CVM Explanatory Note 06

CVM EXPLANATORY NOTE NO. 6.
Ref.: Resolution No. 460 of the National Monetary Council, decided in the Meeting of February 22, 1978.

I. INTRODUCTION

Law 6.435, of July 15, 1977, provided that the CMN would establish guidelines on the investment of the reserves of private pension entities. The National Congress delegated this authority to the Council, considering that the total reserves of the Private Pension System should be used as an instrument of the Government's economic policy. Below are transcribed the excerpts of the aforementioned Law that granted the CMN competence to regulate the subject:

Article 15 - To guarantee all its obligations, open entities shall constitute technical reserves, special funds, and provisions, in accordance with the criteria fixed by the regulatory body of the National System of Private Insurance, in addition to reserves and funds determined in special laws.

§ 1st - The investments resulting from the provisions of this article shall be made in accordance with the guidelines established by the CMN.

§ 2nd - It shall be the CMN's responsibility to establish differentiated guidelines for certain entities, taking into account the existence of peculiar conditions regarding the investment of their respective assets.

§ 3rd - In the case referred to in the previous paragraph, the entity shall have a minimum period of 5 (five) years to adjust to the guidelines established by the CMN all investments made up to the date of publication of this Law.

Article 40 - Identical to Article 15, except that it applies only to closed entities.

§ 1st - Identical to Paragraph 1st of Article 15.

§ 2nd - The CMN may establish differentiated guidelines for a specific entity, or group of entities, taking into account the existence of peculiar conditions relative to their sponsors.

Article No. 87 of Law No. 6.435 also provided that the Executive Power would regulate it within 180 days, that is, by January 16, 1978. This regulation would be issued by the Presidency of the Republic, regulating the application of the Law in the cases of open and closed private pension entities. In addition to these Acts of the Executive Power, the CMN would also have to pronounce itself by that date regarding the structure of the investments of such entities.

Aiming to establish a set of rules that would regulate the activity of private pension entities as investors, the CMN decided to form a working group composed of representatives from all bodies that have direct or indirect interest in the subject. Thus, the Ministries of Industry and Commerce (open entities), of Social Security and Assistance (closed entities), the Central Bank, and the Securities and Exchange Commission were designated to study the topic. These last two bodies are directly involved with the assets of such entities, i.e., their investments, while the first two are more linked to the liabilities (actuarial plans, commitments assumed, etc.).

Effectively constituted such Working Group, under the coordination of the CVM, after a series of meetings, a consensus was reached on the main aspects of the matter, resulting in a draft Resolution that, after modifications imposed in the CMN plenary, was embodied in Resolution No. 460, of February 23, 1978.

Three were the main objectives of the work, regarding the structure of the investments of the technical reserves of Private Pension Entities, namely:
a) to enable such Entities to achieve the return rate considered by their actuarial plans as the minimum necessary to ensure the fulfillment of the Entities' commitments to their participants; b) to ensure that the savings to be accumulated by such Entities are invested in the most relevant sectors of the economy, with a long-term focus; c) to ensure that such Entities, in their investing activity, present behavior harmonious with the government's economic policy.

Taking into account the criterion adopted by Law No. 6.435/77 itself, to treat each type of Entity (Open and Closed) distinctly, it prevailed that the same differentiated norm should guide the investment regime of the reserves of each type of Entity. Indeed, the various and peculiar characteristics of each of the two species of Entity (due to the type of participants, benefit plans, and presence, in the case of Closed Entities, of a sponsoring company), justified the adoption of different investment criteria.

II. BASIC PRINCIPLES

Thus, Resolution No. 460 obeyed the following basic principles:
a) classification of the technical reserves of Private Pension Entities based on the term in which they will be due to fulfill assumed commitments: Committed Reserves were named as reserves linked to cash disbursements scheduled for the short term (understood as up to 360 days), and Non-Committed as the others, that is, those linked to cash disbursements expected to occur in the long term (above 360 days). The Actuarial Plans of each Entity, recalculated with systematic frequency (annually), would establish the projected cash flow for the following twelve months, allowing, therefore, the sizing of the two types of reserves provided for in Resolution No. 460. Regarding the investment of resources from Committed Technical Reserves, they were directed under the exclusive focus of indispensable high and ready liquidity. Regarding the investment of resources from Non-Committed Technical Reserves, they were directed under the focus not necessarily of ready and high liquidity, but rather of investment profitability; b) establishment of global limits for each type of investment, always with a view to achieving the allocation of such resources across a wider spectrum of sectors of economic activity. For this purpose, five genres of investments were considered, namely (see Table I):

• Government Bonds, issued by the National Treasury, States, Municipalities, Eletrobrás, BNDE, and BNH;
• Securities issued by Open Companies;
• Bonds issued or guaranteed by financial institutions;
• Real Estate and mortgage bonds;
• Loans to participants in benefit plans (in the case of Closed Entities);
  c) establishment of basic diversification rules for each investment, aiming to contain portfolio risk at bearable levels; d) directing investments in shares and debentures to securities issued by Open Companies (BACEN Resolution 457), considered among these, predominantly, those controlled by national private capital; e) consideration, as transitional provisions, and regarding Entities existing at the time of Law No. 6.435/77, of criteria for the progressive adaptation of such entities to the established norms. In this particular, the Special Working Group sought to address the various aspects inherent to the situation of these Entities, leaving, in accordance with the legislation, to the executive bodies of MIC and MPAS the attribution to examine the plans for the gradual adaptation of their investment portfolios to the guidelines to be established by the National Monetary Council.

