EXPLANATORY NOTE TO CVM INSTRUCTION NO. 489, OF JANUARY 14, 2011

Ref: CVM Instruction No. 489, OF JANUARY 14, 2011, which provides for the preparation and disclosure of Financial Statements of Credit Rights Investment Funds – FIDC and of Investment Funds in Shares of Credit Rights Investment Funds – FIC-FIDC, governed by CVM Instruction No. 356, of December 17, 2001; of Credit Rights Investment Funds within the scope of the Program for Incentive to the Implementation of Projects of Social Interest – FIDC-PIPS, governed by CVM Instruction No. 399, of November 21, 2003; and of Non-Standardized Credit Rights Investment Funds – FIDC-NP, governed by CVM Instruction No. 444, of December 8, 2006.

1 – INTRODUCTION

The growth of the receivables securitization market and, particularly, of credit rights investment funds since the issuance of CVM Instruction No. 356, of December 17, 2001, is indisputable. This growth has required the CVM to implement more intense regulation, both to increase and to improve the level of information, mainly accounting, provided by these entities to the securities market. Added to this is the need for Brazilian accounting practices to be aligned with international accounting practices issued by the International Accounting Standards Board (IASB).

In this sense, CVM Instruction No. 489, of 2011, fills a regulatory gap existing regarding the accounting standardization of credit rights investment funds, bringing the concepts used in international accounting standards issued by the IASB, regarding the measurement, classification, presentation, and disclosure of financial instruments. It is worth noting that this Instruction also took as a reference Resolution CMN No. 3.533, of January 31, 2008, which is currently with its effects suspended.

In summary, the concept used by the international standard, as well as by Resolution CMN No. 3.533, of 2008, to guide the recognition of financial instruments in transfer operations, is that of the retention of the risks and benefits of the financial asset subject to the operation. In fact, this concept was not created by the respective international standard; it is part of the conceptual accounting framework that must be taken into account for the recording of any asset in any entity.

Regarding the way operations are being structured in the funds, it is generally verified that the financial instrument issued by the funds, referred to as senior shares, presents much more a characteristic of a liability than of equity (according to Pronouncement CPC No. 39 – Financial Instruments: Presentation). This is because it is not possible to identify a residual interest in the fund's assets attributable to the senior shares. It implicitly expresses a contractual obligation of profitability because, once the benchmark is reached, the remaining value remunerates the subordinated shares.

However, this is not always true, and the managing institution must evaluate, in light of the principles of the Instruction, each structure, both in contractual and non-contractual terms (usual behavior and interests of the assigning institution), to reach a conclusion regarding the best classification.

2 – ACCOUNTING CRITERIA APPLICABLE TO OPERATIONS WITH CREDIT RIGHTS AND TO THE OTHER ASSETS COMPONENTS OF THE FUND'S PORTFOLIO

As provided in Article 2 of the Instruction, FIDCs and FIDC-NPs must apply the accounting criteria for recognition, classification, and measurement of assets and liabilities, as well as those for revenue recognition and expense appropriation, provided in CPC Pronouncements Nos. 38, 39, and 40.

Thus, the investment fund must classify the acquired financial assets into one of the categories listed below:

• measured at fair value through profit or loss;
• loans and receivables; or
• held to maturity.

Classification in the available-for-sale category is prohibited, as provided in the sole paragraph of Article 2. According to CPC Pronouncement 38, gains and losses arising from the measurement of assets classified in this category must be recognized directly in equity, a procedure not applicable to investment funds.

Financial assets classified as measured at fair value through profit or loss are divided into (i) financial instruments held for trading, and (ii) financial instruments that, at the time of initial recognition, are designated by the fund at fair value through profit or loss.

Financial assets designated at fair value at initial recognition are assets that are not held for frequent and active trading, but are so designated by the fund for better information due to the adopted business model. Assets held for trading and those designated at fair value through profit or loss are evaluated at fair value through profit or loss.

Financial assets classified as loans and receivables are financial assets with fixed or determinable payments, a defined maturity, and that do not have a quote in an active market. These are assets in which, essentially, the risk of non-recovery of the substantial invested capital is the issuer's credit risk. Instruments that have characteristics of loans and receivables, but whose risk of non-recovery of the substantial invested capital is other than credit risk, must be classified at fair value through profit or loss. Financial assets classified as loans and receivables are measured, after initial recognition, at amortized cost, without taking into consideration the fund's intention to hold them to maturity.

Financial assets classified as held to maturity are assets with fixed or determinable payments, a defined maturity, and that have a quote in an active market, regarding which the fund has the positive intention, ability, and financial capacity to hold them to maturity. Assets classified in this category are evaluated at amortized cost.

As seen above, the objective of the fund's business model defines the classification to be adopted for the financial asset and, consequently, its measurement. If an asset is held for cash flow management, the correct classification to be adopted is that of measuring at fair value through profit or loss. Similarly, it is not enough for the fund to have the intention to take an asset to its maturity to classify it as held to maturity; it must demonstrate financial capacity for such and the classification must be in tune with the objective of the adopted business model. The specific criteria that must be met to define the classification of financial assets are set forth in CPC 38.

