Harvard Business Law Review (HBLR)

The Harvard Business Law Review (HBLR) aims to be the premier journal covering the laws of business organization and capital markets. HBLR will publish articles from professors, practitioners, and policymakers on corporate law and governance, securities and capital markets law, financial regulation and financial institutions, law and finance, financial distress and bankruptcy, and related subjects.

Volume 4

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An Evaluation Of The U.S. Regulatory Response to Systemic Risk and Failure Posed by Derivatives

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Kimberly Summe*

Derivatives, understood by few but disparaged by many, are often blamed for the collapse of the United States economy in the wake of Lehman Brothers’ bankruptcy in September 2008.[1] A legislative response to the crisis was inescapable and on July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)[2] was signed into U.S. law. While the Dodd-Frank Act addresses many aspects of the financial markets, this Article will focus on Titles II and VII in order to examine how transacting in derivatives has changed in the aftermath of this legislation and to assess how the bankruptcy of a systemically important financial institution engaged in derivative transactions will be approached.

A Bid to Limit Systemic Risk and Failure

The Dodd-Frank Act has two primary objectives that relate to derivatives: first, to limit the systemic risk of modern finance, in part by changing the locus of trading in derivatives and the conduct of derivatives market participants; second, to limit the damage caused by the failure of a systemically important financial institution.[3] With respect to the first objective, the Dodd-Frank Act’s principal strategy required that certain derivatives be “cleared.” With respect to the second objective, the Dodd-Frank Act singled out the entities most likely to cause systemic problems if they failed and subjected them to a new bankruptcy process. This Article will focus on the second objective of the Dodd-Frank Act and in particular on how the failure of a systematically important financial institution would relate to the treatment of derivatives.

Reducing Systemic Risk

The estimated $632 trillion notional over-the-counter derivatives market[4] is in the early transformational stage of where and how such transactions are executed. Title VII of the Dodd-Frank Act requires that all eligible derivatives be cleared through a central clearinghouse, known colloquially as a “central counterparty” or “CCP.” Unlike an over-the-counter derivative transaction where each of the two parties face the risk that its counterparty might fail to perform its obligations, a cleared derivative transaction mitigates this risk of performance failure by having a third party, the CCP, stand between the two parties and absorb that risk.[5]

Two years after the passage of the Dodd-Frank Act, the Commodity Futures Trading Commission (CFTC) proposed that certain credit default swaps and interest rate swaps be cleared. The CFTC’s decision to focus initially on these two products was a function of their importance in the market and the fact that a significant percentage of those swaps were already being cleared. End users of derivatives, such as corporations, are not, however, required to clear swaps if such entities can demonstrate that the swap is being used to hedge or to mitigate commercial risk, the CFTC (or the Securities and Exchange Commission (SEC)) was notified as to how the end user generally meets the financial obligations associated with entering into uncleared swaps, and the entity’s Board of Directors approved such an approach.

Clearinghouses perform a valuable function in their mitigation of counterparty risk. To sustain this function, the clearinghouse’s financial resources must be sufficiently robust to meet its members’ obligations notwithstanding the default of one of its members. Given that J.P. Morgan Chase Bank, Citibank, Goldman Sachs Bank USA, and Bank of America are the four largest derivative counterparties in the United States, the collapse of any one of those institutions could mean the termination of anywhere between a $42.67 and $71.28 trillion notional derivatives portfolio—roughly seven to eleven percent of global notional derivatives value.[6] In addition to the financial resources marshaled by each clearinghouse, another critical component of the clearing model is the provision requiring collateral. The requirement that the parties post collateral every day underpins the purported safety of the clearing model.

Policymakers were correct to focus on collateralization as a risk-mitigation technique. The collateralization of over-the-counter derivative transactions has existed for twenty years, so the posting of collateral for cleared and uncleared transactions to mitigate exposure is not new. Before the economic crisis began, the International Swaps and Derivatives Association (ISDA) reported in its 2006 Margin Survey that the gross amount of collateral in use for over-the-counter derivative transactions was $1.335 trillion, with fifty-nine percent of mark-to-market credit exposure covered by collateral.[7] Today, large dealers reported that eighty percent of over-the-counter derivatives are subject to collateral arrangements, with ninety-six percent of credit derivatives exposure being collateralized.[8] The type of collateral is important as well. Cash has long been the preferred form of collateral. At the end of 2006, nearly eighty percent of collateral was cash, mostly provided in U.S. dollars, and nearly seven years later, similar percentage is true today.[9]

What shifted under the Dodd-Frank Act is that the CCP’s calculation of required collateral is substituted for the individual counterparty’s assessment of its risks. Counterparties to cleared swaps will be required to post initial (or upfront) collateral to the CCP based on the CCP’s assessment of the risk profile of that transaction.[10] In addition, each day the CCP will set the variation margin associated with each transaction by recalculating the value of the transaction and accordingly calling for or releasing collateral, ensuring that counterparties have neutral risk positions in relation to the value of the underlying asset. In other words, the goal is that the CCP receives margin payments every day from counterparties whose contracts moved against them to ensure that the CCP and those that participate through the CCP always have funds to satisfy their obligations under contracts.

The posting of collateral is closely related to how the derivative transactions of an insolvent clearinghouse member are handled. For example, LCH. Clearnet Group’s contract and related rules state that upon a clearing member’s default, the clearinghouse may close out and terminate the cleared transactions and will not transfer such positions. CME Clearing and ICE Trust, by contrast, allow cleared transactions and associated collateral to be transferred to another consenting clearinghouse member.[11] Had Lehman Brothers been a clearing member of CME Clearing, for example, upon its insolvency its $35 trillion notional derivatives portfolio (and associated collateral) would have been ported to another clearinghouse member. The concern in a marketplace where major participants such as Bank of America, Citibank and Morgan Stanley, among others[12] were vulnerable at that same time means that the portability of Lehman Brothers’ derivatives portfolio may not have allayed counterparty risk to the non-defaulting party population because arguably an equally unstable counterparty was receiving those transactions. Alternatively, a stronger clearing member may have rejected the transactions being proposed for transfer without some sort of government backstop for the unknowable counterparty risk being assumed.

Albeit one of the Dodd-Frank Act’s goals was to reduce systemic risk through clearing and collateralization of derivatives, little has changed in terms of how collateralization operates both before and after Lehman Brothers’ bankruptcy. A clearinghouse will determine the collateral required for cleared trades while for over-the-counter derivatives, the counterparties will agree to the extent of such collateralization. As the OCC Quarterly Reports demonstrate, there have actually been very limited counterparty credit losses incurred from over-the-counter derivatives trading activity by U.S. banks. At the end of June 30, 2013, eighteen U.S. banks (out of 1,400) reported a total of $61 million in charge-offs of over-the-counter derivatives exposures, down from $84 million in the first quarter of 2013.[13] Net current credit exposure or the netted amounts of contracts with positive values against those with negative values was reported as $339 billion at the end of the second quarter of 2013—a figure that peaked at $800 billion at the end of 2008.[14] These figures reflect the importance of collateralization and netting in the over-the-counter context and indicate that a very small fraction of the gross notional outstanding of derivatives held at U.S. banks is subject to net current credit exposure. Even with these high collateralization rates in place, at least as reported by U.S. banks, it should be noted that no consensus has formed as to whether there is sufficient collateral in place to mitigate counterparty loss. Researchers at the International Monetary Fund estimated that under-collateralization of derivatives relative to risks in the financial system may be $2 trillion.[15] The TABB Group contended that interest rate and credit derivative transactions’ migration to a clearinghouse would require an additional $240 billion in collateral.[16]

Dealing with Failure

If the Dodd-Frank Act’s first objective was to limit risk before an institution collapses, the second objective was to limit destruction after a systemically important financial institution has failed or is in danger of failing. To accomplish this second objective, the Dodd-Frank Act introduced a new framework in Title II to facilitate the “orderly liquidation” of systemically important financial institutions.[17] The population of systemically important financial institutions includes bank holding companies that have at least $50 billion in assets and nonbank financial institutions such as investment banks or insurance holding companies that the new Financial Stability Oversight Council (Council) deems to be systemically important.[18] At present, there are eight U.S. banks deemed systemically important, along with three Japanese banks, seventeen European banks, and one Chinese bank. Before the Title II orderly liquidation authority procedures apply, however, it must be demonstrated that the use of the U.S. Bankruptcy Code would not be appropriate in the resolution of the institution without the destabilization of the U.S. financial system or a resort to a taxpayer bailout being likely.

It seems certain that all systemically important financial institutions will transact in derivatives and those transactions are more likely today than in 2008 to be booked with a U.S. commercial bank. U.S. banks dominate as derivatives counterparties. The most recent OCC Quarterly Report on Bank Trading and Derivatives Trading reported that out of the 1,400 U.S. banks engaged in derivatives trading, four U.S. commercial banks hold ninety-three percent of that exposure.[19] The concentration of a small number of financial institutions in the derivatives market has not shifted much in many years, including prior to Lehman Brothers’ bankruptcy.[20] The vast majority of this derivatives trading activity focuses on interest rate swaps: in the OCC’s First Quarter Report in 2008, that figure was seventy-nine percent, whereas in the OCC’s Second Quarter Report in 2013, it was eighty-one percent.[21] Interest rate swaps are perhaps the least complicated derivative instrument, particularly as compared to the challenges historically associated with credit derivatives in terms of credit event triggers and settlement, the complex calculations and dependencies of equity derivatives, and the inherent volatility of commodity derivatives, so presumably there is less risk in trading interest rate swaps than other derivatives. In addition, the OCC reports that fifty-nine percent of the top four commercial banks’ net current credit exposure is to other banks and securities firms, with corporates representing thirty-two percent and hedge funds, the most overly collateralized group at 325 percent, being two percent of net credit exposure.[22]

Thus, our financial landscape is dominated by the world’s largest banks, which in turn are among the world’s largest derivatives counterparties. While these banks will be more closely regulated under Title I of the Dodd-Frank Act, the way in which their insolvency will be handled has shifted.

Banks have historically been excluded from application of the U.S. Bankruptcy Code[23] and instead bank insolvencies were addressed under the Federal Deposit Insurance Act (FDIA). The FDIA provides that the Federal Deposit Insurance Corporation (FDIC) may operate as a conservator to preserve the value of a failing bank and return it to financial health or the FDIC may operate as a receiver in order to liquidate a failed bank.[24] Unlike a proceeding under the U.S. Bankruptcy Code, an FDIC receivership or conservatorship is not subject to direct supervision by the courts.[25] In large part, this policy choice was designed to ensure that bank failures were not subjected to the assumed-to-be lengthy proceedings under Chapter 11 of the U.S. Bankruptcy Code and placed more discretion with the FDIC to act expeditiously.

Under an FDIC regime, upon bankruptcy the FDIC has limited repudiation and avoidance powers with respect to derivatives. For example, regardless of whether the FDIC is acting as a conservator or a receiver, it must either disaffirm or repudiate all or none of the qualified financial contracts (derivatives) between the failed bank and the same counterparty, together with associated credit support or collateral.[26] In addition, the FDIC has the right to transfer qualified financial contracts to creditworthy bridge depository institutions.[27] If the FDIC is acting as receiver, it must provide notice of the transfer by 5:00 p.m. EST on the business day after its appointment as receiver.[28] At that time, the counterparty to the failed bank may elect to terminate the qualified financial contract (that is, the non-defaulting counterparty to the failed bank could follow the termination and close-out provisions in Section 6 of the ISDA Master Agreement for derivative transactions). If the FDIC is acting as conservator, there is no time limit on its right to transfer qualified financial contracts and the counterparty may not terminate the qualified financial contracts unless the conservator defaults to a degree that would permit termination under applicable non-insolvency law.[29]

From available reports, it appears that in every recent case where a large U.S. bank has become subject to a receivership proceeding, all qualified financial contracts and associated collateral of the failed bank were transferred in their entirety to a single bridge bank or third party acquirer. When the assets of Washington Mutual Bank, the largest U.S. bank failure to date, were sold in September 2008 to J.P. Morgan Chase, the FDIC transferred to J.P. Morgan Chase all qualified financial contracts to which Washington Mutual Bank was a party. While that process seemed to go well, Washington Mutual was not exactly a powerhouse derivatives market participant. Thus, it is not known whether the FDIC is resourced effectively to be able to handle a systemically important financial institution’s bankruptcy, a clearinghouse’s bankruptcy or multiple simultaneous bankruptcies. To date, the FDIC has fortunately not had the opportunity to deal with a derivatives portfolio approaching anything even near the size of Lehman Brothers’ derivatives portfolio—and Lehman Brothers was not as significant a derivatives market participant as the four largest U.S. commercial banks that trade derivatives.

While it is impossible to know whether the FDIC could effectively administer the bankruptcy of a systemically important financial institution, it is known that Title II’s orderly liquidation authority shifts away from the legal certainty of the bankruptcy processes under the U.S. Bankruptcy Code by permitting the FDIC to engage in ad hoc interventions under Title II. In addition, Title II allows the FDIC to discriminate among similarly situated secured creditors in a bankruptcy. Under Section 506(a)(1) of the U.S. Bankruptcy Code, a creditor’s secured status is determined when the collateral securing the claim is sold or when the Chapter 11 plan is judicially confirmed.[30] In contrast, under the regulations implementing the Dodd-Frank Act, the collateral securing the debt of the covered financial company is valued as of the date of the receiver’s appointment.[31] If the FDIC is unable to find a third party to purchase the collateral, the FDIC may transfer that collateral to a bridge financial company that the FDIC has organized.[32] While the bankruptcy process under the U.S. Bankruptcy Code mandates that the use or sale of the debtor’s property can only occur after there has been due notice and hearing, thereby ensuring the highest price is paid for such assets, Title II allows the FDIC to be on both sides of the transaction and to determine the consideration paid for the assets, with no court or creditor oversight.

The deficiencies of Title II resulted in the development of a proposed new U.S. Bankruptcy Code Chapter 14.[33] Chapter 14 offers two distinct approaches: either a conventional reorganization or a two entity recapitalization of a holding company. Under the Dodd-Frank Act, the FDIC focused on a two entity recapitalization, with a systemically important financial institution’s holding company being recapitalized through the transfer of its assets and liabilities to a new bridge financial company, and this bridge financial company in turn dealing with its operating subsidiaries. By contrast, Chapter 14 provides that if a motion is approved for the transfer of assets and liabilities in the first forty-eight hours of a bankruptcy, then the systemically important financial institution’s operations and ownership of subsidiaries shifts to a new bridge company that is not in bankruptcy. Qualified financial contracts such as derivatives would be kept intact and transferred to the bridge company. Through the transfer, the new bridge company will be effectively recapitalized by leaving the long-term unsecured debt behind in the bankruptcy proceeding.

Conclusion

It was a foregone conclusion that policymakers would respond to the economic crisis in the aftermath of Lehman Brothers’ bankruptcy and the near-collapse of other financial institutions. While it is arguable that the effort to prevent systemic risk through the mandate of clearing derivatives is a useful step, it is not a prophylactic. It remains entirely possible that a clearinghouse itself is capable of failure, as several have failed in the past, and the concentration of derivatives trading in the largest global financial institutions has exacerbated this possibility. Certainly, having the clearinghouse as the counterparty mitigates counterparty credit risk, but there may be costs involved if we have simply migrated to a more focused nucleus of systemically important financial institutions that could possibly fail. In addition, addressing the potential or eventual failure of a systemically important financial institution could have been addressed in a more judicially sound manner than the ad hoc approach policymakers chose to burden the FDIC with. There are attractive features of Title II, such as coordination with foreign regulators, but not at the expense of due process and judicial review. While the markets have already moved to accommodate the clearing of mandated derivative transaction types, it is hoped that efforts can be made to revise Title II as it relates to how the failure of a systemically important financial institution is handled.

 

Preferred citation: Kimberly Summe, An Evaluation of the U.S. Regulatory Response to Systemic Risk and Failure Posed by Derivatives, 4 Harv. Bus. L. Rev. Online 76 (2014), https://www.hblr.org//?p=3779.

[*] Kimberly Summe is the Chief Operating Officer and General Counsel at a multi-billion dollar San Francisco based investment advisor, Partner Fund Management, LP. She previously served as a Managing Director at Lehman Brothers and General Counsel at the International Swaps and Derivatives Association. Ms. Summe is a lecturer in law at the Stanford Law School and is a member of the Resolution Working Group at the Hoover Institution, which focuses on bankruptcy reform.

[1] On April 20, 2010, U.S. Treasury Secretary Timothy Geithner testified to the House of Representatives Financial Services Committee that “the market turmoil following Lehman’s bankruptcy was in part attributable to uncertainty surrounding the exposure of Lehman’s derivatives counterparties.” See Treasury Secretary Tim Geithner Written Testimony before the House Financial Services Committee, U.S. Dept. Treasury, (Apr. 20, 2010) http://www.treasury.gov/press-center/press-releases/Pages/tg645.aspx.

[2] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).

[3] See id at 1376.

[4] Bank for Int’l Settlements, Quarterly Review, Table 19, (June 2013), http://www.bis.org/statistics/dt1920a.pdf. Notional, of course, does not reference the amount that is at risk and does not account for the effect of netting and the provision of collateral.

[5] See Dodd-Frank Act §723(h) at 1676.

[6] See Office of the Comptroller of the Currency, Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013 (2013) available at http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq213.pdf.

[7] Int’l Swaps and Derivatives Ass’n, ISDA Margin Survey 2007, 4, (Apr. 15, 2007) available at http://www2.isda.org/functional-areas/research/surveys/margin-surveys/. The ISDA Margin Survey covers U.S. and non-U.S. market participants. In 2007, for example, twenty-five percent of respondents were based in the United States, while fifty-two percent were based in Europe or South Africa. The OCC Quarterly Reports, by contrast, only cover U.S. national banking associations. Id.

[8] International Swaps and Derivatives Association, ISDA Margin Survey 2013, 2, (Jun. 21, 2013) available at http://www2.isda.org/functional-areas/research/surveys/margin-surveys/.

[9] See id at 9; International Swaps and Derivatives Association, ISDA Margin Survey 2006, 4, (Apr. 15, 2006), available at http://www2.isda.org/functional-areas/research/surveys/margin-surveys.

[10] As it relates to uncleared swaps, the Dodd-Frank Act requires swap dealers and major swap participants to notify their uncleared swap counterparties of their right to segregate their initial margin with an independent third-party custodian. See Protection of Cleared Swaps Customer Contracts and Collateral; Conforming Amendments to the Commodity Broker Bankruptcy Provisions, 77 Fed. Reg. 6336-01 (Feb. 7, 2012).

[11] See CME Clearing Financial Safeguards, CME Group, (2012), http://www.cmegroup.com/clearing/files/financialsafeguards.pdf.

[12] Federal Reserve chairman Ben Bernanke testified to the U.S. Financial Crisis Inquiry Commission: “If you look at the firms that came under pressure in that period . . . out of . . . thirteen of the most important financial institutions in the United States, twelve were at risk of failure within a period of a week or two.” See Thomas Russo and Aaron J. Katzel, The 2008 Financial Crisis and Its Aftermath: Addressing the Next Debt Challenge, Group of Thirty 7, 11 (2011).

[13] See Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, supra note 6 at 8.

[14] Id at 6.

[15] Manmohan Singh and James Aitken, Counterparty Risk, Impact on Collateral Flows and Roles for Central Counterparties, (International Monetary Fund, Working Paper 09/173, 2009).

[16] E. Paul Rowady Jr., The Global Risk Transfer Market: Developments in OTC and Exchange Traded Derivatives, TABB Group, 6 (November 2010), http://www.world-exchanges.org/files/statistics/pdf/V08-030%20Global%20Risk%20Transfer%20Market.pdf.

[17] See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §204, 123 Stat. 1376 1454 (2010).

[18]  Title II is not limited to financial companies already designated as “systemically important” but can apply to any potentially failing entity the Council determines is systemically important and “in default or in danger of default.”

[19] Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, supra note 6, at Graph 4.

[20] In the OCC Quarterly Report on Bank Trading and Derivatives Activities, First Quarter 2008, the five largest commercial banks represented ninety-seven percent of the total banking industry notional amount of derivatives trading activity. In order by notional, those institutions were JPMorgan Chase Bank, Bank of America, Citibank, Wachovia Bank, and HSBC Bank USA. In the OCC Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, Table 1, the five largest commercial banks in order by notional were JPMorgan Chase Bank, Citibank, Goldman Sachs Bank USA, Bank of America and HSBC Bank USA. The number of insured U.S. commercial banks engaged in derivatives trading has increased: at the end of the first quarter of 2008 there were 1,003 banks, see Office of the Comptroller of the Currency, Quarterly Report on Bank Trading and Derivatives Activities, First Quarter 2008, 7, (2008) available at http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq108.pdf, whereas at the end of the second quarter of 2013, there were 1,400. See Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, supra note 6.

[21] See Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, supra note 6, at 1; Quarterly Report on Bank Trading and Derivatives Activities, First Quarter 2008, supra note 20, at 1.

[22] See id. at 7.

[23] See 11 U.S.C. § 109(b)(2) (2010).

[24] See 12 U.S.C. § 1821(c)(1) (2013).

[25] See § 1821(c)(6).

[26] See § 1821(e)(1)-(3).

[27] See § 1821(e)(9), (10)(C).

[28] See § 1821(10)(B)(i)(I).

[29] See § 1821(10)(B)(ii).

[30] See 11 U.S.C. §506(a)(1) (2005).