III. DIVERSIFICATION

Table I, at the end, exposes the various investment modalities contemplated in Resolution No. 460. It can be noted that the sum of the maximum limits of each modality exceeds 100%, allowing, therefore, the portfolio manager wide flexibility in its composition.

In addition to the maximum limits, some minimum limits were stipulated for investments in: federal public debt bonds (ORTN and LTNs) and shares and debentures. In the first case, it was sought to confer greater security and liquidity to private pension entities, which are today excessively concentrated in real estate investments and loans to participants. In the second case, it was sought to establish a minimum proportion of total resources to the securities market, aiming to attract to this type of asset such entities, since traditionally they have preferred other investments. The model of capital associativity is a clear option of the Government, and it is therefore incumbent to direct resources to the securities market.

A realistic position was adopted regarding real estate investment, taking particularly into account the Brazilian tradition of investments in this sector, preserving, however, that mutual aid societies and closed funds do not become real estate speculators, a sector where, due to contingencies of historical tradition, a significant portion of resources is already concentrated. The contrary reactions to the imposed limitations were understood, as, on the surface, investing in real estate seems much simpler than investing, for example, in shares and debentures. It was considered that, over time, these relative barriers will be overcome with the sophistication of financial intermediaries. The alternative of leaving private pension entities to transform into true real estate banks, besides being socially debatable and economically uninteresting, could seriously compromise future liquidity (even considering that this variable is not the most relevant in long-term reserves) and even the profitability of investments, as there is no way to guarantee that profitability earned in the past in this sector will be guarantees to obtain, at the same level of liquidity, an equal level of future profitability.

Certain restrictions or comments have been made regarding the portion destined for indexed public bonds. These restrictions aim at the situation of these bonds. Some time ago, this situation was exactly the inverse, as it is expected that it will tend to invert again in the future (with the fall in the inflation rate). Therefore, the restrictive allegations regarding this type of expansion seem very linked to today's market. These bonds must be supported, as they contain the entire strategy of the Government of coexistence of fixed-income bonds with the inflation phenomenon.

Regarding investments in securities, it was sought to break a link of the vicious circle that has long been observed in the market: there are no large national private companies because there are no resources directed towards their capitalization, in volume compatible with needs; and there is no interest in investing considerable volumes in the securities market because there is no list of alternatives of national private companies. The Government decided to use private pension entities to break this vicious circle, directing a considerable part of their resources towards investments in securities issued by national private companies. It was not intended to direct supplementary social security funds only to investment in shares, but also to debentures, simple or convertible, since they are typical long-term investors. In fact, it was considered that debentures are even more suitable than shares, due to their characteristics as long-term bonds with assured profitability. Complementarily, investments in investment fund quotas were also permitted, as it is another modality of investing diversely in securities.

IV - SECTORAL DIVERSIFICATION RULES

Regarding investments in bonds and securities, it was sought to follow what good portfolio administration technique suggests, that is, the reduction of global portfolio risk by composing a diversified portfolio. Thus, it is intended to induce these new institutional investors to apply in securities issued by companies from all sectors of economic activity, without any individual investment having a weight that could compromise the portfolio's return rate. In addition to this objective, the Government also sought to stimulate the formation of a more active market for the securities of national private companies, and for this reason imposed rules that will lead to the dispersion of ownership. Although liquidity is not a priority in the application of non-committed reserves, but rather profitability, the development of a more active market for those securities will necessarily confer greater liquidity to the entities' portfolios. The diversification rules included in Resolution No. 460 are explained below:
a) at most 2.0% of the value of the reserves (committed and non-committed) in shares issued by the same company; b) at most 4.0% of the value of the reserves (committed and non-committed) in debentures (convertible and simple) issued by the same company; c) at most 10.0% of the voting capital or total of any company; d) at most 10.0% of the value of non-committed technical reserves in quotas of the same investment fund; and e) at least 3/4 of investments in shares and debentures must be in values issued by national private companies.

As the value of the securities portfolio may vary from 20% (10% until 12.31.79) to 40% of non-committed reserves and from 0% (nihil) to 50% of committed reserves, diversification rules were fixed based on the total of reserves, of both types, since this will not vary as much as the securities portfolio. Thus, if for example an entity has 10 of committed reserves and 90 of non-committed reserves, and wishes to invest in securities 30% of the former and 20% of the latter, the imposed rules would restrict it to:

RESERVES committed non-committed investments in securities 3.0 18.0 maximum permissible value for investment in:

• shares 2.0 2.0
• debentures 4.0 4.0
• fund quotas 0.0 9.0

In this example, the manager could compose its portfolio with quotas of two investment funds, totaling, therefore, 18% of the reserves, and add debentures from a single company (3%) or shares from at least eleven companies; or if preferred, with debentures from six companies. What is noted from these examples for pure illustration is that the field of variation is enormous, and thousands of different portfolios could be composed without violating the restrictions provided in the Central Bank Resolution. It is worth remembering, however, that there would still be requirements that at least 75% of shares and debentures be issued by open companies controlled by national private capital, and that no more than 10% of the social or voting capital belong to a single pension entity.