The command contained in Article 3 of the Instruction details that credit rights acquisition operations must be classified, for accounting recording purposes, into two groups: with or without substantial acquisition of the risks and benefits of ownership of the credit right subject to the operation.

In operations where the fund acquires substantially all the risks and benefits of ownership of the credit right subject to the operation, it will be exposed to variations in the expected cash flow associated with the asset.

On the other hand, in the absence of substantial exposure to this variation, it is presumed that the fund did not acquire the risks and benefits of ownership of the credit right.

Paragraphs 1 and 2 of Article 3 present, respectively, a non-exhaustive list of the types of operations that can be considered as with substantial acquisition and without substantial acquisition of the risks and benefits of ownership of the credit right.

Paragraph 1 highlights operations where the fund is exposed to the fair value of the credit right, which in turn is directly related to the cash flow of this asset.

Paragraph 2 exemplifies operations where the fund is not exposed to the variation of the cash flow of the credit right and, consequently, to its fair value. Examples of operations where the risks of exposure to the variation of the asset's cash flow (and to its fair value) are not with the fund, because another party is guaranteeing the operation. This guarantee can be made through negotiation with derivative contracts or insurance, direct guarantee by the assignor, acquisition of subordinated shares, mechanisms for substitution or repurchases of defaulted credit rights on a recurrent and systematic basis and outside market conditions.

All the conditions mentioned in the previous paragraph are examples of operations where, in the event of default of the credit right, the loss will not be absorbed by the fund, but by another party. The important point in this analysis is to take into consideration the essence of the relationship and not only its form.

Moreover, guarantees, repurchases, substitutions, etc., do not need to be expressed in any contract, as long as there is behavior or interest in guaranteeing the operation.

The main risk associated with the credit right is the risk of default, of non-receipt of the initial invested value. Therefore, the analysis of risk retention is based on exposure to this risk, that is, whether the fund is exposed to the probable default of the credit right.

In a simple example, we can say that if the level of subordination retained by the assignor when transferring the credit rights is, for example, 20% (twenty percent) in relation to the transferred asset and the expected losses for this transferred asset are around 10% (ten percent), it is clearly verified, in this case, that the assignor retained all the risks associated with the credit right, a fact that does not allow the derecognition of these credit rights in its accounting records.

In summary, the principle that should guide the analysis of the acquisition of the risks and benefits of ownership of the credit right subject to the transfer operation is that of exposure to variations in the expected cash flow associated with the asset. This analysis is the exclusive responsibility of the managing institution.

2.1 – Operations with Substantial Acquisition of Risks and Benefits

In operations with substantial acquisition of the risks and benefits of ownership of the credit right, the asset must be recorded in an account representing credit rights with substantial acquisition of risks and benefits, in conformity with the nature of the original operation (Commercial, Financial, Public Sector, etc.). The important point to be highlighted in this classification is the perfect, effective, and complete assignment of credits, not only formal, but mainly economic.

2.2 – Operations without Substantial Acquisition of Risks and Benefits

In operations without substantial acquisition of the risks and benefits of ownership of the credit right, the asset must be recorded in an account representing credit rights without substantial acquisition of risks and benefits. The fund's managing institution must maintain analytical controls that allow the identification and movement of the credit rights subject to the operation.

Although the concept of effective and definitive sale is not shaken, in legal terms, by the retention, by the assignor, of part or all of the risks of the transferred credit rights, whether through the existence of subordination or the possibility of repurchase/substitution of defaulted assets, in economic terms, these characteristics prevent the perfect recognition of the asset in the assignee, given that accounting has, as one of its conceptual pillars, the prevalence of the economic essence of the operation over its legal form, when there is divergence between them.

2.3 – Operations in which the Substantial Acquisition of Risks and Benefits over the Credit Rights Cannot Be Defined Objectively

There may be cases where it is not possible to define objectively who retained substantially all the risks and benefits of ownership of the credit right, that is, it is not possible to define whether the assignor retained substantially or the assignee acquired substantially all the risks and benefits of the credit right. In these cases, it is likely that the assignor retains some risks and the assignee acquires others.

In these cases, a detailed quantitative analysis will be necessary to define the acquisition of the risks and benefits of ownership of the credit right. This analysis must be guided, preferably, by the exposure to variations in the expected cash flow associated with the credit right. If, as a result of this analysis, it is concluded that the assignor retained some risks and benefits of ownership of the credit right and the assignee acquired others, the accounting recording must be made proportionally to the risk retained and acquired.

The proportion of the risks and benefits of the credit right assumed by the fund must be recorded in the asset in an account representing credit rights with substantial acquisition of risks and benefits, and the proportion of the risks and benefits of the credit right not assumed by the fund, in the asset, in an account representing credit rights without substantial acquisition of risks and benefits.

