Explanatory Note CVM 18

Ref.: CVM Instruction No. 12, of September 4, 1980, which defines the types of buy and sell orders for securities traded on stock exchanges and establishes norms and procedures to be observed by brokerage firms and their clients in their execution.

I. ORIGINS AND OBJECTIVES

On several occasions during its contacts with participants in the Securities Market, the CVM had the opportunity to verify that, although similar, the procedures adopted by different intermediaries for the reception, registration, and execution of buy and sell orders differ from each other in many details. It was observed that no existing regulation precisely defines the various types of orders and the appropriate way to execute them, which frequently causes differences in interpretation among brokerage firms. For example, an order labeled as "at market" can be understood both as an order for immediate execution and as an order that allows the trader to choose the best time and price for its execution. These differences are even more pronounced among the various Stock Exchanges, due to the terminology employed in each of them. Only a clear definition of each type of order and its interpretation can lead to uniformity that avoids misunderstandings between clients and brokerage firms, and this was the first objective of the project that generated the Instruction in epigraph.

The initial phase of this project included a series of meetings with participants in the Securities Market, whose objective was to identify the order modalities effectively practiced in the Brazilian market. These meetings allowed us to observe that, in addition to the issue of order interpretation, there were also other problems in the broker/client relationship that deserved new regulation. These were issues already regulated by CMN Resolution No. 39, of October 20, 1966, but whose regulation was incomplete or had become inadequate with the evolution of the market, and referred mainly to client registration, the registration of orders, and the priorities to be respected in their respective execution. It was decided, therefore, to study the necessary modifications and include them in the same Instruction that would come to deal with the types of orders.

The first draft of CVM Instruction No. 12 was submitted to public hearing in October 1979, and the version now published includes many of the suggested modifications.

II. REGISTRATION FORMS AND KNOWLEDGE OF CLIENTS
(Articles 1 to 4)

One of the objectives of the registration form is to identify the client. The CVM understands that for this purpose, some minimum information fixed in the Instruction in question is necessary. Taking into account that not all clients operate with the same frequency and that many registered clients go through several years without issuing a single order, CVM Instruction No. 12 does not define the periodicity for updating the registration files, but determines that only orders from clients whose files are updated may be executed. This allows the intermediary to update the file at the moment when it is easiest, that is, when the client wishes to conduct a transaction in the market.

The CVM understands, however, that the main objective of the registration form should be to contribute to the intermediary's ability to effectively know their client. As stated in the Fundamentals and Principles of Regulation of the Securities Market, approved by the National Monetary Council, through CMN Vote No. 426/78:

"The intermediary has the duty to know their client, their financial capacity, and their investment objectives, making recommendations that are compatible with their interests and needs."

For this purpose, it is necessary for the brokerage firm to make all necessary efforts to know the main characteristics of its clients. The registration form established by this Instruction is a necessary element, but not sufficient for obtaining this knowledge, since such a form does not require certain information that proves essential for intermediaries to know their clients.

The CVM understands that, in order to evaluate such characteristics, the intermediary should maintain personal contact with their client. The intermediary's guidance, to be technically acceptable, presupposes that the professional providing such service knows not only the market and the companies, but also their clients and their respective investment objectives.

However, the CVM opted, once the principle was established that the brokerage firm is responsible for knowing its client, to leave it to the self-regulatory bodies and the intermediaries themselves to determine the best way to do so.

Thus, CVM Instruction No. 12 determines that "brokerage firms shall make every effort to know the client and their characteristics." And, in order to meet this requirement, brokerage firms are allowed to request from their clients, in addition to the minimum established in the Instruction, any other information they deem necessary.

It should be noted that the requirements regarding the maintenance of complete and updated registration files and the perfect knowledge of clients do not apply only to brokerage firms, but to any and all intermediaries who receive from their clients orders to trade securities. This means that when a distributor, for example, receives from its clients an order to trade securities on their behalf, it is obliged to maintain an updated registration identical to that required of brokerage firms. If the order is passed on, it is not necessary for the distributor to provide the brokerage firm that executes it with the registration information - except for the indication that it is a professional market client, when applicable. However, in any case, the intermediary who receives the order directly from the client may only arrange for its execution if they have a complete and updated registration file of the principal.

In addition to more information in the registration files of legal entities, a new and very important requirement is that of the administration contract, when the client's portfolio is administered by third parties. Cases of portfolio administration through tacit agreement, without formal mandate, are common in our market. In addition to potentially causing many misunderstandings, this exposes brokerage firms to the risk of not being able to document the origin of their actions when executing orders issued by these "unofficial" administrators.

III. DETERMINATION OF THE CONDITIONS UNDER WHICH BUY OR SELL ORDERS FOR SECURITIES MUST BE EXECUTED

No previous regulation precisely defines the concept of a buy or sell order for securities, which is found in Article 5 of CVM Instruction No. 12. It is important to emphasize that, according to the definition adopted therein, the determination of the conditions under which the order must be executed, i.e., its type, is an integral part of the order.

The types of orders and the description of the way to interpret and execute them constitute the subject matter of Article 6. The result of the public hearing indicated that the number of order modalities provided in the first draft was indeed excessive for a norm that would reach all brokerage firms, regardless of their size and the markets in which they operate. In this final wording, we have retained only the types of orders proven to be most used in our market, including, however, a group of special orders, which may be defined and regulated by the exchanges that deem it convenient to introduce the practice of more sophisticated order modalities in their trading floors.

Among the types of orders defined in the Instruction in question, it is worth highlighting especially the "FREE" and "IMMEDIATE" orders, and the differences between them. The orders, which now become known as "FREE", differ essentially from those conceptualized as "IMMEDIATE ORDERS".