Regarding other investments in fixed-income bonds, a restriction was also imposed to prevent more than 10% of the reserves from being applied in certificates of deposit, real estate letters, mortgage bonds, or bills of exchange issued or co-obligated by the same financial institution. In the case of bonds issued by States, Municipalities, Eletrobrás, BNDE, or BNH, the maximum percentage applicable to bonds issued by the same State, Municipality, or government entity was also limited to 10% of non-committed reserves.

V - OTHER PROVISIONS

1. Open Companies
   In the entire text of the Resolution, one can notice the care in prohibiting investment in securities issued by non-open companies. Article 4 of LAW NO. 6.404/76, and the recent RESOLUTION NO. 457 of the Central Bank, regulated the new norms for a company to be considered "open". The mandatory "disclosure", as well as respect for minority shareholders and other provisions of LAWS NOS. 6.385 and 6.404, confer to the investor in values issued by open companies a level of security much higher than those who apply in closed companies. The Government sought, by prohibiting pension entities from investing in values of non-open companies, to reduce the risk of their portfolios, as well as to stimulate the capital opening of companies with a vocation for the capital associativity model.

2. Conflicts of Interest
   Article XI of Resolution No. 460 is entirely dedicated to avoiding investment in shares or debentures issued or co-obligated by companies "linked" to the private pension entity. The concept of linked company was practically the same already adopted in Insurance legislation, seeking to place pension entities in a posture of simple investors, who will pursue the best investment alternatives. Brazilian experience and that of other countries show that, if such rules were not imposed, the fund is often led to invest inadequately, to serve objectives other than those implicitly and explicitly defined in the actuarial plans.

3. Risk of the Closed Fund with the Sponsor(s)
   Article No. XII of Resolution No. 460 is entirely dedicated to containing the risk of the closed fund with the sponsor at bearable levels. Employees of a company, in case this is unsuccessful, will lose their jobs, but will not have their pecuniary assets formed in the closed fund linked to it also swept away. At least this was the Government's objective, by limiting the fund's investment in the sponsor's values. Law No. 6.435/77 allowed sponsors to cease contributing 30% of the contributions destined to form the reserves of benefits to be granted in the form of income, registering such reserve deficiencies as a long-term credit of the fund against the company, yielding interest equal to the minimum rate required in the actuarial plans.

The resolution does not prohibit the fund's investment in shares and debentures of the sponsor(s), but limits them to the same maximum levels stipulated for those of other companies (Art. No. IX, items "a", "b" and "c"). A maximum ceiling was created for the risk of the fund with the sponsor(s), limiting it to 10% of its net equity (of the consolidated net equity, in the case of a group of sponsors): by maximum risk was considered the sum of the deficiency permitted in Art. 45 of Law No. 6.435, with possible investments in shares and debentures of the sponsor(s). The deficiencies must be covered by specific guarantees provided by the sponsors to protect the participants' reserves (pledge, lien, mortgage, or other modality of guarantee accepted by regulatory bodies). In the case of the sponsor being closed, and using the facility to take a loan from the fund linked to it in the form of "deficiency", it will be obliged to submit to independent accounting audit. This provision aimed to guarantee to the participants of the closed fund that the said deficiency will be adequately registered in the company's accounting. No limitation was imposed on the rent by the sponsor, of real estate owned by the fund linked to it.

4. Positioning of Private Pension Entities in the Business Community.
   Articles XV and XVI of Resolution 460 place Private Pension Entities in their real position: that of important institutional investors but not as financial institutions. The only permissible business activity for such entities is private pension. Acting as financial institutions, competing with specialized and authorized institutions, is strictly prohibited as it constitutes a circumvention of the existing legislation on the National Financial System.

5. Transitional Provisions
   Private Pension Entities that were already operating before the issuance of Law No. 6.435/77, were subject to quite liberal rules, regarding the adaptation of existing reserves to the guidelines of Resolution No. 460. This is because the Government did not oblige them to immediately reconstitute their investment portfolios, but rather to adapt them gradually, through the application of the entire flow of new reserves to investment modalities that do not appear exceeded by the criteria issued. This is equivalent to saying that the application percentages will, initially, be different from those fixed in the Resolution, exactly to allow the correction of the structure of existing investments.

Regarding new entities, greater flexibility of applications was also permitted in their initial phase, aiming to gain familiarity with the various application alternatives existing in the market while their dimensions are reduced (up to 5,000 ORTNs), or in the first two years of operation, prevailing the limit that is reached first.