BANCO ESPIRITO SANTO
NYSE Euronext Lisbon: BES                                         Meeting Date: 7/31/2014

Banco Espírito Santo was unexpectedly thrust into the spotlight earlier this week when it sparked a steep but short-lived decline in global stock markets. Shareholders will be carefully watching the Company’s next moves, including the likely contentious upcoming general meeting called at the request of the largest shareholder, the Espírito Santo family, to reorganize the board and management. Considering that the Company’s problems stem from poor corporate governance and risk management practices by the Espírito Santos within their opaque business empire, the proposals will be highly scrutinized. In fact, the Portuguese central bank already vetoed the Espírito Santos’ initial proposals, forcing the family to regroup with new outside candidates for the positions of CEO, CFO and chairman of the board, each of whom were ousted this month. Pressure from the market and regulators resulted in all members of the Espírito Santo family, as well as their close business affiliates, resigning from their board and management positions.

Determined not to disappear entirely, the Espírito Santos have put forth an unusual proposal to create a new strategic committee tasked with providing non-binding advice to the board on key strategic decisions. Three of the five nominees put forth by the Espírito Santos are (surprise!) members of the Espírito Santo family. Although the proposal appears to be a compromise between the family, regulators, and Crédit Agricole, the Company’s second largest shareholder, minority shareholders may question what they have to gain from allowing discredited members of the Espírito Santo family to continue to benefit from a formal right to review all the Company’s strategic moves.

Why so much sudden disdain for the Company’s founding family? It starts with an exposé by the Wall Street Journal in 2013 that showed the privately held Espírito Santo International (ESI), the family’s investment vehicle, was exposed to excessive financing from related parties and pursued questionable accounting procedures. A subsequent audit commissioned by Portuguese regulatory authorities found accounting irregularities at ESI and determined that ESI was in “serious financial condition.” The Espírito Santo’s family’s fortunes quickly began to unravel in mid-2014 amid increasing speculation about the extent of the problems. The Company was forced to admit financial and reputational exposure to liabilities throughout the business empire of the Espírito Santos after a Swiss bank revealed delayed interest payments from ESI and Portugal Telecom, a public company partly owned by the Company, disclosed an €897 million liability towards a different entity in the Espírito Santo Group. Mounting questions about the exact state of affairs in the Espírito Santos’ businesses, complicated by an absence of disclosure from privately-held entities, caused investors and ratings agencies to question the Company’s solvency. It quickly became clear that the Espírito Santos were not in a position to steer the Company out of troubled waters.

On a broader level, the case illustrates the potential problems at family-controlled entities when appropriate checks and balances are not put in place. The Espírito Santos’ fall from grace may have been prevented if they had entrusted management or oversight of the business to outsiders, rather than the complicated network of cross-directorships that saw family insiders serving in management and board positions at various entities in the group. Reasonable stakeholders could certainly ask whether short-sightedness and “group think” got the better of the Espírito Santos, without the outside perspective of a strong counterbalance to question risky business practices that appeared to benefit the family (at least until recently). Although the Portuguese central bank has now caught on to the problem and pushed for independent leadership, perhaps the Espírito Santo case will also lend a sense of urgency to the European Commission’s current push to improve transparency and shareholder oversight of related party transactions.

For now, shareholders can only watch and wait as the Company is forced to reconfigure management and improve disclosure to prevent massive capital flight and potentially worse, market panic. Many questions remain unanswered, including how the Espírito Santos intend to restructure their troubled empire to save it from financial ruin. It may not be the last time that Espírito Santo is thrust into the headlines, but for now, with the family members mostly out of the picture, the Company has the opportunity for a fresh start.