Brazil: Credit Risk Rating In Brazil

On April 25, 2012, the Brazilian Securities and Exchange Commission (Comissão de Valores Mobiliários - CVM) issued CVM Instruction No. 521 (CVM Instr. 521/2012), regulating the activity of credit risk rating (classificação de risco de crédito) in the Brazilian securities market, with emphasis on registration and recognition requirements, information disclosure, and rules of conduct and internal controls of the credit rating agencies (CRAs). The existing CRAs will have to be adapted to the new regulation until January 1, 2013.

The role of the CRAs is a theme widely discussed worldwide. The global financial crisis of 2008 has revealed certain weaknesses of the financial and capital markets and the international community recognized the need to revise the regulations of some sectors and agents, aiming to prevent the occurrence of similar crisis with systemic impacts. Among the agents who deserved a reassessment of the regulator are the CRAs, which issue credit risk ratings as regards solvency and quality of certain assets and institutions.

Two were the paths internationally adopted: (i) elimination or reduction of the compulsory use of the credit risk rating for regulatory purposes1; and (ii) regulation of the CRAs2. The main aspects of the new Brazilian regulation are outlined below.

I. - Definition

For the purpose of CVM Instr. 521/2012, CRA is a legal entity registered or recognized by CVM performing professionally the activity of credit risk rating in the Brazilian securities market, and "credit risk rating" is the activity of giving opinions about the credit quality of an issuer of shares or debt, a structured operation, or any financial asset issued in the securities market3.

II. – Registration and Recognition

This type of activity can only be performed by a CRA registered or recognized by CVM. Registration is the process required for a CRA domiciled in Brazil to be authorized to operate in the country and recognition is the application to be made by a CRA domiciled abroad that intends to issue reports to be used in the Brazilian securities market.

The application for authorization submitted by the CRA domiciled in Brazil to CVM shall be accompanied by the following documents: (i) the application signed by the administrator responsible for the CRA's activity; (ii) a copy of the constituent acts (in its current and updated version) of the CRA, duly registered with the competent registry office, whose corporate purpose must provide the credit risk rating activity; (iii) registration information; (iv) reference form (formulário de referência)4 duly completed and updated until the last working day of the month preceding the date of protocol of the receipt of the application by CVM; (v) the CRA's code of conduct; (vi) description of the CRA´s internal controls mechanisms; and (vii) the CRA´s financial statements together with the independent auditor´s opinion, whenever these documents are available at the time of the application.

To be recognized by CVM, the CRA domiciled abroad must meet the following requirements: (i) be registered and subject to supervision by the competent authority in its country of origin5; (ii) be governed by rules at least equivalent to the provisions of CVM Instr. 521/2012; (iii) have a legal representative in Brazil duly empowered to receive summons, subpoena or notifications on behalf of the foreign CRA; and (iv) submit the same documents required of any CRA domiciled in Brazil, including the applicable governing rules of its country of origin and the reference form.

Furthermore, regardless of recognition, if the CRA domiciled abroad and a CRA domiciled in Brazil are part of the same conglomerate, the Brazilian CRA can validate the rating issued by the foreign CRA, if it is intended for the Brazilian securities market, provided that the foreign CRA rating note issuer is regulated in its country of origin and is subject to standards at least equivalent to the provisions of CVM Instr. 521/20126.

III. – Reference Form

Annually the CRA must send to CVM the reference form, based on the date of December 31st of the preceding year.

This document will be made available in the CVM webpage, to be accessible to the public investor, and in the CRA webpage, along with its code of conduct and rules, procedures and internal controls.

A range of information is required on the reference form, including the administrative and operational structure, identification of the administrator responsible for the management of the CRA and the administrator responsible for the supervision of compliance with the rules, procedures and internal controls and the provisions of CVM Instr. 521/2012, in addition to the methodologies, internal control policies, remuneration and managing conflicts of interest.

IV. - Report of Credit Risk Rating

In line with the principle of broad dissemination of information, CVM details the minimum aspects that must be observed when preparing the reports of credit risk rating, highlighting the clear and accessible language, the possible limitation of the evaluation and the disclosure of potential situations of conflicts of interest.

