The Economic Freedom Act and its impacts on the Brazilian investment fund industry
Caio Ferreira Silva
Pinheiro Neto Advogados, São Paulo
Rafael Garcia Santana Martins
Pinheiro Neto Advogados, São Paulo
On 20 September last year, President Bolsonaro sanctioned Law No 13,874, the so-called Economic Freedom Act, as a result of the conversion of Provisional Measure No 881, which had been enacted a few months earlier. An important milestone for the Brazilian legal system, the Economic Freedom Act asserted the principles of free enterprise and minimal state intervention in the economy and introduced a new set of rules designed to facilitate the way business is carried out, in keeping with the incumbent government’s efforts to foster new businesses and increase economic activity across different sectors.
To this effect, the Economic Freedom Act amended several prevailing laws, including the Civil Code (Law No 10,406 of 10 January 2002). Among such amendments, the Economic Freedom Act brought in important innovations to the investment fund industry, especially those bearing on the limitation of liability of fund investors (also known as quota-holders in Brazil) and fiduciary service providers of domestic investment funds. These features alone are expected to bolster investors’ confidence in a wide array of investment strategies and opportunities channeled through funds in Brazil, including by making the legal framework governing funds very similar in this regard to those typically available in investor-friendly jurisdictions.
In this context, the Economic Freedom Act introduced in the Civil Code a legal definition of investment funds: a ‘pool of funds organised as a condominium and intended for investment in financial and other assets and rights of any nature’. This definition essentially restated the prevailing provisions under Brazilian regulations issued by the Securities and Exchange Commission of Brazil (CVM), according to which investment funds are treated as condominia, thus qualifying from a legal perspective as unincorporated entities through which co-ownership over specific assets is exercised by a pool of investors.
Apart from linking the legal concept of investment funds to investments in financial assets, which at present fall within the scope of the CVM’s regulatory authority, notably CVM Ruling No 555 of 17 December 2014, as amended (CVM Ruling No 555/2014), the Economic Freedom Act further specifies, in line with existing regulations, that its provisions likewise apply to other investment fund categories investing in different asset classes. These include equity interests in private companies, receivables of any nature (including distressed assets) and real estate properties, including the so-called structured funds, such as: private equity investment funds (FIPs) regulated by CVM Ruling No 578 of 30 August 2016, as amended (CVM Ruling No 578/2016); investment funds in credit rights (FIDCs) regulated by CVM Ruling No 356 of 17 December 2001, as amended; and real estate investment funds (FIIs) regulated by CVM Ruling No 472 of 31 October 2008, as amended.
Among the remarkable improvements brought by the Economic Freedom Act with regard to the regulation of investment funds, what stands out is the possibility created for any investment fund to provide in its bylaws for the: (1) limitation of the liability of each investor (quota-holder) to the value of its quotas in the fund; and (2) limitation of the liability (as well the parameters for such verification) of the fund’s fiduciary service providers, both in relation to the fund they service and among themselves, to the fulfilment of their specific regulatory duties, without being jointly and severally liable in such capacity.
The possibility for the fund’s bylaws to limit the quota-holders’ liability to the value of their respective quotas, which the market has been praising as a key tool to bring greater legal safety and predictability to cross-border and domestic investments made through investment funds, is in our view the greatest innovation put in place by the Economic Freedom Act when it comes to regulation of the Brazilian investment funds industry. It has the potential to allow a contractual solution for a longstanding and recurring demand from investors, especially those of structured funds such as FIPs and FIDCs. It should be noted that, for existing investment funds, the limitation of liability only applies to facts taking place after their bylaws are amended to include such liability limitation provision.
With the exception of FIIs, for which limitation of liability of quota-holders under very specific terms was already provided for under Law No 8,668 of 25 June 1993, as amended, prior to the enactment of the Economic Freedom Act, there was no express legal ground or case law support for the bylaws of investment funds to provide for the limitation of quota-holders’ liability. Pursuant to Article 15 of CVM Ruling No 555/2014, quota-holders are liable in case the fund’s net equity in which they invest becomes negative for any reason, apart from any potential liability of the fund’s administrator and/or the portfolio manager in case of breach of the fund’s investment policy or concentration and diversification requirements set forth on bylaws and on CVM Ruling No 555/2014.