[31] See 12 C.F.R. § 380.1-380.53 (2011).

[32] See 12 U.S.C. §5390(h)(1) (2010).

[33] The Hoover Institution established a Resolution Project Working Group in 2009 (of which this author is a member) to develop an alternative approach to bankruptcy and related issues.

By

Making Equity Crowdfunding Work for the Unaccredited Crowd

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Jeff Thomas*

I.       Introduction

The idea behind equity crowdfunding is both simple and revolutionary. Entrepreneurs will be able to use the Internet to pitch business ideas to millions of potential investors and allow “anyone with a few dollars to spend [to] become an investor.”[1] While this may seem like an obvious use of the Internet, until now, securities laws have prohibited new ventures from using this approach[2] to raise capital from “average Joes” and other unaccredited investors.[3] However, the Jumpstart Our Business Startups (JOBS) Act[4] creates a new “crowdfunding exemption” that will allow companies to raise up to $1 million every twelve months by selling their stock (or other unregistered securities) to both accredited and unaccredited investors, provided that the sales are made through registered intermediaries.[5] This article summarizes why the crowdfunding exemption is important, explains how its expected costs are problematic, and proposes ways to mitigate those costs without sacrificing investor protection.

II.       Importance of the Crowdfunding Exemption

The crowdfunding exemption is important because it allows for new sources of capital for new ventures. New ventures, and the jobs they create, are significant to our economy.[6] New ventures also often need external capital,[7] but due to securities laws, it is difficult for them to raise that capital.[8] When selling stock and other securities, new ventures (and other issuers) must either register their securities under the Securities Act of 1933[9] (the Securities Act) or satisfy federal and state requirements for an exempt offering.[10]

On average, issuers must pay $2.5 million to initially register their securities under the Securities Act and an additional $1.5 million each year thereafter to comply with ongoing requirements, making registration impractical for most new ventures.[11] Without the crowdfunding exemption, unaccredited investors are limited in their ability to participate in exempt offerings,[12] and, as of 2010, only 7.4% of U.S. households were accredited based on the net worth standard.[13] Additionally, only a small percentage of the accredited households are likely to participate in exempt offerings.[14]

Thus, the crowdfunding exemption is critical because it will provide cash-hungry new ventures with access to a large and currently under-tapped source of capital—unaccredited investors.

III.      Crowdfunding Exemption’s High Expected Costs

In order to protect investors, the JOBS Act[15] and the Securities & Exchange Commission’s (SEC) Proposed Crowdfunding Rules[16] impose several requirements on issuers[17] and intermediaries.[18] Unfortunately, the costs associated with these requirements may threaten the usefulness of the exemption in practice. As one practitioner notes:

To produce an offering disclosure document, enlist a funding portal, run background checks and file an annual report with the SEC year after year might well cost upwards of $100,000. The high expenses compared to the low maximum amounts that can be raised by a company and invested by an individual make public equity crowdfunding one of the costliest forms of (legal) capital raising.[19]

The SEC also provides cost estimates for issuers and intermediaries in the Proposed Crowdfunding Rules. These costs are summarized below.

A.     SEC Estimates of Issuer Costs

The SEC estimates that issuers relying on the crowdfunding exemption would incur the following initial and ongoing annual costs for three different offering amounts[20]:

Offering Amount
$50,000 $300,000 $750,000
Initial Costs:
     Compensation to the intermediary[21] $5,000 $30,000 $75,000
     Cost to prepare and file initial disclosure document[22] $6,000 $6,000 $6,000
     Cost of review or audit of financials[23] N/A $14,350 $28,700
     Other initial costs[24] $460 $460 $460
Total Initial Costs $11,460 $50,810 $110,160
Initial Costs as a % of the Offering Amount 22.92% 16.94% 14.69%
Ongoing Annual Costs:[25]
     Cost to prepare and file annual disclosure document[26] $4,000 $4,000 $4,000
     Cost of review or audit of financials[27] N/A $14,350 $28,700
Total Ongoing Annual Costs $4,000 $18,350 $32,700
Ongoing Annual Costs as a % of the Offering Amount 8.00% 6.12% 4.36%

Thus, considering these estimates, a new venture that sells $50,000 of stock would initially net only $38,540 and it must continue to pay outside professionals an additional $4,000 each year to comply with ongoing reporting requirements. Although these costs already seem high, additional issuer costs, intermediary costs, and other costs must also be factored in.

B.     SEC Estimates of Intermediary Costs

To qualify for the crowdfunding exemption, issuers must use a registered broker or funding portal.[28] The SEC estimates the following initial and ongoing annual costs for three different types of intermediaries[29]:

 

Intermediaries That:

Register as Brokers

Register as Funding Portals

Are Already Registered as Brokers
Initial Costs:
     Registration and Membership Costs[30] $275,000 $100,000 N/A
     Compliance Costs[31] $245,000 $67,000 $45,000
     Platform Development Costs[32] $250,000 $250,000 $250,000
     Total Initial Costs $770,000 $417,000 $295,000
Ongoing Annual Costs:
     Registration and Membership Costs[33] $50,000 $10,000 N/A
     Compliance Costs[34] $180,000 $40,000 $30,000
     Platform Development Costs[35] $40,000 $40,000 $40,000
Total Ongoing Annual Costs $270,000 $90,000 $70,000

 

The SEC also estimates that, on average, intermediaries will generate $200,000 per year in revenue from offerings made under the crowdfunding exemption.[36] Thus, it may be difficult for intermediaries to cover these and additional overhead costs even if they are able to collect 10% of the amounts they help issuers raise.

C.     Other Costs

As mentioned above, the SEC estimates do not reflect all of the costs that issuers will have to bear when using the crowdfunding exemption. Additional issuer costs include an expected return for the investors[37] and the value of issuer time required to prepare and file the initial offering document[38] and ongoing annual disclosures.[39] Moreover, the SEC estimates do not include transactional costs that investors will incur. For instance, reasonable investors will require time to learn about an issuer’s business (for example, the issuer’s current and anticipated products, customers and revenue model) as well as the terms of the offering (such as the rights attached to the shares being offered, the number of shares outstanding, and the rights attached to the outstanding shares). Because some people will be investing only a few hundred dollars (or even just “a few dollars”)[40] it would be easy for an investor’s transaction costs to be a significant percentage of, or even exceed, her total investment amount.[41] Furthermore, costly disputes related to offerings may arise in the future.

IV.    Ways to Mitigate the Exemption’s Costs without Sacrificing Investor Protection

If the issuer, intermediary, and other costs are too high, use of the crowdfunding exemption will be limited. This will leave the large unaccredited investor market under-tapped and new ventures without the funds they need to thrive. There are, however, several ways to mitigate the expected costs without sacrificing investor protection. Five suggestions for mitigating costs are provided below.

A.     Allow Intermediaries to Acquire Equity Interests

Funding portals and other intermediaries should be allowed to take an equity interest in the issuers they service in lieu of at least a portion of the cash fees,[42] provided that intermediaries taking such an interest do so as a standard practice. While the Proposed Crowdfunding Rules prohibit intermediaries from doing this,[43] the JOBS Act itself does not.[44] Furthermore, the JOBS Act’s legislative history in fact supports the idea of allowing intermediaries to invest in issuers using their services in order to protect investors.[45] Granting an intermediary an equity interest would still result in an economic cost to issuers and doing so may not always improve an issuer’s cash position.[46] However, there would be many instances where granting equity in lieu of paying cash to an intermediary would improve an issuer’s cash position.[47] Reserving this additional cash is critical for issuers.[48] Moreover, intermediaries who acquire equity interests in issuers would likely service only those issuers they see unique value in—namely, ventures they believe are currently underpriced. This perceived discount by intermediaries could be shared with issuers in the form of a lower stated fee.[49]

B.     Let Unaccredited Investors Test into Accredited Status

The crowdfunding exemption is important because it gives new ventures bona fide access to unaccredited investors—a large source of potential capital. However, this access could be broadened by amending the accredited investor definition[50] to welcome currently unaccredited investors who demonstrate they are capable of investing in exempt offerings (for example, by passing an appropriate exam). These investors could then participate in “506(c) offerings” which are currently not subject to many of the crowdfunding exemption’s requirements such as: (i) the use of an offering document; (ii) an annual reporting obligations; (iii) the use of a registered intermediary; and, (iv) the $1 million offering amount cap.[51] Thus, changing the accredited investor definition could generate many of the benefits of the crowdfunding exemption, at a much lower cost, for those that pass the exam. Although such an exam would likely have imperfections, amending the accredited investor definition to consider an investor’s knowledge of exempt offerings would make the regulation smarter. Instead of concluding from an individual’s net worth and income levels that she is incapable of investing in exempt offerings, the exam would allow her to prove that she has the knowledge and experience in financial and business matters reasonably necessary to evaluate the risks and merits associated with investments in early stage ventures—and thus eliminate much of the need for costly protections assuming the opposite.[52] Perhaps this is why the SEC has requested comment on the current accredited investor definition.[53]

C.     Use Strategic Templates and Deal Structures

Intermediaries should require issuers to use essentially the same formation and financing documents or templates to organize entities and complete financings. Repeatedly using smart templates and deal structures should reduce transaction costs, promote consistency between documents and among transactions, protect entrepreneurs and investors, and help ensure compliance with laws and regulations.[54] This is why leading accelerator programs and attorneys who regularly represent venture capital-backed companies already use templates to form and finance the ventures they help.[55] Given that crowdfunding investors will typically invest smaller amounts than venture capitalists, and therefore transactions costs are likely to represent a larger percentage of their investment, templates seem even more important in the equity crowdfunding setting. Moreover, intermediaries could strategically design the templates and deal structures to make the most of the unique requirements imposed by the JOBS Act[56] and Proposed Crowdfunding Rules.[57] The JOBS Act’s legislative history[58] and Proposed Crowdfunding Rules[59] support intermediaries taking this approach. However, to further reduce the risk of engaging in the unauthorized practice of law, intermediaries should consider taking precautionary steps such as requiring issuers to use the templates and deal structures, instead of merely advising issuers on what to do. Furthermore, issuers should be encouraged to seek legal counsel.[60]

It is beyond the scope of this article to provide details about how equity crowdfunding templates and deal structures should be structured. However, by way of example, a funding portal could require issuers using its service to:

 

  • Be formed as Delaware C corporations, with the funding portal providing templates for issuers’ Certificate of Incorporation, Bylaws and initial corporate resolutions;[61]
  • Prepare an executive summary, pitch presentation, and business plan to be made available on the funding portal’s website, with the funding portal providing templates designed to ensure that the necessary information is provided in a logical and concise format;[62]
  • Use a two-class equity system whereby inexpensive common stock is granted to or reserved for employees and more expensive preferred stock, with special rights,[63] is sold to outside investors thereby allowing issuers to raise external funds with less demoralizing dilution to the employee-owners than would otherwise occur;[64]
  • Make their common stock subject to “vesting” to help ensure that employees earn their stock over time,[65] with the funding portal providing a template Common Stock Purchase Agreement and related forms;[66]
  • Raise exactly $100,000, thereby eliminating the need for reviewed or audited financial statements;
  • Use standard capitalization tables (for example, a fixed number of shares of common stock could be granted to or reserved for each issuer’s employees thereby allowing employees and investors to more quickly understand what their ownership interests represent and more easily compare valuations of different issuers); and,
  • Reserve the right to redeem their preferred stock at a multiple of the price it was originally issued at, thereby giving issuers a path to escape the ongoing annual costs imposed by the crowdfunding exemption.[67]

 

Repeated use of the same templates and deal structures should lead to familiar standards and even a “one size fits many” model.[68] In addition to significantly reducing transaction costs, such a model would help ensure that parties take necessary and desired steps, thereby increasing issuer compliance, investor protections, and economic value.

D.     Leverage Educational Organizations

Having a “one size fits many” model would give schools exciting new ways to connect their students in the classrooms to real world new ventures. Instead of simply reading about different types of business entities and seed financings, students could complete projects using the same templates used by live issuers relying on the crowdfunding exemption. Among other things, this would empower more students and alumni to launch their own ventures. Schools could even form, or develop a relationship with, funding portals.[69] Reputable entrepreneurship programs at prestigious universities have already undertaken initiatives to help their students and others raise capital for new ventures.[70] A funding portal could revolutionize this process and create new ways to engage students, parents, alumni, and others—and to raise funds to support entrepreneurship education.[71] To the extent that schools and other organizations, such as accelerators, can extract educational value from the equity crowdfunding process, the high costs of the exemption would become more tolerable. That is, the costs would support both the exempt offerings and entrepreneurship education objectives. Further, if alumni and others are motivated to invest in student ventures for both economic and non-economic reasons, expected returns should become more issuer-friendly and participating unaccredited investors would receive an education while experiencing the thrill of being angel investors.

Moreover, expenditures already being made could help reduce the incremental cost of building and running a funding portal. For example, a university’s existing business plan competitions, social networks,[72] and news publications could all be used to help drive potential issuers and investors to funding portals and thus reduce issuer search costs and intermediary marketing costs. Additionally, business plan competitions could adopt rules mirroring the crowdfunding exemption’s requirements, thus reducing future compliance costs for ventures choosing to pursue equity crowdfunding. By way of further example, law school clinics already assisting entrepreneurs[73] could be tapped to provide issuers with affordable assistance. If there is a “one size fits many” model, law students and clinicians could more easily “ramp up” and offer clients a defined and meaningful new service, such as offering entrepreneurial ventures assistance with the crowdfunding exemption process.

E.     Arbitrate Disputes in a Forum Designed for Equity Crowdfunding

Issuers, investors, and intermediaries should agree to arbitrate disputes related to offerings made under the crowdfunding exemption. These parties should also agree to use a forum that specializes in equity crowdfunding and is willing to become familiar with its unique players, rules, templates, deal structures, and repeat issues. The Financial Industry Regulatory Authority  (FINRA) currently operates the largest dispute resolution forum in the securities industry.[74] Given the need to mitigate costs further in the equity crowdfunding setting, and its potential educational nature, perhaps an organization like FINRA could work with law school clinics to develop something that resembles a chain of minor league dispute resolution forums.[75] In addition to respecting the laws and practical issues surrounding equity crowdfunding, such an organization could provide expedient and affordable services to issuers, investors, and intermediaries while also creating unique experiential learning opportunities for students.

V.      Conclusion

New ventures are important to our economy. We can support these ventures by giving them better access to capital. In theory, the crowdfunding exemption will open the door to unaccredited investors—a large and currently under-tapped source of capital. However, the crowdfunding exemption is expected to impose significant costs on issuers, intermediaries, and investors. In order to make equity crowdfunding work for the unaccredited crowd, we must mitigate those costs without compromising investor protection.

 

 

Preferred citation: Jeff Thomas, Making Equity Crowdfunding Work for the Unaccredited Crowd, 4 Harv. Bus. L. Rev. Online 62 (2014), https://www.hblr.org//?p=3773.

[*] Jeff Thomas is the Chair of the School of Business at Johnson & Wales University in Charlotte, NC. He also serves on the Board of Directors of Queen City Forward, an accelerator for social ventures. He has extensive experience in counseling entrepreneurial ventures through law firms and law school clinics in Chicago and Silicon Valley.

[1] C. Steven Bradford, Crowdfunding and the Federal Securities Laws, 2012 Colum. Bus. L. Rev. 1, 10 (2012).

[2] See, e.g., Edan Burkett, A Crowdfunding Exemption? Online Investment Crowdfunding and U.S. Securities Regulation, 13 Transactions: Tenn. J. Bus. L. 63, 75 (2011) (“[S]ecurities laws . . . are a formidable barrier to investment crowdfunding in the United States.”).

[3] Unaccredited investors (also referred to as non-accredited investors) are investors who are not within the definition of an “accredited investor.” The term accredited investors includes natural persons: “whose individual net worth, or joint net worth with that person’s spouse, exceeds $1,000,000”; “who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year”; or, who serve as a “director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer.” See 17 C.F.R. § 230.501 (2013).

[4] Jumpstart Our Business Startups (JOBS) Act, Pub. L. No. 112-106, 126 Stat. 306 (2012) (codified at scattered sections of 15 U.S.C.A. (West 2012)).

[5] See JOBS Act §§ 301–05, 15 U.S.C.A. §§ 77–78 (West 2012).

[6] See, e.g., Vision Statement: Can Start-Ups Help Turn the Tide?, Harv. Bus. Rev., Sept. 2012, at 30 (“[N]ew businesses—and the jobs they create—are more important than ever.”). An abstract is available at http://hbr.org/2012/09/can-start-ups-help-turn-the-tide/ar/1.

[7] See, e.g., 2013 State of Entrepreneurship Address, Ewing Marion Kauffman Foundation, Financing Entrepreneurial Growth 2 (2013), http://www.kauffman.org/~/media/kauffman_org/research%20reports%20and%20covers/2013/02/soe%20report_2013pdf.pdf (“For the fast-growing (but mostly small) companies on the 2012 Inc. 500 list . . . one-third said access to external capital had been essential to company growth.”).

[8] See, e.g., Burkett, supra note 2, at 82–92.

[9] 15 U.S.C. §§ 77e–77f (2012).

[10] See Bradford, supra note 1, at 42–47.

[11] See Proposed Crowdfunding Rules, 78 Fed. Reg. 66,428, 66,509 (proposed Nov. 5, 2013) (to be codified at scattered parts of 17 C.F.R.) (citing two surveys).

[12] See id. at 66,510–11.

[13] See Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, 78 Fed. Reg. 44,771, 44,793 (July 24, 2013) (to be codified at 17 C.F.R. pts. 230, 239 & 242) (citing data from the Federal Reserve Board’s Triennial Survey of Consumer Finances 2010).

[14] See id. at 44,794 (citing an analysis by the Securities & Exchange Commission’s (SEC) Division of Economic and Risk Analysis that was based on the stock holdings of retail investors from more than 100 brokerage firms covering more than 33 million accounts during the period June 2010–May 2011).

[15] See §302(b), 15 U.S.C.A. § 77d1(a), (b) (West 2012).

[16] See Proposed Crowdfunding Rules, 78 Fed. Reg. 66,428.

[17] See JOBS Act § 302(b), 15 U.S.C.A. § 77d-1(b) (West 2012). Examples of issuer requirements include: (i) providing the SEC, intermediaries, and investors with a description of issuer’s (a) business, including its anticipated business plan, (b) financial condition (and, in some cases, reviewed or audited financial statements), (c) anticipated use of the offering proceeds, (d) ownership and capital structure, and (e) method for valuing the securities being offered; (ii) not advertising the terms of the offering, although issuers may direct investors to intermediaries; and (iii) reporting the results of operations (and, in some cases, providing reviewed or audited financial statements) each year to the SEC and investors. See id.; see also Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,552–54 (stating proposed regulations regarding these requirements).

[18] See JOBS Act § 302(b), 15 U.S.C.A. § 77d-1(a) (West 2012). Examples of intermediary requirements include: (i) registering with the SEC and a self-regulatory organization; (ii) providing investor-education materials; (iii) ensuring each investor (a) reviews the investor-education materials, (b) affirms she understands that she may lose her entire investment and can bear such a loss, and (c) demonstrates she understands the applicable investment risks; (iv) obtaining background checks on officers, directors and stockholders holding 20% of each issuer; and (v) making each issuer’s information, see supra note 17, available to the SEC and potential investors at least 21 days prior to the sale of issuer’s securities. See id.; see also Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,555–56 (stating proposed regulations regarding these requirements).

[19] Brian Korn, SEC Proposes Crowdfunding Rules, Forbes.com (Oct. 23, 2013, 2:41 PM), http://www.forbes.com/sites/deborahljacobs/2013/10/23/sec-proposes-crowdfunding-rules/.

[20] See Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,521 & n.918 (midpoints of the offering amount ranges provided by the SEC were used for this section). The SEC used both its ranges and these same midpoints to estimate items. See id.

[21] See id. (compensation to the intermediary is assumed to be 10% of the offering amount, which is the midpoint of the SEC’s estimated range of an intermediary compensation fee of 5–15%).

[22] See id. The Form C would be used to provide the required initial offering information about the issuer and the offering. See id. at 66,524. The SEC estimates it will take 60 hours to prepare and file the Form C and any amendment to disclose material information. See id. at 66,540. The SEC estimates that 75% of that burden, or 45 hours, would be carried by the issuer but that the other 25%, or 15 hours, would be carried by outside professionals charging $400 per hour. Id. Thus, the $6,000 amount reflects only the cost of outside professionals working for 15 hours at $400 an hour—it does not include any cost for the estimated 45 hours of issuer time. If, for example, issuer time was valued at $50 per hour, this would increase estimated costs by $2,250. Total Initial Costs would then be $13,710 for a $50,000 Offering Amount, or 27.42% of the Offering Amount.

[23] See id. at 66,521. For offerings of more than $500,000, the financial statements must be audited; for offerings of more than $100,000, but not more than $500,000, the financial statements must be reviewed by an independent public accountant; and offerings of $100,000 or less require merely that the issuer’s principal executive officer certify that the financial statements are true and complete in all material respects. See JOBS Act § 302(b), 15 U.S.C.A. § 77d-1(b)(1)(D) (West 2012).

[24] See Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,521 & nn.919–20 (assuming a cost of $60 to obtain an EDGAR access code on Form ID and $400 to prepare and file progress updates on Form C-U).

