CVM Explanatory Note 07

CVM EXPLANATORY NOTE NO. 7.
Ref.: Central Bank of Brazil Resolution No. 470, consolidating a decision of the National Monetary Council, taken in the Meeting of April 24, 1978.

I - INTRODUCTION
The philosophy that guided Resolution No. 470 was to emphasize the use of DL 157 System as an inducer for the development of the Brazilian stock and debenture market. With this approach, it was sought to achieve the three global objectives described below:

I - Educate and Attract Individuals with Savings Potential to the Stock and Debenture Market:
Efforts were made to sensitize the contingent of income tax payers, which already reaches 2.2 million people, to the relevant aspects of long-term investment operations;

II - Strengthening of National Private Companies:
Efforts were made to further reinforce the direction of resources from fiscal funds towards the capitalization of companies under national private capital control;

III - Development of the Securities Distribution System:
The list of measures contained in the Resolution also aimed to stimulate competition among the administrators of the System's resources, encourage the core of institutions focused predominantly on the securities market, and increase marketing efforts in the underwriting activity.

These three objectives are prerequisites for achieving an efficient market, that is, a market that functions with high allocative efficiency, channeling a significant portion of national savings to the most dynamic companies and sectors and operating at the lowest cost. It is also intended that the efficient market have the conditions to induce individuals to a higher level of voluntary savings, in addition to reorienting part of the existing savings towards investment in stocks and debentures.

II - ASPECTS RELATED TO THE EDUCATION AND ATTRACTION OF THE TAXPAYER TO THE SECURITIES MARKET Resolution No. 470, in several of its items, aims to reach the taxpayer-investor, in consonance with the basic goal referred to above. The items dealing with this point refer to:

I - Diversification Criteria (item I):
The reduction of the maximum percentages of portfolio concentration in securities issued by a single company (from 5% to 4%) and of participation in the capital of companies (from 20% to 10%), aims, among other objectives addressed, to reduce the global risk of fund portfolios;

II - Administration Fee (items III, IV and V):
The alteration in the progressive table established in Resolution No. 385, of 07/21/1976, introducing lower administration fees for funds with assets above Cr$ 1.8 billion, aims to transfer to the taxpayer-investors part of the gains resulting from the economies of scale obtained by fund administrators with portfolios above that value.

III - Contribution to the Capital Market Disclosure Committee:
CODIMEC (item VII): Part of the revenue (3%) earned by DL 157 fiscal fund managers will be invested in programs for the education and disclosure of the stock market, aiming at a medium and long-term institutional investment that may result in the effective education and attraction of the taxpayer to apply in securities;

IV - Information to Unitholders (items XI to XVII):
The Resolution introduces a more complete information system for all unitholders, providing them, with an educational character, the data that can truly influence the decision-making process, in addition to keeping them fully informed about the performance of the funds and the updated position of their investments. The additional cost to be incurred by the funds, due to the huge mass of taxpayers to be better informed, should be greatly compensated by the educational aspects of the system;

V - Dividend Distribution (items XVIII to XXIII):
Starting in 1979, based on the results obtained in the current year, all DL 157 funds must establish a dividend distribution policy, in the form of cash payment or, alternatively, in free quotas for redemption, called "dividend quotas". This obligation, consistent with the philosophy of the new S/A Law, will give taxpayers the possibility to realize part of the gains obtained by the funds during the mandatory holding period in the System. It is expected that investors, fund managers, and publicly held companies will come to view dividends with the same positive focus with which the National Congress approached the matter, in LAW NO. 6.404. The Resolution made the distribution of dividends mandatory starting from the monetary revenue (dividends, cash bonuses, interest on debentures, and LTN yields) of the funds, aiming to educate taxpayers under the focus that long-term investment should be viewed more from the aspect of generated income than from capital gains. The distribution of dividends, until then optional but not adopted by funds, was limited to monetary revenue with the sense of inducing administrators to transfer to unitholders only the income in kind received from companies and from possible LTN applications, keeping the invested capital unchanged. With such a policy, two objectives are compatible: that of distributing to unitholders the portion of the portfolio return coming from income in kind, and that of limiting the leakage of resources aimed at the development of the market. It is worth mentioning that investment companies governed by DL 1.401 already maintain dividend policies consistent with the principle introduced in Resolution No. 470.