A "FREE ORDER" confers upon its executor enormous discretionary power and, consequently, a great fiduciary responsibility towards the principal, regarding the conditions under which it was effected (price/time of execution). On the other hand, an "IMMEDIATE ORDER" confers no discretionary power on the operator, and must be executed as quickly as possible, from the moment it is received in the trading floor. It must be emphasized that it is assumed that for the person giving the "IMMEDIATE" order, the most important variable is the speed of execution. An "IMMEDIATE" order must be executable at all times, as at some price it will always be possible to find a buyer or seller in the market. Brokerage firms must clarify this point well to their principals who issue "IMMEDIATE" orders, because, due to the peculiarities of our market and sharp price fluctuations, such orders may be executed at prices very different from those on which the client has information, and based on which they may have made the decision to buy or sell.

Also defined in Article 6 are the "LIMITED" and "COUPLED" orders, widely known and used in our market. Regarding "COUPLED" orders, which correspond to a swap of positions held in one security for a position in another, and involve a purchase and a sale, the definition does not determine which operation should be executed first; this may be determined by the client, or left to the operator's discretion.

The determination of the conditions under which an order must be executed involves, in addition to its type, the definition of its validity period. The classification of orders according to this period, found in Article 7, explains itself. It is worth noting, however, that:

(a) according to the adopted definition, an order "for the day" does not necessarily need to be executed on the same date it was issued; the principal may determine a specific day for which it will be valid; (b) "fixed-term" orders may be valid for several days, or also for periods shorter than the duration of a trading session.

Finally, we observe that, according to Article 8, an order may only be canceled by the same person who issued it, or by another person specifically authorized by them. This measure aims to avoid misunderstandings, especially in cases of corporate clients or administered portfolios.

IV. PROCEDURES FOR THE RECEIPT AND REGISTRATION OF ORDERS (Articles 9 and 10)

Article 9, which regulates the minimum information that must appear on the order registration form, presents some innovations compared to what was already required by CMN Resolution No. 39. Almost all these innovations aim to facilitate compliance with the norms regarding the execution and distribution of orders. The main ones are as follows:

a) identification of the type of order; b) identification (by name or code) of the person who actually transmitted the order, in the case of corporate clients or administered portfolios; c) the indication that the client is a professional of the market, when applicable, even when it is a passed-on order.

Brokerage firms are also allowed, at their exclusive discretion, to require that certain orders be given in writing and signed by the client; with this, brokerage firms will have a protection mechanism, which they may use when they deem necessary.

V. PROCEDURES FOR THE EXECUTION AND DISTRIBUTION OF ORDERS; PRIORITY RULES (Articles 11, 12, and 13)

The priority rule for order execution, determined by 1st CMN Resolution No. 39, became operationally inadequate over the years, due to the evolution of business and practices in the Securities Market. In fact, certain situations occur with some frequency in our market where the execution of orders by chronological sequence of receipt, as determined by that Resolution, is not recommended. Therefore, brokerage firms, often acting in the best interest of their clients and the market, are led to disregard that norm, exposing themselves to legal sanctions. These inconveniences can only be eliminated by establishing new preference rules for attending to orders, more compatible with the reality of our market.

The characteristics of this market, on the other hand, are such that it is inappropriate to speak of priority rules for the execution of orders; it is more realistic to determine rules for the distribution of transactions carried out to attend to the received orders. In fact, in our market there is no correspondence between the number of orders received and attended to and the number of transactions executed: a single transaction on the trading floor may be intended to attend to more than one order, just as several transactions may be effected to attend to a single order. The distribution of purchases and sales to attend to each order is generally done "a posteriori", and not at the moment of execution.

Furthermore, it must be recognized that, when there are orders of different types, it is the professional, following the trading floor, who has the best conditions to determine the best moment for the execution of their client's order - provided, of course, that it is not an immediate order. Thus, if we wished to determine precise rules for establishing priority in execution, we would have to define a rule for each combination of "order type/market situation", which would, in fact, be very impractical.

Therefore, CVM Instruction No. 12 comes to modify the approach of CMN Resolution No. 39, with regard to the establishment of priority, transferring it from priority in execution to preference in the distribution of transactions. It is worth observing, however, that, although the distribution is done "a posteriori", only orders already received and capable of execution at the moment of the effective realization of a transaction may compete for the respective distribution.

The preference rules for the distribution of transactions carried out in attendance to the orders were established based on the following principles:

1. Professional market clients, as defined in Article 11, that is, all natural and legal persons, who act directly or indirectly in the intermediation and regulation of securities, are holders of knowledge that provides them with a significant advantage over other investors; thus, in equality of other conditions, brokerage firms shall always give preference to attending to the interest of their non-professional market clients.

2. when a principal gives an immediate order, it is assumed that this implies that the most important variable for them, in the realization of the transaction, is the speed of execution; thus, immediate orders must be attended to before all others, and the client is considered best attended to in their interest if their order is attributed the first transaction executed.

3. in orders of other types, it is considered that price is the most important variable for the principal; thus, the brokerage firm may distribute, according to criteria established by it, its transactions to attend to those orders that it had already received at the moment of their realization, provided that, in equality of other conditions, it attributes the transactions of best price to the attendance of non-professional market clients.

These additional priority criteria, which must be clearly established by the brokerage firm, aim basically at the delineation of a possible specialization in a certain segment of the market. It is still up to the brokerage firm to disclose to its clients the manner in which the various orders will be attended to.

The preference rules thus determined intend to endow brokerage firms with a certain freedom of action in the distribution of transactions executed by order of their clients, requiring only that privileged treatment be given to non-professional market clients.

Rio de Janeiro, September 4, 1980.
Original signed by
JORGE HILÁRIO GOUVÊA VIEIRA
President