Publications
- Category: Litigation
In April of this year, Brazil ratified the Convention on the Taking of Evidence Abroad in Civil or Commercial Matters. This is one of the main multilateral instruments for international legal cooperation and brings in improvements to the speed and effectiveness of measures to produce evidence abroad. Brazil had signed the Convention in 2008, but its entry into force only occurred with the enactment of Decree-Law No. 9,039, of April 27, 2017.
In practice, the convention allows a judge in the courts of a signatory country to request the taking or production of evidence in another signatory country by means of a letter rogatory. As in other bilateral and multilateral agreements on international legal cooperation, each country designates a central authority (in the case of Brazil, the Ministry of Justice) to receive requests and replies from its domestic judges and forward them to the foreign central authority, which in turn handles communication with the local Judiciary.
The Convention provides that evidence may be produced not only by judges but also by diplomatic representatives or consular agents. Brazil, however, approved the Convention with reservations and will only accept that evidence be produced in Brazilian territory by the Judiciary.
With more than 50 signatory countries, the Convention can be used to perform any other judicial act, and not only for the production of evidence. Along the same lines, Articles 26 and 27 of the New Brazilian Code of Civil Procedure established that instruments of international legal cooperation may also be used for summons, subpoenas, recognition, and enforcement of a decision and granting of injunctive measures.
The production of evidence abroad through legal cooperation between the courts of different countries, based on international treaties, is not, however, the only instrument to be considered by the parties when defining their litigation strategy. It is also possible to initiate an independent proceeding for production of evidence directly in the country where the evidence is found. Depending on the specific circumstances of the case, this may be more convenient for the parties.
In the United States, for example, Section 1782 of the U.S. Code expressly allows for a suit for production of evidence to assist cases in other countries, regardless of whether a letter rogatory is submitted.
In Brazil, Article 381 of the New Code of Civil Procedure provides for the possibility of filing for early production of evidence in three cases, where: (i) "there is reasoned fear that it will become impossible or very difficult to verify certain facts while the action is pending"; (ii) "the evidence to be produced is capable of facilitating a settlement or other appropriate means of conflict resolution"; or (iii) "prior knowledge of the facts may justify or avoid the filing of an action".
Although Brazilian courts have not ruled on the possibility of using an action for early production of evidence for suits that may be filed in other countries, they have not specifically prohibited it. To permit the application of Article 381, in particular its item III, to justify the production of evidence that could eventually be used in legal proceedings abroad would reflect precisely the spirit of the New Code of Civil Procedure, which values speed and settlements of the proceedings.
- Category: Capital markets
Offering safe alternatives for companies and investors to carry out investments and raise funds is undoubtedly crucial in fostering Brazil's economic activity and capital markets, especially in a crisis scenario.
An instrument widely used in day-to-day operations of Brazilian companies are the preferred shares. In addition to allowing greater flexibility in defining the capital structure without a loss of corporate control, preferred shares may offer a wide range of rights to investors, thereby attracting those investors who have no interest in participating in the management of the company.
Since they do not usually grant voting rights to their holders, but rather award them, in exchange, with preferences that often resemble the economic advantages inherent to debt instruments, preferred shares are usually considered as hybrid instruments. This fact was taken into account in the analysis of financial statements, but did not result, until 2010, in the obligation to account for certain preferred shares as financial liabilities.
Since 2010, when large Brazilian companies and enterprises began to adopt the Brazilian Accounting Board - CPC Rule No. 39 - "Financial Instruments: Presentation", drafted based on the IAS 32 - Financial Instruments: Presentation (IASB) (CPC 39), even shares, which by their nature represent a portion of capital stock, can be considered as financial liabilities. That is, regardless of the legal form, analysis of the essential characteristics of a given instrument is fundamental for properly classifying it as a liability or an asset.