VI - Conflicts of Interest (item X):
The Resolution establishes that orders to buy and sell stocks in Stock Exchanges, originating from 157 Funds, be executed by brokerage companies without any links to the managing institution or to other fiscal funds. It is intended, with such a measure, to reposition the administrator and turn it totally towards the search for the optimization of the performance of the fund under its management, without any interests in other businesses that are sub-products of the existence of the fund under its management.

III - ASPECTS RELATED TO THE STRENGTHENING OF NATIONAL PRIVATE COMPANIES Since 1974, the Government has been directing institutional investors to apply their resources predominantly in national private companies (DL 157 Funds, Insurance Companies, Investment Companies of DL 1.401, Private Pension Entities, and Social Participation Fund) in order to reverse the trend of concentration of demand for securities of state-owned companies. With this Government stance, a growing interest of holders of voluntary savings in securities of national private companies has already been observed, including in the primary market.

In addition to the greater direction of DL 157 System resources to those companies, it is considered opportune to stimulate the "underwriting" industry, aiming to create a multiplier effect of the resources destined by the Government for the development of the sector, since these are recognized as insufficient to solve the private company capitalization problem. The Resolution covered this objective in the items explained below:

I - Direction of Resources to Securities Issued by National Private Companies (item I):
The increase in the portion of the portfolio (from 75% to 80%) of the funds that must be obligatorily invested in securities of national private companies aims to guarantee that practically all the increase in System resources in 1978 will be invested in stocks and debentures of those companies. This change is based on the fact that after the extension of the redemption period, System resources have been growing rapidly, and this expansion should intensify in 1978, 1979, and 1980. It is worth mentioning that the recent RESOLUTION NO. 457 of the CMN has practically doubled the list of alternatives of national private publicly held companies, which may benefit from the greater volume of resources directed by this item of Resolution No. 470;

II - Development of the Underwriting Industry (items VIII, IX and XXIV):
The limitations on the absorption of public offerings of surplus emissions of securities, individually by fund and, in aggregate by the set of DL 157 funds, aimed to induce institutions operating in the "underwriting" sector to develop marketing efforts to attract voluntary savings to new launches. It is expected that this measure will result in a multiplier effect of fiscal funds in the primary market. Additionally, item I, already commented on above, introduced new diversification criteria that also tend to compel funds to invest a greater proportion of their resources in companies in which they do not yet have significant applications, including primary emissions of companies without a tradition in the stock exchange. It was also intended, with such diversification criteria, to disperse the ownership of companies and thereby provide for the emergence of a natural market for their shares.

Recognizing the existence of a large number of publicly held companies with few minority shareholders and a small percentage of capital dispersed in the market, flexibility was provided for the rule for the first two launches of companies with low liquidity (not included in the IBV and BOVESPA portfolios) and more than 90% of shares in the hands of the controlling shareholder (as defined in LAW NO. 6.404). In the case of public offerings, in which the surpluses are less than Cr$ 5.0 million, it was allowed that only one fund absorb 100% of the surpluses, as a measure of rationality and economic viability, without prejudice to the maximum ceilings of participation in the capital of companies (10% of voting or total capital) and of application of part of the portfolio in securities issued by a single company (4% of the total value of the portfolio).

Regarding the costs of distributing securities in the primary market, the maximum fee chargeable to issuing companies was reduced from 4% to 2%, in the case where the subscriber of the shares is a fiscal fund, aiming to benefit the companies raising resources from the DL 157 System, as well as to induce "underwriters" to make greater efforts to place with other investors, when the fee is free. The 4% fee previously in force was maintained for public offerings of securities in which there is effectively greater difficulty in placement, given the little or no liquidity of the securities of the issuing companies.

