CVM Practice Bulletin No. 40 – Summary and Comments

On October 11, 2022, CVM Practice Bulletin No. 40 was published, which provides for crypto assets (or digital assets) and the Securities Market (“Practice Bulletin No. 40”).

Below is a summary of each of the nine chapters that comprise Practice Bulletin No. 40, together with preliminary considerations drafted by our Capital Markets and Blockchain and Digital Assets teams.

Chapter 1 – Practice Bulletin No. 40 Subject

In this Chapter, the Brazilian Securities and Exchange Commission (“CVM”):

(a) assigns crypto assets one of the definitions regularly employed by the market;

(b) acknowledges that regulating this type of asset represents a cross-border challenge that demands guidance, in line with the Organisation for Economic Co-operation and Development’s (OECD) understanding;

(c) clarifies that the content of the Practice Bulletin constitutes the consolidated understanding of the Agency in regard to the topic, based on several judgments; and

(d) clarifies that, due to a lack of specific regulations, the document aims to ensure greater certainty and security in crypto transactions, as well as foster a favorable environment for the development of crypto assets, including the protection of investors and public savings, and the prevention and battle against crimes or wrongful acts of various kinds.

Our Comments: In contrast to other jurisdictions and to Bill 4,401/2021 itself – which provides for digital asset service providers – the CVM opted for the “crypto assets” terminology instead of “digital assets”. From a technological perspective, the latter is more neutral, as certain digital assets can be issued even without the use of distributed ledger technologies (DLT) or blockchain technology.

However, regardless of the technology employed to issue digital assets, the Agency requests that the target audience concentrate on the of Practice Bulletin No. 40.

Chapter 2 – New Technologies and Regulation

In this Chapter, the CVM:

(A) adopts a receptive stance regarding the adoption of new technologies;

(b) acknowledges that blockchain technology is not subject to regulation within the securities market, but remarks that products and services developed within its scope can be subject to specific regulatory frameworks; and

(c) determines that, even if new technologies are employed, the administration of organized markets for the trading of tokens that classify as securities, as well as ancillary services provided within their scope (bookkeeping, intermediation, compensation, etc.), remain subject to the regulatory rules that govern them.

Our Comments: Certain countries have tried to “regulate” digital assets through bans, criminalizations and sanctions – some quite severe – against those who attempted to or effectively carried out operations in the crypto market. Such restrictions have achieved hardly any success, especially due to the cross-border nature of the internet and the decentralized nature of blockchain technology. In this regard, the Agency’s awareness of the global landscape, as well as its perceptiveness and action-oriented approach, merit positive remarks concerning its role in the development of a more secure and transparent market to all parties involved.

Chapter 3 – Functional Criteria for Token Taxonomy

In this Chapter, the CVM:

(a) recognizes that crypto assets (commonly called “tokens”), which apply to numerous functions and serve various purposes, still lack a uniform taxonomy;

(b) determines that, at first, the taxonomy adopted by the regulator will be divided into the following categories:

• payment tokens (e.g., Bitcoin, Ether);
• utility tokens (e.g., projects “funded” through pure donation from third parties, which supposedly prefer to acquire products or services offered by the funded project); and
• asset-backed tokens (e.g., tokens that represent ownership interest, court-ordered debt payments, and real estate ownership);

(c) recognizes that the abovementioned concepts can interconnect, so that a particular crypto asset fits into more than one category;

(d) states the understanding that asset-backed tokens may or may not be framed as securities – depending on the economic nature of the holders’ rights, as well as the role they play in the course of the underlying project – which requires the analysis of the concept of security, provided for in article 2, item IX, of Law No. 6,385, of 1976, as amended (“Law 6,385/76”); and

(e) acknowledges that, considering the numerous structures subject to tokenization, its carrying out, in certain situations, will continue to depend on analysis of each specific case.

Our Comments: The taxonomy adopted by the CVM is aligned with the concepts that have been discussed and adopted by other regulators around the world. Certainly, the Agency’s biggest lies in the increased proximity of asset-backed tokens to securities – especially collective investment agreements.

A noteworthy inclusion is that although the underlying asset itself cannot be framed as a security, the combination of efforts derived from the specific features of the underlying asset and this token, may lead the CVM to reach the understanding that, as a whole, the offer of a given token can potentially be framed as a public offering of securities – consequently falling under the competence of the Agency.