[25] These costs must be incurred until: (i) “issuer becomes a reporting company required to file reports under Section 13(a) or Section 15(d) of the Exchange Act [of 1934]”; (ii) “issuer or another party repurchases all of the securities issued in reliance on [the crowdfunding exemption]”; or (iii) “issuer liquidates or dissolves its business in accordance with state law.” Id. at 66,554.

[26] See id. at 66,521. The Form C-AR would be filed annually with the SEC, beginning the year after the initial offering. See id. at 66,540–41. It would include information substantially similar to that reported via the Form C. See id. at 66,541. The SEC estimates it will take 40 hours to prepare and file each Form C-AR. See id. The SEC estimates that 75% of that burden, or 30 hours, can be carried by the issuer but that the other 25%, or 10 hours, would be carried by outside professionals charging $400 per hour. See id. Thus, the $4,000 amount reflects only the cost of outside professionals working for 10 hours at $400 an hour—it does not include any cost for the estimated 30 hours of issuer time. If, for example, issuer time was valued at $50 per hour, this would increase estimated costs by $1,500. Total Ongoing Annual Costs would then be $5,500 for a $50,000 Offering Amount, or 11% of the Offering Amount.

[27] See supra text accompanying note 23. Costs to review or audit financial statements may be required in connection with each year’s Form C-AR. See Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,554.

[28] See JOBS Act, § 302(a), 15 U.S.C.A. § 77d(a)(6)(C) (West 2012).

[29] See Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,526–28.

[30] See id. at 66,528. The initial and ongoing costs for an entity to register as a broker would be higher than the initial and ongoing costs for an entity to become a funding portal since the SEC assumes brokers would provide a broader range of services, such as providing investment advice, soliciting investors, and managing customer funds and securities. See id. at 66,527. For intermediaries already registered as brokers, there would be no incremental registration or membership costs. See id. at 66,541. The SEC also estimates it would take an intermediary approximately 220 hours to register as a broker-dealer compared to 110 hours to register as a funding portal, and that it would cost intermediaries $10,000, on average, to register with a national securities association. See id. at 66,542.

[31] See id. at 66,528.

[32] See id. This equals the midpoint of the range provided by the SEC, which varies from $100,000 to $400,000 and depends on whether an intermediary can tailor an existing platform to comply with the JOBS Act or would need to develop a new platform from scratch. See id. at n.987.

[33] See supra note 30.

[34]See supra note 31.

[35] See supra note 32.

[36] See Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,539, 66,543 (estimating that each offering will average $100,000, that each intermediary will facilitate an average of 20 offerings annually, and that each intermediary will be compensated with 10% of the offering amount).

[37] Early stage investors generally expect large returns given the risk of their early stage investment. See, e.g., Constance E. Bagley & Craig E. Dauchy, The Entrepreneur’s Guide to Business Law 137 (3d ed. 2008) (“Venture capitalists generally are not interested in investing unless the expected return is in the range of 35 to 45% compounded annually.”).

[38] See supra note 22.

[39] See supra note 26.

[40] Bradford, supra note 1.

[41] For example, if X is contemplating an investment of $200 into venture V and X’s time is worth $200 an hour, once X spends just one hour learning about V’s business and the terms of the offering, X’s transactional costs will equal 100% of the contemplated investment amount.

[42] See supra note 21 (estimating that an intermediary’s fee will be 5% to 15% of the offering amount).

[43] See Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,555–56 (to be codified at 17 C.F.R. pt. 227) (“An intermediary . . . may not have a financial interest in an issuer that is offering or selling securities in reliance on [the crowdfunding exemption] through the intermediary’s platform, or receive a financial interest in an issuer as compensation for services provided to or for the benefit of the issuer in connection with the offer or sale of such securities.”).

[44] See JOBS Act § 302(b), 15 U.S.C.A. § 77d-1(a)(11) (West 2012) (prohibiting an intermediary’s “directors, officers, or partners (or any person occupying a similar status or performing a similar function) from having any financial interest in an issuer using its services” but not prohibiting the intermediary itself from having such an interest).

[45] See 158 Cong. Rec. S2231 (daily ed. Mar. 29, 2012) (statement of Sen. Scott Brown) (“[I]ntermediaries should also be allowed to take an equity stake in offerings. This however, does not mean that intermediaries should be able to choose which offerings to participate in but rather it should be a standard process for any offering that the intermediary facilitates. This will incentivize an intermediary to focus on issuer quality over quantity, providing more vetting for investors and greater alignment of interests.”).

[46] For example, an issuer’s cash position would not improve if: (i) the issuer is selling $1 million of stock; (ii) there is sufficient investor demand; and, (iii) the shares being granted to the intermediary for its services “count” towards the JOBS Act’s $1 million offering cap. See supra text accompanying note 5.

[47] For example, when an issuer grants its stock to an intermediary for services and those shares are in addition to shares the issuer would have otherwise sold to investors. This would be the case if the shares to the intermediary would not cause the offering to exceed the $1 million JOBS Act cap or if the shares would not “count” towards the amount being raised (for example, if the SEC adopts final rules both allowing intermediaries to take equity interests and stating that said equity does not count towards the offering amount). Moreover, the issuance of the additional shares must not trigger incremental costs, such as kicking in the requirement to provide audited financial statements, that would offset the amount of cash saved by not paying the intermediary’s fee in cash.

[48] See, e.g., Guy Kawasaki, Reality Check: The Irreverent Guide to Outsmarting, Outmanaging, and Outmarketing Your Competition 107 (2008) (quoting the great Silicon Valley corporate finance lawyer, Craig Johnson: “The leading cause of failure of startups is death, and death happens when you run out of money.”).

[49] For example, if intermediary Z values venture V’s shares at $1 each while investors are expected to value V’s shares at $0.60 each, Z and V could split the $0.40 per share difference in valuations. That is, if intermediaries typically charge a 10% fee and V is raising $600,000, Z would require only 60,000 shares to equal the $60,000 fee and not 100,000 shares (even though 100,000 shares would need to be sold to investors to bring in a $60,000 cash fee). Further, both V and Z would prefer a transaction with 80,000 V shares to a $60,000 cash fee. When using the investor value, this would suggest V is paying only an 8% fee ($48,000/$600,000) even though Z would value 80,000 shares at as much as a 13.33% cash fee ($80,000/$600,000). While one may argue it is illogical to consider more than one value for the same V’s shares, new ventures are unique. First, as a typical Shark Tank episode illustrates, it is common for people (and Sharks) to disagree about the value of new ventures. Second, whatever the “objective” value is, it is based on assumptions that can quickly change and, when those assumptions change, the impact can be significant. For example, one new client contract could cause a venture to quadruple its total sales. Regardless, if intermediaries are allowed to take an equity stake in issuers, they have an economic incentive to welcome those they see as good bets. The intermediaries thus would serve a vetting role, leading to greater capital flow from more confident investors.

[50] See supra note 3 and accompanying text.

[51] See Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, 78 Fed. Reg. 44,771, 44,804 (July 24, 2013) (to be codified at 17 C.F.R. §230.506(c)). 506(c) offerings also allow issuers to “offer securities through means of general solicitation, provided that . . . all purchasers of the securities [are] accredited investors” and several other requirements are met. See id. at 44,776 (“Issuers relying on Rule 506(c) for their offerings will not be subject to the prohibition against general solicitation found in Rule 502(c).”).

[52] However, to protect against investors losing too much, there could be limits on the amount people may invest in such offerings (for example, limits based on a percentage of an investor’s net worth and/or income levels).

[53] See Amendments to Regulation D, Form D and Rule 156, 78 Fed. Reg. 44,806, 44,830 (proposed Jul. 24, 2013) (request from the SEC for comment on whether the net worth and income tests are “the appropriate tests for determining whether a natural person is an accredited investor” and, if not, “what other criteria should be considered as an appropriate test for investment sophistication”).

[54] See Model Legal Documents, National Venture Capital Association, http://www.nvca.org/index.php?option=com_content&view=article&id=108&Itemid=136 (last visited Mar. 28, 2014) (expressing similar goals with respect to a set of model documents the National Venture Capital Association makes available for venture capital financings: “The model documents aim to: reflect and in a number of instances, guide and establish industry norms; be fair, avoid bias toward the [investor] or the company/entrepreneur; . . . include explanatory commentary where necessary or helpful; anticipate and eliminate traps for the unwary (e.g., unenforceable or unworkable provisions); provide a comprehensive set of internally consistent financing documents; promote consistency among transactions; and reduce transaction costs and time.”).

[55]  See, e.g., Leena Rao, YC-backed Clerky Helps Startups Save Time And Money On Legal Incorporation, Stock Issuance Forms And More, TechCrunch (Mar. 11, 2013), http://techcrunch.com/2013/03/11/yc-backed-clerky-helps-startups-save-time-and-money-on-legal-incorporation-stock-issuance-forms-and-more/. For an example of actual templates for startups, see Open Sourced Model Seed Financing Documents, Techstars.com, http://www.techstars.com/docs/ (last visited Mar. 28, 2014) (publishing templates prepared by Cooley LLP).

[56] See supra notes 17 & 18.

[57]See supra notes 17 & 18.

[58] See 158 Cong. Rec. S2231 (daily ed. Mar. 29, 2012) (statement of Sen. Michael Bennet) (“[F]unding portals should be allowed to engage in due diligence services. This would include providing templates and forms, which will enable issuers to comply with the underlying statute. In crafting this law, it was our intent to allow funding portals to provide such services.”).

[59] See Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,560 (to be codified at 17 C.F.R. §227.402(b)) (“A funding portal may . . . [a]dvise an issuer about the structure or content of the issuer’s offering, including assisting the issuer in preparing the offering documentation.”).

[60] For example, legal counsel could advise on the risks associated with using the templates and assist with matters not covered by the templates, such as becoming “qualified to do business” in the state where the issuer’s offices are physically located. In this way, attorneys will become familiar with the templates and be able to efficiently provide add-on services.

[61] Orrick, Herrington & Sutcliffe LLP provides examples of such templates. See Start-Up Forms: Corporate Formation, Orrick, Herrington & Sutcliffe LLP, http://www.orrick.com/Practices/Emerging-Companies/Startup-Forms/Pages/Forms-Corporation.aspx (last visited Mar. 28, 2014).

[62] See, e.g., Kawasaki, supra note 48, at chs. 8, 9, & 17 (providing rules of thumb for what should be included in an executive summary, investor pitch, and business plan—as well as how to format such items).

[63] An example of such a right is a “liquidation preference.” A liquidation preference ensures that, if a company is acquired (or otherwise liquidated), any assets remaining after payment of the company’s debts get distributed first to the preferred stock holders—until they receive an amount at least equal to their original investment plus any accrued and unpaid dividends. See e.g., Bagley & Dauchy, supra note 37, at 150; Fenwick & West LLP, Venture Capital for High Technology Companies 13 (2010) [hereinafter Fenwick VC Guide], http://www.fenwick.com/FenwickDocuments/venture_capital_final_2010.pdf.

[64] See, e.g., Bagley & Dauchy, supra note 37, at 64–65; Fenwick VC Guide, supra note 63, at 13.

[65] See, e.g., Bagley & Dauchy, supra note 37, at 93–94; Fenwick VC Guide, supra note 63, at 2.

[66] Orrick, Herrington & Sutcliffe LLP provides such templates, including a Common Stock Purchase Agreement with vesting provisions, an “Assignment of IP and Other Assets” form, and paperwork to help with 83(b) elections. Start-up Forms: Founders’ Stock Purchase, Orrick, Herrington & Sutcliffe LLP, http://www.orrick.com/Practices/Emerging-Companies/Startup-Forms/Pages/Forms-Founders.aspx (last visited Mar. 28, 2014).

[67] See supra note 25.

[68] When items need to differ from the standard, they will be highlighted on a concise schedule of exceptions, thereby making it easy for parties to see what changes are needed for particular deals.

[69] To reduce liability exposure, the funding portals would be set up as separate entities.

[70] See, e.g., U-M Based Student-Led Investment Funds, The Samuel Zell & Robert H. Lurie Institute for Entrepreneurial Studies, http://www.zli.bus.umich.edu/wvf/ (last visited Mar. 28, 2014) (providing summaries for three different “Wolverine/Student Venture Funds”: the Wolverine Venture Fund, the Zell Lurie Commercialization Fund, and the Social Venture Fund); About the Irish Entrepreneurs Network, The Irish Entrepreneurs Network, https://www.business.nd.edu/gigot/irishangels/about_ia.cfm (last visited Mar. 28, 2014) (describing the Irish Entrepreneurs Network as consisting of “a select group of Notre Dame alumni and friends having experience with entrepreneurial endeavors” and having a mission to “serve as a focal point for entrepreneurially-minded members of the Notre Dame family worldwide”).

[71] Instead of itemizing charitable deductions, people who invest in for-profit ventures that fail could take a more favorable ordinary loss deduction. See I.R.C. § 1244 (2012).

[72] Social network ties have been found to be important in non-equity crowdfunding. See, e.g., Ethan Mollick, The Dynamics of Crowdfunding: An Exploratory Study, 29 J. Bus. Venturing 14 (2014).

[73] See e.g., Law School Entrepreneurship Clinics, Ewing Marion Kauffman Foundation, http://www.entrepreneurship.org/entrepreneurship-law/law-school-entrepreneurship-clinics.aspx (last visited Mar. 28, 2014) (listing U.S. law school clinics that provide assistance to entrepreneurs and innovators).

[74] See Arbitration & Mediation, FINRA, http://www.finra.org/ArbitrationAndMediation/index.htm (last visited Mar. 28, 2014).

[75] To avoid potential conflicts, some clinics could help with exempt offerings while others could assist with arbitrating disputes.

By

The CFTC’s Cross-Border Guidance for Swaps and Substituted Compliance Regime

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James Schwartz*

The derivatives market was seen as having contributed substantially to the financial crisis of 2007–08.[1] This led to efforts to regulate derivatives in many of the countries in which their use was commonplace.[2] Historically, the swaps market consisted primarily of bilateral transactions agreed upon by telephone or electronic messages, which, in the absence of any reporting or clearing requirement, remained known only to the two principals.[3] At a September 2009 summit in Pittsburgh, however, G-20 leaders agreed in concept to wholesale reforms.[4] These reforms included the requirements that by the end of 2012, “all standardized OTC [over-the-counter] derivative contracts should be traded on exchanges or electronic trading platforms[] where appropriate,” “cleared through [a] central counterpart[y]” standing between the two original parties, and “reported to [a] trade repositor[y].”[5]

The G-20’s original timeframe did not hold, and today, almost a year after the G-20’s 2012 year-end target date, implementation of the contemplated reforms remains problematic.[6] Many of the delays reflect issues on the national level—mainly that the derivatives market is large, complex, and not especially familiar to many policymakers. However, beyond the need for action at the national level, the regulation of the swaps market, in which transactions between counterparties in wide-ranging jurisdictions have long been routine, requires international coordination and cooperation. If this were lacking, the consequences could include regulatory arbitrage, outsized compliance costs for, or incomplete compliance by, market participants, the fracturing of liquidity among different jurisdictions, and perhaps even political tensions.

The most aggressive regulator of the swaps market to date has been the U.S. Commodity Futures Trading Commission (CFTC), the primary U.S. regulator of derivatives. The CFTC is empowered to regulate the swaps market under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).[7] The CFTC’s rules are significantly closer to being implemented than those of many regulators outside the U.S.[8] As a result of the CFTC’s guidance regarding the extraterritorial application of its regulations[9] and the timeframe that the CFTC has set for implementation of that guidance, December 21 of this year may be a key date for many market participants.[10] On that day, according to the CFTC’s current timetable, many of the CFTC’s rules may become applicable to many transactions involving U.S. counterparties acting through non-U.S. offices or non-U.S. swap dealers registered with the CFTC by reason of their substantial U.S.-facing swap activities.[11]

Under the terms of the CFTC exemptive order issued on July 22, 2013, many such market participants are exempted from compliance with a number of the CFTC’s rules until the earlier of December 21, 2013 or thirty days following the issuance of an applicable substituted compliance determination.[12] As detailed below, a substituted compliance determination is an assessment by the CFTC that the relevant foreign jurisdiction’s rules are sufficiently comprehensive and comparable to the CFTC’s own rules to be followed in lieu of the CFTC’s rules.[13]

The CFTC’s timeframe, and the uncertain prospects of such substituted compliance determinations,[14] have put many market participants in an uncomfortable position. Because foreign swaps regulations are generally in a less advanced state than the CFTC’s own rules, the extent to which substituted compliance determinations may even be possible by December 21 is not entirely clear. Where the corresponding non-U.S. rules are in place, it is unclear whether the CFTC will actually make substituted compliance determinations related to those rules. Where the corresponding foreign rules are not yet in place, these could come into effect shortly after December 21. If the CFTC on December 21 requires compliance with U.S. rules, this could mean that market participants will be required to comply with both sets of rules. Moreover, the CFTC’s cross-border guidance contemplates requirement-by-requirement determinations on comparability of non-U.S. swaps regulatory regimes.[15] This mix-and-match approach makes it likely that many market participants will be required to comply both with certain (as yet unspecified) elements of the CFTC’s rules and certain (as yet unspecified) elements of non-U.S. regulatory regimes.

Issues in the cross-border market brought about by the CFTC’s mandatory clearing requirement, which went into effect on October 9 of this year for many market participants,[16] indicate that a significant delay in substituted compliance determinations could be the worst outcome for the U.S. swaps market. Upon the CFTC’s clearing requirement becoming effective, the absence of a substituted compliance determination with respect to clearing prompted certain non-U.S. market participants to avoid dealing with U.S. swap dealers.[17] This has moved swap trading activities with non-U.S. market participants into non-U.S. affiliates.[18] A further, related concern that may be limiting trading by swap dealers through their non-U.S. branches, in the absence of a substituted compliance determination, is that if transactions entered into by such branches are subject to mandatory clearing, they may soon also be subject to U.S. rules which in certain cases will likely require execution on a swap execution facility.[19]

The CFTC’s approach to cross-border matters is complex and nuanced. It divides the CFTC’s requirements into two separate categories: Transaction-Level Requirements and Entity-Level Requirements.[20] It then splits each of these categories into two subcategories.[21] The Transaction-Level requirements are split into Category A Transaction-Level Requirements (which include clearing and swap processing, trade execution, swap trading relationship documentation, and real-time public reporting of swap data) and Category B Transaction-Level Requirements (which consist of the CFTC’s external business conduct standards).[22] Similarly, the Entity-Level Requirements are divided into First Category Entity-Level Requirements (which include capital adequacy, chief compliance officer, risk management, and most swap data recordkeeping) and Second Category Entity-Level Requirements (which include, among others, swap data repository reporting and reporting for large traders of swaps linked to certain commodities).[23]

The CFTC’s regime, with respect to the Transaction-Level Requirements, may be summarized—albeit in a vastly simplified manner—as a continuum.[24] At one end of the spectrum such requirements will apply to swaps involving a CFTC-registered swap dealer (whether or not a U.S. Person[25]) acting through a U.S. branch or a U.S. Person other than a swap dealer.[26] Contrariwise, at the other end of the spectrum, such requirements will not apply (unless one party is a swap dealer acting through a U.S. branch[27] or a U.S. Person[28]) to swaps involving a party that is not a U.S. Person and not otherwise linked to the U.S. as a “guaranteed affiliate”[29] or an “affiliate conduit.”[30] With respect to swaps that do not fall at either end of the spectrum, such as swaps involving a CFTC-registered swap dealer acting through a non-U.S. branch, a substituted compliance determination is possible in relation to many such requirements.[31] With respect to the Entity-Level Requirements, for U.S. dealers, such requirements will apply, and for non-U.S. CFTC-registered swap dealers, substituted compliance determinations will be possible for many such requirements.[32]

On its face, this approach has a certain logic to it—the more closely linked to the U.S. a counterparty or transaction is, the more likely it is that the CFTC’s rules or similar rules, by way of substituted compliance, should apply. In practice, however, the approach seems likely to cause significant issues in the absence of substantial and close coordination among regulators—which, to date, does not appear overly abundant.[33]

These issues can be illustrated using the first cross-border example above, a transaction involving a U.S. swap dealer acting through a U.S. branch. If the swap were transacted between, for example, the New York head office of a U.S. swap dealer and the Paris head office of a French swap dealer, the EU’s rules should presumably govern the transaction to the same extent the U.S. rules do. If the EU were to take a position parallel to that of the CFTC and require the application of the EU’s rules to a transaction involving an EU swap dealer, the transaction would be governed by both U.S. and EU rules. Any material differences between these two sets of rules could be a significant issue for the parties to such a transaction and, by extension, for the swaps market as a whole.

