Explanatory Note to CVM Instruction No. 408

Ref. CVM Instruction No. 408, which provides for the inclusion of Special Purpose Entities – SPEs – in the consolidated financial statements of open companies.

1. Introduction to SPEs
   An entity may be constituted to achieve a specific and well-defined purpose, such as, for example, conducting a financial lease, developing research and development activities, exploring electrical or thermal energy, gas, or a securitization of financial assets. Such a Special Purpose Entity - "SPE" - may take the form of a company, foundation, partnership, or another form that is not a usual corporate structure. Frequently, SPEs are created with legal, statutory, or contractual provisions that impose strict limits on the decision-making process of their management bodies. These provisions generally specify that the policy guiding the continuous activities of the SPE cannot be modified, except perhaps by its creator or sponsor; that is, they operate under a mechanism known as "autopilot."

The sponsor or the entity for whose benefit the SPE was created may transfer assets to the SPE, obtain the right to perform services or use the assets owned by it, while other parties, considered "capital providers," may provide resources to finance the Special Purpose Entity, charging for these resources a type of rent, fee, or even a share in the results. A company that maintains transactions with a Special Purpose Entity, usually the creator or sponsor, may substantially control the SPE.

The constitution of an SPE often seeks to utilize financing opportunities by segregating the specific risks of assets or activities from the global risks of the company benefiting from its creation. Participation in the benefits generated by it may, for example, take the form of a debt instrument, an equity instrument, a participation right, a residual participation, or a lease. Some interests in these benefits may simply return to the owner a fixed or declared rate of return, while others give the owner the right or access to other future economic benefits from the SPE's activities. In most cases, the creator or sponsor retains a significant participation in the benefits of the SPE's activities, although it may have a small or no participation in the SPE's equity.

2. The duty to consolidate
   The Companies Law, in its Article 249, sole paragraph, item "a", grants the CVM the power to issue rules that determine the inclusion, in the consolidated financial statements of open companies, of entities that, although not controlled, are financially or administratively dependent on the company. In addition, the Basic Conceptual Framework of Accounting, approved by CVM Deliberation No. 29/86, as well as the Fundamental Accounting Principles approved by CFC Resolution 750/93, require that transactions and other events be accounted for according to their substance and economic reality, and not merely by their legal form. The Conceptual Framework mentions that an "entity, in its organizational dimension, can be regarded as a person or group of people exercising control over revenues and expenses, over investments and distributions." This means control over the activities and over the benefits arising from these activities, which can be exercised by either a single entity or a set of entities, without necessarily having share control or even any participation in the share capital.

The objective of this rule is not to restrict or make impossible the use of special purpose entities, but to improve the disclosure of financial information of open companies. The CVM understands that, regardless of the existence of shareholding, if a company actually controls an SPE, the assets, liabilities, and results of the activities of that entity must be included in the consolidated financial statements of the controlling company. Furthermore, for the purposes of the consolidation process, if there is shareholding, these investments must be evaluated by the equity method, with the results obtained by the SPE presented in the controlling company in the same period in which they were generated, thus complying with the principle of the competence of periods.

3. Justification for the application of the equity method and the consolidation of accounting information
   The objective of producing satisfactory accounting information for the user of the capital market is based on the ability of the open company to present financial statements with elements that support the quality of its results and its financial position, as well as allowing the evaluation of the performance of its administration over the resources entrusted to it. The process of consolidating and disclosing accounting information and the application of the equity method is an important part in the search for this quality of accounting information, through the inclusion of all economic relationships that may substantially influence the company's performance (on this subject, paragraph 8 of the Standing Interpretations Committee – SIC – 12 may be consulted).

The consolidation of this information is currently regulated by CVM Instruction No. 247/96, which requires the full consolidation of controlled entities or proportional consolidation of jointly controlled entities. For consolidation to be required, the existence of a corporate link between the controlling company and its subsidiaries has been considered necessary. However, transactions involving SPEs have become increasingly common today, and the consolidation approach, based exclusively on voting capital, has sometimes proven ineffective in identifying effective control over the economic activity. CVM Instruction No. 247 does not provide specific guidance regarding the mandatory inclusion of these entities in the consolidated financial statements, making it necessary to issue a specific rule on this matter.

Currently, we encounter various situations where an entity actually holds control over the activities and benefits of another, without there necessarily being a direct or even indirect corporate link or participation. As a result of this exercise of control, risks are also assumed. This type of situation may allow certain businesses "controlled" by open companies to cease being evidenced in the consolidated financial statements, often significantly affecting information about the financial and equity situation of the company as a whole. Consequently, assets, liabilities, revenues, and expenses may end up not appearing in the information disclosed about the economic entity.

Thus, full or proportional consolidation is applied to the SPE when the essence of the relationship between the open company and the SPE indicates that, individually or jointly, the latter is economically controlled by the open company.

4. Control over an SPE
   In the context of an SPE, control may arise from the predetermination of the SPE's activities (operating in a kind of "autopilot") or in other ways. CVM Instruction No. 247 requires various circumstances that result in economic control, even in cases where an entity holds less than half of the shares representing voting power in another entity. Similarly, this type of control may exist even in cases where an entity holds a small or no share of the SPE. The application of the concept of control requires, in each case, judgment in the context of all relevant factors.

However, it should be noted that the application of the concept of economic control provided for in this Instruction and adopted for the purpose of presenting the best accounting information through the consolidation method does not correspond to the concept of control established in corporate law, nor does it imply the disregard of the legal personality of the individual entities.