The application of IAS 32 and CPC 39 has raised and continues to raise many questions and controversies at the international and national levels. Some foreign and local studies argue that preferred shares, regardless of their characteristics, should be classified as a financial liability. These analyses also show that the application of IAS 32 would have resulted in the disuse of preferred shares in certain countries, such as the Netherlands.
Given the great practical importance of its guidelines and the significant impacts of classifying them as assets or liabilities in the capital structure of a company, CPC 39 remains a topic of debate in the market and its implementation often presents a challenge for companies.
In this context, we have analyzed the circumstances that would allow for classification of preferred shares as financial liabilities based on the legal instruments of the Brazilian Corporation Law and the guidelines set forth in CPC 39.
Pursuant to Article 17 of the Brazilian Corporation Law, preferred shares may have the following advantages: (i) priority in the distribution of dividends, whether minimum or fixed; (ii) priority in the reimbursement of capital, with or without a premium; and/or (iii) accumulation of the foregoing preferences.
Priority in capital reimbursement, with or without premium, is a right that can easily be classified within the concept of equity, since it addresses a residual interest in the assets of the company. Meanwhile, priority in the distribution of dividends, whether fixed or minimum, is a right that more closely resembles the concept of a liability.
A liability can be defined as: (i) a contractual obligation to deliver, or exchange under unfavorable circumstances, cash or financial assets with another person, or (ii) a present obligation arising from past events, the settlement of which is expected to result in the outflow of funds from an entity capable of generating economic benefits.
For example, fixed dividends and prefixed interest are similar in the sense that such disbursements can be fixed on a predetermined basis, often related to the invested capital itself. However, despite the similarity, it seems incorrect to classify preferred shares as financial liabilities based solely on this characteristic. This is because the distribution is conditioned to the future generation of profits. That is to say, the company does not, per se, have a present obligation to pay in this case.
Therefore, in principle, we understand that preferred shares, in essence, should be classified within the concept of assets. It so happens that various other rights may be linked to the preferred shares and provided for in the company's bylaws, such as (i) partial or full rights of redemption of the investment and/or (ii) rights that affect the company's discretion in the distribution of dividends.
CPC 39 expressly provides that preferred shares are considered financial liabilities whenever they grant a right of redemption to be exercised on a determined date or at the discretion of the holder, regardless of the potential inability of the company to redeem such shares. On the other hand, when redemption is at the discretion of the company, such preferred shares do not represent a present obligation and, therefore, do not meet the requirements of a financial liability.
In addition to redemption, CPC 39 also indicates that preferred shares with priority in dividend distributions, whether or not cumulative, will be considered assets, provided that distributions can be made at the issuer's discretion. That is, if there is any obligation of distribution on the part of the issuer, such shares, on the contrary, should be considered as financial liabilities.
CPC 39 gives no other concrete examples; it establishes that all other rights conferred by a certain preferred share should be analyzed to identify whether it has fundamental characteristics of an asset or a financial liability.
Because CPC 39 is not exhaustive, the correct classification of preferred shares should reflect the essence of the rights granted thereby within the concepts of liabilities and assets. Often, this makes classification complex, especially in unconventional fundraising structures with various nuances.
Companies should evaluate, as soon as possible, the substance of the rights linked to preferred shares under the Brazilian Corporation Law and CPC 39 in order to avoid any surprises or questions regarding the accounting of such investment.
If the accounting is different from the initial intent, the impacts may be material in what concerns to financial covenants, which may lead to acceleration of debt and cross-default on financial agreements. In addition, considering the different tax treatment of dividend income and debt instruments (interest), incorrect classification may result in tax liabilities for both the holders and the company.
The correct classification of preferred shares is fundamental for the financial standings of a company to be properly reflected in its financial statements, thereby avoiding asymmetries of information within the market which could harm creditors and investors.
- Category: Infrastructure and energy
Just over two years after the water crisis in Southeast Brazil, its effects still have repercussions on the concession instruments or programs in effect within the public sanitation services. Even with the normalization of the droughts, the level of concessionaire indebtedness is inversely resilient to the volume of the reservoirs, which leads to further discussions in the tariff review processes conducted by the state regulatory agencies.