Even in this relatively straightforward case, some understanding among relevant regulators with regard to cross-border swaps would seem highly desirable. The genius of the CFTC’s approach is that, by implementing its rules first and, by means of substituted compliance determinations, setting a bar for other regulators to reach, it has claimed the power to shape significantly discussions in foreign jurisdictions regarding the substance of swaps regulations. On the other hand, by making its own rules without agreements from other regulators and then delaying compliance dates, the CFTC is putting pressure on other regulators to fall into line to avoid causing conflict.[34] Given the need for cooperation, this approach seems incongruous and even slightly imperious.[35] There is a distinct lack of an institutional framework for making international regulatory swaps determinations,[36] in the absence of which the CFTC contemplates that foreign regulators, industry groups and even individual market participants may request a substituted compliance determination.[37]

Even for requirements in which substituted compliance is possible, the CFTC’s guidance is unclear. It offers scant insight into whether the CFTC will in fact make a substituted compliance determination, and, if it does make such a determination, what conditions it may impose on market participants seeking to rely on such determination. In order for a party to a swap to substitute compliance with the requirements of a non-U.S. jurisdiction for compliance with the CFTC’s own requirements, the CFTC must determine that the foreign jurisdiction’s requirements “are comparable with and as comprehensive as the corollary area(s) of regulatory obligations encompassed by the Entity- and Transaction-Level Requirements.”[38] However, they need not be “identical requirements to those established under the Dodd-Frank Act.” [39] In cases where the CFTC does not find foreign laws and regulations to merit substituted compliance, the relevant non-U.S. Person or foreign branch of a U.S. Person “may be required to comply” with the applicable CFTC regulations.[40]

The CFTC may consider both swap-specific regulations of the relevant foreign regulator and other provisions that may “achieve comparable and comprehensive regulatory objectives as the Dodd-Frank Act requirements, but on a more general, entity-wide, or prudential, basis.”[41] Moreover, the CFTC may vary its approach depending on the particular foreign jurisdiction.[42] In certain cases it may seek to influence the contents of foreign regulations by “coordinating with the foreign regulators in developing appropriate regulatory changes or new regulations, particularly where changes or new regulations already are being considered or proposed by the foreign regulators or legislative bodies.”[43] In other cases, the CFTC “may include conditions that take into account timing and other issues related to coordinating the implementation of reform efforts across jurisdictions”[44] or otherwise “include in its substituted compliance determination a description of the means by which certain swaps market participants can achieve substituted compliance within the construct of the foreign regulatory regime.”[45]

The CFTC does not intend to make substituted compliance determination with respect to foreign regulations as a whole, but instead with respect to particular foreign regulations.[46] Partly because “many foreign jurisdictions” are in the process of implementing derivatives market reforms “in an incremental manner,” a “comparability analysis will be based on a comparison of specific foreign requirements against specific” provisions of the Dodd-Frank Act and CFTC regulations for each of the categories of regulatory obligations for which substituted compliance may be available.[47] As a result, the swap counterparties to whom substituted compliance may apply will likely be expected to comply with a mixture of U.S. and non-U.S. regulations.

At the same time, however, the CFTC, somewhat puzzlingly, has stated that it expects to “rely upon an outcomes-based approach to determine whether these requirements achieve the same regulatory objectives of the Dodd-Frank Act.”[48] In this context, “outcomes-based” is often understood to refer not to what regulations state, but instead to the actual consequences that they cause.[49] It is not clear why an outcomes-based approach would necessitate a requirement-by-requirement review such as the CFTC contemplates. The SEC, in contrast to the CFTC, stated in its proposed cross-border rules that it would not focus on “a rule-by-rule comparison” but instead “on regulatory outcomes” with a “holistic approach.”[50]

If the CFTC guidance regarding substituted compliance sounds vague enough to support whatever ad hoc arrangement the regulator believes is warranted in any particular case, perhaps that is exactly the point. A commitment to the substituted compliance regime did not prevent the CFTC from agreeing to another approach entirely just days before the release of its cross-border guidance.[51] In one of the relatively few concrete signs of cooperation with foreign regulators, the CFTC and EU authorities agreed in July of 2013 to an understanding known as the “path forward.”[52] In that understanding, they agreed to a “stricter-rule-applies” approach with regard to mandatory clearing, one of the fundamental reforms sought by the G-20.[53] This approach, not referenced in the CFTC’s cross-border guidance, would be applicable “where exemptions from mandatory clearing would exist in one jurisdiction but not in the other.”[54] Although this approach may indeed “prevent loopholes and any potential for regulatory arbitrage,”[55]imposing stricter regulations on cross-border swap transactions than on transactions undertaken in a single jurisdiction would seem not to promote a liquid international market.

In the longer run, it seems likely that the swaps regulations of the major jurisdictions will converge. For the foreseeable future, however, both before and after December 21, questions will continue to abound, and the swaps market will continue to be burdened by regulatory uncertainty. As it was the G-20 process that delineated and put in process the swaps market reforms in G-20 member nations, international bodies such as the Basel Committee on Banking Supervision and the Financial Stability Board could likely play a productive role in minimizing confusion and disruption and in bringing much needed clarity to the swaps market.[56]

 

Preferred citation: James Schwartz, The CFTC’s Cross-Border Guidance for Swaps and Substituted Compliance Regime, 4 Harv. Bus. L. Rev. Online 52 (2013), https://www.hblr.org//?p=3676.

* Of Counsel, Morrison & Foerster LLP.

[1] See, e.g., Colin Barr, Geithner to Rein in Derivatives, CNNMoney (May 13, 2009), http://money.cnn.com/2009/05/13/news/derivatives.fortune/.

[2] See, e.g., G-20, Leaders’ Statement: The Pittsburgh Summit (September 24–25, 2009) [hereinafter Leaders’ Statement], available at http://www.treasury.gov/resource-center/international/g7-g20/Documents/pittsburgh_summit_leaders_statement_250909.pdf.

[3] See, e.g., Randall Dodd, Derivative Study Center, The Structure of OTC Derivatives Markets 2 (2002), http://www.financialpolicy.org/dscotcstructure.pdf.

[4] See Leaders’ Statement, supra note 2.

[5] Leaders’ Statement, supra note 2.

[6] See, e.g., James K. Jackson & Rena S. Miller, Cong. Research Serv., Comparing G-20 Reform of the Over-the-Counter Derivatives Markets (2013), http://www.fas.org/sgp/crs/misc/R42961.pdf.

[7] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §§ 701–74, 124 Stat. 1376, 1641–802 (2010) (codified as amended in scattered sections of 7, 12 and 15 U.S.C. (2012)). The Dodd-Frank Act permits the U.S. Commodity Futures Trading Commission (CFTC) to exercise authority with respect to activities outside of the United States if those activities “have a direct and significant connection with activities in, or effect on, commerce of the United States” or “contravene such rules or regulations as the [CFTC] may prescribe [] as are necessary or appropriate to prevent the evasion of any provision of [the Dodd-Frank Act]”. Id. at § 722(d) (codified at 7 U.S.C. § 2(1)). Title VII of the Dodd-Frank Act gives the CFTC jurisdiction over “swaps” and the U.S. Securities and Exchange Commission (SEC) jurisdiction over “security-based swaps.” Id. at §§ 722(a), 761(a) (codified at 7 U.S.C. § 2(a)(1), 15 U.S.C. § 78c(a)). The Dodd-Frank Act defines each term, id. at §§ 721(a), 722(a), and a joint rulemaking by the CFTC and the SEC has further defined them. See Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 Fed. Reg. 48,208 (Aug. 13, 2012) (to be codified at 17 C.F.R. pts. 1, 230, 240, and 241). Unlike the CFTC, the SEC has not yet finalized its rules regarding extraterritoriality, and its proposed cross-border rules are outside the scope of this article. See Cross-Border Security-Based Swap Activities; Re-Proposal of Regulation SBSR and Certain Rules and Forms Relating to the Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, 78 Fed. Reg. 30,968 (proposed May 23, 2013) (to be codified at 17 C.F.R. pts. 240, 242, and 249). More broadly, in contrast with the CFTC, the SEC has finalized few of its rulemakings under the Dodd-Frank Act, and has postponed the application of many provisions that would treat security-based swaps as “securities” or would otherwise subject security-based swaps to the Dodd-Frank Act. See Extension of Exemptions for Security-Based Swaps, 78 Fed. Reg. 7,654 (February 4, 2013); Order Extending Temporary Exemptions Under the Securities Exchange Act of 1934 in Connection With the Revision of the Definition of “Security” to Encompass Security-Based Swaps, and Request for Comment, 78 Fed. Reg. 10,218 (February 13, 2013); Temporary Exemptions and Other Temporary Relief, Together With Information on Compliance Dates for New Provisions of the Securities Exchange Act of 1934 Applicable to Security-Based Swaps, 76 Fed. Reg. 36,287 (June 22, 2011).

[8] As the CFTC has noted, “many foreign jurisdictions have been implementing OTC derivatives reforms in an incremental manner,” and “because many jurisdictions are in the process of finalizing and implementing their derivatives reforms incrementally,” the CFTC’s determinations, discussed infra text accompanying notes 38–50, as to which foreign rules are sufficiently comprehensive and comparable to the CFTC’s own rules “may need to take into account the timing of regulatory reforms that have been proposed or finalized, but not yet implemented.” Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45,292, 45,343–44 (July 26, 2013) (to be codified at 17 C.F.R. § 1). For an analysis of one area in which there is a significant difference in timing between U.S. rules and analogous foreign rules, see James E. Schwartz, Marissa N. Golden & Robert J. Dilworth, First Steps on the Path Forward, 32 Int’l Fin. L. Rev. 36, 36–37 (2013), available at http://www.iflr.com/Article/3247985/The-path-forward-for-EU-US-derivatives-regulation.html (analyzing the status of the trade execution mandate in the U.S. and the EU, and noting that while the CFTC’s mandate will be in effect shortly, the EU’s is not expected to be in place until possibly as late as 2016).

[9] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45,292.

[10] See Exemptive Order Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 43,785, 43,794–95 (July 22, 2013) (stating that numerous requirements for certain non-U.S. market participants and certain non-U.S. branches of U.S. swap dealers will go into effect on the earlier of December 21, 2013 or 30 days after the issuance of an applicable substituted compliance determination).

[11] See id.

[12] See id.

[13] See id. at 43,789.

[14] Even close followers of regulatory matters could be forgiven for not recognizing the words “substituted compliance” when the CFTC used and defined the term in its 2012 proposed interpretive guidance regarding cross-border matters. See Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, 77 Fed. Reg. 41214, 41229 (proposed July 12, 2012). The term appears to have its origins in a seminal 2007 article in the Harvard International Law Journal, in which the authors argued that foreign stock exchanges and broker-dealers should be able to provide services in the United States “based on their compliance with substantively comparable foreign securities regulations and laws and supervision by a foreign securities regulator with oversight powers and a regulatory and enforcement philosophy substantively similar to the SEC’s,” instead of based on compliance with U.S. securities regulations and SEC supervision. Ethiopis Tafara & Robert J. Peterson, A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework, 48 Harv. Int’l L.J. 31, 32 (2007). Although the SEC signed a “mutual recognition agreement” with Australian regulators in 2008, it apparently shelved its plans to increase mutual recognition activities shortly thereafter, driven partly by the financial crisis. See Jerry Ellig & Houman B. Shadab, Talking the Talk, or Walking the Walk? Outcome-Based Regulation of Transnational Investment, 41 N.Y.U. J. Int’l L. & Pol. 265, 268 (2009).

[15] See Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, 77 Fed. Reg. at 41,229.

[16] See Exemptive Order Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. at 43,794.

[17] See, e.g., Anish Puaar, EU Firms Forced to Take Action to Avoid US Clearing Rules, Financial News (October 10, 2013), http://www.efinancialnews.com/story/2013-10-10/eu-firms-forced-to-take-action-to-avoid-us-clearing-rules?ea9c8a2de0ee111045601ab04d673622 (“[S]ome European buyside firms are not prepared to clear their swap trades, leading them to either switch to US banks’ European entities or stop trading with them altogether.”).

[18] See id.

[19] The Dodd-Frank Act amended the Commodity Exchange Act, 7 U.S.C. §§ 1–27f (2012), to provide that swaps that the CFTC subjects to mandatory clearing must be executed on either a swap execution facility or a designated contract market, unless no swap execution facility or designated contract market makes the swap available to trade. See Dodd-Frank Act at § 723(a)(8); 7 U.S.C. § 2(h)(8). Mandatory execution on a swap execution facility for certain transactions is expected to commence in the near future, as swap execution facilities have started submitting “made available to trade” determinations, which the CFTC will consider pursuant to its rules. See Process for a Designated Contract Market or Swap Execution Facility To Make a Swap Available to Trade, Swap Transaction Compliance and Implementation Schedule, and Trade Execution Requirement Under the Commodity Exchange Act, 78 Fed. Reg. 33,606 (June 4, 2013) (to be codified at C.F.R. pts. 37 and 38); Provisions Common to Registered Entities, 76 Fed. Reg 44,776, 44,793-96 (July 27, 2011) (to be codified at C.F.R. pt. 40); Silla Brush, Javelin Files to Trade Interest-Rate Swaps, Spurring Sef Shift, Bloomberg (October 19, 2013), http://www.bloomberg.com/news/2013-10-19/javelin-files-to-trade-interest-rate-swaps-spurring-sef-shift.html.

[20] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45,292, 45,331–40 (July 26, 2013) (to be codified at 17 C.F.R. § 1).

[21] See id. at 45,335–36.

[22] See id. at 45,336.

[23] See id. at 45,335–36.

[24] See id. at 45,369 apps. D & E.

[25] The CFTC’s cross-border guidance defines a U.S. Person “generally to include, but not be limited to: (i) Any natural person who is a resident of the United States; (ii) any estate of a decedent who was a resident of the United States at the time of death; (iii) any corporation, partnership, limited liability company, business or other trust, association, joint-stock company, fund or any form of enterprise similar to any of the foregoing (other than an entity described in prongs (iv) or (v), below) (a ‘legal entity’), in each case that is organized or incorporated under the laws of a state or other jurisdiction in the United States or having its principal place of business in the United States; (iv) any pension plan for the employees, officers or principals of a legal entity described in prong (iii), unless the pension plan is primarily for foreign employees of such entity; (v) any trust governed by the laws of a state or other jurisdiction in the United States, if a court within the United States is able to exercise primary supervision over the administration of the trust; (vi) any commodity pool, pooled account, investment fund, or other collective investment vehicle that is not described in prong (iii) and that is majority-owned by one or more persons described in prong (i), (ii), (iii), (iv), or (v), except any commodity pool, pooled account, investment fund, or other collective investment vehicle that is publicly offered only to non-U.S. persons and not offered to U.S. persons; (vii) any legal entity (other than a limited liability company, limited liability partnership or similar entity where all of the owners of the entity have limited liability) that is directly or indirectly majority-owned by one or more persons described in prong (i), (ii), (iii), (iv), or (v) and in which such person(s) bears unlimited responsibility for the obligations and liabilities of the legal entity; and (viii) any individual account or joint account (discretionary or not) where the beneficial owner (or one of the beneficial owners in the case of a joint account) is a person described in prong (i), (ii), (iii), (iv), (v), (vi), or (vii).” Id. at 45,316–17.

[26] See id. at 45,369 apps. D & E.

[27] See id. at 45,350 n.513.

[28] See id. at 45,369 apps. D & E.

[29] A “guaranteed affiliate” is a “non-U.S. person that is an affiliate of a U.S. person and that is guaranteed by a U.S. person.” Id. at 45,318.

[30] See id. at 45,369 apps. D & E. The CFTC has not precisely defined “affiliate conduit” but has stated that certain factors are relevant to the consideration of whether a non-U.S. Person constitutes an affiliate conduit. See id. at 45,369 app. D n.1. Such factors include “whether (i) the non-U.S. person is majority-owned, directly or indirectly, by a U.S. person; (ii) the non-U.S. person controls, is controlled by, or is under common control with the U.S. person; (iii) the non-U.S. person, in the regular course of business, engages in swaps with non-U.S. third party(ies) for the purpose of hedging or mitigating risks faced by, or to take positions on behalf of, its U.S. affiliate(s), and enters into offsetting swaps or other arrangements with such U.S. affiliate(s) in order to transfer the risks and benefits of such swaps with third-party(ies) to its U.S. affiliates; and (iv) the financial results of the non-U.S. person are included in the consolidated financial statements of the U.S. person.” Id.

[31] See id. at 45,369 app. D. Substituted compliance does not apply with respect to the external business conduct rules that constitute the Category B Transaction-Level Requirements. See id. at 45,369 app. E. This may be partly because such rules, which require dealers in certain transactions to provide pre-trade and daily mid-market marks, and, upon request, scenario analyses, are not expected to have analogs in many non-U.S. jurisdictions. See Business Conduct Standards for Swap Dealers and Major Swap Participants With Counterparties, 77 Fed. Reg. 9,734 (February 17, 2012) (to be codified at 17 C.F.R. pts. 4 and 23).

[32] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations,78 Fed. Reg. at 45,368.

[33] Even with regard to the EU, one of the only foreign regulators with which the CFTC has appeared to have tangibly productive discussions, see infra n.51–53 and accompanying text, the lack of a detailed agreement between regulators is reportedly harming the negotiation of a U.S.-EU free trade agreement. Luke Baker & Stephen Adler, Derivatives Dispute Harming EU-U.S. Free-Trade Talks, Reuters (October 29, 2013), http://uk.reuters.com/article/2013/10/29/uk-eu-us-regulation-idUKBRE99S0G220131029.

[34] See Edward F. Greene & Ilona Potiha, Issues in the Extraterritorial Application of Dodd-Frank’s Derivatives and Clearing Rules, the Impact on Global Markets and the Inevitability of Cross-Border and US Domestic Coordination, 8 Cap. Mkts. L.J. 338, 353 (2013).

[35] See id.

[36] See id. at 386.

[37] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. at 45,344.

[38] Id. at 45,342.

[39] Id. at 45,342–43. “In evaluating whether a particular category of foreign regulatory requirement(s) is comparable and comprehensive to the applicable requirement(s) under the [Commodity Exchange Act] and Commission regulations, the Commission will take into consideration all relevant factors, including but not limited to, the comprehensiveness of those requirement(s), the scope and objectives of the relevant regulatory requirement(s), the comprehensiveness of the foreign regulator’s supervisory compliance program, as well as the home jurisdiction’s authority to support and enforce its oversight of the registrant.” Id. at 45,343.

[40] Id. at 45,344.

[41] Id. at 45,343.

[42] See id.

[43] Id. at 45,343–44.

[44] Id. at 45,343.

[45] Id. at 45,344.

[46] See id. at 45,343.

[47] Id. at 45,343–44.

[48] Id. at 45,342.

[49] See Ellig & Shadab, supra note 14, at 282 (“Outcomes are the actual benefits created, or harms avoided, for citizens. . . . [R]egulations issued are outputs that may affect outcomes, but they are not outcomes.”).

[50] Cross-Border Security-Based Swap Activities; Re-Proposal of Regulation SBSR and Certain Rules and Forms Relating to the Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, 78 Fed. Reg. 30,968, 30,975 (proposed May 23, 2013) (to be codified at 17 C.F.R. pts. 240, 242, and 249).

[51] See Press Release, U.S. Commodity Future Trading Commission, The European Commission and the CFTC Reach a Common Path Forward on Derivatives (July 11, 2013), available at http://www.cftc.gov/PressRoom/PressReleases/pr6640-13.

[52] Id.

[53] Id.

[54] Id.

[55] Id.

[56] See Greene & Potiha, supra note 34, at 385–92.

By

The Regulatory Challenge Of Distributed Generation

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David B. Raskin*   

I.   Introduction

Recent published reports point toward a growing conviction that the demand for utility service from the U.S. electric grid may soon decline, perhaps substantially, due to the expanding use of distributed generation.[1] One report prepared by a division of Citigroup describes the improving economics of distributed solar power, which the authors expect will continue.[2] A second Citigroup report projects reductions in the demand for utility service in developed markets of up to fifty percent by 2050.[3] Favorable projections for distributed generation, however, depend on assumptions about technological change that may turn out to be overstated, and even if distributed generation grows substantially, millions of homes and businesses will continue to rely on the electric grid for many decades.[4]

Germany has gone further to promote distributed generation[5] than any other industrialized nation, and its experience provides a cautionary tale. More than a decade after Germany initiated its Energiewende,[6] the average residential price for electricity is almost 36 cents per kWh,[7] and rates are projected to rise another thirty to fifty percent in the next ten years.[8] Without a change in policy, German residential electric rates may therefore approach 50 cents per kWh by the end of this decade. In contrast, the average residential rate in the U.S. is approximately 12.5 cents per kWh.[9] Because the average U.S. residence uses approximately 1,000 kWh of electricity per month,[10] the current German rate would be equivalent to an average household tax of $3,000 per year. Rates anywhere near the levels being experienced in Germany would be unacceptable in the U.S.[11]

Even with extraordinarily high and increasing electric rates, aggregate carbon dioxide emissions by the German electric sector are rising.[12] In contrast, U.S. emissions are falling even though renewables constitute a much smaller percentage of the electric energy mix in the U.S.[13] The stability of the German grid is also being put at risk: it has relied more heavily on variable, renewable generation at the same time that grid resources capable of rapidly balancing supply and demand have been shutting down due to anomalous market price signals.[14] Energiewende has also taken a toll on the utility companies that may have to make the grid investments to fix these operating problems. Equity values for Germany’s biggest utilities have fallen by fifty percent or more over the past three years.[15]

While Germany struggles with Energiewende, the growth of distributed generation in the U.S. is being fueled by a controversial regulatory practice known as net metering. If distributed generation comes to play a significant role, the loss of demand for service from the grid may eventually make it difficult for the owners of grid assets to recover their costs, creating what the utility industry calls “stranded costs.” This Article explores the debate over net metering and then turns to the longer-term prospect of having to address potential stranded costs produced by the expanded use of distributed generation.

