Co-authored by Marina Procknor and Ana Carolina Lima Nomura of Mattos Filho, Veiga Filho, Marrey Jr e Quiroga Advogados in São Paulo, Brazil and Philip T. von Mehren and Damien G. Scott of Venable LLP in New York, NY. This Overview does not constitute legal advice, and was prepared and updated as of February 8, 2016. [printfriendly]
1.What are the Brazilian Regulations that affect international private equity firms investing in Brazil?
Two regimes affect international private equity firms generally investing in Brazilian companies: (i) a direct investment in a Brazilian corporation (sociedade por ações) or a limited liability company (sociedades limitadas);1 or (ii) an investment in the Brazilian financial and capital markets, which the resolution expressly defines as including an investment in securities issued by listed companies and, most importantly for private equity firms, quotas of locally-formed private equity funds (Fundos de Investimento em Participações or “FIP”s)2 In addition, foreign investors are afforded, a preferred tax and regulatory regime with respect to their investments in a FIP, subject to complying with certain requirements.3
Brazil does not impose any specifically targeted limitations on foreign private equity funds investing, directly or indirectly, in a Brazilian portfolio company; nor does Brazil impose limits on foreign investments, except for certain specified sectors, directly or indirectly, in Brazilian companies.4
Under Resolution No. 4,373, investments of foreign investors in the Brazilian financial and capital markets (including a FIP) requires (i) the prior appointment of a representative in Brazil, which must be a financial institution duly authorized by the Central Bank and Brazilian Securities Commission (Comissão de Valores Mobiliários or “CVM”), with the necessary authority to perform all the financial transactions and services relating to the FIP’s investment; (ii) the registration as a foreign investor with the CVM; (iii) the prior appointment of a custodian authorized by the CVM for the FIP’s investments; and (iv) the registration of the foreign capital that the foreign investor will invest in Brazil with the Central Bank of Brazil.
2. What are the Brazilian Regulations that affect the international private equity firms raising funds in Brazil?
In 2003, “CVM Rule 391” created the FIP structure. Investment funds in Brazil, FIPs included, are not considered legal entities (such as companies, corporations, partnerships or trusts). Under this structure, each investor (called a quotaholder) owns a pro-rata amount of quotas which corresponds to a notional fraction of all assets held by the fund.
After the introduction of the FIP structure, international and local private equity funds, pension funds and other strategic investors, have increasingly structured investments through FIPs due to their flexibility and tax benefits.5 FIPs are closed-end funds that, can acquire shares, debentures and other securities issued by portfolio companies. FIPs permit the managers and the quotaholders to incorporate a wide range of covenants into their formation documentation, mimicking global private equity standards regarding such issues as the general partner’s carry, payment of expenses, indemnities, preferred returns for quota holders, and rules regarding capital calls.
A main benefit is that Brazilian legislation affords significant tax relief if certain conditions are met.6 As a general proposition, non-Brazilian residents are subject to income tax in Brazil with respect to income paid and remitted from a Brazilian source or on gains related to Brazilian assets. The withholding tax rate (“WHT”) normally applicable on capital gains is 15% arising from foreign investments under Law No. 4.131 and in FIP via Resolution No. 4,373/14. However, the applicable tax regime under Resolution No. 4.373 reduces the WHT on income from investments through a FIP by non-resident investors not located in a Low Tax Jurisdiction to 0%, subject to certain requirements.7
The FIP must be registered with the CVM. The FIP must also comply with regulatory diversification requirements (which are broader than the tax requirements with respect to the eligible securities), including the obligation to invest at least 90% in shares, debentures, warrants, or other bonds and securities, convertible or exchangeable, into shares of a portfolio company.
All sales of quotas by a FIP are required to be made through “public offerings” under Brazilian law. In order to sell quotas in a FIP, the FIP must either (i) register the quotas with CVM pursuant to a full-fledged registration requirement for a registered public offering in Brazil, which would include the basic materials necessary for any public offering in the Brazilian market (such as a full blown prospectus, marketing materials for the underwriters, etc8) or (ii) avail itself to far less onerous registration requirements if the issuance complies with the rules regarding “public restricted placement efforts.” Nearly all FIPs raise funds under the “public restricted placement efforts.”9 In order to qualify for it, CVM requires that no more than 75 investors are contacted in the offering period and that no more than 50 investors subscribe for quotas, with a minimum capital commitment of R$1 million per investor. In such case, no prior registration or authorization from the CVM is required for the offering.10
3. What Brazilian Regulation and Rules affect international private equity firms seeking to raise capital from Brazilian pension funds and insurance companies specifically?
