Brazil: Basic Concepts Of Brazilian M&A - Introduction And Restrictions On Foreign Investments

Last Updated: 18 December 2014
Article by Thiago Sandim


Me and most of my colleagues started on the M&A legal business back in the 90s. At that time, most of the international M&A business would come from US based companies, in the form of investments in the Brazilian "old school" industry. The financial and capital markets were very small and risk investment virtually not feasible as a result of the high inflation and institutional instability.

That landscape changed very fast in the late 90s, with the surge of the privatizations. By the early 2000s, We had seen and had the pleasure to work with colleagues from several nationalities, from all over Europe and the Americas. The surge of the commodities, the intense need of the Asian markets either for the supply of these goods or new markets to explore, coupled by the institutional stability of Brazil are now bringing a new type of investors into Brazil. Large international private equity funds, sovereign wealth funds and large Asian companies and banks are now joining (and sometimes getting more important than) the Europeans and Americans. On top of that some of the local players have matured and developed into global class players. The current situation of Brazil (and one should remember that this is 2014) looks gloomy, but democracy is stable and there are 200 million people to feed. There is little room for failure and the government knows it. Any government.

Over the years and as a result of our global approach and overseas business development efforts, we also learned that these new investors are eager for information about how to properly do business in the country. Be it for the huge geographical distance or for the just recently acquired capacity to do cross-border M&A, such new investors have very limited access to information on the local legal landscape or the pitfalls that they may face them when they are first investing in the country.

It is mostly these readers that this article targets.

Of course we do not have the intention to be comprehensive or even to be highly technical, but will try and put in a nutshell some very basic local legal concepts that are very straightforward knowledge for Brazilian lawyers and transactional personnel, but that we learned over the year may sound very strange in foreign ears.

With some noticeable exceptions. It is these exceptions that this article targets.

So here is our attempt to put some basic issues in a nutshell. We do that because some of our fellow colleagues from other nationalities may not be familiar with the very basic legal concepts that are valid in Brazil. In our mind, it is only a matter of creating awareness and making such concepts familiar, as Brazil is as investor friendly as any of the most advanced countries in the world.

Here we go.

Chapter 1 - Restrictions on Foreign Investments

The last constitution enacted in the country dates back to 1988. It was generally a constitution designed to protect the Brazilian business, while at the same time creating an environment that would attract foreign investments. It initially created a distinction between Brazilian companies controlled by Brazilian entities or nationals and Brazilian entities controlled by foreigners. This particular distinction created the basis for restrictions that were passed under the form of "ordinary" laws, which are significantly easier to pass in Congress. Late in 2001, when this distinction proved to be unrealistic and counterproductive, the constitution was changed to eliminate it. This made restrictions to foreign investments harder to approve because they need to be on the Brazilian constitution, or be based on the Brazilian constitution. By eliminating the distinction between entities controlled by Brazilians and entities controlled by foreigners, the country basically eliminated the broad concept that foreigners and companies controlled by foreigners may receive treatment different than that awarded to Brazilians. Today, a company incorporated in Brazil is considered to be a Brazilian entity, irrespective of its shareholders.

Of course there are still restrictions in place, but they tend to be limited to activities that are considered to be strategic by the country. The restrictions can be very basically divided in 3 types.

The first type would be activities that are 100% reserved to Brazilian nationals and companies controlled by Brazilian nationals (sometimes with 100% of the shares). Economic activities in the borders of the country can be quoted as a good example of this type of restriction. Whilst, for example, the ownership of real estate by Brazilian nationals may not be an issue, on the borders of the country they are restricted to foreigners. This type of restriction is to be taken very seriously. Some mining and pulp companies had problems to exercise their activities in these areas due to aggressive legal structures that were later disregarded by the Brazilian authorities. It is also important to understand the background of this particular restriction, which lies in the fact that Brazil has one of the largest continuous borders in the world. A very large portion of this border is in the Amazon, where vigilance is almost impossible. On top of that, unlike, for example the USA (which also has a very large border) Brazil has borders with all South American countries but Ecuador and Chile. This makes us a US size type country, with European - type complex borders. There are also restrictions with regard to the amount of land that may be held by a foreign in a single municipality, which was created because at a stage in the late 2000s very large pieces of land were being acquired by companies controlled by foreign governments, which the Brazilian executive branch considered worth paying attention to.