II.   Net Metering: The Current Battlefield

Most renewable generation in the U.S. is subsidized through investment or production tax credits.[16] This Article focuses on an additional subsidy to distributed renewable generation alone that exists as a result of “net metering” as applied in about forty states. Under net metering, retail customers (including commercial and industrial customers) can offset their electricity purchases from the grid with energy generated behind the retail meter, such as from rooftop solar panels. In most of the states that allow net metering, the credit equals the bundled retail rate. The credit applies not only to foregone consumption but also—with limited exceptions—to the energy generated from behind the meter in excess of the customer’s own use and delivered to the utility.[17]

Net metering therefore values the energy produced by distributed generators at the bundled retail rate for electricity. The bundled retail rate includes, in addition to the cost of producing electric energy, the costs associated with investment in and operation of transmission and distribution facilities and other costs incurred to ensure reliability and fund public policy initiatives endorsed by utility regulators. As noted above, the average residential price of electricity (the average bundled rate) is currently around 12.5 cents per kWh.[18] According to published data as of November 2013, the market price of energy from grid-connected[19] generators is averaging, in most locations, between 2 and 3 cents per kWh during off-peak periods and between 4 and 5 cents per kWh during on-peak periods.[20] Recent sales of grid-connected renewable energy have been priced near or below 3 cents per kWh.[21] Therefore, net metering allows the owners of distributed generation to effectively sell their energy at prices between two and six times the market price for energy.

Grid-connected renewable generators are paid the much lower market price for their energy, so the issue is not, as advocates of distributed generation allege, merely about promoting “clean” energy. A grid-connected solar generator at the same location as a distributed solar generator receives a fraction of the compensation for providing energy using similar—and equally clean—technology.[22] Grid-scale solar generation is actually more efficient, so net metering provides a huge subsidy to a less efficient form of renewable energy.

Utilities point out that the differential is paid by other retail customers. Because virtually all retail service is billed based on energy usage, net metering causes a re-allocation of transmission, distribution, and reliability costs to those customers who do not own distributed generation. Yet, the owners of distributed generation continue to rely on utility service from the grid for back-up and supplemental energy (for example, at night and when it is cloudy). Presently, the use of distributed generation in the U.S. is sufficiently limited that the cost-shifting effects are minor. However, subsidies this large can induce rapid changes. A report recently issued by the California Public Utilities Commission forecasts that net metering will cost the State $1.1 billion per year in 2020.[23] It also finds that the average net metering customer in California has an income almost twice the state’s average, [24] confirming claims that net metering entails a wealth transfer from low- to high-income consumers.

Net metering raises a number of legal issues that are just beginning to be explored. The definition of “net metering service” in the Energy Policy Act of 2005 indicates that Congress did not endorse the subsidy described above.[25] Section 111(d)(11) of the Public Utility Regulatory Policies Act (PURPA)[26] was added in 2005 to a list of retail ratemaking practices that state utility commissions are required to evaluate for use in their jurisdictions. This provision defines “net metering service” as follows:

Net Metering – Each electric utility shall make available upon request net metering service to any electric consumer that the electric utility serves. For purposes of this paragraph, the term “net metering service” means service to an electric consumer under which electric energy generated by that electric consumer from an eligible on-site generating facility and delivered to the local distribution facilities may be used to offset energy provided by the electric utility to the electric consumer during the applicable billing period.[27]

Under this definition, “electric energy” generated by a retail customer’s on-site facility may be used to offset “energy” provided by the utility. The language strongly implies that Congress meant only to ensure that consumers would receive an appropriate credit for the energy supplied from on-site generation and not a credit based on the bundled retail rate that includes costs associated with transmission, distribution, and reliability. If this is correct, net metering as applied in most states is inconsistent with this part of PURPA.[28]

In 2002, the Supreme Court of Ohio addressed this very issue in connection with interpreting Ohio legislation that required public utilities to offer net metering.[29] In that case, FirstEnergy proposed a net metering regime under which net metered customers would receive a credit for energy supplied from on-site generation based on the unbundled generation component of the retail rate.[30] This proposal was rejected by the Ohio Public Utilities Commission, which directed that FirstEnergy offer a credit based on the full bundled retail rate.[31] The Ohio Supreme Court held that FirstEnergy had correctly applied statutory language requiring utilities to provide a credit for the “electricity” produced by on-site generators by offering to credit only the generation component of the retail rate.[32] The Court found that FirstEnergy was correct in contending that a net meter customer “does not provide transmission, distribution or ancillary services,” and therefore the term “electricity” in the statute did not require a credit for the costs associated with these other unbundled services.[33]

Net metering also appears to be inconsistent with provisions of PURPA that were designed to protect electric consumers from cross-subsidization. Under PURPA, utilities are required to purchase energy from qualifying “small power production” facilities that meet eligibility standards established in the law.[34] Under FERC regulations, retail customers that own on-site generators with a maximum net generating capacity of less than 1 MW are permitted to self-implement PURPA’s mandatory purchase requirement without any notification to or approval from FERC.[35] Most retail customers using net metering rely on the mandatory purchase requirement to require their host utilities to purchase their energy.[36] Absent the PURPA requirement, utilities would generally have no obligation to buy energy from distributed generators because the Federal Power Act[37] (the law that applies in the absence of PURPA) does not obligate utilities to purchase energy at wholesale.[38]

PURPA, however, while requiring utilities to buy, also caps the price paid to qualifying facilities at the purchasing utility’s “avoided cost,” which is defined as the cost of energy that would have been supplied from the utility’s own system if the energy had not been supplied by the qualifying facility.[39] Because net metering compensates owners for the energy supplied from distributed generation at the utility’s bundled retail rate, this practice would appear to violate the avoided cost rate cap that is based on the cost of energy alone.

The FERC, however, permits net meter customers to avoid this price cap. The FERC holds that unless a retail customer with on-site generation is a net supplier of energy to the grid over the state retail billing period (almost always one month), no sale takes place under PURPA or the Federal Power Act, even if there are substantial deliveries of energy to the grid during the month.[40] In the absence of a “sale” to the utility, FERC deems that no mandatory purchase of energy is taking place under PURPA and the avoided cost price cap does not apply.[41]

The FERC’s theory, that the existence of a “sale” can be determined by netting metered inflows and outflows over the course of a month, was recently rejected in two appellate cases involving FERC’s use of this same theory to determine whether a retail sale has occurred when generators acquire energy for station service purposes, the mirror image of the net metering situation.[42] In these two cases, the D.C. Court of Appeals held that netting could not be used to determine whether a sale has taken place and that there is a sale whenever energy is delivered from the generator to the utility and vice versa.[43] The FERC’s disclaimers of jurisdiction in MidAmerican and SunEdison may therefore be subject to a renewed challenge, which, if successful, would require net metering rules to be changed at the state level.

This same “netting” theory allows FERC to avoid facing the fact that the prices inherent in net metering are discriminatory. The Federal Power Act prohibits charges for wholesale energy that are “unduly discriminatory,”[44] but this prohibition only applies if there is a FERC-jurisdictional wholesale transaction. MidAmerican Energy and SunEdison therefore provide a rationale for FERC to avoid addressing the huge differential between the prices paid to distributed and grid-connected generators for the energy they supply.

From both economic and environmental perspectives, energy from distributed generation is no more beneficial than other forms of renewable generation. Energy available to meet electric load, whether generated behind the retail meter or from grid-connected generation, provides equivalent value to the electric system. Therefore, the price discrimination inherent in net metering cannot be justified based on differences in the value of the services offered. If anything, distributed solar is less valuable than most energy from grid-connected generators because the energy output of solar facilities varies uncontrollably. Consequently, utilities must have sufficient grid-connected capacity on hand to supply the entire load when solar generation is non-productive. For the same reason, retail customers with distributed generation require access to grid-supplied energy up to their full load at unpredictable times.[45] Indeed, solar generation has a pernicious effect on energy markets because energy from solar generators tends to suppress energy market prices during peak-load periods, providing less revenue for grid-connected generation and falsely signaling to the market that grid-connected generation that is needed for reliability is no longer economic.[46]

In conclusion, net metering as currently practiced in most states provides a huge subsidy to distributed generators over and above the tax subsidy provided to all renewable generation, discriminates against all forms of grid-connected generation (including renewables), forces an inappropriate re-allocation of the costs of the grid to remaining (and disproportionately lower income) customers, and sends a faulty price signal that can cause under-investment in (or early shut down of) grid-connected generation that is needed for real-time balancing purposes and to meet peak demands. These same problems—in larger scale—are among the primary causes of Germany’s growing dysfunction.

III.   The Return of Stranded Costs

Broadly speaking, the current dispute over net metering is about managing the growth of distributed generation during the period when growth is being fueled by subsidies. If projections such as those made by Citigroup are correct, the cost of energy from distributed generation will decline, eventually making it competitive with energy from the grid without subsidies, and the pace of growth will accelerate. At some point, distributed generation could be married to behind-the-meter storage capability, permitting customers to disconnect from the grid or significantly limit their use of utility service. Investments in distributed generation combined with storage should expand rapidly when and if the combined cost of distributed energy and storage reaches parity with the cost of bundled service from the grid.

In this scenario, as the demand for service from the grid declines and utilities need to recover the cost of the grid from a smaller customer base, utilities will have to respond by filing to raise rates. While this is occurring, a large body of customers will remain dependent on electricity from the grid for a considerable period of time since many customers may not have the resources to install distributed generators and others may choose to take their electric service from the grid.

Even as this possible transition approaches, billions of dollars of grid investments are being made, mostly in response to regulatory mandates.[47] As the use of distributed generation grows, investors in grid assets will demand that regulators provide assurance that their investments will be recoverable over time with a reasonable return. Otherwise, the cost of capital will rise, exacerbating the problem of rising rates during the transition, and in a worst case making it impossible for utilities to raise the capital needed to serve remaining customers and compensate investors for their prior investments in the grid.

Around the turn of the century, the utility industry faced the prospect that investments in generation might be unrecoverable. In those jurisdictions that permitted “retail choice” of electricity suppliers, utility generation was unbundled and re-priced to market. This competitive transformation produced debates over whether utilities were entitled to recover the costs associated with prior generation investments from departing customers when sunk costs exceeded the revenues recoverable at market prices. The differential was known as “stranded costs.”

Utilities argued that they were entitled by law to recover their stranded costs pursuant to an implicit bargain with the government under which utilities had assumed an obligation to serve the public in return for assurance that they would be compensated for their prudent investments made to meet that obligation. Along with many scholars, utilities argued that the law recognized this “regulatory compact” and that failure to permit the recovery of stranded costs represented an unconstitutional taking of utility property.[48] Others argued that no such legal right exists and that allowing utilities to recover their stranded costs would be inconsistent with the transition to competition.[49]

In the states that endorsed retail choice, legislative or regulatory compromises were reached in which utilities recovered most of their stranded costs. The underlying legal question was never resolved decisively in the courts. The stranded cost issue will be different in the context of utility loss of demand to distributed generation. In this context, stranded cost issues will not appear at one point in time (such as a legislative determination to permit retail customer choice) but will emerge gradually as utilities and regulators respond to reductions in aggregate demand for utility service. The stranded cost issue may also include stranded investment in transmission and distribution assets as well as generation. Further, stranded cost recovery will have to be addressed in the context of a declining utility customer base that may ultimately become too small to support recovery. In the last round of stranded costs, customers changing power suppliers remained as transmission and distribution customers of the utility and stranded costs could be recovered in the rates for these unbundled services.

A.  Cost Recovery for Regulated Assets

Assuming distributed generation becomes economical without subsidies, retail customers will be making independent decisions about whether to reduce or jettison utility service, and these decisions will occur over time as the relative economics of grid-produced and distributed electricity change. The stranded cost issue is therefore likely to arise in individual rate proceedings as utilities file to increase their rates to offset the effects of declining demand and regulators respond by requiring offsetting cost reductions to cabin these rate increases to remaining captive customers. As this process unfolds, history teaches that there will be disputes over the prudence of past utility expenditures and over whether particular assets remain “used and useful” and thus eligible for cost recovery.

The Supreme Court’s decision in Duquesne Light Co. v. Barasch holds that a utility’s Constitutional right to recover its costs to serve the public is not infringed by regulatory decisions disallowing individual items of cost.[50] An unlawful “taking” occurs only when the overall level of rates produces insufficient revenue to satisfy the “end-result” test established in FPC v. Hope Natural Gas Co.[51] Hope held that overall rate levels “which enable a company to operate successfully, to maintain its financial integrity, to attract capital, and to compensate its investors for the risk assumed . . . ” are sufficient to pass Constitutional muster.[52] The Hope test is fairly subjective and may not produce rates that are attractive to investors. Duquesne suggests that stranded cost issues will have to be addressed through rate litigation, which means the availability of relief to distressed utilities may be delayed.[53] Without legislation, moreover, the remaining customer base will eventually become too small, forcing utilities to try and convince regulators to permit them to charge exit fees to departing customers. For these reasons, substantial pressure will arise to resolve stranded cost recovery issues through legislation. Legislative fixes will be a hard sell politically, but legislators may be convinced to act in order to prevent important energy policy issues from being decided in the courts.[54]

In determining which facilities remain used and useful, regulators will have to balance reliability and environmental effects as well as economics. They will also have to address complex competing interests. For example, utilities supply power using a combination of owned generation and purchases in the form of FERC-jurisdictional power purchase agreements (PPAs), most of which are the product of regulatory mandates. Federal law protects FERC-jurisdictional PPAs by requiring state regulators to pass through the costs incurred by utility buyers in their retail rates.[55] But this “trapped cost” protection will be a two-edged sword for utilities that face premature retirement of their own generation while continuing to pay third parties for purchased power. FERC may therefore face a host of contract termination disputes. The transition will be made more difficult by the fact that most utility-owned generation is subject to state regulation, PPAs are regulated by FERC, and substantial generation is publicly owned and not subject to traditional rate regulation.

Generation cost recovery is likely to be under pressure before transmission and distribution. For the most part, the electric delivery system operates as an integrated network, and it will be difficult to identify specific assets that are no longer required as demand declines. Nonetheless, a substantial portion of the cost of electricity consists of investments in transmission and distribution, and a regulator under pressure to reduce rates would eventually have to pay attention to the cost of these facilities. Stranded transmission and distribution cost issues will play out simultaneously at FERC (which regulates most unbundled transmission) and in state proceedings (for bundled transmission and local distribution) unless Congress changes jurisdictional responsibilities.[56]

Disputes will likely arise over which assets should be targeted for early retirement. The interstate transmission grid, for example, is an integrated network of facilities owned by a large number of entities.[57] One can imagine a form of competition among transmission asset owners to protect their assets and avoid stranded costs. Most publicly-owned transmission is not subject to FERC or state jurisdiction, which will further complicate the process.

As this process unfolds, utility investors will be watching. As cost recovery uncertainty rises, debt and equity investors will demand higher returns, making it more expensive to maintain a reliable grid and putting further upward pressure on utility rates. At some point, the risks could be large enough that investors will not provide capital on acceptable commercial and regulatory terms, and investment in the grid will become problematic, even as many consumers continue to rely on it.

B.  Unregulated Generation

In regions where utilities have already divested their generation to merchant power producers, capacity and energy is transacted in wholesale markets under the control of RTOs, subject to overarching FERC regulation. Market forces will therefore play a significant role in determining which generators survive as demand declines. The owners of unregulated generation have assumed the market risk and are much less likely to have valid stranded cost claims.

But electricity markets will only provide a partial solution. With recent reductions in natural gas costs and flat demand, grid-connected generation is already under considerable economic pressure, and regulators are being asked to approve additional revenue streams to support reliability and new investment. In response to disputes over market rules, regulators are making critical decisions on the economic margin. Therefore, even where generation is subject to market forces, the future portends complex regulatory disputes over how wholesale markets should be organized to respond to reductions in the demand for energy from the grid. At the core of these disputes, an enduring tension will exist between economics, reliability, and fairness.

IV.   Conclusion

Once a sizable number of customers have invested in distributed generation in response to the subsidies afforded under net metering, changing the economic rules will be difficult, both because some customers will have relied on subsidies to make their investments and others will want the same opportunities as their neighbors. Policymakers therefore should not long defer addressing the consequences of providing these subsidies in order to promote distributed generation over other alternatives. What may appear politically attractive in its early stages can quickly become a regulatory and political quagmire, as the Germans are learning. The U.S. will not countenance electric rates anywhere close to German levels, nor an electric system that is not reliable. Over the long term, any required unwinding of the utility-owned grid due to distributed generation will be extraordinarily complex and will raise many novel and intractable legal and policy issues.

 

 

Preferred citation: David B. Raskin, The Regulatory Challenge of Distributed Generation, 4 Harv. Bus. L. Rev. Online 38 (2013), https://www.hblr.org//?p=3673.

* David Raskin is a partner in the Washington, DC office of Steptoe & Johnson LLP. He has represented stakeholders in the electric power industry for more than thirty years. During this time, he has been involved in most of the significant federal regulatory initiatives designed to increase competition in the electric industry and has assisted clients in managing the unprecedented changes that have occurred in recent decades.

[1] E.g., Diane Cardwell, On Rooftops, a Rival for Utilities, N.Y. Times, July 26, 2013, http://www.nytimes.com/2013/07/27/business/energy-environment/utilities-confront-fresh-threat-do-it-yourself-power.html; Peter Kind, Disruptive Challenges: Financial Implications and Strategic Responses to a Changing Retail Electric Business, Edison Electric Institute (Jan. 2013), www.eei.org/ourissues/finance/Documents/disruptivechallenges.pdf‎.

[2] Citi Research, Rising Sun: Implications for US Utilities (Aug. 8, 2013), http://www.wecc.biz/committees/BOD/TEPPC/SPSG/Lists/Events/Attachments/706/CITI-Rising%20Sun%20Implications%20for%20US%20Utilities.pdf.

[3] Jason Channell et al., Energy Darwinism: The Evolution of the Energy Industry, Citi Global Perspectives & Solutions 73-75 (Oct. 2013), https://ir.citi.com/Jb89SJMmf%2BsAVK2AKa3QE5EJwb4fvI5UUplD0ICiGOOk0NV2CqNI%2FPDLJqxidz2VAXXAXFB6fOY%3D.

[4] Even if Citi’s aggressive prediction of fifty percent demand reduction by 2015 turns out to be accurate, that prediction leaves fifty percent of electric load dependent on grid service.

[5] In this Article, references to “distributed generation” refer to energy sources located behind the retail meter or connected to a micro grid, where the intent is to remove some load or demand from the system of integrated electric generation, transmission, and distributed facilities that comprise what is referred to in this Article as the “grid.”

[6] Energiewende, or energy transformation, is the product of the German Renewable Energy Act of 2000 (Erneuerbare-Energien-Gesetz) that put in place substantial subsidies for distributed generation and grid-connected renewables. See General Information: Transformation of Our Energy System, Ger. Fed. Ministry for the Env’t, Nature Conservation and Nuclear Safety, www.bmu.de/P118-1/ (last visited Nov. 24, 2013).

[7] Jesse Morris, How Germany’s Solar Evolution Impacts America, Earth Techling (Oct. 12, 2013), http://www.earthtechling.com/2013/10/how-germanys-solar-evolution-impacts-america. Ironically, this article laments the fact that the German feed-in tariff rate for distributed solar is only 20 cents per kWh, well below the full retail rate.

[8] Institute for Energy Research, Germany’s Energy Policy: Man-Made Crisis Now Costing Billions (Oct. 30, 2012), http://www.instituteforenergyenergy research.org/10/20/2012. Many Germans claim they can no longer afford to buy electricity. Germany’s Energy Poverty: How Electricity Became a Luxury Good, Spiegel Online Int’l (Sept. 4, 2013), http://www.spiegel.de/international/germany/high-costs-and-errors-of-german-transition-to-renewable-energy-a-920288.html.

[9] Energy Info. Admin., Table 5.6.A. Average Retail Price of Electricity to Ultimate Customers by End-Use Sector, (Nov. 20, 2013), http://www.eia.gov/electricity/monthly/epm_table_grapher.cfm?t=epmt_5_6_a.

[10] Energy Info. Admin., How Much Electricity Does an American Home Use?, http://www.eia.gov/tools/faqs/faq.cfm?id=97&t=3 (last updated Mar. 19, 2013).

[11] Germany’s Environment Minister, Peter Altmaier, has acknowledged that Germany has overdone the subsidies and needs to cut them back. Diarmaid Williams, Altmaier says German energy transition could cost $1.34trn, Power Energy International (Feb. 21, 2013), http://www.powerengineeringint.com/articles/2013/02/Altmaier-says-German-energy-transition-could-cost-134trn.html; Minister Altmaier: EEG Cuts Needed—or Energiewende Costs Will Reach Trillion Euro Mark by 2040, German Energy Blog (Feb. 20, 2013), http://www.germanenergyblog.de/?p=12278.

[12] Spiegel Online Int’l, supra note 8; Max Luke, Jessica Lovering & Alex Trembath, Trash, Trees and Taxes: The Cost of Germany’s Energiewende, Energy Collective (Sept. 16, 2013), http://theenergycollective.com/maxluke/274041/trash-trees-and-taxes.

[13] An environmental critique of Energiewende can be found in Will Boisvert, Green Energy Bust in Germany, Dissent (2013), http://www.dissentmagazine.org/article/green-energy-bust-in-germany.

[14] Tilting at Windmills, Economist, June 15, 2013, available at http://www.economist.com/news/special-report/21579149-germanys-energiewende-bodes-ill-countrys-european-leadership-tilting-windmills.

[15] How to Lose Half a Trillion Euros, Economist, October 12, 2013, available at http://www.economist.com/news/briefing/21587782-europes-electricity-providers-face-existential-threat-how-lose-half-trillion-euro.

