Circular Letter CVM/SIN No. 3/2008: Guidelines on Procedures for the Operation, Administration, and Distribution of Investment Fund Shares

CIRCULAR LETTER CVM/SIN No. 3/2008
Rio de Janeiro, August 7, 2008

To the Responsible Directors of the Administration of Investment Funds Regulated by CVM Instruction No. 409/04

Subject: Guidelines on Procedures Related to the Operation, Administration, and Distribution of Investment Fund Shares

Dear Sir,

The publication of this Circular Letter aims primarily to clarify doubts regarding the best way to comply with the Instructions that regulate investment funds, as well as to present the understanding of regulatory provisions and, consequently, the method of application currently adopted by the Superintendence of Institutional Investor Relations (SIN).

Observance of the recommendations listed below will contribute to minimizing potential deviations and, consequently, reducing the need for the technical area of this Commission to formulate requirements, thereby allowing the registration and supervision process of investment funds to proceed efficiently, seeking to guarantee investor protection and market integrity.

We note, in passing, that some positions and interpretations of this Superintendence regarding certain aspects of the regulation presented here do not necessarily represent the final interpretation of the Securities and Exchange Commission (CVM) on the subject.

Thus, we set forth below recent understandings expressed by this Superintendence resulting from consultations and complaints made by market participants.

1. Investment in Privately Issued Debentures – Art. 2, VIII

Investment of fund resources in privately issued debentures, i.e., those that have not been the subject of a public offering registration for distribution with the CVM, is permitted, under the provisions of Art. 2, item VIII.

We remind you that such assets must be registered in a registration, custody, or financial settlement system duly authorized by the Central Bank of Brazil (BACEN) or by the CVM, within their respective areas of competence, as established by § 3 of the cited article.

Furthermore, the administrator must verify, upon investment and even during the maintenance of these debentures in the fund's portfolio, compliance with the limits established in Articles 86 and 87, relating respectively to concentration by issuer and by asset category.

However, we alert that if the issuers of the debentures are not open companies registered with the CVM, the administrator must have procedures for accessing the information and documents necessary for pricing and evaluating the debentures, prior to their acquisition, and also during their maintenance in the fund's portfolio, employing in the analysis and evaluation of this information the care and diligence that any prudent and active person usually exercises in the administration of their own business.

2. Hiring Third Parties to Provide Asset Custody Services Abroad for Investment Funds – Art. 2, §5

Art. 2, § 5, II, provides that, for the acquisition of assets traded abroad, the fund's custodian must ensure their existence, specifically hiring third parties duly authorized to exercise the activity of custody in other jurisdictions and supervised by a recognized local authority.

However, if the institution responsible for the fund's custody can perform the custody of the assets acquired abroad, it will not be necessary to hire a third party to perform this activity, as the principles of the regulation are met.

In the event of hiring third parties to ensure the existence of assets abroad, the criteria adopted by the contracted institution must be verified by the fund's custodian, to ensure they meet its own control criteria and those established in current Brazilian legislation.

We draw attention to the fact that, despite the requirement attributed to the custodian contracted abroad being limited to ensuring the existence of the fund's portfolio assets, when dealing with shares of funds constituted abroad, the shares of which are not admitted to trading in public markets supervised by a recognized authority, the fund administrator must, in accordance with their duty of diligence, employ all effort required by the circumstances so that this guarantee also extends to the underlying assets held by the invested fund.

Finally, regarding Art. 2, § 5, I, we believe that the obligation for the existence of a cooperation agreement with the CVM, which is imposed on the jurisdiction where the registration, custody, and financial settlement system used is located, does not extend to the jurisdiction where the institution responsible for registering the assets in those systems is headquartered.

3. Extension of Distribution Period for Closed-End Funds – Art. 9

The Instruction allows the CVM to extend the distribution period for shares of closed-end investment funds for a maximum period of 180 days.

Reading item II of Article 9 of the Instruction may lead to the understanding that extension requests will only be appreciated by the CVM if the minimum number of shares representing the initial net asset value of the closed-end fund is not subscribed within the 180-day period from the registration of the offering.

In reality, the device for the compulsory cancellation of closed-end funds that do not reach a minimum number of subscribed shares aims to avoid burdening shareholders with the operating costs of a fund that does not have a minimum scale for such.