The credit risk rating report must be drawn up in strict compliance with the procedures and methodologies adopted by the CRA and will focus on: (i) the identification of the analyst responsible for drafting the report and of the person responsible for approving the note attributed or members of the credit risk rating committee, if applicable; (ii) the relevant sources of information used in preparing the risk rating; (iii) the main elements justifying the classification of risk; (iv) the methodology used for determining such classification; (v) the date on which the classification of risk was issued for the first time and for the last time; (vi) the periodicity of update; (vii) the attributes and possible limitations of classification issued, in respect of the extent, quality and accuracy of existing historical documents and data; (viii) if the CRA is assessing the financial asset for the first time; (ix) if the risk rating was communicated to the assessed entity or any related party thereof and if, as a result of this fact, the note attributed was changed prior to the issuance of the report; (x) other services provided to the assessed entity by the CRA in the last 12 months; (xi) services to the assessed entity by any related party of the CRA in the last 12 months; and (xii) any situation that evidences potential conflicts of interest.

Whenever the risk rating has not been hired by the assessed entity or any related party thereof, the report should highlight that fact.

In the case of structured financial products, the risk classification report should also contain: (i) the information about the analysis performed, or in which it is based in relation to bad debt and cash flows, as well as an indication of possible modifications in the classification of risk; and (ii) the level of diligence employed in relation to assessment of the underlying asset, disclosing if the CRA was responsible for such assessment or based it on the evaluation made by a third party.

As examples of structured financial products we can mention: (i) the Credit Rights Investment Fund (Fundo de Investimento em Direitos Creditórios - FIDC) and its Units´ Fund (Fundo de Investimento em Cotas de Fundo de Investimento em Direitos Creditórios - FICFIDC); (ii) the Credit Rights Investment Fund under the Program to Encourage the Implementation of Projects of Social Interest (Fundo de Investimento em Direitos Creditórios no âmbito do Programa de Incentivo à Implementação de Projetos de Interesse Social - FIDC-PIPS); (iii) Credit Rights Investment Fund Non-Standard (Fundo de Investimento em Direitos Creditórios Não Padronizados - FIDC-NP) and its Units´ Fund (Fundo de Investimento em Cotas de Fundo de Investimento em Direitos Creditórios Não Padronizados - FICFIDC-NP); (iv) the Real Estate Receivables Certificate (Certificado de Recebíveis Imobiliários - CRI); (v) the Agribusiness Receivables Certificate (Certificado de Recebíveis do Agronegócio - CRA) and (vi) the debenture which payment of principal and interest arises out of the financial flow resulting from the transfer of credit rights.

V. – Ratings Shopping

The CRA must disclose fully its credit risk rating reports and all preliminary opinions, even those issued as a result of an analysis request or consultation from the applicant, regardless of whether the CRA has been engaged or not by the applicant for the preparation of the risk rating and this disclosure must occur immediately after the transaction is announced. This requirement aims to combat the practice of ratings shopping. This practice occurs when an applicant seeks from different CRAs preliminary opinions on the note of a certain structure or financial asset and hires effectively the one that provides the best risk rating or that it is less demanding.

CVM believes that the practice of ratings shopping is harmful because it hides from the investor information about consultations made with other CRAs, and besides it potentially encourages predatory competition between the CRAs7.

VI. – Rules of Conduct

CVM Instr. 521/2012 brings a series of obligations and prohibitions to the CRAs, which must exercise its activities with honesty, good faith and professional ethics.

The high standard of conduct required of CRAs should be widely publicized through the code of conduct and its manual of internal controls, which should address the principles described by IOSCO. The code of conduct must have at least provisions about: (i) the adoption of procedures that ensure the quality of the reporting process of grading the risk; (ii) the commitment to search for reputable and reliable information to be used in the preparation of their risk ratings; (iii) the monitoring and updating of credit risk ratings8; (iv) the independence of the CRA, the analysts and other persons involved in the process of issuing the risk rating, including regarding the remuneration policy and segregation of activities; (v) the adoption of mechanisms for identification, elimination, management and disclosure of conflict of interests in the exercise of the activity of credit risk rating; (vi) the treatment of confidential information; (vii) the policy of negotiation of the terms of contracts with the assessed entities; and (viii) the adoption of policy on trading of securities by analysts and other persons involved in the issue of risk rating.