In the cases submitted to its analysis, the CVM, for a few years, has been adapting the application of the Howey Test to the regional landscape, which seeks to answer the following questions:

• was there a public offering?;
• did investors contribute to a collective project with money or other assets subject to economic evaluation?;
• were the contributions carried out with expectation of profits from equity rights, partnership or any form of remuneration?; and
• will the expected results come, exclusively or preponderantly, from the efforts of the entrepreneur or third party?

If the answers to all questions above are affirmative, the asset is a security.

Chapter 4 – Framing of Crypto assets as Securities 

In this Chapter, the CVM:

(a) clarifies that the concept of security – which is instrumental in nature – is aimed at establishing the boundaries of the Agency’s competence to legislate and regulate operations involving crypto assets;

(b) clarifies that crypto assets can be framed as securities, if they amount to the digital representation of any type of security provided for in items I to VIII, article 2 of Law 6,385/76, or if they fall under the open concept of collective investment agreements, provided for in item IX, Article 2 of Law 6,385/76;

(c) clarifies that the framing of a crypto asset as a collective investment agreement – and therefore, a security – does not depend on any prior statement by the CVM;

(d) clarifies that any derivative instrument, regardless of its underlying asset, is framed as security, due to the wording provided for in item VIII of such article; and

(e) addresses the nuances of the framing of a collective investment agreement as security, in line with the Howey Test, emphasizing three specific elements for such framing: expectation for economic return, effort of the entrepreneur or third party and public offering.

Our Comments: In line with their assessment of specific cases, the CVM has reinforced its opinion on the need for an in-depth analysis on the framing of securities within the scope of the Howey Test.

In regard to the most controversial aspects of the Test, we highlight that:

• regarding the expectation for economic return, such return must result from the efforts of the entrepreneur or third party – and not from external factors that escape the entrepreneur’s influence. This was the rationale used, for example, in the analysis of multifamily real estate investment, as well as in the “tokenization” of the solidarity mechanism of professional football players;
• regarding the efforts of the entrepreneur or third party, the nature and extent of the agent’s performance must be evaluated with a view to the success of the project. In other words, it is possible to infer from the wording of Practice Bulletin No. 40 that the positive interference of the entrepreneur or third party is an important factor for the success of the project; and
• regarding public offerings, there is special concern over securities issued abroad and offered in Brazil through the internet – a matter that has already been addressed in Practice Bulletins 32/05 and 33/05, whose contents are reaffirmed by the Agency, which also recognizes the need for supplementary guidelines.

Chapter 5 – Information Reporting Framework and Emphasis on Transparency

In this Chapter, the CVM:

(a) recognizes the importance of the principle of full and fair disclosure and reiterates that transparency in crypto operations is one of the guiding principles of its operation;

(b) reaffirms that the CVM is responsible for protecting investors, through the requirement to disclose precise, clear and exhaustive information – consequently reducing inconsistencies;

(c) stresses the existence of general and specific rules, already published by the Agency, which address the information reporting framework applicable to securities, and must be consistently complied with in regard to tokens that can potentially be framed as securities;

(d) advises those who wish to carry out the public offering of crypto assets to consider the advantages of including a minimum set of specific information related to the security, within the context of drafting the offering documents – which may influence the CVM’s judgment in future applications and, additionally, encourage the development of more flexible systems in the future; and

(e) introduces a list of information that can be made available to the target audience, such as: information on token holders’ rights and information on negotiation, infrastructure, and ownership of tokens – in addition to a more detailed list of items that must be addressed in each section of the list.

Our Comments: Unfortunately, we have witnessed the proliferation of products and services that, under pretense of being based on blockchain technology, attempt to avoid the duty to properly inform the investor on the information requirements deemed minimum for evaluation of any application – and also required for any type of investment; not only securities.

As a result, the market, as a whole, is jeopardized by the practices of those who prioritize their individual interests over collective interests. Consequently, the CVM has provided such recommendations on the information reporting framework and the emphasis on transparency in an opportune moment.

One additional remark, however, concerns the market infrastructure underlying the issuance of tokens. Unlike traditional capital markets, when it comes to blockchain technology, the number of intermediaries (and even their importance) within the offers is expected to reduce – given that blockchain essentially proposes to establish increasingly decentralized and disintermediated environments. In addition, the CVM acknowledges that technology applied to blockchain is still in its early stages – and as such, there is expectation for the gradual development of the regulation, aimed at moving closer towards the reality of the market.