In general, the water crisis created a substantial change in the material circumstances in which utilities provided sanitation services due to both the forced reduction of demand (less availability of water) and the increase in water production costs and the need for new investments in more complex capture and adduction processes.
Conformity of the cycle was achieved through emblematic projects. In Minas Gerais, for example, Copasa carried out catchments in the main aquifer supply system of the Metropolitan Region of Belo Horizonte, Paraopeba, in addition to new artesian well drillings. In São Paulo, Sabesp interconnected some of the Cantareira System dams (such as the Jaguari with the Atibainha) and implemented a new schedule for the São Lourenço Project, one of the most successful public-private partnerships in terms of financing. The implementation of dams in the PCJ basin, with funding from multilateral agencies, is in the final phase of environmental licensing and about to be finalized.
This framework reveals not only an increase in current service expenses, but also, and above all, a significant change in the remuneration assumptions (pay back/amortization, risk, and opportunity cost) of the concessionaires' investors and creditors, since new investments (capital expenditures) had to be anticipated or conducted beyond the parameters originally designed and approved by the state regulatory agencies. These entities generally define a Regulatory Remuneration Rate in establishing the methodology for calculating cost recovery and capturing capital opportunities used in the expansion of services.
In the sanitation sector, the Regulatory Remuneration Rate must consider, by virtue of law, factors that, in general, are not mandatory in other regulated industries. As a financial discount rate for the calculation of the net present value of the concession contract (or, as the case may be, the project), the Regulatory Remuneration Rate is a necessary parameter in promoting tariff revision, not a mere readjustment. It is bound by article 46 of Law No. 11,445/07, which states that "in a critical situation of scarcity or contamination of water resources that requires the adoption of rationing, declared by the water resources management authority, the regulator may adopt contingency tariff mechanisms, with the objective of covering additional costs incurred, thereby ensuring a financial balance between service delivery and demand management."
The regulatory decree (No. 7,217/2010) further determines that the regulations should contemplate a tariff model that ensures not only the tariff modality, but also the economic-financial balance of the contracts, it being the responsibility of the agencies to define “system, structure, and tariff levels, as well as procedures and deadlines for setting, readjusting, and revising them." It is also incumbent on the agencies to ensure the participation of owners, users, and service providers, as well as to create mechanisms to induce efficiency, including productivity factors in the new tariff models.
In the tariff revision procedures, after the initial stage of establishing criteria and methods by which the concessionaire's current costs are calculated, one proceeds to an analysis of the elements that should compose the tariff structure and the respective risk matrix, which establishes as parameters remuneration and any events linked to obtaining financial return by the respective shareholders and creditors.
As the cost of capital for each source of financing is differentiated, most of the tariff revisions in the sanitation sector use WACC (Weighted Average Cost of Capital) as the average cost of owned and third-party equity. By this methodology, the financing costs are weighted according to the company’s capital structure, that is, according to the sources of financial resources employed, not considering their tax effects. The following aspects are principally considered in this analysis: (i) remuneration of the investment made by the service provider with its own funds, arising from both the generation of cash and the contribution of new resources by the shareholders (equity); and (ii) funds obtained from sources outside the company, for example, loans from financial institutions, issuance of debentures, promissory notes, and other credit rights (third-party capital). Therefore, more than one Regulatory Remuneration Rate, specific to each source of funding, is allowed.
The main controversies are concentrated, as a rule, in the measurement of the cost of equity. This is due to the fact that third-party capital still comes mainly from the domestic market, in which interest rates (Selic, TJLP, TR, and preferential rate) are directly or indirectly regulated by the monetary authorities, especially the Central Bank. Thus, quantification of the cost of capital is subject to even more objective metrics. Regarding equity, on the other hand, the Regulatory Remuneration Rate, according to some precedents in the sanitation sector, within the purview of the state regulatory agencies, has been following the Capital Asset Pricing Model (CAPM), by which one tries to establish a balancing relationship between the expected return and the risk factor, assuming as parameters of the latter the profitability of an unencumbered asset, the profitability of the market portfolio, and the sensitivity of the company's assets to market returns.
