Revamping CVM Instruction nº 555 Is An Important Step To Update The Brazilian Fund Industry

The public hearing of the Instruction nº 555 issued by the Brazilian Securities and Exchange Commission (CVM) has introduced improvements that may lead to a revolution in the fund industry. The proposals make efficiency practices official and bring the sector closer to international standards.

“The reform represents a win-win situation for the economy, especially at a time the government faces difficulties to invest. Funds can drive investments in infrastructure and privatization. There is no use in having investors who wish to invest but have no proper investment vehicles or safeguards,” says Pedro Rudge, a board member of Amec.

Mr. Rudge, who is also a director of the Brazilian Financial and Capital Markets Association (Anbima), coordinated a group of 160 people, from 70 organizations, who worked during the past months to prepare suggestions that were gathered in a 500-page document. According to him, the set of proposals will reduce costs, bring scale gains and provide local and international investors with more security by the time they are issued.

The revamp adapts several rules in the fund industry to abide by the Economic Freedom Law, which was sanctioned in 2019. One such example is the greater role of essential service providers, like fund managers and fund administrators. In the proposal, the manager will no longer be hired by the administrator. Both will be part of the fund and the manager will hire third-party distributors.

“This is an example of market practice that must become official. Besides ensuring managers will have more responsibility, the changes make it clear service providers should not share responsibilities. It provides legal security, as there were doubts on whether the manager and administrator should share responsibilities,” says Mr. Rudge.

Daniel Celano, Country Head at Schroders Brazil, also took part in the debates and believes the changes should be followed by governance practices and clear standards regarding fund managers and administrator’s responsibilities. Just like Amec, he also supports more financial education for investors and the inclusion of independent members in boards.

“CVM wishes to separate responsibilities, aligning Brazil’s fund industry to international standards, but it is too soon to evaluate how this will actually happen and how CVM will carry out the oversight process. Overseeing a handful of administrators is different from supervising 500 managers in Brazil, or even the 100 who have a critical amount of assets under custody,” he says.

Marcelo Ferraz, Securities chief at XP and coordinator of Anbima’s Credit Rights Committee, joined debates focused on the proposals for Credit Receivables Investment Funds (FIDC). He highlights that Instruction nº 356 (regarding FIDC) had already been updated in 2013. Moreover, Instruction nº 531 had already altered service providers’ role, especially custodians, in order to strengthen financial backing checking, due to the volume of transactions.

Back then, regulators encumbered custodians by demanding they should do the checking procedures and, since then, the industry has become more modern thanks to new technology. “CVM believed service providers and custodians must have a relevant role. Then, it drafted a norm, demanding credit rights must be paid through related payment institutions, not only through related bank accounts, which was already a practice,” he says.

To Ferraz, the end of shared responsibilities between service providers will shed light on the activities each part must perform. In this context, another important change introduced by CVM is focusing on attributions. Some activities carried by custodians were mandatory according to previous rules, such as receiving payments and keeping documents. Now, they are optional and can be done by other service providers.

Liability limits

The Economic Freedom Law brought another advance to funds shareholders by establishing limits to their liabilities. Therefore, shareholders do not have to provide resources for funds that have a negative net worth. In case the funds find themselves in default, they may resort to loans. “This rule has placed funds closer to the Corporate Law. When a public company goes bankrupt, shareholders lose everything they had, but they do not need to invest more money. This is a relevant issue when it comes to international investors, who have become wary of investing in Brazil because they could be forced to pay more than they expected,” says Mr. Rudge.

He highlights the law gives funds the freedom of choice to remain under the current rules or to adopt the new limits. However, he believes most funds will limit liabilities, especially structured funds, which can be more concentrated and have negative results. The change, he says, sets the Brazilian fund industry closer to international, more developed standards, making funds more attractive. As a result, funds may go bankrupt and into default. According to the new rules, shareholders do not have to pay for the fund’s bills, which can default on creditors. Funds can also have access to tools like borrowing credit, which is currently not allowed.

