. . . as appeared in . . .

Published by WorldTrade Executive, a part of Thomson Reuters

LATIN AMERICAN
Law & Business Report
Volume 20, Number 1 January 2012

Brazilian Securities and Exchange Commission Issues New Rule Amendment Affecting the Ability of Mutual Funds to Invest in Brazilian Depositary Receipts:
What It Means for Brazilian Investors and Other Participants
By Tarik A. Gause (K&L Gates LLP) 1
The Commisso de Valores Mobilirios (the CVM), Brazils Securities and Exchange Commission, adopted on December 20, 2011, Instruction No. 512,2 a rule amendment which allows for Brazilian mutual funds to invest up to 100% of fund assets in certain Brazilian Depositary Receipts (BDRs). BDRs, first launched in Brazil in 2000, are the equivalent of American Depositary Receipts (ADRs) traded in the United States and are backed by securities issued by foreign public companies.3 Specifically, under Instruction No. 512, if certain conditions are met, funds may invest an unlimited amount of fund assets in the so-called Unsponsored BDRs,4 a category of BDRs issued by financial institutions rather than securities issuers directly. Under the rule amendment, funds are allowed to invest in Unsponsored BDRs in exactly the same manner that they invest in similar domestic securities. The conditions for any fund seeking to take advantage of the rule amendment are that: (i) the fund must cater exclusively to so-called qualified investors,5 and (ii) the fund must use a prescribed phrase in its name to indicate that the fund will be trading securities backed by foreign equity.6 So, what does the Instruction No. 512 mean in practice for qualified investors in Brazil? And who else stands to benefit from its implementation? In order to appreciate fully responses to these questions, it is useful first to look at CVMs gradual liberalization of Brazils funds sector and to note the magnitude of the Brazilian fund industry in a global context. hedge funds, and governs their establishment, administration, operation and disclosure requirements. Instruction No. 512 is one of several significant amendments to Instruction No. 409 effected by the CVM over the past several years in order to gradually grant Brazilian funds the ability to participate in the global asset market. Prior to 2007, all investment funds in Brazil were limited to investing 10% of their assets in foreign securities, with one exception.8 However, in March and June 2007, the CVM issued rule amendments allowing multimercados, a term used to describe onshore hedge funds, to invest up to 20% of fund assets in foreign securities similar to those which such funds trade domestically.9 In February 2008, the CVM issued what was, until adoption of Instruction No. 512, the most liberal rule amendment with respect to foreign investment. Instruction No. 465 allows funds exclusively serving clients seeking to invest at least R$1,000,000, informally known as super-qualified investors, to invest up to 100% of fund assets in foreign securities.10 Such funds must also have Investimento no Exterior, or Foreign Investment, in their names. The main policy objective behind adopting the aforementioned rule amendments over time, rather than in more condensed timeframe, was to pace foreign investment liberalization with the CVMs ability to address investor protection concerns. The Brazilian mutual fund industry is sophisticated, tightly regulated and transparent. Currently, in Brazil there are approximately 400 fund managers registered with the CVM and supervised by the Associao Brasileira das Entidades dos Mercados Financeiro e de Capitais (ANBIMA), the industrys self-regulatory organization. These managers are responsible for more than 9,000 funds. According to the most recent data on registered funds from the Investment Company Institute, a national association of U.S. investment companies, the fund management industry in Brazil had assets of US$980 billion at the end of 2010, making it the sixth largest asset management market in the world, ahead of both the United

Mutual Fund Industry in Brazil

CVM Instruction No. 409, as amended,7 is the primary body of law regulating Brazilian investment funds, including
Tarik A. Gause ([email protected]), an Associate in the Washington, DC office of K&L Gates, focuses his practice on investment management and related corporate finance matters.