Chapter 6 – The role of Intermediaries 

In this Chapter, the CVM:

(a) clarifies that intermediaries involved in offerings of crypto assets framed as securities must comply with the applicable CVM regulations, and ensure the investor an adequate level of transparency and information regarding the product offered;

(b) clarifies that such intermediaries must carry out appropriate due diligence on crypto service providers in order to mitigate any risks that can affect the intermediary;

(c) recommends that the intermediary agent evaluate the pertinence of informing the investor of the nature and extent of the commercial partnership with crypto service providers, as well as assess the need to separate intermediaries and such service providers; and

(d) reinforces the need for the intermediary to provide information, in clear and accessible language, on the risks involved in this type of application.

Our Comments: The partnership between crypto asset service providers and intermediaries is a reality and the CVM seeks to provide investors with as much information as possible in order to mitigate potential disputes due to underlying incentives; a practice, in fact, consistent with what is required in the offerings of other securities.

Chapter 7 – Investment Funds

In this Chapter, the CVM:

(a) clarifies that, as new products are incorporated into the scope of the regulation, new criteria and measures must be adopted by the regulator;

(b) ratifies that fund managers must assess the appropriate level of disclosure of potential risks, especially in regard to assets backed by new technologies;

(c) reinforces the applicability of specific regulations for specific scopes of crypto assets; and

(d) clarifies that Practice Bulletin No. 40 does not introduce any innovations to the understanding already published by the Agency in Circular No. 1/2018/CVM/SIN, of January 12, 2018, and Circular No. 11/2018/CVM/SIN, of September 19, 2018.

Our Comments: In Brazil, there are already index funds (called ETFs) authorized by CVM to invest in crypto assets. Likewise, other funds constituted in Brazil can also carry out indirect investments in crypto assets internationally, for instance, through the acquisition of shares of funds and derivatives, among other assets traded in other jurisdictions, provided that they are admitted and regulated in those markets.

Through this new Practice Bulletin, the CVM displays a consistent understanding on the matter, acknowledging the possibility that new adjustments may be implemented in the future, depending on the development of the crypto market.

Chapter 8 – Regulatory Sandbox 

In this Chapter, the CVM:

(a) moves away from the first admission procedure within its Regulatory Sandbox, within which four projects were approved, three of which were allocated for the tokenization of securities;

(b) clarifies that the approved projects obtained temporary authorizations to operate in this market and, therefore, such practices have been undergoing testing by the CVM; and

(c) clarifies the main goals of the Regulatory Sandbox.

Our Comments: Demarest had the privilege of serving as legal advisor of one of these companies within the scope of the Regulatory Sandbox. Numerous discussions have been carried out regarding the benefits and the opportunity of application or waving from several rules within the scope of tokenization of securities.

It is our understanding that certain regulatory adjustments still must be implemented in order for the rules to encompass more accurately, the challenges, particularities and opportunities introduced by this new technology. In turn, the CVM has shown great interest in cooperating with such developments.

Our Capital Markets and Blockchain and Digital Assets teams are fully available to assist those interested in dedicating their efforts to the development of innovative solutions within this market. Don’t forget to visit our Disrupt page – Demarest’s program aimed at promising startups.

Chapter 9 – FINAL CONSIDERATIONS 

In this Chapter, the CVM:

(a) states their intention to amplify its studies on the applicability of new technologies in the capital market;

(b) clarifies that it remains cautious regarding the marginal market of crypto assets framed as securities and will continue to suppress any violations of the rules with the help of the Public Prosecutor’s Office and the Federal Police;

(c) offers to remain available for the consultation of participants; and

(d) reiterates that the content of Practice Bulletin No. 40 is aimed at consolidating the CVM’s understandings on the matter, but remarks that its wording is not unalterable – and is subject to future adjustments.

Our Comments: Practice Bulletin No. 40 has long been expected by the market. As predicted, the Bulletin cannot resolve any discussions, nor impose strict rules specific to that market – but rather establish guidelines for those interested in building an innovative market with best practices.

Demarest’s Capital Markets and Blockchain and Digital Assets teams are available to provide any clarifications that may be necessary.