Lowering costs

The minutes also establish changes in the structure of the funds, leading to operational and system modifications. There is a chance funds will be divided into classes, with separated assets. In short, a kind of “holding” that includes fixed-income funds, stocks funds, and multi-asset funds, but does not let them interact. If one of the classes suffers losses, shareholders that invested in the remaining will not be affected by it.

“This is an interesting way to reduce costs. Instead of creating different funds for different strategies, you can create an ‘umbrella’ fund and divide it into classes, but without the same costs of a standalone fund. It also streamlines the current operational work and increases managers and administrators’ productivity,” says Mr. Rudge. In Brazil, investors commonly assemble “feeder funds” known as investment funds in funds’ quotas (FIC) that acquire Master Feeder’s quotas, leading to multiple layers of funds.

The concept of subdivision in funds is another structural change that creates economic and liquidity differences. That means a single asset class can have subdivisions with different redemption periods and management fees according to the target audience. “It is interesting to create differences within funds, but without the need to create new ones, which allows companies to increase their scale,” he says.

According to Mr. Rudge, market participants suggested even bigger advances during the public hearing, such as the side pocket tool, which splits a fund automatically in case its assets face liquidity issues. According to the current rules, if a part of a fund becomes illiquid, for any reason, the entire fund is required to close to prevent a shareholder from withdrawing and leaving others without funds. “In side pocket, if 10% of the assets run out of liquidity, you can slice the fund and assets, it is possible to split the fund and leave part of it in a closed structure, which does not allow withdrawals, and 90% of the fund remains in the current structure. It’s a separation that creates a liquid fund and an illiquid fund,” he explains.

Mr. Ferraz notes the revamp ends with part of the costs for FIDCs established by Instruction nº 356, like registration fees. Such changes have an impact on the costs’ composition. Besides it, now, the settlement will be handled by the registration entities and no longer by the custodian, who becomes responsible for the quarterly financial backing checking. “These are relevant measures to add flexibility for FIDCs for professional investors who can understand associated risks,” he says.

Schroders’ Celano says the revamp is for the best, but there is still a great challenge ahead. “It’s hard to predict the public hearing’s result. Will they adopt the classes’ structure? In the second round of talks, regulators will have to show a clear incentive for managers to change from a Master Feeder to classes of quotas,” he says. In his view, if the classes of quotas demand balance sheets, earnings reports, auditing, Cetip, and CVM fees, which costs the same as FICs and Master’s, the market may feel there are no reasons to make the change.

Changes in allocation and buybacks

The minute also offers the possibility of increasing resource allocation thresholds for investing abroad. That fixes an asymmetry in the market, as individual investors can allocate 100% of their funds in BDRs, but professionals are limited to 20% to 40%. “We will offer better products that suit investors’ need for diversification,” says Mr. Rudge.

There is also a proposal allowing listed funds to buy back their quotas when the prices are low, which is common in international markets and a legal activity for listed companies.

According to Mr. Ferraz, another positive change is that retail investors may be able to invest in FIDCs, as long as they offer more safeguards. Managers that have retail investors as their target audience can diversify their portfolios with this product.

Mr. Rudge pointed out that the fund’s leverage ratios are the most complex issue in the minutes, as it is a highly technical subject. CVM has suggested a limit of 10% for funds focused on retail investors and 50% for funds for professional investors. Anbima has proposed thresholds should not be defined according to the funds’ target audience, but it’s kind. The recommended thresholds are 10% to 20% for fixed income funds, up to 40% for stocks and currency funds, and up to 70% for multi-asset funds, with no limits for Long & Short strategies.

“I believe that, out of all the topics for debate, this one will take longer to elaborate. Leverage ratios are hard to define anywhere in the world. That poses operational challenges too, as the industry has over 20,000 funds that will need to adapt to changes that are not simple. So, there are operational, control, and system challenges too,” says Mr. Rudge. He believes that, after CVM issues the regulation, which is expected to happen by the end of the year, it will take the industry from a year and a half to two years to implement them.

Mr. Celano believes regulators will read every contribution proposed by market participants. Then, they will resume debates, showing which changes are viable. “In the next months, debates will hover around details, risk mitigation, and dimension. Several of the market’s demands are not easy to address, but CVM is doing a nice job, going towards the right direction”.