Circular Letter CVM/SMI No. 5/2019

18/10/2019 SEI/CVM - 0862487 - Circular Letter https://sei.cvm.gov.br/sei/controlador.php?acao=documento_imprimir_web&acao_origem=arvore_visualizar&id_documento=913421&infra_sistem… 1/4 SECURITIES AND EXCHANGE COMMISSION OF BRAZIL (CVM) Rua Sete de Setembro, 111/2-5th and 23-34th Floors, Centro, Rio de Janeiro/RJ – CEP: 20050-901 – Brasil - Tel.: (21) 3554-8686 Rua Cincinato Braga, 340/2nd, 3rd and 4th Floors, Bela Vista, São Paulo/ SP – CEP: 01333-010 – Brasil - Tel.: (11) 2146-2000 SCN Q.02 – Bl. A – Ed. Corporate Financial Center, S.404/4th Floor, Brasília/DF – CEP: 70712-900 – Brasil -Tel.: (61) 3327-2030/2031 www.cvm.gov.br Circular Letter No. 5/2019-CVM/SMI Rio de Janeiro, October 11, 2019.

To
Directors responsible for CVM Instruction No. 539/13 at intermediary firms

Subject: Best practices for monitoring operations with excessive costs for investors.

Dear Directors,

This circular letter aims to bring recommendations to intermediaries regarding measures that can be adopted to avoid the execution of excessive operations by their clients with the purpose of generating brokerage fees or other commissions.

I - INTRODUCTION

Article 30 of CVM Instruction No. 505/11 states that intermediaries must conduct their activities in good faith, diligence, and loyalty towards their clients (Article 30, main text), being prohibited from privileging their own interests or those of persons linked to them to the detriment of their clients' interests (Article 30, sole paragraph).
In parallel, CVM Instruction No. 539/13 – the CVM's suitability regulation – requires intermediaries to evaluate and classify (i) their clients into previously established risk profile categories (Article 2) and (ii) the product categories they operate with, identifying characteristics that may affect their suitability to their clients' profiles (Article 4). Furthermore, § 5 of Article 2 of said regulation highlights that the intermediary must consider the direct and indirect costs associated with products, services, or operations, refraining from recommending those that, individually or collectively, imply excessive and inadequate costs to the client's profile.
The recommendations made in this circular letter take as a basis recent manifestations by the CVM on the matter and seek to present intermediaries with good ways to give concreteness to the duties mentioned above.

II - CHURNING

Churning is a type of fraud in which individuals leverage the control they exercise over third-party resources to cause these to be traded excessively, aiming not at the best interest of the investor, but at generating fees and commissions for themselves or others.
Over the years, the CVM has instituted and judged several administrative sanctioning proceedings related to the practice of churning. Jurisprudence has consolidated the understanding that there are three characterizing elements of churning: (i) excessive turnover of the investment portfolio, in light of the client's profile; (ii) control over the operations carried out in the name of the investor; and (iii) intention to generate brokerage revenues or other commissions.

Precedents highlight that, in light of current legislation, it is not possible to define purely objective metrics for measuring excessive turnover. It is emphasized, in this sense, that the investor's profile is the best measure to determine if the turnover was, in fact, excessive. In this sense, see for example Administrative Sanctioning Process 11/2013, judged by the CVM Board on 01/30/2018[1].
Notwithstanding, specialized literature and jurisprudence, here and abroad, rely on churning indicators, among which the following stand out due to their widespread use:
a) Portfolio Turnover Rate (Turnover Ratio: ‘TR’[2]) b) Cost-to-Equity Ratio (Cost/Equity Ratio: ‘C/E’[3])
Objective indicators, such as ‘TR’ and ‘C/E’[4], provide only indications of churning and will not always be sufficient to demonstrate the practice of the offense. In other words, the fact that the portfolio was moved in volume superior to the market average, or that the costs incurred in negotiations consumed a significant portion of the invested assets, do not demonstrate, by themselves, an irregularity, but rather a relative presumption of irregularity.