Gradual Regulatory Liberalization

Brazil
Kingdom and Canada.11 The U.S. market is the worlds largest with approximately $11.8 trillion in assets.12
Of course, the Brazilian qualified investor is the most obvious beneficiary of Instruction No. 512, which will enter into force on July 2, 2012. At that time, Brazilian mutual funds will have the latitude to invest more heavily in BDRs, which are a valuable asset for investors seeking greater diversification, more foreign exposure and less volatility. Furthermore, in the near future, BDRs are likely to become an even more attractive investment option as long-term inflation and rates of return on domestic investments continue to fall in Brazil. Yet, there may be other beneficiaries. For example, the International Market segment of the Bolsa de Valores, Mercadorias e Futuros (BM&FBOVESPA), the second largest exchange in the Americas and where the bulk of BDRs backed by U.S. companies are traded,13 will likely receive a boost to its liquidity because of Instruction No. 512. The recently launched BDRs segment is still very much in its incipient stage in Brazil, and there is much room for growth given the size and sophistication of the Brazilian capital markets. As the BDRs market matures, so too does the possibility of BM&FBOVESPA becoming a regional hub for such trading. Futhermore, it follows that, as demand for BDRs increases, interest from financial institutions that issue BDRs likely will increase as well. The time and transaction costs to launch a BDR in Brazil, to sell the underlying securities abroad and to transfer fund assets back to Brazil are relatively small.14 To date, Banco Bradesco, Ita Unibanco, Citibank and Deutsche Bank have all established a presence in this arena, each with BDRs backed by shares of foreign companies. Fund managers stand to benefit as well. Unlimited access to foreign equity and to a broader group of investors will allow fund managers to design products and optimize investment strategies in unprecedented ways in Brazil. Moreover, it is important to note that, outside of foreign investment quotas, fund managers previously faced a number of other obstacles that Instruction No. 512 appears to mitigate. For example, foreign direct investments by funds are subject to a number of fiscal penalties, including high taxes. However, investing through BDRs circumvents this issue because such investments are treated as investments in domestic securities. Lastly, Instruction No. 512 is an additional opportunity for foreign issuers to reach investors in Brazils evolving economy. Increasing demand for foreign equity via BDRs will not only provide foreign issuers with greater exposure among Brazils qualified investors, but it will also create more of an incentive for fund managers and brokers in Brazil to familiarize themselves with a larger number of foreign issuers. This would likely lead to more coverage by local corporate analysts and hopefully result in better informed investors and higher demand for exposure to foreign equity.

developments in Brazilian regulatory framework governing the mutual fund industry. o

1 Nothing in this article should be construed as containing legal advice either under the laws of Brazil or any other jurisdiction. It should not be relied upon in relation to any specific or general circumstance, and readers should consult appropriate legal counsel for advice with respect to their particular situation. 2 Instruo CVM N. 512 (December 20, 2011). 3 The foreign companies whose securities back BDRs are limited to those based in countries who are signatories to the International Organization of Securities Commissions (IOSCO) Multilateral Memorandum of Understanding or who otherwise have relevant bilateral agreements with Brazil. 4 Sponsored BDRs are issued, registered with the CVM and listed at BM&FBOVESPA by financial institutions which have been contracted by foreign companies to do so. Sponsored BDRs generally are backed by shares of foreign issuers with operations based in Brazil. Unsponsored BDRs are issued, registered and listed by financial institutions without the participation of the foreign companies whose shares back the BDRs. Unsponsored BDRs are backed by shares of foreign issuers with headquarters outside of Brazil. 5 Qualified investors in Brazil include: financial institutions; insurance firms and private equity firms; open and closed supplementary pension plans; natural or legal persons having financial investments of more than R$300,000 and who confirm their status as qualified investors with an executed written statement; investment funds serving qualified investors exclusively; portfolio managers and consultants authorized by the CVM, with respect to their own investments; and certain federal, state and municipal social security regimes. Since the beginning of 2011, the CVM has permitted the creation of funds investing up to 100% of assets in BDRs as long as the funds only served certain pension plans and natural and legal persons investing more than R$1,000,000, or so-called super-qualified investors. 6 The fund must use in its name the phrase Aes BDR Nvel 1, indicating that the fund will be purchasing BDRs on Bovespas International Market exchange. 7 Instruo CVM N. 409 (August 18, 2004). 8 The exception was for foreign debt funds. Other primary fund classifications in Brazil are short-term; indexed; fixed income; equity; external debt (federal bonds); and foreign exchange funds. 9 Instruo CVM N. 450 (March 30, 2007) and Instruo CVM N. 456 (June 22, 2007). 10 Instruo CVM N. 465 (February 20, 2008). 11 2011 Investment Company Fact Book: A Review of Trends and Activity in the Investment Company Industry, 5th Edition. www. icifactbook.org. Luxembourg, France, Australia, and Ireland have the second, third, fourth, and fifth largest markets, respectively. 12 Id. 13 The following companies are among those that traded as Unsponsored BDRs on BM&FBOVESPAs International Market exchange as of the end of 2011: Apple, Avon, Goldman Sachs, Citibank, Google, ArcelorMittal, Walmart, Exxon Mobil, McDonalds, Pfizer, Alcoa, Cisco Systems, Citigroup, Freeport-McMoRan Copper & Gold, General Electric, Intel, Merck, Microsoft, Procter & Gamble and Wells Fargo. 14 Comisso de Valores Mobilirios (CVM) Edital De Audincia Pblica SDM N 11/11, 9 de setembro de 2011. (CVM Solicitation for Public Comment on Instruction No. 512, dated September 9, 2011.)

Beneficiaries

Conclusion Foreign issuers, financial entities and others interested in attracting investors and pursuing opportunities in Brazil successfully should make it a priority to remain current on January 2012

Reprinted from Latin American Law & Business Report 2012 Thomson Reuters/WorldTrade Executive www.wtexecutive.com

LATIN AMERICAN LAW & BUSINESS REPORT