Thus, it should not be generally prevented that funds seek to reach the number of shares enabled by their structurers in the offering, by obtaining a more extended public distribution period for shares, as this could act against the interests of investors in this type of financial asset.

Therefore, this technical area considers the prerogative to request the CVM to extend the distribution period for shares of closed-end funds to be broad, even in cases where the minimum number of shares has already been subscribed.

Such understanding is supported by the text of § 4 of Art. 28, which requires the return to subscribers of the amounts paid, "...if the predicted number of shares is not subscribed within 180 (one hundred and eighty) days, extendable by an equal period..."

The request must be made with relative advance notice before the end of the placement period, so that the CVM has sufficient time to adopt a careful decision by that date, and must be justified with a reasoned basis, ensuring the absence of prejudice to the subscribers of the shares up to the moment of the request.

To this end, it is necessary that the request includes the expression of agreement from all such subscribers, given the mandatory application of paid-in resources, during the distribution process, in federal public bonds or in shares of investment funds classified as "Short Term."

4. Fiduciary Assignment of Investment Fund Shares – Art. 12

The Collegiate Body expressed its understanding, in a meeting on 03.07.08, that the constitution of guarantees for open-end fund shares through fiduciary assignment operations is regular, in accordance with Art. 66B of Law No. 4,728, of July 14, 1965.

This decision was based on the possibility that such guarantee enables the granting of credit under more favorable conditions for the assigning shareholders, which would stimulate greater circulation of wealth; and also, it is a practice already adopted in the market – based on a legitimate interpretation of the regulation – such that a new CVM orientation would shake market legal security and impose restrictions, without an apparent benefit to justify it.

Without prejudice to the above, the Commission will prepare studies aimed at creating rules that address the relevant aspects related to the use of this mechanism, such as, for example, the appropriate information flow between the fund administrator, assigning debtors, and assigning creditors, and the definition of the duties of administrators and shareholders regarding redemption, voting, and other events related to encumbered shares.

5. Establishment of Fixed Dates for Share Conversion – Art. 15, I

It is regular to establish fixed and determined dates for share conversion, as referred to in Art. 15, I, provided that the fund's regulations address the matter clearly and objectively, and the prospectus alerts regarding the special liquidity condition of the shares of this fund, in accordance with the requirements of Art. 39.

We emphasize that this freedom to stipulate deadlines for share conversion does not coincide with the maximum deadline, also permissible, of five business days for the payment of redemption requests, as provided in Article 15, III, since this is a deadline that must be counted only from the realization of said share conversion.

6. Payment of Redemption After Banking Business Hours – Art. 15, III
   nIt is common market practice to adopt the closing share price methodology as a parameter for the daily calculation of values due for redemption requests.

However, for specific cases, where the redemption payment occurs on the same day as the request, it is certain that this calculation can only be performed after the closure of the markets in which the fund operates, which will impose the payment of this redemption at a time when it may no longer be possible for the shareholder to perform, for example, various banking movements with the paid resources, in the case of payment via bank account credit.

Thus, for a fund that trades its assets on the São Paulo Stock Exchange, for example, the payment of redemption can only occur after 5:00 PM, i.e., at a time when Electronic Available Transfers (TED) can no longer be performed.

Therefore, in cases where the fund provides for redemption payment on the same day as the request, and also adopts calculation based on the closing share price, it is important that investors and shareholders are specifically alerted, through a specific mention in the prospectus, of the particular liquidity restrictions to which they may be subjected by the payment of redemption at a time that will no longer allow the realization of various banking movements with their resources.

7. Distinct Minimum Initial Application Limits in the Fund – Art. 40

There is no irregularity in adopting distinct minimum initial application limits in the same investment fund, varying according to different segments of the target audience to which it is destined. As an example, we cite the use of lower initial application limits for investors who already have other investments with the same administrator.

We emphasize, however, that these criteria must always appear clearly and objectively in the fund's prospectus, in conformity with the requirements of Art. 40, I and VI, of the aforementioned Instruction.

8. Means of Document Availability – Art. 48

As is well known, it is the administrator's duty to ensure that the disclosure of any information related to the fund is given under equal conditions to all its shareholders, in accordance, especially, with what is determined by Art. 40, XIII.