II.2 - Control over the operations carried out in the name of the investor

As already mentioned, the second characterizing element of churning is the control over the client's account. Initially, the fact that the account was moved at excessive levels, incompatible with the investor's profile, normally does not constitute fraud, provided that the account holder themselves carried out the operations consciously, as stated in the judgment of Administrative Sanctioning Process SP2014/0465, judged on 11/06/2018 by the CVM Board[5].
In several precedents, the practice of churning occurred in situations where irregular portfolio administration was also characterized, e.g., PAS CVM No. 24/2010). In many cases, however, control over the account was exercised lawfully. In this sense, churning has already been concluded in the context of managed portfolios (e.g., PAS CVM No. 22/2013), investment fund management (e.g., PAS CVM No. RJ2015/6143), or investment clubs (e.g., PAS CVM No. 11/2013).
However, necessary diligence must be adopted to identify whether the investor, due to lack of knowledge and experience regarding securities operations, consistently followed the agent's recommendations out of trust, without being able to understand them adequately.
Thus, a relationship of trust is established between the investor and the agent, who allegedly possesses expertise in the capital markets, but whose performance is based not on the client's interests, but on seeking remuneration for themselves rather than profitability for the client.

II.3 - Intention to generate brokerage revenues or other commissions

The third and last element is the intention to generate brokerage. In most cases, there is no documentary proof of this volitional element, which remains demonstrated by indications.

II.4 - Preliminary conclusions

Given what has been said, it can be concluded that intermediaries must establish routines and adopt procedures to prevent their clients from becoming victims of churning, as well as to prevent their employees and proxies from recommending products, services, or operations whose direct and indirect costs are, individually or collectively, excessive and inadequate to the client's profile.
It is important to emphasize that the violation of Article 2, § 5, of CVM Instruction No. 539/13 is independent of any consideration regarding who exercises control – including de facto – over the client's account.

III - HOW INTERMEDIARIES MUST DISCHARGE THEIR OBLIGATIONS

III.1 - The importance of rules, procedures, and internal controls

As already highlighted, CVM regulation requires intermediaries to conduct their activities in good faith, diligence, and loyalty towards their clients, being prohibited from privileging their own interests or those of persons linked to them to the detriment of their clients' interests.

18/10/2019 SEI/CVM - 0862487 - Circular Letter https://sei.cvm.gov.br/sei/controlador.php?acao=documento_imprimir_web&acao_origem=arvore_visualizar&id_documento=913421&infra_sistem… 3/4

For the realization of these duties, it is fundamental that the intermediary establishes rules, procedures, and internal controls that are capable of preventing clients' interests from being harmed due to conflicts of interest.
CVM Instruction No. 539/13 further requires intermediaries to also establish written rules and procedures, as well as verifiable internal controls, in accordance with Art. 7, item I, with the purpose of identifying the imposition of excessive costs on a specific client, even when executing operations suitable for their profile. Moreover, the procedure must clearly indicate how this monitoring will occur, with evidence of its implementation.