The second type of restriction applies to market were foreign investment is limited to a certain threshold. As Brazilian corporations can have voting and non-voting stock, the restrictions can be applicable in a different manner for voting and non-voting stock, depending on the industry. In media companies, for example, total foreign investment is limited to a certain percentage of the capital stock of the company, whilst in airlines it has no limits for non-voting stock and a percentage threshold for voting stock. This last one creates a curious situation – if one takes a look at the securities of Brazilian airlines which are traded in the São Paulo stock exchange, it will become clear that only "IPO companies" (companies which are at the level of the parents of the operational company) are the companies that are actually listed or that a very strong lock-up is in place with regard to the common voting shares of these companies -or, alternatively - that there is a lockup in the documents of the IPO, restricting the ability of the controlling shareholders to float a number of shares beyond such thresholds. Media and airliners are not the only markets with restrictions in place, but the more visible. The markets with this type of restriction in Brazil are regularly seen in other countries.

There are finally some markets in Brazil where foreign investment depend on the "declaration of interest by the government". This is pretty much limited to the financial industry, where the government wants to examine on a case-by-case basis where it would be of interest for the country to welcome a given investor or not. This was inserted in the constitution of 1988 and was put in the hands of the president of Brazil – which made the task to get the declaration of interest very delicate, to say the least.

Over time it became obvious that such a deep control was obviously not in the interest of the government, and also that the restriction was preventing the Brazilian financial institutions to capitalize through equity in the open markets. This is because, in theory, every investor buying equity of a Brazilian financial institution in the open market would require an express authorization of the president of Brazil, which is obviously impossible This problem was solved through "umbrella decrees" which basically treat every foreign investment in non-voting stock of Brazilian financial entities as "of interest of the country". This was the basis for the first wave of IPOs of non-voting shares of Brazilian companies, which followed this decree.

To this date it is also unusual that the president refuses to grant the decree to a foreign institution that acquires control of a Brazilian company. I have indeed seen foreign institutions get refused, but that is usually implemented through informal advise by the Central Bank of Brazil (which is responsible for the technical analysis of the cases) for the foreign applicants to withdraw their requests before they are formally denied. It is also important to notice that, as foreigners can not actually acquire the voting stocks before the decree (unless there is already a decree authorizing such acquisition), there is usually a 6 to 8 months period ranging from signing to financial closing.

In acquisitions involving financial institutions it is hence very important that the approval process is managed professionally, involving not only lawyers, but also other advisors who are familiar with the Central Bank procedures and formalities. It is also very important to bear in mind that unlike some banking regulatory agencies throughout the world, there is frequently no deadline for approval of transactions by the Central Bank of Brazil, which tends to make the approval process much more complex than usual.

Over time, I have watched lawyers and investment bankers come up (and have designed some myself) with sophisticated "negative control" structures, mostly based on debt, to overcome or stretch these restrictions to their limit. Our general advise to our clients in this case is generally very conservative. Do not do it. If the government does not want foreign investment or restricts foreign investment in a certain market, one may discuss the merits of the restrictions and the interest of the country to continue with them. But the law is there to be followed, and not to be creatively circumvented.

In a nutshell, , what you need to keep in mind from this Section is, thus, that with very specific exceptions, Brazilian law does not create different treatment for local entities based on the nationality of their shareholders.

Foreign Exchange Controls

This is something that European clients have some trouble to understand, particularly in light of the existance of the Euro for quite some time. Although the Brazilian currency is freely tradeable, the government keeps a close scrutiny of the balance of payments, and that is implemented in practice through the electronic registration of every exchange transaction of Brazilian currency with the Central Bank of Brazil. It is called electronic declaratory registration system. Not to be confused with a system which requires authorization for a transaction to be implemented. As defined by its own name, it is a system where the interested parties declare the facts (amount invested, equity or debt transaction, etc.) and implement the transaction, in principle, without the need of a prior authorization of the Central Bank.