In this context, considering the wide reach that certain funds have in the distribution of their shares in the Brazilian market, we understand that the availability of documents related to proposals submitted to general assemblies, as provided in Art. 48, § 4, must be done in a manner compatible with the dispersion of the fund's investors and with the means used by the investor to access fund information and make their investment decision. Thus, for example, it is recommended that availability be provided through the maintenance of specific access to these documents on the administrator's website on the worldwide computer network.

9. Shared Management in Investment Funds – Art. 56

In a decision made in a meeting on 6.5.2008, the CVM Collegiate Body considered it regular the constitution of an investment fund that contracts more than one manager, as it does not contradict any regulatory norm, and is a natural consequence of the growing specialization of markets for the administration of third-party resources.

On the other hand, in that specific case, it was also verified that the hiring of two managers for the fund was the subject of deliberation in a general assembly of shareholders convened for this purpose, in accordance with Art. 47, II, of the cited Instruction, and that the responsibility for management acts was fully assumed, under a contractual joint liability regime, by both service providers.

Thus, in recognizing the regularity of shared management in an investment fund, that decision required that the following conditions be respected:

(i) execution of a contract in accordance with Art. 56, § 1, which (1) ensures the joint liability of managers for acts of shared management; (2) grants authorization for orders, to the fund's custodian, limited to the specific market of operation of each manager, in accordance with Art. 59, Sole Paragraph, I; and (3) authorizes the administrator to intervene as an arbitrator in case of eventual conflicts in investment decisions.

(ii) alert to investors, through the regulations and prospectus, that management will be exercised by more than one service provider, in order to inform, prominently, the specific attribution of each; and

(iii) information in the prospectus regarding (a) the benefits and risks resulting from the shared management structure; (b) the condition of joint operation of managers in conducting the fund's investment policy, including with respect to the joint liability provided in Art. 57, § 2; and (c) the role of the administrator as an arbitrator for the resolution of conflicting investment decisions.

At the time of publication of this circular letter, the CVM is endeavoring to adapt its electronic information reception system, in order to allow the inclusion of more than one manager in an investment fund.

Thus, while the sending of information about more than one manager is not available on CVMWeb, the administrator must highlight the fund's condition to the market and its investors, by sending a relevant fact regarding it, as provided in Art. 72 of the Instruction.

10. Promise of Minimum Profitability – Art. 64, V

The Collegiate Body, in a meeting on 14.2.2008, within the scope of process CVM RJ200710500, emphasized that the promise of predetermined profitability, referred to in Art. 64, item V, of the Instruction, is that considered frivolous and illusory, i.e., that may induce the investor to judge that the investment is exempt from the risk of not remunerating as promised.

Thus, a perspective of profitability measurable by strictly objective and previously known parameters, when accompanied by the necessary alerts that this profitability may not be obtained, does not constitute a "promise of predetermined yield," which would remove the prohibition under analysis.

It is important to say that objective and previously known parameters do not coincide with mere expectation, opinion, or desire of the administrator, even if theoretically grounded. In this sense, mechanisms are required, such as: put options, insurance contracts, etc., that allow ensuring the achievement of the desired profitability, despite typical market fluctuations.

Therefore, whatever guarantee is adopted, its nature and extent must always be clarified, with the inclusion of a warning that its adoption does not completely exclude the risk that the targeted profitability may not be achieved. The same logic also applies to the disclosure of information in the sale or distribution of fund shares, as regulated by Art. 74 of the Instruction.

11. Restructuring of Investment Fund Families – Art. 64, VI

In decisions made in the Meeting of 17.06.08, the CVM Collegiate Body established the guidelines and parameters that must be observed in requests for approval or waiver of compliance with requirements provided in the Instruction for restructuring of investment fund families, with requests for trading of shares, shares of open-end funds, and other assets outside the stock or over-the-counter market, and thus, in waiver of the prohibitions contained in Articles 12, 64, VI, and 110, I of the Instruction.

With the objective of making the procedure for such operations more expedient, the CVM delegated competence to this Superintendence to authorize the transfer of assets of investment funds privately, through the issuance of CVM Resolution No. 546, of August 4, 2008.

As a rule, these operations involve the constitution of a fund that begins to concentrate an investment policy already adopted in a dispersed manner by several existing investment funds. On the other hand, these funds are transformed into fund-of-funds that begin to have as their objective to invest, exclusively, in that fund.

The need for consultation will exist when these operations involve funds that are not destined exclusively to qualified investors, because, otherwise, the operation between the funds may occur based on Article 110, I, of the Instruction.