[16] German subsidies primarily take the form of “feed in tariffs” that guarantee minimum per kWh payments to those employing favored technologies, which are paid out of a pool funded by consumers. See Stefan Nicola, German Industry Wants End of Feed-in Tariff on Rising Power Cost, Bloomberg (Sep 19, 2013, 5:53 AM), http://www.bloomberg.com/news/2013-09-19/german-industry-wants-end-of-feed-in-tariff-on-rising-power-cost.html.

[17] As discussed below, the Federal Energy Regulatory Commission (FERC) has disclaimed jurisdiction over energy supplied from behind-the-meter distributed generation so long as the customer does not supply more excess energy than it acquires from the grid over the course of a monthly retail billing period.

[18] Energy Info. Admin., Table 5.6.A, supra note 9.

[19] This Article refers to generators that are connected on the utility side of the customer meter as “grid-connected generation” for ease of reference. This is a misnomer, however, because all generation, including generation located on a retail customer’s property on the customer side of the meter, is connected to and part of the electric grid. Electricity does not recognize the difference in location; at all times sufficient energy must be supplied to meet the aggregate demand of all users, and the system must be kept in precise balance (supply equaling demand) in order to prevent outages and serious damage to facilities.

[20] See Platts, Megawatt Daily, at 2-10 (November 27, 2013).

[21] American Wind Energy Association, The Cost of Wind Energy in the U.S., http://www.awea.org/Resources/Content.aspx?ItemNumber=5547 (last visited Nov. 24, 2013).

[22] The analysts at Citi put it succinctly: “While residential solar has the advantage of competing against higher residential electricity prices, merchant utility scale solar must compete against wholesale power prices.” Citi Research, supra note 2 at 21.

[23] See Cal. Pub. Utils. Comm’n, California Net Energy Metering (NEM) Draft Cost-Effectiveness Evaluation (2013), available at http://www.cpuc.ca.gov/NR/rdonlyres/BD9EAD36-7648-430B-A692-8760FA186861/0/CPUCNEMDraftReport92613.pdf.

[24] Id. at 110.

[25] Energy Policy Act of 2005, Pub. L. No.109-58, sec. 1251, § 111(d), 119 Stat. 962 (codified as amended at 16 U.S.C. 2621(d)(11)).

[26] See id.; Pub. Util. Reg. Policies Act of 1978, Pub. L. No. 95-617, § 111(d), 92 Stat. 3117, 3142-43 (codified as amended at 16 U.S.C. § 2621(d)(10)(E)(11) (2006)).

[27] Energy Policy Act § 111(d); 16 U.S.C. § 2621(d)(10)(E)(11).

[28] Congress also did not define what it meant by “delivered to the local distribution facilities” in this provision. It may have intended the energy credit to apply only to energy in excess of the customer’s on-site use, or it may have intended that all energy produced on-site be treated as energy provided to the grid because all such energy substitutes energy that would otherwise be supplied from the grid. Either way, the definition provides only for an energy credit, which is not what occurs in most jurisdictions.

[29] FirstEnergy Corp. v. Pub. Utils. Comm’n of Ohio, 768 N.E.2d 648 (Ohio 2002).

[30] Id. at 650.

[31] Id.

[32] Id. at 652.

[33] Id.

[34] Pub. Util. Reg. Policies Act § 210 (codified at 16 U.S.C. § 824a-3(a) (2006)). FERC regulations refer to these as “qualifying facilities.” 18 C.F.R. § 292.101(b)(1).

[35] 18 C.F.R. § 292.203(d) (2010).

[36] See Stephanie Watson, How Net Metering Works, How Stuff Works, http://science.howstuffworks.com/environmental/green-science/net-metering2.htm (last visited Nov. 24, 2013).

[37] 16 U.S.C §§ 791a-825r.

[38] From the earliest days of Federal Power Act jurisprudence, courts have emphasized that wholesale power transactions under the Federal Power Act are voluntary. Fed. Power Comm’n v. Sierra Pac. Power Co., 350 U.S. 348 (1956). In organized Regional Transmission Organization (RTO) markets, any generator that signs a service agreement with RTO is permitted to bid its energy into the market and, if dispatched, gets paid the locational marginal cost of energy, even if the generator does not have a contract with a specific buyer.

[39] Am. Paper Inst. v. Am. Elec. Power Serv. Corp., 461 U.S. 402, 404 (1983).

[40] See MidAmerican Energy Co., 94 F.E.R.C. P 61,340 (2001); Sun Edison LLC, 129 F.E.R.C. P 6,1146 (2009).

[41] Id.

[42] See S. Cal. Edison Co. v. FERC, 603 F.3d 996 (D.C. Cir. 2010); Calpine Corp. v. FERC, 702 F.3d 41 (D.C. Cir. 2012).

[43] See S. Cal Edison Co. 603 F.3d at 1000-01; Calpine Corp. 702 F.3d at 45.

[44] 16 U.S.C. § 824e(a).

[45] California is attempting to overcome this issue by requiring utilities to purchase storage capacity using new technologies to help balance supply and demand. Order Instituting Rulemaking Pursuant to Assembly Bill 2514 to Consider the Adoption of Procurement Targets for Viable and Cost-Effective Energy (published October 17, 2013), Cal. Pub. Utils. Comm’n, 2013 Cal. PUC LEXIS 569, available at http://docs.cpuc.ca.gov/PublishedDocs/Published/G000/M078/K912/78912194.PDF. Whether these alternative technologies will become available in sufficient quantities and at a reasonable cost to replace balancing generation from the grid, and how long this may take, is unknown.

[46] The Economist notes: “Renewables can depress wholesale prices, e.g. when the sun creates a midday jolt. This discourages investors in the flexible, gas-powered generation needed to provide backup for windless, cloudy days.” Energiewinde, Economist, July 28, 2012, at 3. Citi Research, noting that solar production causes lower utilization rates for conventional generation plants, concludes: “This would in a perfect economic world lead to the closure of some higher heat rate gas plants, but the problem of course is that much of this generation capacity needs to remain to cover lost generation on less sunny days and at night, and through the winter . . . .” Citi Research, supra note 2, at 17.

[47] For example, the electric industry is investing significant sums in response to state laws imposing renewable portfolio standards. Large additional investments are being made to modernize the transmission and distribution systems and incorporate so-called “smart grid” technologies. One utility executive recently noted that half the existing transmission grid is more than fifty years old, so sizable investments to sustain it are inevitable. Lisa Barton, IHS The Energy Daily, September 26, 2013, at 14. Several northeastern states are requiring utilities to invest in “hardening” their systems in response to recent storm-related outages. See Diana Cardwell et al., Hurricane Sandy Alters Utilities’ Calculus on Upgrades, N.Y. Times, Dec. 28, 2012, at B1. Since 2005, the utility industry has also been subject to mandatory reliability standards approved by the FERC that require significant ongoing investments in the grid. 16 U.S.C. § 824o (2005).

[48] See, e.g., J. Gregory Sidak & Daniel F. Spulber, Deregulatory Takings and Breach of the Regulatory Contract, 71 N.Y.U. L. Rev. 851 (1996).

[49] See, e.g., Susan Rose-Ackerman & Jim Rossi, Disentangling Deregulatory Takings, 86 Va. L. Rev. 1436 (2000).

[50] 488 U.S. 299, 314-15 (1989) [hereinafter Duquesne].

[51] 320 U.S. 591, 602-03 (1944) [hereinafter Hope].

[52] Id. at 605.

[53] The takings issue will recur if demand declines further over time. If demand declines after rates have been set, utilities will once again under-recover their costs, forcing them to file for another round of rate increases to offset the effect of the loss of load since the prior rate case. Utilities will be playing

“catch-up” to get the revenues needed to recover their costs and attract investment.

[54] Assuming much of the utility industry will have moved into other business lines, including distributed generation, legislators could be less inclined to provide full stranded cost relief in these circumstances.

[55] See Nantahala Power & Light Co. v. Thornburg, 476 U.S. 953, 970 (1986); Entergy La., Inc. v. La. Pub. Serv. Comm’n, 539 U.S. 39, 48 (2003).

[56] In Texas, the Public Utility Commission of Texas (PUCT) regulates all of these functions. In other states where retail rates remain bundled, states will have most of the control over this process for both transmission and distribution assets, unless the FERC chooses (or is forced) to assume jurisdiction over interstate transmission costs that are bundled into retail rates pursuant to the Supreme Court’s opinion in New York v. FERC, 535 U.S. 1 (2002).

[57] FERC has recently decided that more entities should be eligible to build and own transmission facilities. Transmission Planning and Cost Allocation by Transmission Owning and Operating Public Utilities, Order No. 1000, FERC Stats. & Regs. ¶ 31,323 (2011), order on reh’g, Order No. 1000-A, 139 FERC ¶ 61,132, order on reh’g, Order No. 1000-B, 141 FERC ¶ 61,044 (2012), appeal docketed, S.C. Pub. Serv. Auth. v. FERC, No. 12-1232 (D.C. Cir. 2012).

 

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Investing in U.S. Pipeline Infrastructure: Could the Proposed Master Limited Partnerships Parity Act Spur New Investment?

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Linda E. Carlisle, Daniel A. Hagan and Jane E. Rueger*

The so-called “shale revolution” has upset traditional notions of supply and demand centers for natural gas and crude oil. Demand centers in the Northeast traditionally needed to import natural gas or oil from distant supply centers, such as Texas or Louisiana. However, major plays located near these demand centers, such as the Marcellus shale, are causing directional flows on existing pipelines to change. In addition, these plays have spurred the need for additional pipeline infrastructure development to transport crude oil and natural gas liquids from major shale plays in the Northeast and the Midwest to processing and manufacturing facilities that currently exist or are under development in Texas and Louisiana.

This Article explores combining the traditional oil and gas pipeline structure with solar electric generation to: (1) increase the return on pipeline investments by making the income from a solar electric generation business available to pipeline operators; and (2) lower the cost of operating the pipeline. After a brief overview of the current state of U.S. pipeline infrastructure, this Article describes the structure generally used for current pipeline investment and pending legislation, which would make the structure available to solar electric generation businesses. The Article then explores the potential benefits of combining solar generation and pipeline transportation businesses if the pending legislation passes.

Overview of the Current State of U.S. Pipeline Infrastructure

The past decade has brought sweeping change to the oil and gas industry in the United States. Technological developments in drilling and hydraulic fracturing have allowed extraction of large volumes of shale gas and tight oil that were previously economically infeasible to produce. With respect to natural gas, tight oil and shale gas accounted for forty percent of the total U.S. natural gas produced in 2012.[1] The U.S. Energy Information Administration (EIA) projects natural gas production in the United States will increase from 23.0 trillion cubic feet in 2011 to 33.1 trillion cubic feet by 2040, a forty-four percent increase almost entirely due to projected growth in shale gas production.[2] As of June 2013, EIA ranks the United States fourth in the world with respect to volume of technically recoverable shale gas resources[3] and projects that the United States may become a net exporter of natural gas in years to come.[4] Crude oil production has similarly increased; EIA ranks the United States second in the world with respect to volume of technically recoverable shale oil,[5] and crude oil production from tight plays accounted for nearly all 847,000 barrels per day increase in production in 2012 compared with 2011.[6] This is by far the largest growth in crude oil production in any country.[7]

Development of the infrastructure necessary to fully utilize the wealth of shale oil and gas reserves in the United States has been slow to materialize. Pipelines, particularly large diameter, long-distance interstate pipelines, are very expensive to build. By some recent estimates, onshore pipeline construction costs in the United States can be an average cost-per-mile of $3.1 million.[8] A recently proposed interstate natural gas pipeline is expected to cost approximately $3 billion to build.[9] Moreover, pipelines have a long construction lead-time: it often takes years to work through planning, siting, and obtaining regulatory approvals, prior to beginning construction. Developers have often found it difficult to attract the kind of long-term firm commitments that are necessary to support investment in pipeline infrastructure. Pipelines also face competition from railroads for the crude oil and natural gas liquids transportation business because building new rail is cheaper, and existing rail beds give more delivery point options than pipelines.

Moreover, not all investments in the pipeline transportation business have been successful. For example, the Rockies Express Pipeline (REX), completed in 2009 at a cost of about $6.2 billion, was built to deliver natural gas from Colorado and Wyoming to demand centers as far east as Ohio.[10] The subsequent development of economically recoverable shale gas reserves in the Marcellus and Utica regions has upended REX’s value proposition such that it has operated at a load factor of only sixty-six percent in 2013.[11] This resulted in bond ratings agencies questioning REX’s ability to maintain earnings after its anchor shippers’ contracts expire in 2019, absent timely action to enter into new contracts.[12] Current anchor shippers vigorously oppose entering into new contracts for shale gas shipments from east to west, making REX’s future prospects uncertain.[13]

Master Limited Partnerships[14] Today and the Master Limited Partnerships Parity Act[15]

Master limited partnerships (MLPs) are publicly traded businesses that are taxed as partnerships.[16] A U.S. business entity that is taxed as a partnership, unlike a corporation, is a “pass-through entity” for federal income tax purposes.[17] This means that the partnership does not pay tax as an entity, but rather each partner is allocated his share of partnership income, gain, deductions, losses, and credits annually and pays tax on his distributable share of partnership income regardless of whether the partnership makes any cash distributions to its partners. As a result, there is only a single level of federal income tax (at the partner level) on the income of a partnership. This is in stark contrast to the two levels of tax imposed on the income of a corporation (for a corporation, the income is taxed when earned by the corporation[18] and then again when it is distributed in the form of a dividend to its shareholders).[19]

In 1987, Congress limited the types of businesses that would be taxed as partnerships if they were “publicly traded” out of concern that the widespread use of publicly traded partnerships would erode the corporate tax base.[20] Partnership status, however, was retained for businesses that had traditionally been conducted in partnership form, such as businesses involved in oil and gas exploration and production.[21]

To qualify for MLP status, a business entity that otherwise would be treated as a partnership for federal income tax purposes and whose interests are “publicly traded” must satisfy a “qualifying income” test, which requires ninety percent or more of the gross income of the partnership to be “qualifying income.”[22] Qualifying income includes: (i) passive income such as interest, dividends, and gains from the disposition of property that generates such passive income; (ii) rents and gains from real property; (iii) income and gains from the exploration, development, mining, production, processing, refining, transportation, or marketing of minerals and natural resources; and (iv) income and gains from transactions in commodities in the case of partnerships that buy and sell such commodities as a principal business activity.[23]

MLPs combine the benefits of public corporations whose interests are readily bought and sold on established securities markets and the tax benefits of partnerships, which are not subject to the federal corporate income tax. Such favorable tax treatment allows MLPs to access capital at a lower cost than business entities taxed as corporations. This makes the MLP structure particularly attractive to the capital-intensive pipeline infrastructure transportation business.

In 2008, Congress expanded the definition of qualifying income to include transportation and storage of certain renewable and alternative fuels, such as ethanol and biodiesel, as well as industrial-source carbon dioxide.[24] Income from alternative or renewable energy generation businesses, however, continues to be excluded from qualifying income status.

Legislation has been introduced in the House of Representatives[25] and in the Senate[26] that would expand the definition of qualifying income to allow alternative or renewable energy projects access to the MLP structure. Under the “Master Limited Partnerships Parity Act,” the definition of qualifying income would be expanded to include income from clean energy resources and infrastructure businesses. Qualifying income would include income from renewable energy projects such as wind power, closed and open loop biomass, geothermal, solar, municipal solid waste, hydropower, marine and hydrokinetic, and fuel cells. The legislation would also expand the definition of qualifying income to include income from certain clean energy technologies, including the production, storage, and transportation of renewable fuels, electricity storage, carbon capture and storage, waste heat power production, and energy-efficient building technology.

Opportunities for Solar Generation: Pipeline Infrastructure Synergies

Passage of the Master Limited Partnerships Parity Act could lead to some interesting opportunities and synergies for solar generation and pipeline infrastructure businesses that could begin to address the economic hurdles to pipeline infrastructure development. The Master Limited Partnerships Parity Act would allow a single MLP to be in the pipeline transportation business and the renewable electric generation business because both businesses would generate “qualifying income” that would allow the entity to benefit from favorable tax treatment as a partnership. The solar generation business would give the pipeline operator an additional revenue source from the sale of power, either through bilateral sales, wholesale sales into power markets, or sales under the Public Utility Regulatory Policies Act (PURPA).[27] In addition, the operational costs of the pipeline business would be reduced. For example, while pipeline compressor stations can vary widely by design, they typically incur fuel costs and often emit greenhouse gases and NOx,which imposes additional construction and maintenance costs due to the equipment necessary to meet local or federal emissions limits.[28] As compressor stations are usually spaced approximately every fifty to one hundred miles along a pipeline route,[29] these costs can be significant on long interstate pipelines. Using electricity from solar assets to power compressor operations offers the opportunity to reduce the overall cost of operating the pipeline. Although solar generation only produces power during the day, electric storage devices would allow such power to be used to serve nighttime compressor operations.

Moreover, pipeline companies have right-of-way and permitting institutional knowledge that is readily transferrable to the siting and permitting of solar generation. In the process of constructing a pipeline, pipeline companies must acquire rights-of-way from local landowners along the entire route of the pipeline, including appurtenant parcels for placement of compressor stations that can reach seventy acres each (including the compressor site and additional acreage for sound buffering).[30] Pipeline companies are also familiar with state and local processes for environmental and similar permits. These areas of institutional knowledge are equally relevant to the solar generating facility siting and permitting process.

Infrastructure development related to the shale boom is a complex problem without a single, simple solution. But within every problem lies opportunity, and the beneficial combination of pipeline and solar infrastructure is one potential opportunity that could start to address the need to incentivize investment in pipeline infrastructure in the current economic climate.

 

Preferred citation: Linda E. Carlisle, Daniel A. Hagan & Jane E. Rueger, Investing in U.S. Pipeline Infrastructure: Could the Proposed Master Limited Partnership Parity Act Spur New Investment?, 4 Harv. Bus. L. Rev. Online 32 (2013), https://www.hblr.org//?p=3645.

* Linda E. Carlisle is a Partner in the Tax Group of White & Case LLP. Daniel A. Hagan is a Partner, and Jane E. Rueger is a Counsel, in the Energy Markets and Regulatory Group of White & Case LLP. All are based in White & Case LLP’s Washington, D.C. office. The opinions expressed are those of the authors and do not necessarily reflect the views of the authors’ law firm or its clients.

[1] Energy Info. Admin., Technically Recoverable Shale Oil and Shale Gas Resources: An Assessment of 137 Shale Formations in 41 Countries Outside the United States [hereinafter EIA 2013 Assessment], (June 13, 2013), at 11, http://www.eia.gov/analysis/studies/worldshalegas.

[2] See Energy Info. Admin., Energy in Brief: What Is Shale Gas and Why Is It Important?, (Dec. 5, 2012), http://www.eia.gov/energy_in_brief/article/about_shale_gas.cfm?src=home-f2.

[3] EIA 2013 Assessment, supra note 1, at 10.

[4] Energy Info. Admin., Annual Energy Outlook 2013, (Apr. 2013), at 2, http://www.eia.gov/forecasts/aeo/chapter_executive_summary.cfm.

[5] EIA 2013 Assessment, supra note 1, at 10.

[6] Id. at 12.

[7] Id.

[8] Christopher E. Smith, Worldwide Pipeline Construction: Crude, Products Plans Push 2013 Construction Sharply Higher, Oil & Gas J, (Feb. 4, 2013), http://www.ogj.com/articles/print/volume-111/issue-02/special-report–worldwide-pipeline-construction/worldwide-pipeline-construction-crude-products.html.

[9] Bill Faries & Mike Lee, Spectra Wins $3 Billion Interstate Florida Gas Pipeline, Bloomberg News, (July 26, 2013), http://www.bloomberg.com/news/2013-07-26/spectra-wins-3-billion-interstate-florida-gas-pipeline.html.

[10] Kinder Morgan Energy Partners, Current Report (Form 8-K, Ex. 99.1) at 128 (June 12, 2009).

[11] Peter Behr, Rockies Express shippers fight a proposed change in gas flows, EnergyWire, (July 26, 2013), http://www.eenews.net/stories/1059985120. Load factor refers to customers’ actual utilization of a pipeline’s capacity compared to its maximum capacity.

[12] Id.

[13] See id.

[14] For federal tax purposes, master limited partnerships include both limited partnerships and limited liability companies.

[15] S. 795, 113th Cong. (2013); H.R. 1696, 113th Cong. (2013).

[16] See I.R.C. § 7704(c)(1) (2012).

[17] See id. § 701.

[18] See id. § 11.

[19] See id. § 61(a)(7).

[20] H.R. Rep. No. 100-391, pt. 2, at 1064 (1987), reprinted in 1987 U.S.C.C.A.N. 2313-378, 2313-680.

[21] Id. at 2313-683.

[22] I.R.C. § 7704(c)(2) (2012).

[23] See id. § 7704(d).

[24] See id. § 7704(d)(1)(e).

[25] H.R. 1696, 113th Cong. (2013).

[26] S. 795, 113th Cong. (2013).