The "catchy" bit of the foreign exchange control is that only financial institutions authorized to deal in the foreign exchange markets by the Central Bank of Brazil may implement those transactions. Such institutions need to keep a paper trail of every transaction they implement for a certain period of time in case the central bank wants to clarify something. If the Central Bank tries to gather information on a given transaction and such information is not available, the financial institution may be subject to sanctions (that can range, widely at the discretion of the central bank from a warning to the suspension of the financial institution to trade in the foreign exchange markets). As no financial institution wants to be exposed to this type of problem, it is almost impossible to invest in Brazil without being in full compliance with the regulatory requirements – essentially because the financial institution channeling the investment would not allow it to happen.

There are basically two ways to invest in equity in Brazil. Portfolio investments and foreign direct investments. Both are registered in the electronic registration system of the central bank, but serve different purposes and can generate different tax consequences. The Electronic registration system of the central bank of Brazil also registries financial transactions (debt related) and export and import transactions, among other. This article, however, only refers to equity transactions, mostly in a non-technical style, as made clear in the beginning of the text.

Portfolio investments are essentially investments in the Brazilian capital markets (debt or equity). They could be broadly defined as a type of registry that has an "umbrella amount" and several types of securities held beneath such umbrella amount. The holder of the portfolio investment is allowed to change the securities without the need to create a new registration – which is only required upon the repatriation of capital. Portfolio investments are entitled to some tax benefits in certain circumstances. On the other hand, they are generally currently subject to a higher taxation by the tax on financial transactions (Imposto sobre Operacoes Financeiras – IOF) at the time of their implementation. As this tax is classified as a "regulatory tax" (which rates can be increased or reduced as the government considers appropriate given specific market conditions) one needs to check what rate is applicable at the time of the investment.

The portfolio investments are usually the preferred route for foreign private equity institutions to invest in the country, as provided that some regulatory tax requirements are met, in theory there could be no income tax due upon the repatriation of the investment from the Brazilian capital markets. What essentially happens is an initial investment in quotas of Brazilian private equity funds (the so-called FIPs - Fundos de Investimento em Participacoes) which are at a given stage collapsed into equity of the companies beneath it, which are then sold in the capital markets and repatriated. Of course the whole structure is much more complex than what is described above, but this is a good non-technical description.

Financial institutions are also allowed to create "omnibus portfolio accounts", which carry investments of several of their foreign clients. However, each client has a "sub-account" that is clearly identified to the central bank of Brazil. This is necessary not only to keep the financial authorities up-to-date about those investing in Brazil (for money laundering purposes, for example) but also to allow the exchange of information between several branches of the Brazilian government. The central bank and the securities commission, for example, are known to have identified disguised stake building exercises by crossing the disclosure of material facts issued by the companies with the updates of the electronic registration system. Portfolio investments in Brazil are also called sometimes "2689 investments" because they are implemented under instruction 2689 of the National Monetary Council (Conselho Monetario Nacional -CMN).

Foreign direct investments are straight forward investments in the capital stock of Brazilian companies, implemented outside the stock markets. The amount of the registration is linked to the asset (shares or quotas in the case of Brazilian limited liability companies) beneath it. Registration must be changed every time the asset changes. It is a more solid and non-flexible registration system mostly designed to reflect the long-term investments in the country.

Most important of all, the correct registration of foreign capital invested in Brazil with the central bank is important because it serves as the main basis for the Brazilian tax authorities to access the original cost of a given investment in the country, which is the basis for the calculation of the withholding income tax on capital gains (the main tax assessing the sale of securities in Brazil by foreigners). If the registration is incorrect (or in the slang of the Brazilian capital markets "tainted") the odds are that the foreign investor may have problems to prove the acquisition cost at the time of the repatriation of capital. In extreme cases, the cost of investment could be considered as being zero, which would most certainly reduce the gains or even create losses.

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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