Preliminarily, it is worth observing that the examination of these consultations is limited to the verification, by the technical area, of the feasibility, convenience, and opportunity of waiving the requirement contained in the cited norm, hence we reiterate that, in these cases, no judgment of value is issued regarding the presented operations.

We emphasize that, if the aforementioned funds hold shares of other open-end investment funds in their portfolio, it must also be detailed in the request what treatment the administrator intends to give to these assets, considering the prohibition on transfer of ownership imposed by Art. 12 of the Instruction.

Furthermore, we observe that the prohibition addressed by Art. 64, VI is limited to the specific trading of shares outside the stock or over-the-counter market, which is why operations involving funds that do not hold shares or shares of open-end funds in their portfolio are exempt from prior evaluation by this Autarchy.

We remind you that, in the aforementioned operations, the administrator must demonstrate that there will be no prejudice to shareholders resulting from the operation, such as changes in the investment policy to which investors will be exposed; modification of tax treatment; changes in total administration and performance fees charged; or changes in redemption conditions.

On the other hand, as these processes involve the alteration of regulations, it is a requirement for their approval that the restructuring, with all appropriate detailing of advantages and risks to shareholders, be submitted for consideration by the involved shareholders in a general assembly convened for this purpose.

Furthermore, sufficient homogeneity between the portfolios must be demonstrated, which may evidence a similarity between the funds that justifies the consolidation of portfolios into a single Master Fund, and also to prove that there is no mixing, in the operation, of funds with investors of distinct risk profiles.

Also in this aspect, it is up to the administrator to demonstrate that the portfolio contains only assets of reliable pricing, so as to guarantee that some funds are not prejudiced relative to others in the allocation of assets, which must always be performed at market value.

It is worth observing that this structure allows some funds of the same family to present differences in relevant aspects, such as the deadline for redemption pricing, which implies a risk that, in scenarios of significant redemption demands, the fund with the longer deadline to meet them will be prejudiced relative to the others.

In these cases, we emphasize the need for said risk to be highlighted in the call to the general assembly that will deliberate on the restructuring of the fund with the longer redemption period, and also that a specific alert be included in the prospectus of this fund for this particular risk.

Finally, it is a condition for the regularity of the operation that the funds to be transformed into fund-of-funds respect the provisions of Article 102 of the Instruction, in order to send to the CVM, within 60 days of the effective date of the operation, the audited financial statements of the involved funds.

12. Qualified Investors – Art. 109

By virtue of consultations from market participants to this effect, we have come to remind you that Art. 109, § 2, of the Instruction is a provision of a transitional nature, which only had the objective of regulating the situation of shareholders who, at the time of the entry into force of the Instruction, met the qualification requirements then in force, but who did not fit into those provided by the new regulation.

Thus, we remind you of the understanding of the Collegiate Body on the matter, expressed on 19.04.05 through a Market Communication, that investment funds already adapted to Instruction 409/04 that come to transform into funds for qualified investors, cannot maintain shareholders who, at the time of the alteration, do not meet the qualification requirements of the Instruction.

Also in accordance with that communication, we remind you that the transitional permission contained in the device only extends to shareholders who are retail funds (not destined exclusively to qualified investors) if, alternatively, these funds (a) are transformed into funds for qualified investors, in which case their former shareholders, even if not qualified investors, may remain in them; or (b) do not admit new shareholders, which, in practical terms, will mean their closure for applications, in accordance with Art. 17 of the Instruction.

13. Parameters for Formulating Consultations to the Superintendence

This Superintendence frequently receives consultations from market participants with doubts regarding the correct application of the regulatory norm applicable to the investment fund industry.

Below, we highlight some requirements that must be observed in these consultations to ensure that the technical area has sufficient elements for the analysis of the presented issue.

A first point concerns the need for the consultation to describe the concrete case with the greatest possible detail. If, however, the doubt is not specifically based on any concrete case, the reasons that generated the raised doubt must be detailed.

On the other hand, the consultant must expose what they understand as the best interpretation of the regulation regarding the proposed issue, without failing to rely on all the legal foundation that supports this understanding.

Finally, we request that, as a rule, the consultation be formulated by the responsible director of the administering institution.

Sincerely,

(Signed Original)
Carlos Alberto Rebello Sobrinho
Superintendent of Institutional Investor Relations