[27] PURPA was enacted in 1978 with the intent to spur development of more efficient and renewable generating facilities developed and owned by entities independent from incumbent franchised utilities. See Fed. Energy Regulatory Comm’n, What is a Qualifying Facility? http://www.ferc.gov/industries/electric/gen-info/qual-fac/what-is.asp (last visited Nov. 23, 2013). To that end, PURPA established a new class of generating facilities called qualifying facilities that receive special rate and regulatory treatment. See id. One type of qualifying facility, the small power production facility (SPP QF), is a generating facility of eighty-megawatts or less that uses, as a primary energy source, renewable (hydro, wind, or solar), biomass, waste, or geothermal resources. See id. Facilities that meet the size and fuel requirements to be SPP QFs and file a simple self-certification form with the Federal Energy Regulation Commission enjoy numerous rate and regulatory benefits. See Fed. Energy Regulatory Comm’n, What Are the Benefits of QF Status?

http://www ferc.gov/industries/electric/gen-info/qual-fac/benefits.asp (last visited Nov. 23, 2013).

[28] Ranier Kurz et al., Gas Compressor Station Economic Optimization, Int’l J. of Rotating Machinery, Vol. 2012, available at http://www.hindawi.com/journals/ijrm/2012/715017/.

[29] Energy Info. Admin., Natural Gas Compressor Stations on the Interstate Pipeline Network: Developments Since 1996 (Nov. 2007),

http://www.eia.gov/pub/oil_gas/natural_gas/analysis_publications/ngcompressor/ngcompressor.pdf.

[30] See, e.g., 240 No. 7 Pipeline & Gas J., Millennium Touts Completion of Minisink Compressor Station, (July 2013), http://www.pipelineandgasjournal.com/millennium-touts-completion-minisink-compressor-station.

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Brazilian Private Equity Funds (FIPs): A DNA Change in Brazilian M&A Deals

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José Carlos Junqueira Sampaio Meirelles*

Caio Carlos Cruz Ferreira Silva†

I.  M&A ACTIVITY AND THE PRIVATE EQUITY SCENARIO IN BRAZIL

Brazil has become a preferred destination for private equity[1] investments from all over the globe.[2] The country’s recently achieved investment-grade[3] status was perhaps the missing push needed to put Brazil on the radar of private equity investors and in the mainstream of international business transactions.[4]

The longstanding efforts undertaken in Brazil to reconcile sustainable growth with sound economic policies and reliable legal and regulatory frameworks have helped steer the country out of one of the worst global economic downturns, drawing yet more attention to its promising and underexplored market as an attractive alternative for investors. Mindful of these developments and related opportunities, private equity investors have been deploying substantial funds in Brazil, fueling an unprecedented flow of countrywide M&A activity.[5] The number of private equity deals that have taken place in M&A arena has increased by roughly 168% since 2007,[6] and private equity investors have rapidly developed into one of the driving forces behind business ventures across a variety of industries.[7]

The above data helps put in perspective the rising magnitude of private equity investments in the Brazilian M&A context, a trend that is expected to be further amplified going forward.[8] The data also suggests that private equity investments exert a high degree of influence in the transformation of several sectors in the Brazilian economy, primarily by fostering the reallocation of assets and capital among entities and the reorganization of domestic businesses in pursuit of efficiency and profitability.

From a legal standpoint, the intensification of private equity activity has prompted investors and governmental authorities to come up with creative transactional structures and regulatory approaches to facilitate private equity ventures, while coping with the demands and challenges of an increasingly competitive market. The result of this interaction has been instrumental in reshaping the Brazilian M&A landscape.

M&A deal structures[9] and market players in Brazil have evolved over the past ten years,[10] and private equity sponsors catalyzed several of these changes.[11] This Article, however, focuses on one specific change: most M&A deals in Brazil involving private equity players have been undergoing an important DNA change stemming from the increasing use of the Brazilian Private Equity Fund (Fundo de Investimento em Participações (FIP)) on the buy-side and the sell-side of these transactions.

Unlike U.S. corporate law, Brazilian law does not provide for limited liability partnerships (LLPs) or limited partnerships (LPs), and until recently private equity investments in Brazil were predominantly structured through holding companies. These classic private equity transactions—formally implemented either through direct acquisitions/investments or via local holdings incorporated as a limited liability company (sociedade limitada[12]) or a corporation (sociedade por ações (S.A.)[13])—are now gradually making way for structures involving domestic investment funds[14] as the vehicle to acquire or invest in, hold, and manage portfolio companies until divestment is completed.

The most popular private equity vehicle in the Brazilian M&A practice is by far the FIP, whose structure bears some similarity to the partnership fund model generally adopted in the U.S. and in Europe. The Brazilian Securities and Exchange Commission (Comissão de Valores Mobiliários (CVM)[15]) introduced FIPs to Brazil through Rule No. 391 (CVM Rule 391/03), issued on July 16, 2003.[16]

By laying down the legal and regulatory grounds for the establishment of an investment conduit that local and foreign investors formerly lacked when sponsoring private equity ventures in Brazil, CVM Rule 391/03 largely contributed to a rapid expansion of FIPs in M&A deals.[17] More importantly, investments and exit strategies successfully implemented by FIPs since 2004 created an encouraging track record that helped Brazilian private equity-backed M&A transactions achieve high priority on the agendas of institutional investors.

The regulatory flexibility and generally favorable tax regime accorded to FIPs make FIPs a unique and powerful tool for structuring M&A transactions involving targets in Brazil. Additionally, investors can utilize FIPs for fundraising, deal financing, and implementing exit strategies, as applicable CVM regulations allow the placement of their units in the market. This Article illustrates the many ways in which private equity-backed M&A deals have undergone a DNA change in Brazil, derived—to a large extent—from the rise of FIPs as a common vehicle in such transactions.

II.  THE BRAZILIAN PRIVATE EQUITY FUND (FIP)

CVM Rule 391/03 is the core regulation applicable to FIPs.[18]The self-contained and investor-friendly legal regime applicable to FIPs makes FIPs the preferred and most flexible private equity vehicle in Brazil. The adaptability of the FIP allows investors to contractually stipulate the most suitable set of governance and operational rules that will govern the FIP itself and their legal interaction as owners of the vehicle. These rules are customarily amalgamated in the FIP’s charter, investment commitment agreements, quotaholders agreements,[19] and a variety of service contracts,[20] which regulate matters bearing on investment policy, decision-making procedures, capital commitments and calls, issuance and placement of units (quotas), distribution of proceeds, investment and divestment periods, minimum net equity requirements, management and performance fees, and liquidation, among others.

2.1. Form and Ownership Structure

The FIP is, in essence, a collective investment vehicle formed as a condominium,[21] allowing co-ownership of assets to be exercised among investors. FIPs can only operate in Brazil upon registration with the CVM, and FIPs, along with their securities (quotas) and investors (quotaholders), are subject to the CVM’s oversight. The FIP must be organized as a closed-end[22] condominium consisting of an un-personified pool of assets managed and represented by an administrator[23] registered with the CVM.

The FIP form can be especially attractive to private equity investors seeking lower individual exposure to risks through the gathering of funds by an investor pool and asset diversification.[24] The FIP can also provide its owners with a platform for centralized professional management of target companies with the requisite market and financial skills that otherwise would not be available to investors acting individually or through subsidiaries.[25] Additionally, Brazilian law requires the FIP to obtain a federal taxpayer number and to book the transactions it engages in on its own name and on its own behalf.[26]

2.2. Ownership Rights and Quotas

Equity units known as “quotas” represent the ownership interest rights of the FIP’s investors, or quotaholders.[27] Each quota in an FIP corresponds to a ratable share of the portfolio assets held under joint ownership by the quotaholders.[28] Thus, the value of each quota is calculated as the division of the net equity of the FIP by the number of outstanding quotas. Each quota carries one vote in the quotaholders’ general meeting,[29] unless the organizational documents of the FIP admit classes of quotas with different voting rights.[30]

2.3. Permitted Investments

The FIP’s investment objectives primarily comprise the acquisition of stock, debentures, subscription warranties, or other securities convertible into or exchangeable for stock issued by publicly held (listed) or closely held corporations in Brazil, whose management must be actively monitored by the FIP. The remaining portion of the FIP’s portfolio can consist of liquid fixed-income instruments and other financial assets, mainly for cash management purposes.

The FIP’s charter must establish the eligibility criteria[31] that apply to publicly held companies that the FIP invests in. These companies are also subject to the minimum set of corporate governance standards imposed by CVM Rule 391/03. Closely held companies that the FIP invests in have to comply with certain minimum governance guidelines such as (a) the establishment of a unified one-year term of office for the entire board of directors (no staggered boards); (b) annual audit of their financial statements; (c) disclosure of related-party agreements, shareholders’ agreements, stock option plans, and share buyback plans; and (d) the obligation to adhere to certain differentiated levels of corporate governance practices in case the company goes public.[32]

Investments by the FIP in either closely or publicly held companies are not subject to minimum revenue or net worth requirements. There are no mandatory concentration or diversification requirements that apply to the allocation of the FIP’s portfolio in equity investments, except if otherwise defined in the FIP’s charter. The FIP can concentrate its entire net equity in a single target or distribute its investments in as many targets as decided on by the FIP’s quotaholders or investment committee. Further, there are no restrictions on the number of FIPs that can invest in a single company.

2.4. Investment Restrictions

The FIP cannot invest in derivatives, except for hedging purposes. Furthermore, only the invested companies that make up the FIP’s portfolio may hold direct ownership in real estate assets, not the FIP itself. Consequently, when FIPs are used to structure real estate investments, the invested companies held by the FIP are generally the ones either directly holding the real estate assets or investing in Special Purpose Companies (SPCs), which will then hold the real estate assets.[33] FIPs are not permitted to invest overseas.[34] Further investment restrictions include the prohibition from soliciting or contracting loans (except under very specific limited circumstances) and providing guarantees (except when approved by a qualified majority of 2/3 or more of the quotaholders in a general meeting and as expressly permitted by the fund’s bylaws).[35] These restrictions constrain the FIP’s ability to raise debt in the market to fund acquisitions or investments.[36] Nonetheless, holding companies or SPCs that the FIP invests in can be used as vehicles in leveraged acquisitions of, or investments in, target companies.

2.5. Special Purpose Companies (SPCs)

While companies in which the FIP invests must be publicly or closely held corporations, prevailing regulations impose no restrictions as to the type of business organization of the SPCs that can be held by target companies (S.A.s) directly owned by the FIP. As Figure 1 depicts, the FIP can use these SPCs—through target companies—to channel private equity investments in equity participations and assets that would otherwise not be permitted at the FIP level,[37] which creates liability-shields for the FIP’s quotaholders.[38]

 Image 1, Section 2.5

Peculiarities pertaining to target or asset acquisitions, costs, time, tax efficiencies, and regulatory implications may be some of the motivations that lead corporate planners to adopt multiple corporate layers under an FIP, like the ones exemplified in Figure 1.

2.6. Eligible Investors

The risks associated with private equity investments generally make such investments unsuitable for the general public. As for FIPs specifically, typical risks involve: (a) illiquidity of the securities and assets making up the FIP’s portfolio (as opposed to other investments in more liquid asset classes); (b) concentration in securities issued by only a few target companies or by target companies pertaining to given industries or sectors; (c) failure to comply with the investment policy due to the lack of eligible targets; (d) other risks particularly related to the target companies, including a spectrum of business, financial, and legal risks and contingencies; (e) risks related to the management and operation of the FIP; and (f) market and credit risks.[39] CVM Rule 391/03 acknowledges these risks concern and limits investment eligibility in FIPs to investors whose financial capabilities and sophistication enable them to make informed investment decisions.[40] CVM Rule 391/03 also sets at R$100,000 (approximately US$43,000 as of November 2013) the minimum capital commitment in the FIP per quotaholder.[41] Hence, only “qualified investors” as defined by the CVM, can acquire the quotas of an FIP.[42] This target investor restriction gives private equity investors great latitude to structure FIPs and regulate their operation according to the rules suited for each particular deal or set of deals.

Among local qualified investors, pension funds have been one of the most active players in the domestic private equity scenario.[43] Non-resident investors must make the required investment in accordance with the rules of Resolution No. 2,689, issued by the National Monetary Council (CMN) on January 26, 2000 (CMN Resolution 2,689/00),[44] which apply in addition to the prerequisites of CVM Rule 391/03. CMN Resolution 2,689/00 basically allows non-resident private equity investors to remit funds into Brazil to subscribe for and pay in FIPs’ quotas and repatriate their capital abroad.[45]

2.7. Active Participation in the Management of Target

CVM Rule 391/03 requires the FIP to actively participate in the invested companies’ strategic policies and management, notably by appointing members to their boards of directors.[46] The requirement to actively participate in the decision-making process of the target companies and influence their strategy and management is one of the core features that make FIPs especially attractive to private equity investors. Whatever form the FIP investment in a target company takes,[47] under CVM Rule 391/01, the FIP must retain some degree of effective influence in the invested companies’ strategic decisions.

In order to satisfy the investment eligibility test, the FIP may: (a) hold stocks that are part of the controlling block of the invested company; (b) enter into shareholders’ agreements granting it decision powers over the invested company; or (c) enter into other agreements or arrangements that ensure the FIP’s actual influence on the strategic policy and management of the invested company (agreements or arrangements of this sort can entail, for example, veto rights and supermajority quorums).

2.8. Management and Governance

In contrast to the partnership structure of many U.S. private equity funds, the administration, portfolio management, and distribution of equity interests of an FIP are not performed by a general partner but rather by an independent legal entity accredited with the CVM to engage in securities portfolio administration activities: the so-called FIP administrator (administrador).[48] The administrator is responsible for the legal representation of the FIP as well as for managing the FIP’s routine activities, which include paying fees, receiving dividends and interest, preparing financial statements and reports, signing shareholders’ agreements of companies in which the FIP is a shareholder, providing reports and information to investors, in addition to other activities established in the FIP’s charter or determined by the quotaholders’ general meeting.

The quotaholders who attend the general meeting are the key decision-makers in an FIP and have exclusive authority over key matters such as the amendment of the charter, the removal of the administrator, the merger or liquidation of the FIP, the issuance and distribution of new quotas, the extension of the duration of the FIP, and the operation of the committees and administrative bodies of the FIP. Resolutions of the general meeting generally require a majority vote of the attendees, unless a supermajority vote is mandated by CVM Rule 391/03 or by the FIP’s charter.

Certain FIPs also have internal committees and boards to enrich their decision-making processes and to ensure informed decisions regarding the FIP’s investments and divestitures.[49] More complex FIPs might also have advisory boards and technical committees to advise on matters pertaining to the industry or sector of each target company.[50]

2.9. Distributions and Dividends, and Investment and Divestment Periods

While investors of mutual funds organized as open-end mutual condominia can have their quotas redeemed at any time, quotaholders of closed-end mutual funds like FIPs are only entitled to redeem their quotas at the end of the FIP’s term, and thus remain locked-in for the entire term of the FIP. Nevertheless, the FIP is allowed to make recurring distributions (amortizações) to its quotaholders during the term of the FIP. An FIP may divest itself of one or more of its portfolio companies and distribute the sales proceeds to its quotaholders without having to wait until the termination of the FIP. It may also reinvest such proceeds in other targets, subject to the applicable provisions of the FIP’s charter.[51] Additionally, if the FIP’s charter allows its quotaholders to receive dividends from companies in which the FIP has invested, such dividends may be distributed directly by the target company to the FIP’s quotaholders, ratably according to their respective ownership interests in the FIP.

Quotaholders also have the right to terminate the FIP at any time by qualified majority voting at a meeting, even during the investment period. This right is usually exercised by quotaholders when the FIP has disposed of all of the securities and assets in its portfolio before the end of the FIP’s term of duration or in situations where the FIP has not been able to find eligible target investments.

2.10. FIP Registration and Reporting Requirements

FIPs must be registered with the CVM in order to operate and are subject to continued scrutiny by the CVM.[52] The CVM imposes flexible and relatively simple conditions for registration of FIPs. When an investment channels through an FIP, the CVM requires that the FIP regularly report information about its financial standing and performance, including general information about its portfolio. Other than these CVM reporting requirements, there are no disclosure obligations affecting private equity investments, except for the Central Bank of Brazil’s reporting requirements, which are applicable to foreign investments entering Brazil, and the disclosure requirements that may be imposed by local antitrust authorities. However, if the company is or becomes listed, it must then comply with several disclosure and publicity requirements under Brazilian law.[53]

2.11. Offering of Quotas

The distribution of FIPs’ quotas is considered a public offering of securities under Brazilian securities laws and regulations[54] and, as such, is subject to prior registration with the CVM. If an FIP’s quotas are to be distributed to the public, the requirements set forth in CVM Rule No. 400, of December 29, 2003 are triggered.[55] Nonetheless, under Rule No. 476, issued by the CVM on January 16, 2009 (CVM Rule 476/09),[56] a fast-track procedure applies to certain restricted placements.[57]

2.12. Taxation of FIP and its Quotaholders

FIPs are generally exempt from income tax on the gains derived from their financial investments because of the FIP’s characterization as a condominium under Brazilian law. In contrast, Brazilian tax law does not treat the Brazilian target companies in which the FIP invests as tax-transparent and instead taxes them as independent entities. The fact that the FIP itself is per se exempt from taxation on acquisitions and divestitures makes it a very attractive vehicle for private equity investment. Further, the tax treatment accorded to non-resident quotaholders of FIPs give them an extra incentive to employ such vehicles.

Dividends received by the FIP and repaid to its quotaholders are currently not subject to the Brazilian withholding income tax (WHT). Interest on net equity[58] received by the FIP and repaid to quotaholders as well as other payments made to FIP’s quotaholders domiciled in Brazil are subject to WHT at the rate of fifteen percent.[59] However, WHT assessed on the income earned by non-resident investors arising from an interest in an FIP as well as upon repatriation of the capital originally invested in the FIP are currently subject to a zero percent rate,[60] provided that certain conditions are met.[61] This exemption partly explains why foreign private equity feeder funds and other non-resident investors usually treat FIPs as the preferred vehicles for private equity investments in Brazil.

Savings from a zero reduction on the WHT levied on income distributions made by the FIP may be crucial to determining the economic advisability of an M&A transaction and allow private equity investors to maximize the value-capturing potential of certain opportunities.[62] As the FIP itself is a tax neutral entity (pass-through vehicle), even resident investors take this factor into consideration when structuring M&A deals, with the intent to defer taxes at least for the term of the FIP.

2.13. FIP Structure

 Image 2, Section 2.13

Figure 2 shows a standard FIP structure and the payment flows typically carried out among transaction participants, as enumerated below:

1.  FIP issues quotas to Qualified Investors;

2.  Qualified Investors subscribe and pay quotas to the FIP;

3.  During the investment period, the FIP invests the amounts raised through the offering of its quotas in securities of one or more target companies;

4.  The remaining net equity of the FIP is invested in other assets and securities authorized under the FIP’s charter;

5.  Proceeds arising from payments of dividends and interest on equity by target companies, sales of other assets and securities comprising the FIP’s portfolio, and other distributions are disbursed to the FIP normally following the expiration of the FIP’s investment period; and

6.  The FIP makes distributions to quotaholders.

III.  CONCLUSION

Brazil has become a preferential stop for private equity sponsors seeking high returns from investments in local target companies. The surge of private equity investments carried out in Brazil over the past decade had two major ramifications. First, it powered an unmatched flow of M&A activity across nearly all business sectors of the Brazilian economy. Second, it fostered a revamp of the legal and regulatory framework of private equity-backed ventures in Brazil.

From a legal perspective, the measures that Brazilian authorities adopted primarily focused on making available to local dealmakers cutting-edge tools, features, strategies, and structures that private equity sponsors and conduits generally employ in the international M&A arena. In this context, FIPs came to light in 2003, in a clear attempt to facilitate private equity investments and to adapt to an increasingly competitive market for transnational business combinations. CVM Rule 391/03 tailored FIPs so as to meet such demands, not surprisingly making them the most successful private equity vehicle in Brazil.

As FIPs gain prominence, the classic private equity investment model[63] that prevailed until the late 1990s is rapidly losing ground in Brazil, as are the tools, features, strategies, and structures associated with this deal wave. The benefits of FIPs outweigh corporate-based structures by encompassing more flexibility, less bureaucracy, lower transaction costs, and more tax efficiencies. Moreover, FIPs can also provide synergies as domestic hubs of private equity investments in a diversified portfolio of target companies and can finance such undertakings through the placement of quotas.

The foregoing scenario converges in what this Article claims to be a DNA change in Brazilian M&A deals. Part II addressed the role that FIPs are playing in this process and highlighted the regulatory stability and structuring possibilities introduced by CVM Rule 391/03 that are largely contributing to a swift expansion of such conduits in the Brazilian M&A practice.[64] Some of the distinguishing features of FIPs discussed in Part II also support the conclusion that their widespread use is reshaping the Brazilian M&A landscape. As the roster of reasons supporting this proposition is extensive, it suffices to recapitulate here that the adaptability of FIPs to a wide range of transactional circumstances and requirements, coupled with the favored tax regime accorded both to the fund itself and to its quotaholders, increasingly make FIPs the most suitable structuring option for private equity-sponsored M&A deals in Brazil.

Taking advantage of the investor-friendly legal and regulatory regime accorded to FIPs, private equity investors have found in the FIP form great latitude to engage in domestic M&A transactions. Moreover, private equity investors are now able to influence the management of target companies according to the rules that they consider more suitable for each given deal. This DNA change in Brazilian M&A deals has optimized the investment landscape to the benefit of the investor. In sum, the ongoing boom of M&A transactions involving private equity sponsorship through FIPs means that M&A practitioners should familiarize themselves with FIP structures so as to stay ahead of the legal curve in the rapidly evolving Brazilian investment landscape.

