A new development from the United States has left Brazilian companies in uproar in recent weeks. The movement started in October, when measures issued by the Securities and Exchange Commission (SEC) came into effect to facilitate foreign companies' access to the U.S. market. With the new rules, any company listed in an exchange at their country of origin, with at least 55% of their share trading volume outside the U.S., and which discloses, in English, the information they offer within their own jurisdiction, will have an automatic exemption from having to register to offer their shares in the American OTC market. In practice, this means that companies that conform to the requirements may set up Level 1 American Depositary Receipts (ADR) programs without going through the SEC.

The news is good, but it was not celebrated. At the same time as they made way for interested companies to access qualified U.S. investors, the SEC made life easier for banks that wish to set up ADR programs on their own, without participation of the share's own issuer -- so-called unsponsored programs. The modality already existed, but was further energized by the new rules. Up until then, even if the program was unsponsored, the depositary bank depended on the issuing company requesting exemption from registering with SEC. Now, with automatic exemption, this stage has become unnecessary.
The impact was immediate. This year alone, 605 unsponsored ADR N1 programs were created in the United States; 400 of them arose after the rules were changed. Throughout 2007, 209 similar programs were listed, according to SEC data compiled by The Bank of New York Mellon (BNY Mellon). Issuers of these receipts are spread out around the world. Over 300 of them are European, and the record-holder is Japan, with 136 new programs. Latin America entered the unsponsored list in a modest way. As of this moment, Mexico, Argentina and Peru have listed one program each.

In Brazil, unsponsored ADRs promise to throw quite a party, although this hasn't started yet -- and, truthfully, it may never do so. It all started with the negative repercussions of the rule change promoted by the SEC. The idea of having receipts of their shares traded abroad without their own permission caused discomfort among companies. Many of them fit the three criteria for automatic exemption from listing. The group contains mainly newcomers, who made their debut on the trading floor with massive participation of foreign investors and started to disclose information in English to serve this significant portion of their shareholder base.

Then came the doubts. The companies started to question the possible downsides of unsponsored programs. Their major fear is to fall into noncompliance with the SEC's requirements, even if indirectly. The discomfort was so great that companies started to study bona fide defense strategies, such as reduction of disclosure in English and sponsored programs (which cannot coexist with an unsponsored one). At the same time, many companies asked themselves how it was possible for one bank, alone, to make a decision of such a strategic nature to the company, while a sponsored ADR program depends on approval at a board meeting. PDG Realty was one of the companies who signed on with the process.

At the end of October, the company entered independently into the world of Level 1 ADRs. "We took advantage of the flexible rules and also sought to avoid an unsponsored program", says Michel Wurman, financial and Investor Relations director at PDG. Equatorial Energia was another company that decided to enter the American OTC market. The two programs use Citibank as their depositary bank, which did not consent to an interview request placed by our staff.

UNSPONSORED PRO FORMA — Before issuing a Level 1 ADR, the depositary bank must register the operation with the Brazilian Securities and Exchange Commission (CVM). The autarchy currently has a total of 23 operations undergoing analysis, all of them unsponsored, under the responsibility of BNY Mellon. The list includes names such as Lojas Renner, Natura and ALL (see box below). These target-companies, however, will not need to engage in defense strategies, as PDG did. If they do not want to have their shares involved in the unsponsored program and are justified in this, the CVM promises to comply with their wishes and not allow the operation. Initially, the CVM was considering maintaining a more discrete stance. In conversations with BNY Mellon, they decided that the bank itself would notify the companies and would undertake not to create programs without their consent.

This measure, however, proved inefficient. One of the companies consulted by BNY asked that the CVM not register the operation, using the argument that, at that time, they were negotiating a sponsored program with another financial institution. With this episode, the CVM's Registration Superintendence took the matter to the board members. "We realized that merely notifying the target-company may not be enough", says Felipe Claret, superintendent for the area.

Now, the Brazilian market follows a standard procedure, applicable to all banks willing to explore this market niche. The CVM's board of directors decided that the autarchy itself will consult with the target-company of a protocolled unsponsored program, so as to analyze it, and will comply with any contrary manifestations by the companies. In practice, it's as if the flexible rules that stimulated the unsponsored ADR market worldwide never arrived in Brazil. Banks no longer depend on a company's collaboration to request exemption from listing in the United States, but are now bound to their will. According to BNY, the Brazilian regulator was the only one to create this solution, which aims to preserve issuer interests.

