Circular Letter CVM/SIN 06/2015 — CVM — BR

SECURITIES AND EXCHANGE COMMISSION OF BRAZIL
Rua Sete de Setembro, 111/2-5th and 23-34th Floors – Center – Rio de Janeiro - RJ – ZIP Code: 20050-901 – Brazil Tel.: (21) 3554-8686 - www.cvm.gov.br Circular Letter No. 6/2015/CVM/SIN Rio de Janeiro, August 25, 2015.
To
Portfolio Administrators of Securities
Subject: Recommended procedures for investment in structured financial instruments

Dear Sir/Madam,

This circular letter aims to guide administrators of third-party resources regarding recommended procedures in the process of investing in structured financial instruments. This is a topic of undeniable importance, as instruments of this type have specific characteristics that must be carefully evaluated by administrators to comply with the diligence requirements provided for in regulation, particularly in Article 14 of CVM Instruction No. 306 (Article 16 of CVM Instruction No. 558) and Article 65-A of CVM Instruction No. 409 (Article 92 of CVM Instruction No. 555).
The fiduciary duty that portfolio administrators of securities have towards their clients implies the need to always act professionally, conducting adequate analysis regarding any financial assets in which they decide to invest. Structured instruments, however, have very specific characteristics that make the diligence required of investment professionals in the process of investing in these assets different from that required in the case of investing in simpler assets. The risks involved are different, and therefore, a due diligence process specifically adapted to these risks is necessary. Furthermore, there are various varieties of structured instruments in the market, so compliance with the recommendations mentioned in this circular letter may be very simple for some instruments and quite complex for others.
For the purposes of this circular letter, structured instruments are understood to be complex securitized or structured instruments, particularly when they have a complex capital structure, are difficult to price (such that their pricing depends on specific systems and competencies), and have a limited or non-existent secondary market (being, therefore, potentially illiquid) 1.
The recommendations below are based on best practices recommended by the International Organization of Securities Commissions (IOSCO) and on the supervisory experience of the Institutional Relations Superintendence (SIN).
It is relevant to mention that the mandatory application of the recommendations presented here depends on the reasonableness verified on a case-by-case basis. Some of the practices

1 See regarding the definition used the IOSCO report available at https://www.iosco.org/library/pubdocs/pdf/IOSCOPD300.pdf

SECURITIES AND EXCHANGE COMMISSION OF BRAZIL
Rua Sete de Setembro, 111/2-5th and 23-34th Floors – Center – Rio de Janeiro - RJ – ZIP Code: 20050-901 – Brazil Tel.: (21) 3554-8686 - www.cvm.gov.br presented below may not be applicable or may need to be adapted in certain situations. The analysis of their relevance in light of the concrete case is the responsibility of fiduciary administrators and managers, including taking into account the provisions of current regulation and self-regulation applicable to each type of financial instrument. Furthermore, the intensity of the analysis must be proportional to the relevance of the investments made compared to the portfolio in which they are inserted, and the possible loss vis-à-vis the investor's profile must be considered.

First, it is necessary to warn that the due diligence process cannot be reduced to a mere process of complying with predetermined steps. It is also not a static process, but rather an iterative process that begins before the initial investment and only ends when the instrument reaches its maturity or when divestment occurs.
Before the investment itself, it is necessary to ensure the existence of explicit client authorization, in the mandates signed, for investment in the type of asset being considered for acquisition. Furthermore, it is necessary to verify if there is compatibility between the structured instrument(s) and the client's investment objectives.
The administrator must also evaluate their capacity to understand and price the assets, including legal knowledge. The rule must always be "if you don't understand, don't buy." It is necessary to understand the instrument's cash flow structure and its allocation to different tranches, if applicable. Along the same lines, it is necessary to have the capacity to assess whether the price paid for the instrument is proportional to the risks assumed and to ensure that all relevant risks are identified and evaluated and that one understands how they are mitigated or expanded.
Having the capacity mentioned in the previous item, it is necessary to verify the availability, reliability, and relevance of the information available both about the market in which the underlying assets of the instrument are inserted and about the assets themselves.
The information adequate to the diligence process may not be solely quantitative. In many cases, understanding market dynamics may also involve the collection of qualitative information.
The administrator must ensure that analyses are based on information relevant to the specific type of underlying assets, but must not assume that the properties of the structured instrument are the same as those of the category of assets existing in the instrument's portfolio.
The analysis of the instrument's structure must be conducted both in normal situations and in stress scenarios. The importance of stress tests is reinforced by the fact that many structured instruments have little capacity to adapt to unforeseen situations. The first step for using tests must be the identification of aspects that may have unexpected results and the possible consequences. The administrator must then analyze how stress scenarios are reflected in the instrument's structure and whether existing provisions can be easily and quickly utilized. This analysis must involve both the legal aspects involved and any other relevant aspects of the instrument's structure. The analysis must also involve verifying the expected changes in cash flows in stress scenarios and their impact on the various tranches or classes of the instrument.
Additionally, existing operational risks must be taken into consideration. This analysis must take into account, for example, the impact of the breakdown in the provision of certain services, such as custody.
It is also important to identify the role of third parties in the structuring and operation of the instrument, such as the conditions under which legal opinions on the structuring were prepared. Regarding ratings given by risk rating agencies, if they are used as an additional tool for decision-making, it is necessary to understand the methodology and parameters based on which the opinion was produced and to be able to question these aspects.
Still regarding the role of third parties, the convenience of using mechanisms to align the interests of those who are strategically important in the structure with those of the instrument's investors over time should be evaluated. An example is requiring the third party to subscribe to subordinated shares, if applicable.
Finally, it is important not to base the analysis solely on promotional documents, always taking care to verify if the documents analyzed are legally binding and enforceable. In the case of analysis based on drafts, it is necessary to take care to verify if there are discrepancies with the final version and, if so, their impact.

Sincerely,

Signed original by
FRANCISCO JOSÉ BASTOS SANTOS
Superintendent of Institutional Investor Relations