Analysts and other persons involved in the process of issuing the risk rating must not: (i) solicit or accept money, gifts or favors from anyone who has a business relationship with the CRA; and (ii) omit any information about irregularities committed by others from the administrator responsible for the supervision of compliance with rules, procedures and internal controls and provisions of CVM Instr. 521/2012.

Regarding the prohibitions, the CRA cannot: (i) issue risk classifications for the purpose of obtaining for itself or for others undue advantage; (ii) omit information on conflict of interest; (iii) allow analysts or other persons involved in the process of issuing risk rating to participate in the process of negotiating the terms of contracting the service. Therefore, the activities of the analytical area and the negotiating team must be kept segregated; (iv) condition the remuneration and performance evaluation of analysts and other persons involved in the process of issuing risk rating to the revenue arising out of the assessed entity or any related party thereof; (v) provide to the assessed entity or any related party thereof consulting services or any other services which may undermine the independence of the work of the CRA; (vi) make proposals or recommendations formally or informally concerning financial assets over which the CRA must issue a rating.

Furthermore, the CRA cannot issue or continue following risk rating in the following cases: (a) if the CRA holds directly or indirectly financial assets of the assessed entity or any related party thereof. However, with few restrictions that will be mentioned in the paragraph below, as a general rule, the negotiation of units of investment funds is expressly allowed; (b) if the assessed entity or any related party thereof is directly or indirectly part of the control block from the CRA; (c) if the analysts or other persons involved in the process of issuing risk rating hold directly or indirectly financial assets of the assessed entity or any related party thereof; (d) if the analysts and other persons involved in the process of issuing the risk rating are members of the Board of Directors (Conselho de Administração) or have some power to intervene on the assessed entity; (e) if the analysts or other persons involved in the process of issuing risk rating have kept any relationship with the assessed entity or any related party thereof that may cause a conflict of interest; and (f) if there are no reliable data or if the complexity of the structure of the new type of financial asset can jeopardize the quality of risk rating to be issued.

The only restrictions to the negotiation of units of investment funds by the CRA, its analysts or other persons involved in the process of issuing the risk rating are the following: (i) if the CRA, its analysts or other persons involved in the process of issuing the risk rating can influence directly or indirectly the administration or management of the investment fund; or (ii) if the investment fund concentrates its investments in sectors or companies covered by the risk rating produced by the CRA or assessed by its analysts or other persons involved in the process of issuing the risk rating.

In addition, analysts and other persons involved in the issue of risk rating cannot participate or influence in any case the risk rating of the assessed entity if they: (i) hold directly or indirectly financial assets of the assessed entity or any related party thereof other than units of investment funds; and (ii) have kept any relationship with the assessed entity or any related party thereof that might cause conflicts of interest.

VII. – Conflicts of Interest

The activities developed by the CRA involve many potential conflicts of interest. The simple fact that the services of the CRA are paid mostly directly by the assessed entities generates a situation of potential conflict. For this reason, it is essential that the CRA is able to identify, administer and, in certain situations, eliminate existing conflicts of interest.

The CRA must describe in general terms the potential conflicts of interest and the procedures adopted to minimize them9.

There are rules on situations of potential conflict. The remuneration of the analysts cannot be based on the business performance of the CRA, as well as it is necessary to disclose the main customers of the CRA and the nature of other services not related to the activity of credit risk rating that are rendered by the CRA to the assessed entities.

The following situations are examples evidencing potential conflicts of interest: (i) if the assessed entity or any related party thereof is responsible for more than 5% of annual revenue of the CRA; (ii) if the CRA, its analysts or other persons involved in the process of issuing a certain risk rating, their spouses, dependents or partners have directly or indirectly relevant financial and commercial interests in relation to the assessed entity; and (iii) if the analysts or other persons involved in the process of issuing a certain risk rating have any link to any individual who works for the assessed entity or any related party thereof.

VIII. - Rules, Procedures and Internal Controls

Through the implementation of written rules, procedures and internal controls, the CRA shall ensure the permanent compliance with the existing regulations, concerning its own activity (credit risk classification) and the applicable ethical and professional standards.

The CRA must implement an operational structure compatible with the function of compliance by assigning an administrator (the compliance officer) the responsibility for supervising the compliance with the rules, procedures and internal controls and the provisions of CVM Instr. 521/2012.