JUSTIFIABLE CONCERN? — After the initial scare, attention has been redirected to the pros and cons of an unsponsored program. Many of the questions that arose with the arrival of the SEC's new rules derive from lack of a history for such operations in Brazil. In order to assist the companies, the Brazilian Association of Public Companies (Abrasca) issued, in the last week of November, a primer with the first information about the subject, simplified and in Portuguese. The guide aims to help companies weigh the pros and cons of these operations. "Their doubts are not superficial. There are matters that require further consideration before the decision is made", says Eduardo Lucano, superintendent at the association.

One of the issues that scare companies the most is the possibility of exposure to the SEC's rules. For Level 1, trading is restricted to the OTC market, where only qualified investors operate, so a company will neither have to adhere to Sarbanes-Oxley nor adopt the American accounting standard (US Gaap). If the company ceases to disclose information in English -- a characteristic that will take away its benefit of automatic exemption from registering --, responsibility for interruption of the unsponsored program or its cancellation falls on the depositary bank only.

Another frequently asked question is about coexistence of programs. A company can have several unsponsored programs, set up by different institutions, at the same time. However, none of them may coexist with a program sponsored by the company. If this happens, the depositary bank of the sponsored ADRs will be charged with negotiating with the other institutions. This is standard procedure in the United States, although there are no formal guarantees that the company would be exempt from the costs of migrating from one program to the other.

Questions about liquidity of the shares are also recurring among the companies. For some, it might not be interesting to decentralize trading and run the risk of increasing the volatility of their shares in the local market. But for those that are already part of Bovespa's higher governance levels, which require a minimum free float of 25%, an eventual increase in demand for ADRs is not harmful. According to lawyers consulted by CAPITAL ABERTO, all shares deposited for receipt issuance continue to be part of the group of outstanding shares, given that DRs can be converted and traded in Brazil at any time.

SHAREHOLDER RIGHTS — While, on one hand, there are clarifications, on the other hand new doubts arise. Who owns the deposited shares and what are their shareholder rights? The answer is not obvious. From a legal standpoint, the holder of a DR is not considered a shareholder, despite being its economic beneficiary. "The registered shareholder is the depositary bank", says Tobias Stirnberg, of the Shearman & Sterling law office.

In sponsored programs, shareholder rights, for corporate purposes, are guaranteed by contract to the final investor's bank. In addition to issuing the DRs, the institution provides a proxy vote service. In this way, they exercise the right to vote only for clients who direct them to do so. If such directions are not provided, the institution simply does not speak for those shares at shareholder meetings. According to Ray Fischer, partner at Linklaters, this extension of the right to vote to the DR holder is a contractual standard of sponsored programs, but it is not a legal obligation.

This proxy service at meetings is important not only to the DR holder, who may exercise his or her political rights if they wish, but also to the bank. Through this documentation, the institution shows that, despite holding a significant amount of shares, they do not act with that entire voting potential taken as a whole. This is important so that, in Brazil, the bank does not incur obligations related to concentration of shares, such as poison pills, for example - clauses that establish the acquisition of all of the company's shares if a certain percentage of shares is surpassed.

But the situation changes when it comes to unsponsored programs. In this type of program, contracts do not prescribe the use of proxy tools, which may expose the bank to attempts to enforce the public offering prescribed by the poison pills. The lack of a proxy service may also become a problem for dispersed-control companies targeted by an unsponsored program. They may run into even greater difficulty in meeting minimum shareholder quorums at their meetings.

And it doesn't end there. Let us suppose that a depositary bank holds the equivalent of 5% of a Brazilian company's capital within a non-standard ADR program, without a proxy service. Is this bank is considered a relevant shareholder for purposes related to CVM Instruction 358, which requires identification of holders of 5% or more of shares? The question is relevant, given that the final holders of the certificates are not enabled to vote, due to absence of the proxy service. Roberto Viana, of Lefosse Advogados, believes that if the contract clearly states that the bank will be entitled to the decision on when and how to vote, then the institution, though granting the economic benefit of the shares to others, holds political power over all shares in their custody, which would characterize it as a shareholder per the requirements of Instruction 358. "And even if this is not determined by contract, it's possible to infer that the bank holds voting rights over the shares", he comments.

Following the same logic, it makes sense to question if relevant positions held by depositary banks would also trigger poison pills at the unsponsored issuers. Despite their holding political power, this situation is considered remote. First, because banks do not tend to exercise those share's voting rights and run the risk of displeasing their own clients. Second, because it does not seem feasible for a minority shareholder to demand a public offering, using the argument that the depositary bank, by the sum of the shares that they represent and over which they hold political power, is considered a hostile buyer, even if they refrain from exercising the vote. Furthermore, it is not common for ADR programs to take up large slices of a company's capital, to the point of fitting into poison pill clauses. Nevertheless, it is certain that there's still fertile ground for legal contestations. This unusual situation brought by unsponsored programs is new to all.