III.2 - Best practices

Although objective indicators of excessive turnover cannot be considered conclusive and sufficient proof of any irregularity, they undoubtedly consist of good references for intermediaries to monitor operations performed by their clients. Thus, intermediaries must implement systems that allow monitoring objective indicators, such as ‘TR’ and ‘C/R’ [Note: Text says C/R here, likely typo for C/E, but transcribing as is or correcting to match context? Context implies C/E. The footnote [3] defines C/E. Paragraph 20 says 'C/R'. I will transcribe 'C/R' as written in source text but note it refers to the indicators]. Correction: The source text says 'C/R' in para 20, but footnotes define 'C/E'. I will transcribe faithfully: 'C/R'.
Such systems should ideally generate alerts when certain percentages are exceeded, so that the intermediary can analyze the potential practice of churning or whether their employees and proxies are making recommendations to clients contrary to what is stated in Article 2, § 5, of CVM Instruction No. 539/13.
Among the best practices for this monitoring, contact with the client is exemplified, presenting to them, in a didactic manner, the costs involved in certain operations, evaluating whether the client has the proper understanding of how much is being deducted from potential gains of their operations, as well as the evaluation of the service provided by the operator or the autonomous investment agent who advises them.
And along these lines, the intermediary must monitor the activities of the autonomous investment agent affiliated with it, in order to guarantee compliance with the provisions of CVM Instruction No. 497/11, in accordance with item II of Article 17, highlighting item IV and § 1 of Article 13, which prohibit the autonomous agent from simultaneously exercising the activity of portfolio administration, consulting, or analysis of securities.
Regarding other proxies, who are directly advising the client, the intermediary must also exert diligence to avoid that there may be transgression of other CVM norms:
a) CVM Instruction No. 598/18, which deals with the activity of securities analysts; b) CVM Instruction No. 592/17, which deals with the activity of securities consulting; c) CVM Instruction No. 558/15, which deals with the professional exercise of securities portfolio administration.

III.3 - Communications to the CVM

The intermediary, given all the above, must monitor proxies, so that, upon identifying irregularities, they communicate with the CVM, as determined by Art. 32, item IV, of CVM Instruction No. 505/11.

IV - CONCLUSION

Acting thus, what is expected is that the intermediary acts diligently to mitigate the possibility that individuals, in the capacity of advisors, whether autonomous agents or other proxies, may leverage the relationship of trust they maintain with the intermediary's client to perform operations that impose excessive costs, aiming not at the best interest of the client, but rather to generate commissions for themselves and brokerage revenues for the intermediary.

Sincerely,

Francisco José Bastos Santos
Superintendent of Market Relations and Intermediaries (SMI)

18/10/2019 SEI/CVM - 0862487 - Circular Letter https://sei.cvm.gov.br/sei/controlador.php?acao=documento_imprimir_web&acao_origem=arvore_visualizar&id_documento=913421&infra_sistem… 4/4 [1] Available at http://www.cvm.gov.br/sancionadores/sancionador/2018/20180130_PAS_112013.html [2] Turnover Ratio (TR): indicator of client portfolio turnover, represented by the ratio between total purchases made (C) and the client's average portfolio (PLm), in a given period (n), expressed in annual terms, according to the following expression TR = (C/PLm) * (12/n) [3] Cost/Equity Ratio (C/E): complements the turnover indicator, directly measuring transaction expenses, represented by the ratio between total expenses with brokerages and commissions (D) and the client's average portfolio (PLm), in a given period (n), expressed in annual terms, according to the following expression C/E = (D/PLm) * (12/n) [4] The aforementioned indicators were subject to studies, both by the CVM (available at http://www.cvm.gov.br/export/sites/cvm/menu/acesso_informacao/serieshistoricas/estudos/anexos/Estudo_Churning.pdf), and by the self-regulatory organization, BSM Markets Supervision (available at https://www.bsmsupervisao.com.br/assets/file/REL-GAE-01-2011-Churning.pdf) [5] Available at http://www.cvm.gov.br/export/sites/cvm/sancionadores/sancionador/anexos/2018/SP20140465__COMPLETO.pdf

Document electronically signed by Francisco José Bastos Santos, Superintendent, on 10/18/2019, at 11:20, based on Art. 6, § 1, of Decree No. 8.539, of October 8, 2015.
The authenticity of the document can be verified at the site https://sei.cvm.gov.br/conferir_autenticidade, providing the verifier code 0862487 and the CRC code 89FD2EBF.
This document's authenticity can be verified by accessing https://sei.cvm.gov.br/conferir_autenticidade, and typing the "Verifier Code" 0862487 and the "CRC Code" 89FD2EBF.
Reference: Process No. 19957.010982/2018-12 SEI Document No. 0862487

Circular Letter CVM/SMI No. 5/2019

Lineage: In force