Moreover, the new legal delimitation of the liability of fiduciary service providers dealt with by the Economic Freedom Act should also contribute to bring greater legal safety to investment fund service providers. It is likely to nurture an increasing roster of new products and business lines in which such service providers could in principle be able to operate under a more predictable risk–return trade-off, which could also translate into new compensation levels in a revamped regulatory environment.
As for investment funds regulated by CVM Ruling No 555/2014, the regulation in force sets forth that agreements entered into between investment funds and their service providers in connection with rendering of management services, treasury activities, control and processing of financial assets and bookkeeping of the issuance and redemption of quotas must provide for joint and several liability between the administrator of the investment fund and the respective hired or outsourced service provider for losses caused to the fund’s quota-holders arising out of breaches of law, the fund’s bylaws or regulations issued by the CVM. Specifically in relation to FIPs, CVM Ruling No 578/2016 provides for the same obligation, except for portfolio management services agreements, which are not required to abide by provisions of this kind.
The Economic Freedom Act also broke new ground in the Brazilian legal system by expressly allowing the creation of different classes of quotas in a same fund bearing different rights and obligations, along with the possibility of creation of segregated portfolios within the same fund (ie, comprised of specific and earmarked assets owned by the fund through independent and separate asset compartments) attached to each class of quotas. Although prevailing regulations enacted by the CVM generally allow the creation of different classes of quotas for certain specific fund categories and with respect to certain limited rights and obligations only, the latitude introduced by the new rule, coupled with the pioneering creation in Brazil of segregated portfolios linking specific assets to each class of quotas, paves the way – at least from a legal and regulatory perspective – for the setting up of a whole new line of products in the industry that until then were not able to be even conceived in Brazil due to the constraints imposed by applicable regulations and the very nature of condominia under Brazilian law.
Once regulated by the CVM, this change should give legal practitioners and investors much leeway in the structuring of investment funds (especially structured funds, such as FIPs and FIDCs) and is likely to replace local master-feeder fund or fund-of-fund structures commonly used in Brazil in an attempt to mimic the effects of segregated portfolios in other jurisdictions. This feature may also entail economics of scope and scale for these structures that will certainly be more than welcome to the market.
Consistent with the liberalisation trend that shaped the core of this new legislation, the Economic Freedom Act also cut some red tape in the fund industry by abolishing the need to register investment funds’ bylaws with local registries. The replacement of this requirement by the online disclosure of the fund’s bylaws and related organisational documents is in line with the Economic Freedom Act’s purpose of streamlining procedures and reducing the bureaucracy involved in economic activities in Brazil.
These legal developments within the Brazilian fund industry, along with the many others put forth under the Economic Freedom Act, attest to the promising and hopefully positive impacts that its rules are expected to have in the local fund market, especially by conferring more flexibility and legal safety on both investors and investment funds’ service providers engaged in this industry. It should be noted, however, that in order to be in full force and effect in Brazil, the changes introduced by the Economic Freedom Act still require the issuance of a new set of regulations by the CVM aimed at harmonising the fund regulatory framework with the provisions of the Economic Freedom Act and creating the regulatory grounds required in order for the different investment fund categories available in the country and market players to fully benefit from such legal innovations.
Except for the recently enacted CVM rules allowing funds to no longer register their bylaws with competent registries, such new regulations have not yet been issued by the CVM. Due to the relevance of the upcoming changes and improvements to the investment fund industry as a whole, the CVM has already indicated that it will submit to a public hearing a draft of the new regulations in order to adapt the rules in force with the changes introduced by the Economic Freedom Act.
As the market awaits the CVM’s new regulations, some players in the investment fund industry – both investors and service providers – have already started to prepare for the upcoming regulatory innovations and by interacting with the regulator so as to allow the CVM to already take into consideration some of the market’s suggestions and concerns. Some have even gone further and, as a way to be a step ahead once the new regulations are issued, already included in their investment funds’ bylaws and organisational documents provisions on the limitation of liability of quota-holders and service providers in keeping with the guidelines provided by the Economic Freedom Act but subject, however, to the scope and a content of the CVM’s regulations yet to be issued.
Despite the turmoil also witnessed in Brazil and in the Brazilian fund market as a result of the Covid-19 pandemic and the constantly shifting priorities during these times, including on the regulatory front, the chances are that CVM will hopefully find some time to digest comments from the market on the Economic Freedom Act-related regulations and be in a position to start enacting these long-awaited regulations this year.