If the CRA is part of a conglomerate with operations in other jurisdictions, the compliance officer may be domiciled abroad provided that: (i) he/she is an administrator linked to a CRA domiciled abroad which is a related party to the CRA domiciled in Brazil; and (ii) the foreign CRA holds in Brazil a representative who is an administrator that is linked to the Brazilian CRA, duly empowered to receive summons, subpoena or notifications against him/her proposed based on the provisions of CVM Instr. 521/2012.

Furthermore, the administration bodies of the CRA will receive by March 31st of each year the compliance officer report dated as of December 31st of the previous year10 on the observance of rules, procedures and internal controls and this report shall contain the conclusions of the examinations performed by the compliance officer and his/her recommendations regarding any shortcomings, with the establishment of timelines for correction of the identified shortcomings, when applicable, for adjustment of conduct of the CRA11, together with the manifestation of the administrator responsible for the CRA regarding the shortcomings found in previous examinations and the planned measures, in accordance with a specific schedule, or effectively adopted to correct them.

The CRA must draw up and disclose the remuneration policy, including at least: (i) the method of evaluation of performance of analysts and other persons involved in the issuance of credit rating and of the Risk Classification Committee, if any; (ii) the remuneration of the administrator responsible for the CRA and of the compliance officer. The remuneration of the compliance officer cannot be linked to the business performance of the CRA; and (iii) the periodicity of review of the remuneration policy of the CRA.

The classification of risk activities and the other activities pursued by the CRA or any related party thereof must be completely segregated by the CRA12. To ensure this segregation, the CRA must adopt operating procedures that target: (i) the physical segregation of facilities between areas responsible for the different activities provided by the CRA relating to the securities market; (ii) the proper use of facilities, equipment and files common to more than one sector of the CRA; (iii) the preservation of confidential information by the administrators, analysts of credit and all other persons involved in the issuance of credit risk rating; and (iv) the restricted access to files, as well as the adoption of controls which restrict and identify persons who have access to confidential information.

The outsourcing of relevant operational functions cannot be made if it harms: (i) substantially the quality of internal controls of the CRA; and (ii) the supervision of compliance with obligations arising from the CVM Instr. 521/2012.

IX. – Methodologies

In line with the position adopted in other jurisdictions and with the principles adopted in preparing the rules of the Brazilian securities market, with focus on the dissemination of information, CVM considers important that the methodologies used by the CRA be available to the public13.

The disclosure of the CRA procedures and methodologies for the determination of risk rating will allow the users of the classifications of risk to know exactly the paths and methods that were followed for the assignment of a particular note. This disclosure must be sufficiently detailed to enable the users in general to effectively understand the CRA´s methodology and attribute the weight that they consider appropriate to the opinion issued by the CRA.

CVM Instr. 521/2012 establishes that the CRA must: (i) adopt methodologies of stringent and systematic analysis and, whenever possible, which lead to risk classifications that can be objectively verified; and (ii) review at least annually the procedures and methodologies adopted by it.

If there are significant changes in the methodologies and procedures used for the preparation of the risk rating, the CRA must: (i) disclose immediately the probable list of affected risk ratings issued by the CRA in the same media used to publicize the risk rating; and (ii) review the affected risk ratings as soon as possible, in a period not exceeding six month counted as of the date of the change. In such circumstances, the CRA will highlight immediately that those risk ratings are under observation.

X. - Performance Indices

The CRA shall prepare a document, based on the performance history of the classifications made since 2002 by the CRA, by segment, so as to show within a period of one to three years: (i) the initial risk ratings, their changes and the transition probability for each classification (risk rating matrix); and (ii) the default rate regarding any issuer, structured operation, financial obligation or other classified financial asset within a certain classification (default rate matrix). If the CRA is part of a conglomerate with activities in other jurisdictions, it must also submit the information of both matrices (risk rating and default rate) in the global market.

CVM believes that the disclosure of these two types of matrices will enable the users of the classifications of risk to make comparative assessments between the different CRAs14.


