On August 25, 2015, the Supervision of Relations with Institutional Investors (Superintendência de Relações com Investidores Institucionais – SIN) of the Brazilian Securities and Exchange Commission (Comissão de Valores Mobiliários – CVM) issued Circular-Letter No. 6/2015/CVM/SIN (CL 6/2015) that aims to guide securities portfolios' managers as to the recommended procedures regarding the investment of third party resources in structured financial instruments (SFIs). These recommendations are outlined herein.
This subject is of undisputed importance since the financial instruments of this type have their own features which must be carefully evaluated by the managers in order to comply with the due diligence requirements referred to in the applicable regulation[1].
In the exercise of his/her duties, a securities portfolio's manager shall employ the same care and diligence which an industrious and honest person customarily employs in the administration of his/her own affairs, working with loyalty in relation to the interests of the investors, avoiding practices that could hurt the fiduciary relationship maintained with them, and accounting for any infringements or irregularities that may be committed under his/her administration or management.
The fiduciary duty that securities portfolios' managers must have to their clients implies the need to act with professionalism, always doing the appropriate analysis on any financial assets in which they decide to invest. SFIs, however, have very specific features that make the diligence required of such professionals in the process of investing in these assets different from that it is needed in the case of simpler assets. The risks involved are distinct and, therefore, it takes a tailored due diligence process specifically adapted to these risks[2].
In the context of CL 6/2015, SFIs means securitized and structured finance instruments, that may basically be considered as complex (as opposed to more traditional or plain vanilla investment instruments) notably in consideration of their specific features in particular: where these instruments have a complex capital structure; are difficult to value (so that their valuations require specific skills and systems); and/or have a very limited or no secondary market (and are therefore potentially illiquid).
CVM adopted the same definition used by the Technical Committee of the International Organization of Securities Commissions (OICV – IOSCO) in its Final Report of July 2009 on "Good Practices in Relation to Investment Managers' Due Diligence When Investing in Structured Finance Instruments" (IOSCO Good Practices)[3].
The recommendations contained in CL 6/2015 are based on the
The obligation to implement these recommendations depends on the reasonableness of each specific situation to be checked on a case-by-case basis. Some of the practices presented below may not apply or needs to be adapted in certain situations. The analysis of its relevance in the case at hand is the responsibility of the fiduciary administrators and managers, including taking into account the provisions of regulation and self-regulation in force applicable to each type of financial instrument. In addition, the intensity of the analysis must be proportional to the relevance of the investments made compared to the portfolio in which they fall and it should also be considered the possible loss vis-à-vis the investor profile.
First, it is necessary to warn that the process of due diligence cannot be reduced to a mere process of fulfillment of predetermined steps. Also it is not a static process, but an iterative process[4] which begins before the initial investment and only ends when the instrument reaches its maturity or when the disinvestment is
Before the actual investment, it is necessary to ensure the existence of express authorization in the mandate signed by the client for investment in the type of asset to be purchased. In addition, it is necessary to check whether there is compatibility between the structured instrument(s) and the investment objectives of the client.
The manager must also assess his/her ability to understand and pricing the assets, including legal knowledge. The rule should always be "If you do not understand, do not buy it". It is paramount to know the structure of the cash flow of the instrument and its allocation to the different tranches, if applicable. It is also necessary to have the ability to evaluate whether the price paid for the instrument is proportionate to the assumed risks and make sure that all relevant risks are identified and assessed and that it is understood how they are mitigated or expanded.
If there is the ability mentioned above, it is necessary to check the availability, reliability and relevance of the information available on the market about the underlying assets of the financial instrument.
The appropriate information to the process of due diligence may not be only quantitative. In many cases the understanding of the market dynamics can also involve collecting qualitative information.
The manager must ensure that the analysis is made based on the relevant information to the specific type of the underlying assets, but must not assume that the properties of the SIF are equal to those of the category of assets existing in the securities portfolio.
The analysis of the structure of the instrument must be done in a normal situation as well as in the stress scenarios. The importance of the stress tests is reinforced by the fact that many SIFs have little ability to adapt to unforeseen situations. The first step for the use of the tests should be the identification of: (i) aspects that may have unexpected results; and (ii) possible consequences. The manager must then analyze how the stress scenarios are reflected in the structure of the instrument and if the existing provisions can be easily and quickly used. This analysis should comprise both the legal aspects involved as any other relevant aspects of the structure of the instrument. The analysis must also involve the verification of expected changes in cash flows in the stress scenarios and their impact on the various tranches or classes of instrument.
Additionally, existing operating risks must be considered. This analysis should take into account, for example, the impact of disruption in the provision of certain services such as custody.
It is also important to identify the role of third parties in the structuring and operation of the instrument, as for example, the conditions in which legal opinions on the transaction were issued. With respect to the notes given by risk rating agencies, if they are used as an additional tool for decision making, one must understand the methodology and the parameters on the basis of which the opinion has been produced and be able to question those aspects.
Still with regard to the role of third parties, one should evaluate the convenience of using mechanisms to align the interests of those who have strategic importance in the structure with the interest of the investors of the instrument over time. An example is requiring subscription by third parties of subordinate units (cotas subordinadas), if applicable.
Finally, it is important not to base the analysis only on promotional documents, taking care to verify that the analyzed documents are legally binding and enforceable. In case the analysis is based on drafts, one should take care to verify whether there are discrepancies for the final version and, if so, the impact of such discrepancies.
[1] In particular article 14 of CVM Instruction No. 306 of May 5, 1999 (article 16 of CVM Instruction No. 558 of March 26, 2015) and article 65-A of CVM Instruction No. 409 of August 18, 2004 (article 92 of CVM Instruction No. 555 of December 17, 2014). These provisions reproduce the duty of diligence, as defined in the Brazilian Corporation Law (Law No. 6,404 of December 15, 1976).
[2] In addition, there are several varieties on the market of structured instruments so that the implementation of the recommendations mentioned in CL 6/2015 may be too simple for some and very complex for other instruments.
[3] This report is available at https://www.iosco.org/library/pubdocs/pdf/IOSCOPD300.pdf.
