meetings on our trip included Petrobras, will be crucial in countering this narrative and rebuilding CCR and Ultrapar. With all three companies we held public trust. detailed discussions regarding the impact of the political situation in Brazil and their responses in terms of Brazil broader market developments enhancements to governance, internal controls and Brazil has been hit by the worst economic recession in its compliance programmes. history. There have been eight consecutive quarters of We have had a long history of engaging on board contraction between the start of 2015 and the end of 2016. governance issues in Brazil - particularly with Petrobras with Although growth has returned in 2017, translating into rises whom we have engaged intensively, leading a coalition of in the Bovespa stock index and a strengthening of the international investors to push for a more effective and , the ongoing political crisis around the independent board. Specifically we have supported the corruption investigations has extended the uncertainty and appointment of qualified minority nominees to the fiscal market volatility. While President Temer was able to defend council, something that has now happened several a corruption probe in August 2017, Brazil’s top prosecutor is companies, including Petrobras, CCR and Ultrapar. The expected to file a new charge in September and support fiscal council is a critical board body which requires qualified from his governing is coalition weakening.3 and independent directors to oversee and report on Against this backdrop of political and economic instability, compliance with legal duties including on and this year’s proxy season in Brazil showed again very high corruption. levels of shareholder activism. Governance standards in A more mixed picture emerges around the extent to which Brazil have improved in recent years and 2017 the broader context around Operation Car Wash has demonstrated a few positive developments but also some stimulated more effective controls and compliance systems. missed opportunities. Companies presented to us comprehensive materials One of the focal areas is the strengthening of independent showing positive activities in this area. These include board oversight via minority board and fiscal council overhauls of compliance programmes, increased due nominees. diligence and transparency around handling government

3 See for example https://www.reuters.com/article/us-brazil- politics/new-brazil--charge-may-be-tougher-for-temer-to-stop- maia-idUSKCN1BF22V

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relationships and tendering, as well as better reporting on the Investment Week Sustainable Investment Awards usage and effectiveness of internal systems such as ethics Best Ethical Investment Fund Best Sustainable Investment Management Group 2016 Fund Management Group 2016 hotlines. However, such improvements to systems and processes always beg the question around what actual culture change is taking place within organisations and how such change is sustained? We gained some impressions of such genuine change happening especially in companies where corruption

investigations had led to actual charges being made against

corporate executives. The evidence was reflected less in new Outstanding Contribution 2014 Fair Pensions 2014 policies and systems but in how people spoke to us, especially in less formal settings, reflecting that they and their colleagues now feel more empowered to question and flag suspicious practices.

Conclusion

Despite these positive impressions, there was also a clear sense of the systemic nature of the entanglement of politics and business in Brazil and the powerful vested interests that have made the corruption problem so pervasive. In order to address and overcome this challenge, more than a simple review of the corporate compliance system is needed. It requires a consistent tone from the top, starting with politics and reflected in the corporate sphere. Unless there is a political resolution of this crisis in sight, corporations, especially those sectors with strong links to government, will continue to find it difficult to demonstrate that they have manged to steer clear of legacy corruption risks.

While the reverberations of Operation Car Wash continue to embroil political and corporate leaders, there is still hope that eventually a more transparent and sustainable economic model underpinned by a stable rule of law will emerge. However, as the crisis continues to undermine the country’s fragile democracy and the legitimacy of its political and corporate institution, a real risk of further and deeper uncertainty may take hold. Which political forces will benefit from the widespread disillusionment in society? Will it be those that are able to rebuild and maintain a pluralistic democratic model? Or will it be a rightwing evangelical theocracy or even a return to dictatorship? As with any revolutionary purge, the question is not so much about which leaders are still to fall, but which ones are waiting in the wings to replace them.

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