For this analysis, the calculation must always be based on the proportion of the total risk transferred. For example, if the estimated risk of losses of the portfolio is around 20% (twenty percent) and the assignor guarantees, for example, through subordinated shares, a percentage around 10% (ten percent) of the total risk of this same portfolio and there is no other form of guarantee, formalized or not, it is assumed that some risks were retained and others transferred. By this example, the fund would begin to register 50% (fifty percent) of the operation as credit rights with substantial acquisition of risks and benefits and the remaining 50% (fifty percent) as credit rights without substantial acquisition of risks and benefits.

It is important to remember that the analysis of the risk of the transferred asset is the responsibility of the managing institution, must be consistent and verifiable, employing criteria that allow adequate evaluation of the risk of the transferred credit right, such as characteristics of the debtor, loss history, nature of the operation, existence of guarantees, etc. Significant differences in evaluation between assignor and assignee must be well-founded and justified.

3. FINANCIAL ASSETS EVALUATED AT AMORTIZED COST AND PROVISION FOR LOSSES FROM REDUCTION IN RECOVERABLE VALUE

Assets classified in the loans and receivables or held to maturity categories must be evaluated at amortized cost. Amortized cost is defined as the evaluation criterion based on cost that uses the effective interest rate to recognize interest revenue in the period's result.

The effective interest rate is the rate that exactly discounts the initial estimate of the expected cash flow associated with the financial asset to its recognition value. The recognition value of the financial asset comprises the amount paid (including premium or discount, if applicable) plus transaction costs directly associated with the acquisition.

For the calculation of the estimate of the expected cash flow associated with the financial asset, the managing institution must consider all contractual terms of the financial instrument, including the possibility of prepayment and expected credit losses during the entire duration of the asset.

Since the initial estimate of expected credit losses is already computed in the effective interest rate, a provision for losses from reduction in recoverable value will only be recognized when, after initial recognition, there is a deterioration in the initial estimate of expected losses.

Analogously, a reversal of the provision will only be recognized when there is a favorable change in the previous estimate. There may be cases where, even without a previously recorded provision, a favorable change in the loss estimate occurs and, in this case, the carrying amount of the asset must be increased, demonstrating an improvement in general credit conditions. This increase must also be recorded in a period result account.

It is worth noting that the proposed criterion of expected losses for the recording of loss provision is different from the criterion established in CPC 38 – Financial Instruments: Recognition and Measurement, approved by CVM Deliberation No. 604, of November 19, 2009, which uses the incurred loss model. Thus, Credit Rights Investment Funds must follow the procedures provided in this Instruction for the evaluation and recording of loss provision.

The main advantage of the expected loss model is that it allows for the linearization of the recognition of losses throughout the contract term, enabling a better evaluation of the financial asset.

4 – PRESENTATION OF FINANCIAL INSTRUMENTS ISSUED BY THE FUND

An equity instrument is an instrument that practically evidences a residual interest in the entity's assets, after deducting all liabilities. Thus, an instrument, to be classified as equity, cannot contain any obligation (formalized or not formalized) to deliver money or another financial asset to another entity. The analysis must take into consideration the essence of the relationship.

On the other hand, a financial liability instrument is any instrument whose essence of the contractual relationship evidences an obligation (even if informal) to deliver money or another financial asset to the holder of the instrument, even if this obligation is linked to the holder's will to exercise their right.

It is therefore verified, as a general rule, that an instrument will only be classified as equity when the essence of the contractual relationship indicates a residual interest in the entity's net assets and there is no practical evidence obliging the entity to deliver money or another financial asset to the holder of the instrument. This remains true even if the holder can redeem the instrument, but the issuer has the unconditional right to reject.

There are two exceptions to the general rule stated above. These exceptions refer to two types of instruments that, even existing a contractual obligation of the issuer to repurchase them, are classified as equity.

The first exception refers to instruments called puttable instruments that give the holder the right to redemption when requested or are automatically redeemed in the event of an uncertain future occurrence, such as death or retirement of the holder.

As defined in CPC 39 – Financial Instruments: Presentation (corresponding to IAS 32), redeemable instruments as defined above, which give the holder the right to redeem them for money or another financial asset, will only be equity instruments if all the conditions described in items 16A and 16B of that Pronouncement are met.

The other exception refers to instruments that impose on the entity the obligation to deliver to the holder the proportion of net assets to which it is entitled only in the event of liquidation. It is important to highlight that this obligation arises both because the liquidation is certain to occur (in the case, for example, of an entity with a defined term), as in the case of liquidation being uncertain, but dependent on the holder's will.

In these cases, instruments with these characteristics will only be considered equity instruments if all the conditions described in items 16C and 16D of CPC 39 are met.

The instrument must be classified, at the date of its initial recognition, according to the essence of its relationship, even if its form indicates the contrary. Distributions to financial instruments classified as financial liabilities, consequently, must be recorded as expenses in the period's result.

The fund must reclassify a financial instrument from the date on which the instrument ceases to have one of the characteristics or satisfies all the conditions provided in items 16A and 16B or 16C and 16D of CPC 39.

Signed originally by

MARIA HELENA DOS SANTOS FERNANDES DE SANTANA
President