 

 

Preferred citation: José Carlos Junqueira Sampaio Meirelles & Caio Carlos Cruz Ferreira Silva, Brazilian Private Equity Funds (FIPs): A DNA Change in Brazilian M&A Deals, 4 Harv. Bus. L. Rev. Online 15 (2013), https://www.hblr.org//?p=3636.

* José Carlos Junqueira Sampaio Meirelles: Corporate Partner, Pinheiro Neto Advogados; Adjunct Professor of the University of Illinois; Guest Faculty Member of Duke University School of Law; LL.B., University of São Paulo Law School, 1986; LL.M., University of Illinois, 1989.

† Caio Carlos Cruz Ferreira Silva: Corporate Senior Associate, Pinheiro Neto Advogados; LL.B., University of São Paulo Law School, 2003; LL.M. in International Law, University of São Paulo Law School, 2007; LL.M., Harvard Law School, 2011.

[1] In this Article, references to private equity are used in accordance with the broad definition in article 2 of CVM Rule 391/03, a rule issued by the Brazilian Securities and Exchange Commission (Comissão de Valores Mobiliários (CVM)) introducing the Brazilian version of private equity funds. See infra Part II. Under this definition, private equity includes any acquisition of, or investment in, securities of a Brazilian publicly or closely held corporation with the purpose of actively participating in its decision-making process and influencing its capital structure, management, and operations through the adoption of value-enhancing strategic policies.

[2] See, e.g., Guillermo Parra-Bernal, Big private equity eyes Brazil for tasty deals, Reuters (Dec. 16, 2009), available at http://www.reuters.com/article/2009/12/16/us-brazil-privateequity-analysis-idUSTRE5BF2DL20091216; Spencer Ante, Brazil: The next hotbed of venture capital and private equity, Businessweek.com (Jun. 29. 2009), http://www.businessweek.com/the_thread/techbeat/archives/2009/06/brazil_the_next_hotbed_of_venture_capital_and_private_equity.html; Mike Dorning, U.S. Loses No. 1 to Brazil-China-India Market in Investor Poll, Bloomberg (Sep. 21, 2010), http://www.bloomberg.com/news/2010-09-21/u-s-loses-no-1-to-brazil-china-india-market-in-global-poll-on-investing.html.

[3] In general, “investment grade” refers to a classification assigned by rating agencies to entities that are deemed capable of paying off their debt.

[4] Since September 2009, when Moody’s updated Brazilian government debt’s rating to the investment grade category, Brazil’s investment-grade status has been recognized by all the three major rating agencies. Standard & Poor’s and Fitch Ratings elevated Brazil’s rating to investment-grade in April and May 2008, respectively. Brazil is also rated investment-grade by the Canadian rating agency Dominion Bond Rating Service and by the Japanese agencies Rating and Investment Information and Japan Credit Rating Agency. See Public Debt Strategic Planning Department – Investors Relations, Brazil Becomes Investment Grade by Moody’s, Brazilian Treasury (Tesouro Nacional) (2009), available at http://www3.tesouro.fazenda.gov.br/english/hp/downloads/Nota_Investment_Grade.pdf.

[5] In a recent study on mergers and acquisitions in Brazil, PricewaterhouseCoopers reported an average of 384 announced transactions per year from 2002–2005, while the yearly average for 2006–2009 soared to 646 transactions. The yearly average further increased to 773 transactions announced from 2010–2012. See Mergers and Acquisitions in Brazil, PricewaterhouseCoopers (Dec. 2012), http://www.pwc.com.br/pt/publicacoes/servicos/assets/fusoes-aquisicoes/mea-in-brazil-december.pdf. In 2009, Brazil hosted 79 of the 176 private equity transactions that took place in Latin America, channeling US$2 billion of the US$3.27 billion invested by private equity funds in the region. See Orlando Fernández, Private equity in Latin America, Private Law Company (PLC) (Sep. 21, 2010), available at http://crossborder.practicallaw.com/9-503-3821. Following this trend, in 2012, private equity and venture capital firms invested US$7.9 billion in Latin America, according to the Latin American Private Equity and Venture Capital Association. See Vinod Sreeharsha, Private Equity and Venture Capital Investments Rise in Latin America, The New York Times, DealBook (March 5, 2013), http://dealbook.nytimes.com/2013/03/05/private-equity-and-venture-capital-investments-rise-in-latin-america. Accounting for US$5.7 billion of the total channeled to the region, Brazil stands out as the country attracting the most money in Latin America. Id.

[6] See Mergers and Acquisitions in Brazil, PricewaterhouseCoopers, supra note 5.

[7] These industries include food and beverages, real estate, information technology, health, education, energy, infrastructure, logistics, oil and gas, mining, reforestation and consumer products, among others.

[8] Other factors supporting this trend include the steady improvement of local macroeconomic conditions and the overall investment climate, the rising liquidity of the Brazilian capital market, and the investment gap that exists in pivotal areas such as infrastructure, energy, health and education. See Rodrigo B. Feitosa, Fabio Terepins & Hermano Kemps, Brazilian Private Equity: Moving Centre Stage, INSEAD (Faculty & Research Working Paper, 2011), available at http://www.insead.edu/facultyresearch/research/doc.cfm?did=48210.

[9] See infra the remainder of Part I for a description of typical deal structures and corporate entities more commonly employed in the context of private equity transactions carried out over the last decade.

[10] Economies of scope and scale—other than those typically sought in M&A combinations—have become even more far reaching through arrangements permitting the management centralization of many targets and assets under a single investment conduit, putting the capital of its investors and the expertise of its service providers to the service of several companies, industries, and sectors. Exit strategies otherwise impracticable have become feasible through public or private offerings of securities due to a functional regulatory framework and an evolving capital market, which is capable of providing investors with liquidity to sell their stakes either through initial public offers (IPOs) or secondary offers. See Leonardo L. Ribeiro, Antonio Gledson de Carvalho & Claudio V. Furtado, Private Equity and Venture Capital in an Emerging Economy: Evidence from Brazil, 8–9 (Working Paper, 2006), available at http://ssrn.com/abstract=912523. Nine out of the sixteen Brazilian companies that went public on the São Paulo Stock Exchange (BM&FBOVESPA) between 2004 and 2005 were financed by private equity or venture capital investors. Id. at 8.

[11] Among such innovations, it is worth highlighting a set of measures enhancing governance standards and transparency in the Brazilian capital markets, including the protection of minority shareholders by means of a reduction of the proportion of preferred non-voting stock that may be issued in relation to common voting stock, tag-along rights to minority common stockholders at a price equal to eighty percent of the price paid to the controllers in case of a sale of control, the regulation of going private tender offers affecting takeovers and unsolicited bids, as well as the adoption of voluntary listing levels on BM&FBOVESPA (Nível 1, Nível 2 and Novo Mercado), imposing on companies listed in such segments more stringent corporate governance standards than those required by Brazilian Corporation Law.

[12] The sociedade limitada is the type of Brazilian business organization that most closely mirrors the limited liability companies, limited partnerships, and closely held companies under U.S. and U.K. laws. They are currently the most common company form in the country, especially due to the flexibility accorded to the structuring of this type of business entity and the relatively low level of legal requirements and formalities to which it is subject under Brazilian law. For more information on limitadas, see Pinheiro Neto Advogados, Doing Business in Brazil, Vol. 1, Chapter 2, F (2010).

[13] The sociedade por ações (S.A.) is the type of Brazilian business organization that is similar to corporations and joint-stock companies under U.S. and U.K. laws. An S.A. can be publicly or privately held. A publicly held S.A. and its securities must be registered with the CVM, and its securities can be traded on the stock exchange or on regulated over-the-counter markets. The securities of a closely held company are not available to the general public. For more information on S.A.s, see Pinheiro Neto Advogados, Doing Business in Brazil, Vol. 1, Chapter 2, G (2010).

[14] The Brazilian regulatory framework encompasses a profusion of investment fund categories, each tailored to carry out investments in a particular asset class. As far as private equity investment is concerned, the equity funds that can be used are typically FIPs, Venture Capital Investment Funds (Fundos de Investimento em Empresas Emergentes (FIEEs), focused on start-ups and small targets) and Stock Investment Funds (Fundos de Investimento em Ações, rarely adopted in part on account of regulatory constraints on portfolio composition).

[15] Similar to the U.S. Securities and Exchange Commission, the Comissão de Valores Mobiliários (CVM) is a federal agency linked to the Ministry of Finance that is in charge of the regulation, development, control, and supervision of securities markets in Brazil, including FIPs, their investors, and quotas.

[16] Instrução CVM [CVM Rule] No. 391, de 16 de julho de 2003, Diário Oficial da União [D.O.U.] de 18.7.2003 (Braz.), as amended, [hereinafter CVM Rule 391/03].

[17] As of December 31, 2012, there were 517 FIPs registered with the CVM, with a combined net equity of approximately US$53.5 billion. See CVM’s Register of FIP’s Net Equity (Cadastro de Patrimônio Líquido de FIP) (Mar. 2013), available at http://cvmweb.cvm.gov.br/SWB/Sistemas/SCW/CPublica/ListaPLFdoExcvFech/CPublicaListaPlFdoExcvFech.aspx?TPPartic=73. Nine out of the 517 FIPs currently registered with the CVM were under liquidation. Compared to FIPs, the use of Mutual Investment Funds in Innovative Emerging Companies (Fundos Mútuos de Investimento em Empresas Emergentes Inovadoras (FMIEEs)) is infrequent. As of the same date, only thirty-four FMIEEs were registered with the CVM (two of which were currently under liquidation), with an aggregated net equity of US$376.3 million. See CVM Register of FMIEE’s Net Equity (Cadastro de Patrimônio Líquido de FMIEE) (Mar. 2013), available at http://cvmweb.cvm.gov.br/SWB/Sistemas/SCW/CPublica/ListaPLFdoExcvFech/CPublicaListaPlFdoExcvFech.aspx?TPPartic=72.

[18] FIPs are also governed by a specific regulation, Instrução CVM [CVM Rule] No. 409, de 18 de agosto de 2004, D.O.U de 24.8.2004 (Braz.), as amended (CVM Rule 409/04), which provides for the creation, management, operation, and disclosure of most Brazilian investment funds. This rule applies to FIPs on a supplementary basis, when its provisions do not contravene CVM Rule 391/03. FIPs are subject to Brazilian securities statutes but not to the Brazilian Corporation Law (Lei [Law] No. 6,404, de 15 de dezembro de 1976, D.O.U. de 17.12.1976, as amended).

[19] FIPs held by more than one group of related investors or used as a conduit to implement joint ventures or associations between private equity investors and other strategic partners are often subject to quotaholders’ agreements that regulate the participation of investors in the definition of the strategies and management policy of the FIP, including matters like the exercise of voting rights or control power, preemption rights, and purchase and sale of quotas at the FIP level.

[20] These service contracts include administration and portfolio management agreements, depository or custody agreements, and agreements with consultants, advisors, and industry experts hired by the FIP.

[21] Under Brazilian law, a condominium can be defined as a joint property (in rem) right exercised by two or more persons over a certain asset or pool of assets, each holder (a co-owner or condômino) owning a pro rata fraction of such asset. The condominium itself has no legal personality apart from that of its owners, and the Brazilian Civil Code (Lei [Law] No. 10,406, de 10 de janeiro de 2002, D.O.U. de 11.1.2002 (Braz.), as amended) sets forth its central legal tenets. Statutes and regulations have elaborated on the legal concept of condominium to develop various legal structures, such as joint ownership of common areas of residential and commercial buildings and, most importantly for the purposes of this Article, quotas (securities) of mutual funds regulated by the CVM. For a further discussion of FIP’s quotas, see infra section 2.2.

[22] A mutual fund can be formed either as an open-end condominium, in which quotaholders can redeem their units at any time, or as a closed-end condominium, in which units can only be redeemed at the end of the funds’ term, except in the case of liquidation of the fund. However, distributions can generally be made to quotaholders throughout the term of the fund and pursuant to its organizational documents. See infra section 2.9.

[23] See infra section 2.8.

[24] An FIP can be funded either publicly or privately, at the beginning of its operations or during its term of duration, and in a single offering or a series of offerings. The mix of alternatives available for FIP capitalization is further described in section 2.11.

[25] This feature is especially important in FIPs that invest in multiple target companies in the same industry, allowing quotaholders to benefit from economies of scale and scope that a centralized management structure and FIP-related efficiencies can provide.

[26] While the FIP is an un-personified entity under Brazilian civil law, tax regulations require the FIP to be registered with the National Register of Legal Entities (Cadastro Nacional da Pessoa Jurídica (CNPJ)).

[27] Resembling a limited partner (LP) in a U.S. partnership, the quotaholder of an FIP is the equity owner (co-owner) of a unit (quota) representing a fraction of the FIP’s net equity. According to the legal concept of condominium under Brazilian law, quotaholders of the FIP are not entitled to ownership rights over the securities and assets in its portfolio, but rather to the appropriate proportion of the total assets comprising the FIP’s portfolio and available for distribution.

[28] Section 2.9 discusses how FIP’s quotaholders are remunerated for their investment and the types of distributions they are entitled to receive from the FIP. FIPs having a sole quotaholder (exclusive FIPs) are also permitted, provided that such quotaholder is a qualified investor. See infra section 2.6.

[29] See infra section 2.8.

[30] If the FIP issues more than one class of quotas, each class can have distinct voting rights as defined by the FIP’s charter. This possibility allows the FIP to accommodate in its ownership base investors with contrasting profiles and interests, changing their level of involvement in the FIP’s governance and activities as particular deal circumstances may demand. Additionally, the FIP can attach to each class of quotas different economic rights, but exclusively in connection with the administration and performance fees relevant to each class and respective calculation bases. Consequently, the issuance of classes of quotas establishing different remuneration criteria among quotaholders of distinct classes is not permitted, which grants quotaholders an undivided right in the portfolio securities and assets of the FIP.

[31] Frequently, such criteria are specified based either on those required under the voluntary listing levels on the São Paulo Stock Exchange (BM&FBOVESPA, Nível 1, Nível 2 and Novo Mercado) or the minimum corporate governance standards imposed on closely held companies by CVM Rule 391/03.

[32] See CVM Rule 391/03.

[33] See infra section 2.5 and Figure 1 (FIPs, Target Companies and SPCs).

[34] According to article 35, item VI(a) of CVM Rule 391/03, all companies comprising the FIP’s portfolios must be incorporated and headquartered in Brazil. Despite the growing internationalization of M&A transactions and the demand from local institutional investors for such flexibility, the CVM has not changed this rule.

[35] See art. 35, items II e III, of CVM Rule 391/03.

[36] This differs from the leveraged buyout structures that are common in private equity-sponsored M&A deals in the U.S.

[37] See supra section 2.4.

[38] Under Brazilian Corporation Law, the liability of an FIP with respect to an SPC or any other invested target company is generally limited to the unpaid portion of the issuance price of such SPC’s or target company’s shares (that is, the portion subscribed for but not yet paid in by the FIP). Once the FIP pays in the shares of the SPC or the target company, the FIP and its quotaholders are no longer responsible for any liabilities in connection with companies held in its portfolio, except in very limited circumstances. These limited circumstances include, for example, liabilities associated with acts perpetrated with fault or willful misconduct and in violation of the law or the target companies’ organizational documents, and instances where the application of the disregard of legal entity doctrine can be applied under Brazilian law.

[39] Additionally, equity losses incurred by the FIP’s quotaholders are not limited to the subscribed capital, meaning that they may be called to make extraordinary capital contributions to the FIP in cases where the assets available are not sufficient to fulfill liabilities arising from target companies.

[40] See CVM Rule 391/03.

[41] See id.

[42] The definition of “qualified investors” includes the following investors: (a) financial institutions; (b) insurance companies and special savings companies (sociedades de capitalização); (c) open- and closed-end pension funds; (d) individuals or legal entities with financial investments that hold financial investments in excess of R$300,000 (roughly US$130,000) and that attest in writing their status as qualified investors; (e) investment funds exclusively targeted to qualified investors; (f) portfolio managers and securities consultants authorized by the CVM, in relation to their own funds; and (f) social security regimes instated by the Federal Government, States, Federal District or Municipalities. See CVM Rule 409/04, art. 109.

[43] Pension funds became one of the most active players in the domestic private equity scenario mainly after the National Monetary Council (CMN) recognized private equity as a separate asset class and allowed closed pension funds (Entidades Fechadas de Previdência Complementar) to invest up to twenty percent of their portfolios in quotas of FIPs. See Resolução CMN [CMN Resolution] No. 3.792, de 24 de setembro de 2009, D.O.U. de 28.9.2009 (Braz.), as amended.

[44] See Resolução CMN [CMN Resolution] No. 2.689, de 26 de janeiro de 2000, D.O.U. de 27.1.2000 (Braz.), as amended.

[45] For the purpose of foreign capital registration with the Central Bank of Brazil, the FIP must be registered with the CVM, and its quotas must be tradable either on the stock exchange or organized over-the-counter market. See art. 6 of CMN Resolution 2,689/00.

[46] See CVM Rule 391/03.

[47] Forms that the investment may take include a control acquisition, minority participation, or joint venture, inter alia.

[48] The functions of both the FIP’s administrator and portfolio manager (gestor de carteira) may be performed by the same legal entity. Alternatively, the FIP’s administrator may retain an equally qualified third party to manage the portfolio of the FIP. The administrator and the portfolio manager can be held liable for losses borne by the quotaholders if they act with fault or in violation of the law, the CVM rules, or the FIP’s charter.

[49] These internal bodies are more relevant in FIP structures where the investors have a passive or secondary role in defining investment policies. As a result, in many instances investors prefer to entrust the details of portfolio management of an FIP to groups of private equity professionals, business developers, industry experts or technicians who are also empowered to follow up on the performance of the FIP’s investment portfolio and the administrator’s activities vis-à-vis its obligations to the FIP.

[50] Supervisory boards have become more common in the FIP business due to the rules recently introduced by the Governance and Best Practices Code for Private Equity Funds (FIPs) and Emerging Companies Investment Funds (FIEEs), which state that such boards are to oversee investment decisions made by the investment committee whenever conflicts of interest arise between quotaholders and the FIP’s administrator or portfolio manager.

[51] Normally, distributions occur only after the expiration of the investment period defined in the FIP’s charter. The investment period often goes from the inception of the FIP until two or three years after, and during this period FIP is expected to undertake investments and deploy funds in target companies in fulfillment of its investment policy. Distributions may also be made in kind, such as in assets, rights, or securities, as long as the relevant distribution rules have been previously agreed upon and are stipulated in the FIP’s charter.

[52] Registration is generally granted within five business days from the filing of the proper documentation with the CVM.

[53] See Instrução CVM [CVM Rule] No. 400, de 29 de dezembro de 2003, D.O.U. de 9.1.2004 (Braz.), as amended.

[54] See, e.g., art. 26 of CVM Rule 391/03.

[55] In this case, the FIP must submit the CVM filing, along with a detailed prospectus, notices, and marketing materials for underwriters and offering participants to use in the public offering, as well as statements signed by the FIP’s administrator and the offering’s underwriter in connection with the legality of the offering and the truthfulness of the information then provided to the public. See Instrução CVM [CVM Rule] No. 400, de 29 de dezembro de 2003, D.O.U. de 9.1.2004 (Braz.), as amended.

[56] See Instrução CVM [CVM Rule] No. 476, de 16 de janeiro de 2009, D.O.U. de 19.1.2009 (Braz.).

[57] In restricted placements, a maximum of fifty potential investors are initially approached and no more than twenty investors ultimately subscribe quotas of the FIP. See art. 3, item I, of CVM Rule 476/09. Moreover, the FIP’s quotas offered under CVM Rule 476/09 are subject to a ninety-day lock-up, which begins with their subscription or acquisition by the respective investor, see art. 13 of CVM Rule 476/09, and the FIP cannot carry out another public offer of quotas within four months from the date of termination of the last offer, unless such new offer is submitted for registration by the CVM. See art. 9, of CVM Rule 476/09.

[58] Under Brazilian law, interest on equity (juros sobre capital próprio) is essentially a tax-deductible payment, made by corporations to their shareholders, of a notional interest rate calculated by the application of a long-term interest rate over the company’s capital stock.

[59] See art. 25 of Instrução Normativa [Rule] No. 1,022, de 5 de abril de 2010, D.O.U de 7.4.2010 (Braz.), as amended, and art. 2 of Lei [Law] No.11,312, de 27 de junho de 2006, D.O.U de 28.6.2006 (Braz.) (Law 11,312/2006).

[60] See art. 3 of Law 11,312/2006.

[61] In order to enjoy such tax benefits, the following conditions must be met: (a) the FIP’s quotaholder cannot hold—individually or jointly with related persons—quotas representing forty percent or more of all the FIP’s quotas or forty percent or more of the total income of the FIP; (b) the FIP cannot hold in its portfolio debt securities exceeding five percent of the FIP’s net equity; and (c) the foreign investor cannot be resident or domiciled in a country defined by Brazilian law as a tax haven jurisdiction (a country where income is not taxed or subject to taxation at a maximum rate lower than twenty percent). See id.

[62] From a deal perspective, a positive side effect of this mutually beneficial “increase in the pie” is to induce private equity investors—as owners and controllers of the FIP—to take a more risk-seeking approach towards the closing of M&A transactions in Brazil that would otherwise not be feasible.

[63] See supra Part I.

[64] The investments and exit strategies successfully implemented by FIPs since 2004 likewise created an encouraging track record that stimulated the propagation of FIPs among foreign institutional investors seeking opportunities in emerging markets.