Risk free assets are devoid of volatility in the returns, that is, uncertainties with respect to future gain. Similarly, profitability of the market portfolio relates to the expected return capable of encouraging investors to invest in the stock market. Finally, the sensitivity of the company's assets to market returns is measured by the beta coefficient. This unit of measure symbolizes a systematic risk of an asset (market risk), which reflects possible and future fluctuations in the behavior of macroeconomic variables (inflation, economic growth, external crises, foreign exchange, etc.) that affect the concessionaire.
The CAPM does not automatically introduce, however, a sectorial or microeconomic risk premium, taking into account the specificities of the sanitation sector in a given country or region. In addition to the variables pertaining to the aggregates, captured by the beta coefficient, regulatory risk and now, above all, the risk of water unavailability in Brazil and especially in the Southeast Region, are no longer adequately considered in the calculation of the Regulatory Remuneration Rate.
The lack of attention given by some regulators to these last points has led, even if only for a certain period of time, to an undesirable loss of market value of publicly-held, publicly-traded companies and publicly-traded shares. These market "penalties" have an additional negative factor of increasing the cost of equity of concessionaires, since the perception of regulatory risk increases in direct proportion to the insensitivity of considering and pricing, for the future, further chances of water scarcity. In this sense, the concessionaire's cash flow contingency ends up being the only mechanism to mitigate the financial consequences of the actual occurrence of these risks, which also brings in an implicit loading cost in the business strategy.
There is no other way to deal with this result but to go back and admit that the tariff review procedures must effectively compensate for variation in the cost of executing the contract, including capital costs, taking place in the event of an unpredictable event or, as now, unavailability of water, for the Southeast, a predictable event, but with incalculable consequences.
If the public choice is to preserve moderate tariffs, maintenance of the economic-financial balance of the current concession and project contracts will have no solution except through the institution of state subsidies, which can be contributed through numerous alternatives for structuring or renegotiating the existing arrangements, such as the common concession subsidized pursuant to article 17 of Law No. 8,987/95 or the public-private partnerships governed by Law No. 11,079/04.
The revision procedure symbolizes mutual commitment in the field of responsibilities shared between public and private sectors in an effort for greater transparency and realism with respect to the challenges and perspectives in defining tariffs. In this procedure, the primary and reciprocal commitment should always be to reduce the cost of capital of concessionaires and, as a consequence, at a minimum, preserve their market value, in accordance with the requirements of financeability and bankability of new or ongoing projects.
- Category: Infrastructure and energy
"The Brazilian electrical power sector was designed with a model for a developing country. The rules of the sector did not have an answer for the economic crisis"
Paulo Pedrosa, executive secretary of the Ministry of Mines and Energy
The federal government announced in January that it intends to hold a specific auction for reserve power contract divestment this year, a still unprecedented dispute in Brazil, in anticipation of an average structural surplus of 8.4 GW of energy (difference between physical supply and the system load) by 2018 and the expectation that few new power generation projects could break ground. This is yet another move to adapt the rules of the sector to the scenario of economic stagnation, the so-called "sectoral realism."
The general auction rules are in Decree No. 9,019, of March 30, 2017, which amended Decree No. 6,353/2008 to allow the contract divestment of reserve energy through the conducting of a competitive mechanism. The criterion for the definition of the winner(s) of the dispute will take into account the price negotiated in the respective reserve auctions (advantageousness of contract divestment), associated with the payment of the premium.
The premium, in turn, will be deposited in the Reserve Energy Account (Coner) and must be used to pay for the energy that will remain contracted. The details of the rules, however, have not yet been released by the Ministry of Mines and Energy (MME) and should be defined soon by the Brazilian Energy Research Company (EPE), as well as the amount to be divested.