However, the economic or financial dependence of an entity on the open company (such as supplier relationships with a significant customer) does not, by itself, characterize control.

Below are detailed descriptions and examples of the requirements that may characterize a relationship in which an open company economically controls an SPE and, consequently, when it should include it in its consolidated financial statements. It should be emphasized that this guidance does not intend to constitute a complete list of conditions that must be met to require the consolidation of an SPE.

Indicators of Control over an SPE

a) Activities
The activities of the SPE are, in essence, being conducted for the benefit of the open company which, directly or indirectly, created the SPE according to its specific business needs.
Examples include:

• the SPE is structured primarily to provide a source of long-term capital or financing to support the continuous, main, or central operations of the open company; or
• the SPE provides a variety of goods or services that align with the operations of the open company, which, without the existence of the SPE, would have to be provided by the entity itself.

b) Decision-making
The open company, in essence, has the power to make decisions to control or to obtain, in the future, control of the SPE or its assets, including certain decision-making powers that arise after the formation of the SPE. Such powers may have been delegated through the establishment of an "autopilot" mechanism.
Examples include:

• the open company has the power to unilaterally dissolve an SPE;
• the open company has the power to change the bylaws or partnership agreement of an SPE; or
• the open company has veto power over proposals to change the bylaws or partnership agreement of the SPE.

c) Benefits
The open company, in essence, has the right to obtain most of the benefits from the activities of the SPE, through a statute, contract, authorization, or any other business arrangement. Such rights to the benefits of the SPE may be indicators of control when they are specified in favor of an entity that usually transacts with an SPE and the entity continues to derive these benefits from the financial performance of the SPE.
Examples include:

• the company holds rights to most of any economic benefits distributed by an entity, in the form of future cash flows, profits, net assets, or other economic benefits; or
• the company holds rights to most of the residual benefits in the scheduled distributions or remaining liquidations of the SPE.

d) Risks
An indication of control can be obtained by evaluating the risks of each party that maintains transactions with an SPE. Frequently, the open company guarantees, directly or indirectly, a return or credit protection through the SPE, for external investors who provide substantially resources to finance the SPE. As a result of this guarantee, the open company retains the residual or ownership risks, and investors have an exposure to gains and losses that is limited.
Examples include:

• capital providers do not have a significant interest in the net assets of the SPE;
• capital providers do not have rights to the future economic benefits of the SPE;
• capital providers are not substantially exposed to the risks inherent in the related net assets or operations of the SPE; or
• substantially, capital providers receive an amount equivalent to creditor profitability through a debt instrument or equity participation.

5. Disclosure aspects
   Some companies have been voluntarily preparing and disclosing consolidated financial statements on a quarterly basis. In this case, SPEs must also be included in these statements in the manner provided by the concepts and determinations contained in this Instruction and Explanatory Note.

Regarding the mandatory disclosure of information about SPEs not included in consolidation, in cases where there may be a relevant impact for the open company (Art. 4), it should be considered that the relevance of the information is influenced by its nature and materiality, without disregarding, obviously, the timeliness of its disclosure. Materiality is often related to numerical criteria, typically proportions relative to certain line items presented in the financial statements (net income, equity, assets, liabilities, etc.). The nature of the information is usually related to the evaluation of the enterprise, regardless of the amount involved. In any case, information must be considered relevant, from the viewpoint of the user of the financial statements, if not evidenced or poorly evidenced, it could influence the economic decision-making process of this user, potentially leading them to commit a serious error in the evaluation of the enterprise or its trends.

6. Entry into force
   The mandatory application of this rule will only take effect starting from the 2005 consolidated statements, thereby allowing open companies the necessary time to adapt. The Instruction, however, allows for its immediate adoption, in which case there is obviously no obligation to disclose as required in Article 5.

7. Applicability of the rule
   International accounting standards consider that financial statements are adequate when there is an appropriate application of these standards in virtually all circumstances. However, in extremely rare circumstances, the application of a specific requirement may result in inadequate or even misleading financial statements with respect to the principles that guide them. This may be the case when the automatic application of the procedures provided for in this Instruction is not aligned with the concepts contained therein, potentially generating distorted statements. However, an exception to the application of this Instruction is not justified simply because another type of disclosure could be used, such as in explanatory notes, for example (on this subject, paragraphs 10 and 16 of IAS 1 in the International Financial Reporting Standards may be consulted). In this context, in the rare circumstances where the application of this rule is clearly inappropriate, the company may request the exclusion of the SPE from its consolidated financial statements through a reasoned request, as is currently done regarding other consolidation processes, including cases of non-relevance.

The exercise of judgment by the company's management and its auditors when including or not including an SPE must be based on compliance with the principles that structure the set of financial statements and the general objective of providing useful information. For this reason, economic substance must prevail over legal form to maintain the integrity of consolidated accounting information.

It is important to mention that this rule fits within the CVM's objective of seeking harmonization of Brazilian accounting practices with international accounting standards, aligning, in this case, with the guidelines issued by the IASB - International Accounting Standards Board (SIC No. 12, issued in November 1999) and by the FASB - Financial Accounting Standards Board (FASB Interpretation No. 46, issued in January 2003).

Finally, it should be emphasized that this Explanatory Note is an integral part of the Instruction, and the concepts and additional guidance contained therein must be observed by open companies.

Signed original by
MARCELO FERNANDEZ TRINDADE
President