IV - ASPECTS RELATED TO THE DEVELOPMENT OF THE SECURITIES DISTRIBUTION SYSTEM The Government considers fundamental the development of a Distribution System compatible with the objective of making the market as efficient as possible. For this, some requirements are necessary, such as high competitiveness among institutions and reliability of all market participants (companies, investors, and intermediaries). Regarding both requirements, the CMN sought to include in Resolution No. 470 measures that would increase the degree of competition among fund managers and among stock brokerage companies, in addition to seeking greater reliability of all in the market, mainly by taxpayers (see Chapter II of this Note) and by issuing companies (reducing distribution costs and hinting at the possibility of a greater volume of launches, due to the expected leverage of DL 157 System resources). In the field of the Distribution System, the Resolution contains the following items:

I - Reduction in Maximum Permissible Administration Fees for Larger Funds (item III):

In addition to benefiting unitholders directly, as commented above, this measure will induce a greater effort by the managers of such funds in search of greater productivity and efficiency, which will make competition fiercer and allow better services;

II - Privatization in the Management of DL 157 Fiscal Funds (item VI):
This item met the long-standing claim of private institutions and the recommendation of the Capital Market Advisory Commission (COMEC), an advisory body of the CMN. It is believed that the preservation of DL 157 System resources exclusively for private institutions will stimulate greater investment in technical and marketing structures, including attracting new talent to the sector. Additionally, the presence of state-owned financial institutions in this typically private activity sector may distort the balance of forces that must exist for healthy competitiveness to prevail;

III - Elimination of Conflicts of Interest (item X):
This new measure, already commented on above, seeks to give greater equity in access by brokerages to the resources destined by the Government for market development, in addition to stimulating healthy competition among brokerage companies that do not manage DL 157 funds or are not linked to managing business groups.

The concept of "linked" brokerage company is the same contained in item IX of CMN Resolution No. 340/75, which defined the concept of "linked" company for the purpose of prohibiting the application of fiscal fund resources in securities issued by companies with such classification. The philosophy behind this measure is quite clear, hoping that it will really result in the routing of buy and sell orders directly from the fund to the executing brokerages, even when the fund's managing institution is headquartered in a different location than that where the Stock Exchange where the orders are executed is located. It is intended that any distribution contracts signed between companies of the financial group managing the fund and the brokerage actually executing the orders in any of the Stock Exchanges existing in the Country, come to benefit only the fund through the eventual reduction of brokerage expenses and not the managing financial group. It is worth mentioning that the Government has a position of absolute neutrality regarding the brokerage companies that currently manage fiscal funds, hoping that these opt for the position most compatible with their natural vocation: that of executing orders of the DL 157 System or that of administering fiscal funds.

V - FINAL CONSIDERATIONS
The action of the CVM and the Central Bank regarding the revision of the DL 157 System did not end with the decision taken by the CMN on 04/24/1978, which covered aspects related to the administration of fiscal funds, application of resources, and the relationship of funds with taxpayer-investors. Regarding the project elaborated jointly by the two bodies, and widely analyzed by COMEC, some important administrative measures remain to be taken after appropriate discussion with other government and private instances. They are:

I - In the Area of the Federal Revenue Secretariat - The SRF is analyzing the proposals of CVM/BACEN regarding the alteration in the scheme of incentive collection by fiscal funds, expansion of the network of income tax declaration collectors for individuals, and improvement in the system of resource release by SRF/Banco do Brasil. These measures, which will be forwarded by the Minister of Finance to the Presidency of the Republic for final decision, are aimed at correcting also important aspects of the DL 157 System, complementing those that were sought to be improved with Resolution No. 470.

II - In the Area of the National Bank for Economic and Social Development - COMEC recommended that CCAs not used by taxpayers, which will be transferred to the National Development Fund for contribution to PIS/PASEP, as stipulated by Law No. 6.419/77, be applied by BNDE primarily in quotas of DL 157 fiscal funds managed by private financial institutions, for a period of six years, and according to a criterion of seeking better return rates and dividend distribution. This measure, once adopted by BNDE, would contribute to dispersing the poles of investment decision, in addition to returning to private financial institutions resources destined by the Government for the development of the securities market.

III - In the Area of DL 157 Fiscal Fund Administrators - COMEC recommended that fiscal fund administrators self-regulate regarding the advertising disseminated at the time of CCA collection, avoiding carrying out campaigns through the television medium except in the case where such campaigns were institutional, that is, that they focused on beneficial aspects of the DL 157 System as a whole, but not of any particular fund. It is intended that current fiscal fund administrators turn more and more towards the educational goal sought by the Government. In this case, the Government preferred not to interfere immediately in this field, that of advertising in the collection of incentives (CCAs), hoping that the business community itself establishes healthy and beneficial rules for the taxpayer.