Brazilian regulations vary depending on whether the entity is an open or closed pension fund or an insurance company.11 As a general rule, all of these entities can and do participate in FIPs, subject to certain investment limits and specific restrictions. OPPs, insurance and reinsurance companies are only allowed to invest in assets that are not linked to their reserves and provisions (so-called “free assets”) in investment funds targeted exclusively at “qualified investors.” As for entities managing closed pension funds, they are allowed to invest in quotas of FIPs, subject to some limits imposed by Resolução CMN No. 3.792/09. Moreover, a local private equity investment must be considered, for the purposes of said regulation, as a structured investment and, therefore, the investment is subject to certain additional limits.12 Closed pension funds may invest in funds with the purpose of investing offshore, provided that these investments are limited to no more than 10% of the total reserves of each pension fund plan.
4. What are the Brazilian Regulations that affect the formation of local private equity funds in Brazil?
The rules regarding FIP formation are identical regardless of whether the managers consider themselves international or Brazilian, provided that, if a manager will directly exercise asset management activities in Brazil, such manager must register with the CVM.
In addition to the rules already discussed in Section 2, certain other requirements are necessary to form a FIP. The fund administrator forms the FIP by resolution and also approves the FIP’s bylaws. The bylaws contain the covenants regarding the FIP’s carry, expenses, preferred return etc. that, in a Delaware fund, would be in the Partnership Agreement. The FIP’s bylaws must be filed with the registry of deeds and documents and be registered with the CVM prior to starting operations. The CVM grants registration to the FIP after filing certain documents with the CVM. Even after the registration of the fund is granted, CVM may still request additional information, documents, and even amendments to the formation documents.
The rules in Brazil deviate from international market practice. They define separate roles for a fund’s fiduciary administrator and its investment portfolio manager. The rules give primacy to the fiduciary administrator, as it has the power to hire and fire the investment portfolio manager. Some Brazilian general partners have opted to absorb both roles so as to avoid ceding power to dismiss the general partner to an external fiduciary.
5. What additional Brazilian regulations affect the management of private Equity Funds in Brazil?
The two central yet separate roles of a fiduciary administrator (or administrator) and investment portfolio management may be performed by the same or by two separate legal entities. The administrator is responsible for hiring the FIP’s service providers, including the portfolio manager. Only legal entities that are registered and authorized by the CVM as asset managers may function as administrator and portfolio managers.13 In addition, FIPs must have a custodian, which is responsible for holding the investment portfolio of the FIP. Only an authorized Brazilian financial institution may render custodial services.
The administrator of a FIP has the right to take all actions necessary to form, administer and operate the FIP. In addition, the administrator represents the FIP with respect to third parties, including CVM, the Brazilian Revenue Service and the quota holders themselves. The administrator is also responsible for engaging all other service providers, such as lawyers and accountants, necessary for the operation and maintenance of the FIP. If the administrator is not a financial institution, it must engage a financial institution authorized to carry out treasury services, such as opening and maintaining a bank account, on behalf of the FIP, and the collection and payment of funds in connection with the quota holders’ investment in the FIP.
Usually, the portfolio manager makes the investment decisions regarding buying and selling portfolio companies. As such, the portfolio manager must comply with the rules and investment strategies contained in the FIP’s bylaws. It is also authorized to represent the FIP in the negotiation and execution of any transaction undertaken by the FIP, such as the acquisition and divestment of a portfolio company.
In Brazil, FIP quota holders have voting rights over all material decisions of the FIP, such as approving the financial statements of the FIP, amending the bylaws, replacing the administrator, etc.14 In addition, in some cases, the quota holders must approve certain investment decisions of the portfolio managers by means of an investment committee, in which both the quota holders and the portfolio managers appoint members. Brazilian institutional investors such as pension funds and the Brazilian National Development Bank (BNDES) usually insist on the right to appoint members to the investment committee of FIPs raised in Brazil, which is not a common practice in other jurisdictions, especially the US and Europe.
CVM imposes on FIPs the obligation to ensure that both public and private companies meet certain corporate governance requirements.,Portfolio companies must: (i) refrain from issuing profit-backed securities (“partes beneficiárias”); (ii) have a unified, one-year mandate for all of its board members; (iii) make available to the shareholders all its related-party transactions, shareholders agreements and stock options plans; (iv) settle all disputes via arbitration; (v) adhere to a high standard of corporate governance segment in the stock exchange (e.g. Novo Mercado, Nível 1 and Nível 2 of Brazil’s BM&FBOVESPA stock exchange) in the event of an IPO; and (vi) undertake an audit annually by independent auditors registered with the CVM.15
1See Law No. 4,131.
2See Resolution No. 4,373 of the Brazilian Monetary Council.
3See footnote 5 below.
4Foreign investment is limited in the following sectors: journalistic, broadcasting and audiovisual companies, defense and security sectors, private security, cargo transportation, agricultural properties, activities in the frontier zone, aviation and financial institutions. For journalistic, broadcasting and audiovisual companies’ restrictions, see Article 222 of Brazil’s Constitution; for defense sector restrictions, see Law 12,598; for private security, see Law 7,102; for cargo transportation, see Law 11,442; for agricultural properties, see Article 190 of Brazil’s Constitution and Law 5,709; for frontier zone activities and restrictions, see Law 6,634; for aviation restrictions, see Law 7.565.
