Hedge Fund Regulation in Brazil - Part 1(a)

1. OVERVIEW OF JURISDICTION

   Brazil is both the largest economy in the Latin American region and the most developed in terms of the liquidity and sophistication of its financial services industry. It has long nurtured a vigorous hedge fund industry serving both the domestic market and offshore investors. Brazil is gradually building a reputation as a hedge fund centre for the reasons outlined below.

   With increasing global demand for its agricultural commodities and mineral wealth, and having the benefit of an extended period of political and economic stability, Brazil now enjoys balance of payments and fiscal surpluses, low and controlled inflation and an improving level of public debt. This has created an appropriate environment for public offerings, a longer-term curve and increasing liquidity in derivatives. All these factors generate more opportunities for hedge fund managers.

   In the past, managers in Brazil and other Latin American countries followed predominantly macro strategies, but today there is a second wave of funds, using long/short equity strategies such as pair trading and equity hedge, as well as arbitrage funds and the establishment of genuine multi-strategy funds with independent books for each strategy.

2. BASIC CHARACTERISTICS COMMON TO ALL INVESTMENT FUNDS

   The mutual industry fund in Brazil is highly regulated and is subject to the control and supervision of the Brazilian Securities and Exchange Commission (Comissão de Valores Mobiliários - CVM)1. The law that instituted CVM established that it should observe the following objectives:

   to assure the proper functioning of the exchange and over-the-counter markets; to protect all securities holders against fraudulent issues and illegal actions performed by company managers, controlling shareholders, or mutual fund managers; to avoid or inhibit any kind of fraud or manipulation which may give rise to artificial price formation in the securities market; to assure public access to all relevant information about the securities traded and the companies which have issued them; to ensure that all market participants adopt fair trading practices; to stimulate the formation of savings and their investment in securities; and to promote the expansion and efficiency of the securities market and the capitalization of Brazilian publicly held companies. Under the current applicable regulations, an investment fund (fundo de investimento), also known as a mutual fund, is the gathering of capital, in the form of a condominium, aimed at the investment in certain financial assets available in the financial and capital markets. Therefore, unlike other jurisdictions, a Brazilian fund is a condominium and not a legal entity.

   A fund may invest in the following financial assets:

   public debt securities; derivatives contracts; shares, debentures, subscription bonus, their coupons, rights, subscription slips and share split certificates, certificates of deposit of securities, debenture bills, quotas of investment funds, promissory notes, and any other securities that are not referred to in item (iv) below, with the condition that the issuance of the negotiation is the object of the registry or the authorization granted by CVM; collective investment contracts or titles registered at CVM and publicly offered that generate participation, partnership or remuneration rights, including those resulting from the provision of services whose revenue comes from the efforts of the entrepreneur or of third parties; certificates or slips of deposit issued abroad and backed by securities issued by a Brazilian publicly-held corporation2; gold financial assets, if negotiated at an internationally accepted standard; any titles, contracts and financial institution obligation or co-obligation operational modalities; and warrants, trading contracts for the purchase and sale of products, merchandise or services for future delivery or future provision, titles or certificates representing such contracts and any other credits, titles, contracts and operational modalities if expressly stated in the regulation. The assets whose liquidation can be performed by means of a delivery of products or services shall be negotiated in a commodities and futures exchange that guarantee their liquidation, or be the object of a contract that assures to the fund the right of its alienation before its term, with a guarantee of a financial institution or of an insurance company, observing, in the latter, the applicable regulations of the Brazilian Private Insurance Superintendence (Superintendência de Seguros Privados – SUSEP).

   The fund's portfolio can only be composed of financial assets approved for trading on either the stock exchange or the futures and commodity exchange3, or recorded in the registration system, with custody or financial net liquidation duly authorized by the Central Bank of Brazil (Banco Central do Brasil – Bacen) or CVM, in their respective areas of competence. This registration shall be performed in specific accounts opened directly under the name of the fund. However, quotas4 of open-end investment funds do not depend on such registration.

   The expression "financial assets" also include the financial assets of the same nature traded abroad, in the cases and in the limits admitted in the regulation, if the possibility of its acquisition is expressly stated therein, and: (a) is admitted to negotiation in the stock exchange and in the commodities and futures exchange, or is registered in the registry, custody or financial liquidation systems duly authorized in their original countries and supervised by a recognized local authority. This registration shall also be performed in specific accounts opened directly under the name of the fund; or (b) which existence is assured by the custodian of the fund, which shall hire, specifically for this purpose, third parties duly authorized for such activity of custody in signatory countries of the Asuncion Treaty or in other jurisdictions, since, in this case, the third parties are supervised by a recognized local authority.

   In this regard, CVM has signed a mutual cooperation agreement that allows the exchange of information for operations performed in the markets supervised by it, or with any party that is a signatory to the multilateral memorandum of understanding of the International Organization of Securities Commissions – IOSCO.

   Furthermore, the financial assets negotiated in countries signatory of the Treaty of Asunción are considered to be financial assets negotiated in the domestic market in Brazil, and the Brazilian Depository Receipts (BDRs), classified as level I, are considered to be financial assets negotiated abroad. BDRs are certificates that represent stocks issued by publicly-held corporations or similar, based overseas, and issued by a depositary institution in Brazil. The main characteristics of level I BDRs are: (a) trading is limited exclusively to the non-organized over-the-counter market and only between the persons referred to below in item (d); (b) exception from the need to provide information about the issuing company other than that required by law in its country of origin (in the Portuguese language); (c) exemption from the need to register the company with CVM; and (d) exclusive acquisition by financial institutions and other institutions authorized to function by Bacen, by employees of the sponsoring company or its subsidiary, by insurance brokerage firms and savings capitalization corporations, by corporate entities with a net worth of more than R$ 5 million, and by securities portfolios worth more than R$ 500 thousand, carefully administrated by an administrator authorized by the CVM and by employees of the sponsoring company or its subsidiary.

3. THE HEDGE FUNDS INDUSTRY IN BRAZIL – DIFFERENT TYPES

   Multimarket funds (fundos multimercados), which are deemed to be the Brazilian hedge funds, must have investment policies in place that provide the various risk factors, without any required concentration on a given factor or different factors from the other fund classes5.

   Furthermore, it is possible to have a fund aiming exclusively at qualified investors, which include: financial institutions; insurance companies and capitalization societies; private welfare opened or closed capital organizations; individuals or legal entities that hold financial investments in an amount superior to R$ 300 million and that additionally in writing their qualified investor condition; investment fund directed exclusively to qualified investors; portfolio administrators and securities consultants authorized by CVM, in relation to their own monies; and own social security regimes related to the Federal Government, the States, the Federal District or the Municipalities.

   It is also important to mention the "exclusive" fund. The funds for qualified investors constituted to receive applications exclusively from a sole quotaholder are considered as "exclusive".

   Last but not least, there is the investment fund that invests in quotas of investment funds. Normally these funds shall keep at least 95% of its invested assets in quotas of investment funds of the same class, except when they invest in quotas classified as "multimarket", that can invest in quotas of funds of different classes. The investment funds that invest in quotas classified as "multimarket" can invest in quotas of real state investment funds, credit rights investment funds and investment funds that invest in quotas of investment funds, if this is previewed in their regulations, up to the limit of 20% of its equity. If they are aimed exclusively at qualified investors, investment funds that invest in quotas qualified as "exclusive" or "multimarket" may acquire quotas of venture capital mutual investment funds, real estate investment funds, participation in investment funds, credit rights investment funds, investment funds that invest in credit rights investment funds up to the...