1 The first measure arose from the observation that the ratings, as they were being used, leaded to an excessive confidence on the part of investors and users in general, who did not make their own credit risk analysis, and often served as a sole source to base their investment decisions. The Brazilian Regulatory and Supervision Committee of the Financial Markets, Capital Markets, Insurance, Pension Plans and Capitalization (Comitê de Regulação e Fiscalização dos Mercados Financeiros, de Capitais, de Seguros, de Previdência e Capitalização – Coremec), which is formed by the Central Bank of Brazil (Banco Central do Brasil – Bacen), CVM, the Private Insurance Superintendence (Superintendência de Seguros Privados - SUSEP) and the Brazilian Complementary Pension Superintendence (Secretaria de Previdência Complementar do Ministério da Previdência Social - PREVIC), created a working group to study the possible paths to be adopted for the elimination or reduction of the regulatory use of rating. This work should be completed in the first half of 2012. The initial report on the survey of current usage of rating in the regulations relating to the securities market, insurance, pension and banking is available on the CVM´s webpage.

2 The second measure consists in the regulation of CRAs. The standards issued by CVM are based on the following: (i) Regulation (EC) No 1060/2009 of the European Parliament and of the Council of the European Union of September 16, 2009 on credit rating agencies, especially the rules of equivalence which allow that ratings issued by agencies located in countries outside the European Union continue to be used in Europe; (ii) Rules 17g-1 through 17g-7 of the Securities Exchange Act of 1934 of the U.S. Securities and Exchange Commission (SEC), specially the provisions of Form NRSRO (Nationally Recognized Statistical Rating Organization); and (iii) the Code of Conduct Fundamentals for Credit Rating Agencies of the Technical Committee of the International Organization of Securities Commissions (IOSCO) published on December 23, 2004 and revised on May 29, 2008.

3 CVM Instr. 521/2012 does not apply to private credit risk ratings involving financial assets not traded or not distributed publicly in the Brazilian securities market.

4 This is the model adopted in the United States for registration of authorized agencies to issue risk ratings for regulatory purposes.

5 The expression "competent authority" means any international agency that has entered into with CVM a bilateral Agreement of Technical Cooperation and Exchange Information or is a signatory of the Multilateral Memorandum of Understanding of IOSCO.

6 CVM believes that it is important to stimulate an increase in the number of participants on the market of issuance of credit risk rating and believes that the creation of mechanisms that make possible the provision of services by CRAs domiciled abroad can be useful for this purpose. Furthermore, the European regulation also tackles the possibility of ratings issued in non-member countries of the European Union, differentiating risk ratings issued by CRAs linked and not linked to conglomerates by means of validation and certification, respectively.

7 In Europe and in the United States, a similar measure is adopted for disclosure of preliminary opinions, but only when the opinion relates to structured products. CVM has opted to require the disclosure in the case of any financial asset issued in the Brazilian securities market. Recently the European regulations were changed to also require disclosure of preliminary opinions in relation to any entities and financial assets, but this change still depends on the approval of the European Parliament and the Council of European Union.

8 This monitoring is not required, however, in cases where there is a clear indication that there is no monitoring on an ongoing basis and shall cover: (a) regular review of credit status of the evaluated entity; (b) revision of classification of risk after knowing any information that could result in any action of the CRA, in accordance with the applicable methodology; and (c) updating of the classification, as the case may be, in a timely manner, on the basis of the results of the reviews described in items (a) and (b).

9 CVM has concluded that the theme conflict of interests, which permeates several provisions from CVM Instr. 521/2012, is not limited to the description of procedures. Although it is important to give proper transparency to users of ratings, the mere description of such procedures did not seem sufficient.

10 This report shall be available at the CRA´s headquarters at CVM´s disposal.

11 The administrator responsible for CRA cannot act in functions related to the issue of classification of risk and any commercial activity.

12 In the area of credit risk rating the separation between the activities carried out is especially important, since most CRAs belong to groups that perform activities that can generate potential conflicts of interest with the activity-end of the CRA.

13 There is no seal of approval from the regulator. CVM does not interfere nor guarantees the content of the information disseminated by the CRA to the public.

14 In CVM Instr. 521/2012, the Brazilian regulator considered as a milestone for the matrices the year 2002 for two reasons. First because at the end of 2001 was published the regulation of the FIDC, who brought the obligation of risk ratings in securitization transactions. Second for being a reasonable period of time to have a database that allows a substantial analysis of the performance of risk ratings issued by the CRA in Brazil.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Walter Stuber
Adriana Maria Gödel Stuber
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