5See Resolution No. 4,373 of the Brazilian Monetary Council (“CMN”). Note that a FIP may not directly invest in real estate (although a FIP may do so indirectly through a Brazilian holding company) or invest outside of Brazil.
6On August 31, 2015, the Brazilian Revenue Service (Receita Federal do Brasil) issued Normative Ruling 1585 (“NR 1585”), which consolidates tax rules applicable to investments carried out in Brazilian financial and capital markets. Among the consolidating provisions, a few represented a change in the tax authorities’ interpretation of former tax provisions regarding the taxation applicable to the direct distribution of dividends to quotaholders of investments funds, including FIPs. Prior to NR 1585, according to the Brazilian tax authorities’ understanding, the passing of dividends to the quotaholders was exempt from income tax. Hence, based on the prior wording of previous normative instructions, investment funds, such as FIPs, adopted the practice of passing dividends from the invested companies directly to the quotaholders, considering such transaction as exempt from taxes. According to NR 1585, the dividends distributed to quotaholders are no longer deemed tax-exempt dividends, but rather are supposed to be treated as redemptions or amortizations of quotas, subject to a 15% income tax. However, it is important to point out the applicable tax regime under Resolution No. 4,373 (applicable to non-resident investors), following the requirements established by Law No. 11,312/06, remains unchanged in the face of the advent of NR 1585.
7These requirements are: (i). The investor does not hold, individually or with related parties, 40% or more of the FIP (“Corporate Test”) nor has the right to receive an amount greater than 40% of the total income of the FIP (“Economic Test”, and, jointly with the Corporate Test, the “40% Test”); (ii) at any time, the FIP does not hold bonds in an amount equivalent to more than 5% of net assets, except if such bonds are convertible debentures, warrants, or bonds and notes issued by the Brazilian federal government; and (iii) the FIP must hold at least 67% of its net equity in the form of shares, convertible debentures, and warrants issued by corporations. The FIP must also register with the CVM and comply with regulatory diversification requirements (which are broader than the tax requirements in what regards the eligible securities), including the obligation to invest at least 90% in shares, debentures, warrants, or other bonds and securities convertible or exchangeable into shares of corporations.
8CVM Rule No. 400.
9CVM Rule No. 476.
10For the definition of qualified investors, please see CVM Rule Nos. 476 and 409. These rules, and the criteria for defining qualified investors, have been altered by CVM Rule No. 554.11In Brazil, the supervision of open private pension entities (“OPPs”), insurance and reinsurance companies is carried out by the Brazilian Superintendence of Private Insurance (“SUSEP”), which is subject to regulation by the Ministry of Finance and the National Board of Private Insurance (“CNSP”), which is in charge of setting the relevant regulations applicable to such entities. On the other hand, the National Superintendence of Complementary Pensions (“PREVIC”), subject to the Ministry of Social Security, supervises entities managing closed pension funds and the National Board of Complementary Pensions (“CNPC”), in turn, is in charge of issuing the main regulatory provisions for this sector. When it comes to rules applicable for investment of provisions and reserves, there is a specific regulation applicable to OPPs, insurance and reinsurance companies (Resolução CNSP No. 226, dated December 6, 2010 and Resolução CMN No. 3.308, dated August 31, 2005) and another applicable to entities managing closed pension funds (Resolução CMN No. 3.792, dated September 24, 2009).
12Under Resolução CMN No. 3.792/09, investments in FIPs are classified as “structured investments,” and the entities managing closed pension funds must observe the following allocation or concentration limits when investing in these kinds of assets: (i) up to 20% of the total reserves of each plan may be allocated to “structured investments,” which include FIPs and funds investing in quotas of FIPs (“FIQFIPs”); (ii) up to 10% of the total reserves of each plan may be allocated to an issuer if the issuer is an investment fund classified as a “structured investment” (FIPs and FIQFIPs); (iii) up to 25% of the equity of an investment fund classified as a “structured investment” (FIPs and FIQFIPs), aggregating the global amount of the funds managed by a closed pension fund so invested; and (iv) up to 25% of the same series of securities of a single investment, aggregating the global amount of the funds managed by a closed pension fund so invested.
13See CVM Rule No. 306, to be repealed and replaced by CVM Rule No. 558 on January 4, 2016.
14Other important areas with respect to which quota holders have a vote are: replacing the portfolio manager, approving mergers, incorporations, spin-offs and liquidation of the FIP (but not transactions in which a FIP acquires or sells a portfolio company), approving new issuances of quotas of the FIP, approving changes in the administration fees, extending the term of duration of the FIP, amending the necessary percentages for the general meeting’s quorum, and creating committees of the FIP.
15In accordance with CVM Rule No. 391