Up to now, it is known that those projects whose energy has been contracted in a reserve energy auction and which meet the following conditions cumulatively at the date of publication of the notice of the divestment mechanism will be eligible for divesting:
- currently have a Reserve Energy Contract (CER); and
- did not start an operation under test.
The winners of the auction will:
- have their energy contracts cancelled, as well as those associated with the use of the transmission and distribution facilities of the undertakings that are part of the winning proposal, subject to any associated costs [subject to any costs arising therefrom];
- have their registration with the Special Incentive Regime for the Development of Infrastructure (Reidi) canceled; and
- be obliged to waive any right to any compensation arising under the rescinded contractual instrument.
The termination of the CER will be automatic for those contracts that relate to a single plant. In the case of a CER with more than one plant, the contract must be amended to cover the reduction of amounts sold in installments equivalent to the projects included in the proposal, without applying a fine for termination.
The guarantee of faithful fulfillment of the divestment projects will also be released and, with regard to the maintenance of the concession, which was doubtful for a good part of the sector, the decree establishes that the concessions of the divestment projects will be automatically extinguished. Nothing is reported about the projects that have their amounts partially reduced. The logic in their case demands the maintenance of the concessions, an indispensable requirement for the validity of the commitments.
The decree brings in an important and controversial provision pertaining to the possibility that the sellers with divestment projects participate in future reserve auctions.
Paragraph 8 of the new Article 7-A of Decree No. 6.353 establishes that "the sellers who have their proposals ratified by Aneel will be unable to participate in the two auctions to contract reserve energy subsequent to the realization of the divestment mechanism." The following paragraph goes further, providing that such prohibition may be extended "to the controllers, subsidiaries and controlled companies of sellers who have their proposals approved by Aneel, pursuant to the notice of the divestment mechanism."
In a first analysis, the restriction seems too severe. On the one hand, according to the executive secretary of the MME, Paulo Pedrosa, the rule seeks to curb "opportunistic" moves to sell the energy of a divested project for a higher amount in a new auction. On the other hand, however, to extend this prohibition to controllers, subsidiaries, and shareholding controlled companies, or even to the seller itself (who may be entitled to rights for other ventures in different stages), imposes a penalty on anyone who voluntarily assents to the divestment, with perhaps a much greater burden than an at-fault unjustified rescission of the CERs.
As the rules are likely to be subject to public discussion between agents and regulator, it is expected that the limitations on future participations in reserve auctions will be adequate for the purpose of the rule, thus avoiding disproportionate restrictions on the exercise of the economic activity of these agents.
The responses given by the regulator to the industry's concerns have been adequate and, when implemented in a timely manner, effective. However, the slow pace of adoption of the measures remains the biggest enemy of the advances expected. It was hoped, for example, that the divestment auction would be held as early as April 2017. So far, not even the public notice has been approved, nor has the amount to be divested been disclosed.
The fear of all is that, due to the delay in implementation, the actions will end up becoming maladapted to Brazil’s constantly evolving reality. This would make it impossible to break the normative-reactive system, which is so damaging to the already shaken legal and regulatory stability of the sector, thereby harming the attraction of new investments and economic growth.
- Category: Labor and employment
Both the Federal Constitution (article 8, item VIII) and the Consolidated Labor Laws - CLT (article 543, paragraph 3) grant protection to employees who are union leaders through the benefit of provisional stability, from the time of the employee’s candidacy until one year after the end of employee’s term of office.
Competition compliance programs are part of the risk management systems of companies that are concerned with possible financial losses resulting from any noncompliance with the Competition Law (Law No. 12529/ 2011), such as fines imposed by the Administrative Council for Economic Defense (Cade), devaluation of shares, termination of contracts, and possible civil, administrative, and criminal liability of the company’s directors and officers.